China Is Soros' Ultimate Example Of The Reflexive Disequilibrium Process In Action

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by: Munger Fan

Summary

The probability of real fundamental reforms being successfully implemented is far smaller than what current rhetoric may suggest.

Solving the problem of debt is synonymous with winding down the current system which is extremely pro-cyclical.

There is a fundamental misunderstanding about the true growth capabilities of the Chinese economy and the real estate bubble is key to that misunderstanding.

The world is currently in a period of potential fundamental change. The eurozone is having some difficulty keeping itself together to say the least while America has signaled that it may decide to go its own way. Both are looking towards Asia Pacific and China in particular to establish trade ties for a potential shift in global trade rules. But both are perhaps misreading the situation to a degree due to a fundamental misunderstanding about China's economic model. The model has shown great success over the past decades, but it's a model that prioritizes investment above all else.

As America and Europe both desperately require consumption demand to boost their own economies, they need a trading partner who is willing to bring forth this extra demand. European politicians want to maintain the appearance of optimism that China is willing and capable of reforming and subsequently supplying this demand. For this, they are willing to suffer large trade deficits currently. Trump has taken a somewhat different approach by calling out the trade issue while still maintaining a friendly and cooperative posture overall.

What is Reform?

It is widely recognized that China's current form cannot give what the world needs and this is recognized even by the European Bloc who are most heavily promoting the China story with the intention of justifying the survival of their union through virtue of stronger negotiating leverage. On the one hand, they want to promote the future of China to justify their own continuation, but on the other hand, their actions to ensure their current survival must go in the exact opposite direction via tariffs on steel, etc. The EU is not interested in reality or truth when it comes to China. They are interested in survival. The U.S. can afford to be more honest in their position as they are not in an existential crisis.

Although the problem of reform has been widely recognized as unavoidable, any attempt at actually defining or conceptualizing the reforms and probability of it happening has been barely done. The consensus is simply that China needs to begin consuming more than it produces. There is no map of how they can feasibly get there and anybody who tries in earnest will probably realize that the fundamental issue at hand is political. The casual observer may then look at what the political leadership has been able to accomplish over the past two decades and come to the conclusion that leadership is wise and capable and certainly deserving the title as true "Philosopher Kings". Looking solely at the statistical record, this conclusion seems reasonable.

Common sense dictates that consumption must grow at an appreciably faster rate than investment and the general GDP growth rate in order to reduce its trade surplus bring in its debt and contribute more to sustainable global demand. We will now try to dissect the underlying structure of the system and test the plausibility of these required changes.

Source: Tradingeconomics.com

How the system works

There is no major economy in the world that operates under the current system that China uses and to my knowledge, there hasn't been any successful precedence of it in the past either. The CCP (Chinese Communist Party) directly controls its central bank, owns and controls its banking system and dominates its own economy through SOEs (State Owned Enterprises). The main force in the Chinese economy driving productivity growth are the SMBs (Small to Medium Businesses) who export goods and import foreign currency into the economy which the Central Bank then accumulates to maintain a fixed exchange rate against the USD. Although deciding on opening the economy through the 80s and 90s, the CCP could not give up their control over the SOEs and banking system. Their legitimacy and priority has always rested upon maintaining social harmony through employment and they could not control or promise this without control over key industries.

We know that certain Chinese exports are very competitive by virtue of cheap productive labor and the extensive infrastructure which makes transport and the cost of doing business low. However, due to the opacity of the system itself, it's difficult to know how much of their superficial productivity is due to direct subsidies such as tax refunds on certain products, subsidized input materials through SOEs, preferential lending rates on certain targeted industries or indirect subsidies such as subsidized infrastructure investments. In any case, steel is a prime example that is at the forefront of this dispute and with the commerce secretary's upcoming report on this issue, that should give us an indication on the general stance the Trump administration is willing to take on trade going forward.

So why is the currency of such importance? For one thing, note that the capital account is still largely controlled and closed with capital outflows in particular under intense scrutiny. The legitimacy of the Chinese currency, the RMB, rests on their foreign exchange reserves. Its capital markets and system in general are far too undeveloped to withstand the fluctuations of their currency without the reserves and exchange rate peg. Therefore, any talk of open capital accounts is probably unreliable and the reality of the situation may be moving towards tighter controls if reserves continue to decline.

