Chinese Idle Speculation Conceals A Global Industrial Threat

by: Adam Whitehead

China is worried about the "irrational" behaviour of Donald Trump in relation to trade, should he become president.

There is a growing body of academic evidence which suggests that Chinese trade policy is undermining the American labour market.

China is offshoring industrial overcapacity in anticipation of trade wars.

The country's credit-driven commodity bubble is sending perverse signals to the domestic and global economy.

The derivative commodity bubble is not confirmed by rising physical domestic or global demand.

(Source: NBER)

The global focus on China's speculative bubble is distracting attention away from its strategy to deal with the outbreak of trade wars and protectionism. America recently raised the trade war stakes, when the Treasury put Germany, Japan and China on notice for special scrutiny in relation to whether they should be labeled as deliberate currency manipulators.

The emerging trade war tensions in the steel industry, observed in the last report, took on an interesting perspective as China showed its interest in the US presidential race. Finance Minister Lou Jiwei called Donald Trump "irrational" for signalling that he will put a 45% levy on all Chinese imports. Mr. Lou is now, therefore, an ally of Janet Yellen, who would be fired if Mr. Trump becomes the next president.

Mr. Lou was rather too quick to say that such a penalty is against WTO rules, rather than to respond to Mr. Trump's observation that China is dumping its products on the global markets. The Japanese steel industry is now making rational noises also, in a sign that the contagion is spreading. Japan Iron and Steel Federation Chairman Koji Kakigi recently opined that Chinese steel exports are a "concern".

China evidently believes that Trump will be successful and that there will be trade wars, because it is already taking tactical steps to overcome his threat. Chinese policymakers announced that they will "strengthen financing support for enterprises 'going out'". Apparently, the country wishes to offshore its iron and steel capacity so that it can operate behind enemy lines and avoid penalties and sanctions on its dumping activities.

No doubt, it will then defend its domestic production behind reciprocal barriers and tariffs. The overcapacity then becomes a tool to undermine its global competitors on their home turf. It should be understood that this offshoring drive could be applied to any industry, so the threat is potentially large. China is potentially embarking on a strategy to offshore its low-value industrial capacity, whilst protecting its higher-value industry onshore behind defensive walls.

(Source: NBER)

Unfortunately for Mr. Lou and the rational neoliberals in America, a substantial rational academic body of evidence is building to favour the likes of Trump and Sanders. "The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade", a paper by David Autor of the Massachusetts Institute of Technology, David Dorn of the University of Zurich, and Gordon Hanson of the University of California-San Diego, was released back in January to little acknowledgement. Their paper found that for every $1000 lost to America on Chinese imports, there is an additional $58 lost on severance costs and welfare benefits to the US employees whose jobs went to China. America has stimulated the Chinese economy to the tune of $1000, and then fiscally stimulated the US economy by only $58, with $1000 less to finance this fiscal stimulus. Presumably, QE finances the lion's share of the lost $1000 in exports and the $58 in fiscal spending.

Since the paper's release, however, significant momentum has picked up, despite attempts by the neoliberal establishment to avoid its stark reality. The research paper finds conclusively that the US labour market has been a casualty of Chinese export policy. This finding clearly has implications for the Fed as well as the presidential candidates. The Fed's remedy of QE looks impotent if the Chinese continue with their export-focused policies. Global rebalancing via exports to China also appears to be a myth promoted by neoliberal and globalization elites. The findings are further grist for the mills of Donald Trump and Bernie Sanders. They are also another signal along the emerging path towards trade wars.

Undaunted by the storm clouds on the horizon, Premier Li Keqiang signalled that China intends to intensify the global trade war of attrition. He chose his words carefully to downplay the sense of threat by cloaking it in economic stimulus rhetoric. According to him, "Foreign trade is an important part of the national economy. To stabilize foreign trade and make it stronger is important to ensure the economy runs smoothly and upgrade."

(Source: Bloomberg)

The last report concluded that China's Q1 economic stabilization was predicated upon an unsustainable debt burden. At the last official count, this debt level was 237% of GDP. Standard & Poor's was noted as revising its outlook lower. The ratings agency now sees the situation deteriorating to levels seen in 2003. The Chinese bond market is now beginning to correct for this earlier excess. Rising defaults, rising bond yields and cancelled domestic bond issues are the barometers for growing risk.

(Source: Bloomberg)

Leveraged bond positions are quickly unwinding as bond prices fall and financing costs rise. The drop in leverage is healthy, but the corollary effect is that companies will find it harder to refinance maturing bonds. A credit crunch has been predicted.

The latest property price data hints at where much of this unsustainable debt was headed. Prices in tier 1 cities rose at an annual pace of 63% through March, whilst they went in the opposite direction in the lesser tiers. A speculative bubble in tier 1 cities is creating prices which people from lower tiers cannot afford to migrate to. The wealth effect becomes bifurcated, whilst regional development plans stagnate.

