The Kerosene Truck Speeding For The Chinese Bonfire

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by: Ivan Martchev

While the sell-off in currencies of emerging markets with insufficient foreign exchange (forex) reserves and wide current account deficits - like the Argentine peso and the Turkish lira - is still picking up steam, there is relative calm in China, where the yuan is trading well off its recent multi-year lows.

On the surface, the yuan has plenty of forex reserves (over $3 trillion) and its current account has been in surplus for over 20 years; but under the surface, it very well may have some more serious issues.

China Foreign Exchange Reserves versus Current Account Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The natural question is: If there is no need for external financing, why did China lose $1 trillion in forex reserves between mid-2014 and mid-2016 before briefly arresting that decline (which has now resumed)?

I think America's escalating trade war with China is more dangerous for China than it is for the U.S. Still, in a bad trade war there are no real winners, just various degrees of losers. While I agree with President Trump that the U.S. has been taken advantage of by China in bilateral trade, I am not sure the Chinese are the kind of people to be slapped on the front page of the Wall Street Journal with $50 billion worth of tariff packages. This is as far from the "saving face" modus operandi of Chinese diplomacy as it gets.

United States China Trade Gap Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The point is: Trade war could escalate dramatically, which neither Mr. Trump nor Mr. Xi should want.

In 2002, Ben Bernanke, then a Governor of the Federal Reserve, helped celebrate the 90th birthday of Milton Friedman. Here is a notable line from his prepared comments:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton … Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

I doubt Ben Bernanke was referring only to the monetary policy mistakes of the Federal Reserve in 1929 and subsequent years, when the central bank tightened monetary policy at a time when they should have been doing the opposite. He most likely was referring as well to the Smoot Hawley Tariff Act of 1930, which collapsed global trade. At the time of the enactment of the tariff, U.S. unemployment was only 8%. At the time of its repeal a couple of years later, the unemployment rate was 25%.

I doubt that a sitting U.S. President who wants to "Make America Great Again" wants to repeat that Great Depression's economic record, but neither did Senator Reed Smoot or Congressman Willis Hawley who sponsored the tariff act. The point is: Unintended consequences happen and given the precarious situation in China, they may happen again in the latest tariff imbroglio. President Trump is like the man at the wheel of a kerosene truck, whose brakes are not entirely in order, speeding towards the bonfire burning in the Chinese financial system. While it is possible that he would be able to stop at the very moment before reaching the point of no return, it is also possible that he has underestimated the momentum of his payload of $375.2 billion in bilateral trade imbalance that is likely to hit another record high in 2018.

President Trump in Truck Image

There is a bonfire burning in the Chinese financial system because the bulk of rampant dollar borrowing in emerging markets in the last 10 years has come from China, due to the sheer size of the Chinese economy, which was $11.94 trillion in 2017, and as such the second largest in the world. Furthermore, unlike in India where GDP growth is driven by self-sustainable internal domestic demand, in China GDP growth is driven by accelerating borrowing (see chart below) and aggressive mercantilist tactics.

Non-financial Sector Total Debt Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

If a trade war were to escalate, the fragile balance in the Chinese economy could be tipped and we may very well experience a second Asian Crisis. The important difference here would be that China's GDP is many times larger than the total GDP of all countries involved in the first Asian Crisis in 1997-1998 (when China's GDP was barely above $1 trillion).

While the sell-off in the Turkish lira and Argentine peso is certainly gathering headlines at the moment, it is hard for the Chinese yuan to get the same attention as there are still plenty of forex reserves to maintain the dirty yuan peg and stop the yuan from depreciating further. One could say that because of the bigger war chest of the People's Bank of China, the yuan is not necessarily the same timely market indicator as other emerging markets currencies whose central banks are in considerably less fortunate positions.

The key here remains forex reserve outflows, in which a pick-up similar to what we saw in 2015 after the crash of the Shanghai Composite (and faster than the present pace) would be the major red flag.

Other Market-Driven Indicators

The Shanghai Composite Index closed last week at 3022. It sure looks to have experienced a bad "crack" in 2018. I have previously referred to the rally off the January 2016 lows of 2650 as "the mother of all dead cat bounces," or MOADCB, a bear market rally that could not recover in two years what it lost in a single month (January 2016). The index is now unwinding that MOADCB rather expeditiously.

China Shanghai Composite Stock Market Index versus India Sensex Stock Market Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I am aware that the Shanghai Composite is not as good a reflection of the Chinese economy as India's SENSEX is for the economy of India, as China's economic growth does not necessarily translate into profit growth due to the much bigger government intervention in the economy in the best interest of "social stability," as the Chinese like to say. Still, the troubling developments in the Shanghai Composite cannot be ignored when forex reserve flows have resumed and there is a rather unconventional man at the wheel of a kerosene truck headed for the blazing bonfire of the Chinese financial system.

This year promises to be a more different year for financial markets than 2017, as it is driven by unilateralist "Make America Great Again" policies that frankly have resulted from the failure of the multilateralist approach of several previous administrations.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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