The Negative Halo Effect: China's 'Capitulation' To Creative Destruction Is Bad News Globally

Includes: CYB, FCA, FXI, UUP
by: Adam Whitehead


Capital flight has forced China to abandon its currency weakening tactics and to peg the yuan to the dollar.

China's economic influence is waning whilst America's is growing.

Chinese industrial overcapacity has not been "culled" but rather consolidated.

Consolidated Chinese industrial overcapacity will now compete with unconsolidated global overcapacity.

China is exporting deflation again.

(Source: Bloomberg - link)

The last report explained how China was betting on a weakening US dollar by maintaining its US dollar peg. The first sign of strategic success was evident in the yuan-yen cross rate. China's strategic success is however Japan's strategic loss. The probability that Japan responds with an attempt to devalue the yen, which then triggers a phase of competitive devaluations across all currencies has therefore increased. A renewed interest in gold confirms that markets are now starting to discount the probability of currency wars in 2016.

(Source: Bloomberg - link)

The behavior of Chinese savers also explains the wisdom of, or rather why China has no alternative other than, pegging the yuan to the US dollar. Chinese savers are now frantically converting their newly IMF SDR basket eligible yuan into US dollars. If they carry on doing this at the current rate, China will in fact become a US dollar based economy by default.

(Source: Bloomberg - link)

These US dollars are already leaving the country at an alarming rate, so that a failure to peg the yuan will just lead to a collapse in liquidity and credit in China. The Chinese economy would then simply collapse. The behavior of Chinese savers therefore implies that the yuan is actually backed by the US dollar rather than the Chinese government. Having linked the yuan to the SDR, the Chinese authorities cannot stand in the way of their own people, as the country moves to fully open its capital account.

Premier Li Keqiang signaled that it was time to stop the bleeding of reserves, when he pledged to stabilize the yuan. The negative feedback loop of falling yuan, falling Chinese equities and then faster capital flight has evidently convinced policy makers that they have reached their limits on currency weakening for now. The PBoC gave Li's signal real meaning when it tightened reserve requirements for banks betting against the yuan in the offshore market. The yuan-US dollar peg has now been re-instated.

The US dollar has therefore maintained its reserve currency status and beaten off the recent Chinese challenge. The last report suggested that "China is going to be put to the global superpower test in 2016", and also that "in 2016, China will be confined by its finite economic resources and stretched emerging superpower commitments". Such wild claims need further scrutiny and investigation. When President Obama opined that "the United States of America is the most powerful nation on Earth… Period…", during his final SOTU address, he was articulating what Chinese savers are implicitly saying with their money. America is ahead of the global pack, but must continue to be vigilant.

It was also suggested that the best way to bet against China, inferred from Jim Chanos' research, is by shorting assets in economies which derive their trade revenues from exporting to China. Somewhat more belatedly, George Soros jumped on the bandwagon by opining that China's growth problem and the return of positive real interest rates in developed economies would put emerging economies in crisis.

The IMF's chief economist Maurice Obstfeld provided further fundamental support to the Chanos short theory, when he opined that China's economic slowdown would derail global equity markets. The IMF was followed by the World Bank, which chose to focus on the Latin American dimension of the contagion from the Chinese slowdown.

The latest rail freight data from China for 2015, which showed the largest drop (10.5% per annum) since records were created, suggests that the domino effect from China to the global economy is currently in process.

The Bank for International Settlements (NASDAQ:BIS) has undermined the whole Chinese economy and the PBoC, whilst ostensibly rebuking the ECB. The BIS has decided that it is now time to close the book on QE; and usher in the Schumpeterian creative destruction phase. This has been done by directly challenging the fundamental premises of QE, namely the assumptions of a savings glut combined with secular stagnation. According to the BIS these twin assumptions are bogus.

America has apparently rebounded faster than its peers, because it was swifter to embrace the debt liquidation process. The Europeans have put their heads in the sand; and the Chinese have continued to exacerbate the problem with more QE and debt creation. The BIS knows that it is not wise to antagonize America; therefore it has waited until it is out of the woods on the normalization process before summoning up the courage to speak out. The ECB and the PBoC will now suffer the consequences of what the BIS sees as economic heresy.