When the tier 1 bubble bursts, policymakers will then have to decide on whom to save with their dwindling financial stimulus resources. Should they save the property speculators in tier 1, or should they continue to try and stimulate their less wealthy regional brothers and sisters? Saving the speculators takes wealth away from the country's development plans, so it is going to be a difficult decision to make. It may even be a decision that puts the premier and the president at loggerheads, but more of this later.

(Source: Bloomberg)

Saving property speculators is questionable, but saving speculators in commodities who are leveraging off the property bubble provides a whole new meaning to the concept of moral hazard. The credit bubble has spilled over into the industrial metals markets, where now a whole year's physical steel rebar production is traded in a day on the futures exchange. The rise in steel prices has some interesting unintended consequences.

(Source: Bloomberg)

First, it signals to producers that there is money to be made from producing - so that overcapacity is extended.

(Source: Bloomberg)

The CEO of Vedanta (who was also former CEO of mining giant Rio Tinto (NYSE:RIO)) has already bought into the story. The proof of this buy-in, however, will only come if Vedanta and Rio start increasing their capital expenditures.

Secondly, it drives up the prices of property construction, thus making the property bubble even more inflated in overall price terms. Credit extended against this inflated property bubble is even more at risk.

Thirdly, the iron and steel overcapacity created will get dumped on global markets because there is no use for it in China, thus exacerbating the risks of global recession and trade wars.

(Source: Bloomberg)

Currently, the Chinese steel industry is receiving the signal that profit margins are at a seven-year high. There is no incentive to cut capacity, but there is a high incentive to bring old capacity back on-line. Said steel industry is responding with alacrity and boosting output. The China Iron & Steel Association is forecasting a swing back to profit for the industry, which signals that it has no intention to scale back production.

(Source: Bloomberg)

Chinese steel mills have responded to the price signal by boosting output and bringing back idled capacity. Fitch is already warning of a glut. Goldman is also worried about the situation and is predicting a collapse in prices.

(Source: Bloomberg)

The commodity bubble, however, is not just limited to iron and steel.

(Source: The Daily Shot)

Aluminium has caught the bid. Cotton futures have also caught the bid. In one day, enough contracts traded on the Zengzhou exchange to make a pair of jeans for every person on the planet. Cotton growers will now have to decide whether to follow the signal and start planting. Garment manufacturers will face margin pressures that put them into conflict with consumers who are already pulling in their horns.

Whether the oil price has become a hostage to Chinese speculators at this point is moot, but the probability that it has must have risen, given what is going on in the futures markets. All this, therefore, knocks onto the inflation gauges that central bankers are watching and hoping will rise.

Any rise in global CPIs from the clothing-related basket of goods may therefore prove to be temporary in nature and destructive of consumer demand in the long run. Perhaps more worryingly, the current rise in global inflation levels maybe being distorted by the Chinese speculation in commodities.

The Fed (and also the ECB) needs to look through this bubble carefully when assessing the impact of its expected rate hikes. Should the Fed sit on its hands, the following US dollar weakness will only exacerbate the commodities spike. The Fed, thus, finds itself the tail being wagged by the Chinese credit dog, which must be a very unenviable place to be right now.

(Source: Bloomberg)

Commodity currencies, led by the Aussie dollar, have also started to wobble as Mr. Market started to price in the risk premium for the speculative demand and the chaos that will ensue when it bursts.

There is, in fact, very little to commend the credit bubble behind China's alleged stabilization phase. It has been a period of price speculation with no attendant economic growth, the physical products of which get dumped on global markets. This latest phase in China's economic history should be called idle speculation rather than stabilization.

(Source: Bloomberg)

The signs that the real economy has no use for its domestic manufactured output are clear. The cash conversion cycle continues to attenuate and has now reached 192 days. The supply chain has effectively become a means of extending credit as part of the monetary stimulus.

One has to ask if the supply chain in China has now primarily become a credit story rather than a manufacturing story. If this is the case, suppliers are now finance vehicles and the companies they supply are zombies that exist to provide collateral in the form of products rather than goods for consumption. If this is truly the case, the domestic economy is a financing pyramid scheme rather than a source of economic value creation.

(Source: Bloomberg)

In an attempt to frame the demise of the manufacturing sector in a positive light, policymakers are promoting statistics which suggest that the economy is rebalancing. The nation's statistics authority recently published data which show the service sector growing at an 8.6% annual rate. Policymakers will therefore allege that this high growth rate is compensating for the contraction in the industrial sector. A boom in services, however, is not congruent with a boom in commodity prices; so, there remains something fundamentally wrong with the rebalancing story that is being scripted for general consumption.

(Source: Bloomberg)

Drilling through the headline economic data, which recently showed stabilization, it can be seen that this pattern is not uniform across the economy. As with the property bubble in the tier 1 cities, economic growth appears to be concentrated in these places also. Out of the 29 of 31 provinces and municipalities which have published GDP reports for the first quarter, 25 reported a slowdown from 2015 and 14 are below their expansion targets.