The reasoning behind heavily controlled capital accounts is fairly straightforward with the fact that there is a huge domestic real estate/debt bubble and if that bubble were to uncontrollably collapse under its own weight, China's reserves could be eviscerated in short order causing a major collapse in its currency and potentially setting off a worldwide crisis. It is a bet that hedge fund managers like Kyle Bass are making. However, certain players such as Hugh Hendry have intelligently moved away from the bet after perhaps realizing what the CCP leaders mindset is and what their capabilities are. The mainstream economists' view has largely been that the leadership can and will address the debt issue through reforms and bring it under control in order to reform the domestic economy and financial system. Notice the circular logic involved in their reasoning. Indeed, it's certainly paradoxical to make the claim that they must reform to fix the debt issue and only the resolution of the debt issue may lead to reforms. Ultimately, the resolution of the entire situation rests on the effectiveness and pace of true reforms which also happens to be the least discussed and least understood part of the entire story. This begs the questions of how will the reforms be implemented, who will reform the system, are the main actors motivated to make the necessary reforms, and what ought a reformed system look like?

Source: Author's own work

From the above diagram, we can see that the CCP has effective control of the Central Bank, the banking system, as well as the largest corporations in the country. Obviously this creates a system that is filled with tremendous conflicts of interests. Banks provide preferential lending to SOEs who use that capital to either speculate in real estate, dominate/front run a domestic industry through lower cost of capital or acquire foreign technology and companies. This process is pro-cyclical for the banks since as long as SOEs are buying and committing more capital, bank balance sheets will grow and there are no major losses from asset write offs. Rising real estate prices justify the activities of the SOEs and consumption spending increases as confidence is spread throughout the system. The regular citizenry may view this as the inexorable rise and legitimacy of the Chinese economic system and then greatly contribute to the trend by pouring liquidity into the real estate market. This results in further price increases and the further desire for SOEs and other players to get in on the action. Each party reinforces the beliefs of the other as this reflexive cycle speeds up its ascent. The geometric rise in prices is underpinned by a steady arithmetic rise in Chinese productivity through access to the world markets and it was encouraged along by the SOEs attempt of front running the end buyers of real estate through the government auctions of land (all land is first owned by the State). Of course, with the CCP themselves participating in the games both directly and indirectly through the SOE players and with full control of their Central Bank, they have great incentive to use it as support in keeping the music going. In summary, the fundamental truth of the trend of increased productivity through access to an open market was amplified and turned into a reflexive process first through the natural behavior of the rule makers/regulators and subsequently through prevailing misunderstandings about the reason for the rise in real estate market prices which fed upon itself.

Conclusion

Successful reform by its definition requires consumption to rise faster than investment as a percentage of GDP for a long period of time. What this necessarily means is that wealth must be distributed more evenly over time. Allowing market forces take hold of the system necessarily means taking away the privileges of the SOEs, their implied support and bias from the banking system and redirect capital towards private enterprise and SMBs. The immediate problem you might recognize from that is it means the CCP would have to either successfully regulate itself or to actually forego their own power. Both choices should have the same fundamental effect if implemented properly. The CCP regulators are coming off of the glow of past successes due to a powerful reflexive process. The problems they must solve going forward are of an entirely different nature. I think it is foolish to think of them as any wiser than regulators in any other country. Their veil of omnipotence comes from the system they are allowed to operate in, not in their fundamental ability to determine the course of events. True reform requires certain links that are fundamental to that system to be broken and re-routed. History has shown that bureaucracies will rarely if ever attempt to redistribute power away from itself without severe pressure from outside countervailing forces. The few instances where a bureaucracies self-disintegrated has happened under the most dire of circumstances and has generally resulted in great upheaval afterwards due to the void left behind. To bet on the willing and successful implementation of reforms by the CCP is to bet against human nature itself. The contradiction of self regulation for a bureaucracy is further compounded by the CCP's explicit goal of maintaining economic and social stability and employment at all costs. Effective reforms are diametrically opposed to this explicit goal.

I hope that I have sufficiently convinced the reader that not only is the current rhetoric given by the CCP and echoed by the EU disingenuous and perhaps borderline misleading, it's completely contradictory to reality and to the underlying system described in this article. People have mocked the likes of Carl Icahn for the sale of his stake in Apple (AAPL) due to concerns over China. He has publicly stated that Trump needs to eventually have a trade war with China and that it was up to Trump whether this was sooner or later. There is no debate on whether or not China's current model needs to change. The debate should be on whether China is capable of changing itself or not. Perhaps Icahn's conclusions were based on the recognition that it would ultimately require a forceful outside event to change its current behavior. If so, auto companies like GM (GM) and Ford (F) who heavily depend on China for profits may be adequately priced despite their extreme cheapness. In any case, the economic and psychological results will be profound as China either accomplishes what no other in history has been able to do so in their reform plan or if it has to recognize its excesses head on through international trade conflicts. I would advise investors to refrain from depending on the former possibility in their investment programs.

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.