UBS has allegedly war gamed all the various scenarios. Its worst case scenario is that China only grows at 4% in 2016, but this would involve the unlikely event of a lack of reactive stimulus by policy makers. UBS seems to think that the global economy can avoid recession, despite the Chinese economy flirting with it. Emerging nations however do not escape as lightly as their developed nation trade partners, since they have a much greater reliance on the Chinese economy.

Clearly the way ahead therefore is for emerging nations to decouple their Sinocentric economic policy and recouple with developed markets. China's economic and political influence may therefore be on the wane from 2016 going forwards.

(Source: Bloomberg - link)

The overwhelming negative sentiment and evidence took its toll on Chinese equities again. What is most interesting, about the decline in equities, is that it comes as the yuan is weakening also. In fact the evidence suggests that the latest stock rout was actually triggered by the PBoC's attempt to weaken the yuan, with a lower fix. The thesis that China can devalue its way out of trouble, in a similar way that Japan has been doing with the yen, has got no subscribers.

In fact Chinese equity selling by foreigners is also being triggered by their negative view on the yuan. The yuan and yuan assets are therefore rapidly getting risk premiums discounted into them. China's strategy to promote growth by weakening the yuan has just hit a brick wall.

The eight day attempt to weaken the yuan was ended abruptly, after the pain from the capital markets became a greater threat to the economy in general. Policy makers will now have to support the currency and let asset prices and living standards fall to remain globally competitive. The dip, that allegedly everyone is hoping to buy in China, is now being created.

(Source: Xinhuanet - link)

Premier Li Keqiang has vowed to "cull" the "Zombie" companies. In fact, all that happened was that "Uber-Zombie" companies had been created through state sponsored mergers. These "Uber-Zombies" have stronger balance sheets, that can therefore survive longer periods of economic attrition. Presumably the attrition phase had only just started. Most recently Premier Li renewed his hollow call to cut overcapacity, in the hope that observers would take this as being the capitulation buy signal.

More explicitly, he explained that market forces will be used to address the overcapacity issue. China will be conserving its economic resources; and will therefore not be embarking on another massive fiscal stimulus. He seemed to be sending a clear message, that the phase of consolidation of overcapacity into scaled up national champions is now over. These scaled up companies now have the massive balance sheets to compete globally; so that China's overcapacity becomes a global threat rather than a domestic one.

There is reason to believe that Premier Li's words should be taken with a reasonable modicum of salt these days. It was recently reported that President Xi Jinping's nuncio Liu He had opened up a dialogue with Treasury Secretary Jacob Lew on economic matters such as exchange rates. China watchers have inferred that the President will now take a more hands on role in economic affairs.

Clearly the state of China's economy and its interface with the global capital markets has become national security matter deserving of the President's attention. It could also be that the Premier's handling of the economy has been deemed to have failed. Whatever the reason, Premier Li's words should be placed into this context during future reference.

The initial take on Premier Li's words is that "market forces" will impact the yuan, so that the overcapacity is sustained. The impact on China's trade partners (and the value of their companies) will be immense and nasty. Global equities therefore have begun to correlate inversely with the yuan. In a previous report however, it was suggested that China is going to peg the yuan to the US dollar and bet on the US dollar weakening. The impact on the US economy and US equities may therefore not be as extreme as upon other economies. It is also possible that Premier Li was not just talking about the value of the yuan in relation to "market forces".

(Source: The Daily Shot - link)

Specific focus should be given to the balance sheets of Chinese companies rather than the currency. "Market forces" will also apply to China's global competitors, who may find that they lack the scale or the balance sheet resources to compete. Far from having Chinese overcapacity, there may actually be global overcapacity that gets taken out as China's capacity survives.

A cursory look at the state of the Chinese domestic iron and steel markets suggests that the scaled up national champions are producing at full throttle again. Chinese overcapacity is therefore still working in these industries. What will now ensue is a period of intense and bloody global competition, to see who is truly the world's cheapest producer of various products. This will be painful for all involved, including the Chinese national champions.