The growth bubble in commodities and commodity-related sectors is, therefore, not representative of the real economy. Liaoning became the first Chinese region to have the unenviable statistic of negative growth. Liaoning is an interesting case study because it is home to many steel mills. Evidently, the bubble in steel prices is not strong enough to move the real economic growth needle there.

(Source: Bloomberg)

There is also a suspicion amongst some analysts that the recent boom in housing and steel is bubble driven by the fiscal agenda of the regions. Analysis has shown that housing starts are way ahead of final sales. This has led to an inventory overhang of finished and semi-finished properties. This sudden surge in starts is being put down to the fact that the central government intends to raise its revenue intake from the regions this year through new value-added taxes.

The regions have responded by boosting economic activity before the central government can implement its tax increasing reforms, in order to boost their own fiscal coffers at the expense of the central government. The property bubble is, in effect, a scheme aimed at raising local government income. Clearly, the local government officials have been overzealous in their quest for fiscal revenues and have created a commodity bubble that has wider impacts throughout China and the global economy. This dangerous bubble has been enabled by the PBoC's monetary stimulus and provision of cheap liquidity.

(Source: Bloomberg)

George Soros renewed his war of attrition with Chinese policymakers in his latest broadside, which states that the debt situation resembles America in 2007 pre-credit crunch. In fairness, it could be argued that since the GDP situation is the same as post credit crunch, China is rationally responding with a countercyclical stimulus. The problem will only materialize if the country's reserve position falls significantly, such that it can no longer cover its debts.

The current re-pegging of the yuan to the US dollar, combined with the softening of the dollar as the Fed eases off the tightening breaks also supports Chinese exports. The situation is, therefore, not critical at present unless another round of capital flight on a grand scale occurs. Soros, in fact, said as much when he opined that the chances of capital flight have significantly been reduced.

(Source: IMF)

The IMF has finally weighed in with an opinion on China's plans to make this debt mountain go away by converting bad bank debt into equity. The fund is not impressed and actually thinks the plan is dangerously counterproductive. According to the IMF:

"Converting NPLs into equity or securitising them are techniques that can play a role in addressing these problems and have been used successfully by some other countries... But they are not comprehensive solutions by themselves - indeed, they could worsen the problem, for example, by allowing zombie firms [non-viable firms that are still operating] to keep going."

The PBoC is evidently worried about the credit bubble it has created that is sustaining the current economic stabilization. Whilst the PBoC hasn't changed its official position and remains in stimulus mode, the Xinhua news agency signalled that prudence will figure more prominently this year. This edict is congruent with President Xi's annunciation of the "Four Comprehensives" at the National People's Congress.

Economic resources are being conserved because the future remains uncertain. A new stimulus may be required, or the funds may be needed to defend the currency from capital flight. It seems more likely that the scarce resources will be applied in order for the country to meet its aforementioned growth target range circa 6.5%.

Having successfully achieved the 6.7% GDP level, further stimulus is no longer required for now. In fact, there is evidence that the stimulus is creating a dangerous bubble situation. PBoC Vice Governor Chen Yulu has signalled that time out on the current stimulus is being called, when he opined that financial institutions are facing increasing credit risks.

This risk is clear in the Bank of China's balance sheet. The bank's bad loan buffer level is now below that required by the regulator. The lack of panic that greeted this revelation suggests that the PBoC will just lower the buffer level so that the crisis appears to go away.

If the bad debts cannot be made to vanish into equity, then they will be made to vanish by lowering the reporting bar. Lowering of the reporting bar will in, theory, make it easier to convert the debt to equity, since it is no longer a bad debt per se. In practice, the whole integrity of the banking system is being eroded.

A previous report observed the ascendancy of President Xi Jinping into the pantheon of great men who have led China during significant phases of its history. Evidently, the current media persona of the president is incongruent with the new phase of chaos on the domestic and global fronts. The president is, therefore, undergoing a rebranding in order to project the appropriate persona at home and abroad. Gone is the affectionate eponym of "Xi Dada", and in is the more austere sounding just "Xi". Tough times require tough names and tough decisions.

Commensurate with this image rebranding is the president's attack on his premier Li Keqiang and his power base in the Communist Youth League (CYL). The thought police, known as the Central Commission on Discipline Inspection (CCDI), is headed by Xi's top lieutenant Wang Qishan. The CCDI has investigated the CYL and found widespread corruption and deviation from party doctrine and spirit.

Both President Xi and Premier Li are trying to load the Politburo Standing Committee (NASDAQ:PSC) with their acolytes when its composition is changed next year. The current outbreak in hostilities is occurring within this greater context. The attack on the CYL should be seen as part of President Xi's latest "Four Comprehensives" doctrine, which was discussed in a previous report. The CYL has been the breeding ground for talent, including Premier Li, but going forward it will serve as the channel for the promulgation of party doctrine if President Xi gets his way. Having already seized the media, President Xi is able to seize the providers of media content in total media silence.

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.