Global production capacity will get "culled"; and most of this may occur outside of China. China may actually benefit from gaining pricing power, once this global overcapacity has been taken out. Before this global capacity is taken out, it will no doubt consolidate first; in order to get the balance sheet scale to compete with China. Ultimately however, if the shareholders' equity in these merged entities drops into the negative zone, the "market forces" to which Premier Li refers will take out the overcapacity. The real winners in the intense competition phase will be the consumers.

What dip-buyers were looking for was a signal of capitulation and liquidation of overcapacity. It seems that they have been rewarded for their patience. Having prevaricated about "culling Zombie" companies, to remove industrial overcapacity, Premier Li Keqiang finally bit the bullet. Premier Li therefore just gave the first signal of a capitulation phase in the real economy, represented by a destruction of productive capacity. Speculators responded with alacrity; not only to the signal but also because the state was paying them to respond. The creative destruction phase has ostensibly just begun.

Premier Li has chosen to address the overcapacity in the steel and coal industry first. He may have been prompted to start here for environmental reasons also, because the smogs in Beijing and other cities have become lethal. Coal and steel producing companies will be compensated for laying off workers and idling capacity. There is therefore a cost associated with the creation of this economic benefit.

This cost will be borne by the state, by transferring wealth from state coffers to the mining companies in order to pay for the layoffs. The cost of competitive destruction will therefore be borne by the state and its eroding reserves. The state is literally paying speculators for confirming that the creative destruction phase is in process.

The benefit will accrue to the coal and steel producing companies; since they will have their expenses cut with no cost to them in terms of severance payments. The dip associated with this competitive destruction phase in the coal and steel industry was therefore bought; and shares rose by 10%. If China is going to follow this model of competitive destruction across all sectors with overcapacity, a huge transfer of wealth from state to industry will occur.

The question now becomes how long the state coffers can sustain this transfer of wealth. There is also a further question of what China will do with the unemployed; and how long it can finance their non-participation in the productive economy. Premier Li thinks, or at least says, that he has the answer.

(Source: - link)

He has called for greater technological innovation and investment, presumably to signal that China is successfully transitioning to become a high value added global competitor. Once again, eager buyers of the industrial transformation story should remain vigilant on the high street for signs of these premium priced high tech products. The overwhelming evidence so far is that China is still producing cheaper and lower quality alternatives aimed at constrained emerging market consumers, rather than the genuine article. The next generation of consumer products and devices may show a totally different story.

Things may however be changing, as the latest tie up between Lenovo (OTCPK:LNVGF) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) suggests that China is moving up the value chain. Since this space is very competitive, the ocean just got a little redder with the blood of all the competitors. This kind of competition is generally more beneficial for the consumer than for the producers. Holders of Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) stock should take note and review their investment theses in these names. In fact, perhaps the whole of "Large Cap Tech" is not such a great place to be any more.

(Source: Bloomberg - link)

Goldman recently came out with a big story of how Tech is not the bubble that it was back in 2000. The Goldman thesis is predicated on the facts that Tech now accounts for more of the earnings and less of the market capitalization of equity indices than it did back in the Tech Bubble. A little thought about what Goldman is saying infers that in fact Tech has matured and is less of a growth story than it used to be. A maturing industry with lofty P/E ratios does not make sense however; since lofty P/E's are associated with hyper-growth.

If one then throws in the entrance of China into this space, the valuation question is even more apposite. Following the "Big Short" thesis, Goldman is presumably lightening up on Tech behind the cover of this positive valuation call. Perhaps it is even going short. Countries and companies that supply China have been beaten up in recent memory. Those with long-term memory will also remember that the Western hemisphere is full of derelict factories and unemployed workers who could not compete with Chinese exports. If China now has its sights on Tech, the industrial wasteland on the ground and in valuations will logically follow in this sector too. Since China is now changing its global competitive game, all sectors are threatened.

Q: What's wrong with this picture?

(Hint - Ask yourself why this lady is the only "consumer" swinging shopping bags in this picture. Is it supposed to imply that there is nothing to buy in China because it has all been exported, or that Chinese consumers can't afford to buy anything?)

(Source: Bloomberg - link)

Bloomberg chose a rather one dimensional view; in anticipation of the existential economic war between China's industrial overcapacity shifting up the value chain and the established global manufacturing oligopolies. Bloomberg looked through one rosy monocle at the positive spin on China's trade numbers.

(Source: Bloomberg - link)

A cursory glance at statistics representing the level of workplace unrest, strongly contradicts the rosy picture. Premier Li's culling of overcapacity is having an impact, which is not necessarily a good one for the Middle Kingdom.

Bloomberg also incorrectly inferred that China will benefit; whereas in fact the global consumer will potentially benefit at the expense of all players involved in this manufacturing competition.

· Consumer False Positive 1. (Source: Bloomberg - link)

· Consumer False Positive 2. (Source: Bloomberg - link)

· Consumer False Positive 3. (Source: Bloomberg - link)

The above bullets have been called Consumer False Positives because in actual fact they illustrate how the economic war will appear to benefit the consumer at the expense of both China Inc. and Incumbent Global Oligopoly Inc. For those readers looking for an analogy of what happens to equity prices, the competitive situation in the Oil exploration and production sector should serve as a guide. Oil prices have fallen and so has everything else. In short it's all bad for equities. Even consumer retailers don't benefit because they face intense competition not only on the high streets and in malls, but also from the online sellers.

Global consumers should not be gleefully rubbing their hands however, because the evidence to date shows that they are not getting salary increases to let them go out and spend with gay abandon. In general, China is therefore exporting deflation again. Since it is importing deflation from lower commodity prices, it also has the ability to export far more deflation than its global competitors assume. For those readers who still don't get why developed nation central banks are so keen to create inflation, the above explanation may help to provide the context.

Europe maybe the first region to experience the new Chinese deflationary economic threat. The yuan's accession to the IMF SDR basket was a signal that the Chinese economy has officially matured past emerging market status. As a newly mature developed nation, China is now expected to live up to the gentlemanly pursuit of commerce and exports that is practiced in Europe and North America.

China will be expected not to dump its industrial overcapacity or to pursue a predatory currency policy. This is a tall order. In return however, companies in Europe and North America will not be able to hide behind protectionist tariffs. The eurozone becomes the first developed nation economic bloc to go into the process of debating the removal of protectionist tariffs on Chinese exports. Given China's embrace of all things developed and the IMF SDR currency regime, it will be hard for the Europeans to keep their trade barriers erected.

The Fed speakers Dennis Lockhart and Jeffrey Lacker have recently expressed the opinion that what happens in China stays in China; and will not therefore impact the US economy. It is now time for their convictions to be tested.

(Source: The Daily Shot - link)

On the domestic economic front, China's indirect housing stimulus seems to be bearing fruit. The last report explained how by reclassifying 100 million of the deserving rural poor as urban dwellers, and then financing their purchases of urban dwellings, policy makers were stimulating the housing market and reducing the oversupply conditions. The latest housing data, shows that this strategy is having an impact, as price rises are spreading throughout the urban areas especially the lower tier cities.

(Source: Bloomberg - link)

It may be just as well that fiscal stimulus is starting to bear fruit, because the evidence on the impacts of monetary stimulus to date show the law of diminishing returns is taking its toll. Ma Jun the PBoC's chief economist recently reported that new monetary policy tools were being used to ease in place of reserve requirement adjustments. Whilst it is good to know that the PBoC has got more tools in its toolbox, it is also disappointing to see that none of them are working very well. Recent data shows that for each $1 in credit expansion, only 27 cents of incremental GDP was created; this compares with 59 cents per $1 stimulus in 2011. What is perhaps more worrying is that there is no multiplier effect which creates more than $1 of GDP expansion for every $1 spent. The lack of a multiplier effect suggests that deflation is setting in.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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