Photo: Peter Garnhum on flickr
Please allow me to start off with a few explanatory bits. At The Automatic Earth, we have always defined inflation in a different manner from most other sources. That is to say, we define inflation as an increase in money and credit supply (relative to available goods and services), combined with velocity of money, not as simply an increase in – some – prices.We see this this as significant because if inflation is defined as any price increase, we lose sight of why prices increase, a crucial “detail”. Similarly, we don’t attach much importance to CPI numbers, since they lack the same attention to detail we find with the definition of “inflation” as it is generally reported and used.
That said, I think it’s high time to look at some recent Chinese data and try to draw what – initial- conclusions we can from them. I also think we can peer through them towards a picture of the future that few have acknowledged to date, and perhaps even fewer wish to. If what I’m about to say is even halfway true, the economies of countries like Australia and New Zealand, which we visited recently, as well as many others, are in for a brutal shock.
I single out Australia and New Zealand because their economic growth, indeed by now their entire economic performance, which has been far better than the US and EU in the past 5 years, would be torn and frayed to shreds if the Chinese economy would hit one or more serious snags. And from what I see I can draw just one single conclusion: it will. The consequences down under will be shattering.
Now you may be aware of the fact that I have warned about China for years, and have predicted a civil war there before this decade is over (and/or China waging war abroad). Simply because the rate of growth in the Chinese economy is not “sustainable”, and because trying to achieve that rate, China unleashed, among other things, the by far largest human mass migration in the history of mankind, which has seen 100’s of millions of people move from rural to industrial areas.
And in record time too. Which causes a few problems along the way. John Hempton at Bronte Capital touched on this – and many other topics – in a great piece recently.
Every economy that has moved peasants to an export-orientated manufacturing economy has had rapid economic growth. Great Britain industrialized at about 1 per cent per annum. It was slow because all the technology needed to be invented for the first time. During the 19th Century US economic growth – once started – ran about twice the rate of the UK.
They copied the technology which was faster than inventing it. Later economies (eg Japan, Malaysia, Thailand, Korea) went later and faster. As a general rule the later you industrialized the faster you went – as the ease of copying went up. In the globalized internet age copying foreign manufacturing techniques and seeking global markets is easier than ever – so China is growing faster than any prior economy.
This fast economic growth – which would happen in a more open economy – is creating the fuel for the Chinese kleptocracy.
Not everything scales up well; actually, not much does. China has industrialized at break neck speed, and created a lot of expectations, both at home and abroad, which will be very hard if not impossible to meet. If you want to put it in starker terms, you might say it has unleashed something akin to Pandora’s Frankenstein. A monster the entire world counts on to save them. Not a smart idea.
China’s trade surplus as a percentage of GDP is shrinking. Hence, growth will have to come from domestic demand. The government has tried all sorts of tricks to boost this, but it can’t change people’s habits overnight. The Chinese people are savers. More so perhaps today than ever before. There is no welfare net to catch them, and the one-child policy has left them with too few children to fall back on. Hempton explains:
In most developing countries the way that people save is they have multiple children hopefully to generate a gaggle of grandchildren all of whom are trained to respect their elders. Given most people did not live to old age if you did you became a treasured (and well cared for) family member.
This does not work in China. Longevity in China is increasing rapidly and the one-child policy results in a grandchild potentially having four grandparents to look after. The “four grandparent policy” means the elderly cannot expect to be looked after in old age. Four grandparents, one grand-kid makes abandoning the old-folk looks easy and near certain.
Nor can the elderly rely on a welfare state to look after them. There is no welfare state.
So the Chinese save. Unless they save they will starve in old age. This has driven savings levels sometimes north of 50 per cent of GDP. Asian savings rates have been high through all the key industrializations (Japan, Korea, Singapore etc). However Chinese savings rates are over double other Asian savings rates – this is the highest savings rate in history and the main cause is the one-child policy.
OK, so the Chinese save. But how? They have few options, and – ironically – all of them are money losers. The Chinese can’t invest abroad. And their stock markets are rigged. Bank deposits pay 1% or less, because the government regulates the interest rates (and all banks). Life insurance pays a little more, but not much. Their best bet often is real estate (even if many apartments are left empty), simply because they hope losses will be smaller (though prices have plummeted in many areas). The reason all options are money losers is rising prices (what most call – price – inflation). Hempton:
[..] inflation has been between 6 and 8 per cent (but is now lower than that and is falling fast). At almost all times (except during the height of the GFC) the inflation rate has been higher – often substantially higher – than the regulated bank deposit (or life insurance contract) rate.
In other words real returns for bank accounts are consistently negative – sometimes sharply negative.
You might ask why people save with sharply negative returns. But then you are not facing starvation in your old age because of the “four grandparent policy”. Moreover because of the underlying economic growth (moving peasants into a manufacturing economy) there are increasing quantities of these savings every year. This is the critical point – the negative return to copious and increasing Chinese bank deposits drives a surprising amount of the global economy and makes sense of many things inside and outside China. And those deposits are mostly lent to State Owned enterprises.
It works like this: with price inflation at 6% and a bank deposit return of 1%, Chinese banks and SOEs have access to enormous amounts of savings – which (still) grow all the time – at de facto negative rates. And because of restrictions placed on the banking system, a lot of the savings are reaching the market through the shadow banking system. To what extent Beijing itself is ruled by the kleptocracy is hard to say; the October 2012 elections could be a harbinger of further developments in that sphere. More from John Hempton:
The SOEs are the centre of the Chinese kleptocracy. If you manage your way up the Communist Party of China and you play your politics really well you may wind up senior in some State Owned Enterprise. This is your opportunity to loot on a scale unprecedented in human history.
Us Westerners see the skimming arrangements. If you want to sell kit (say high-end railway control equipment) to the Chinese SOE you don’t sell it to them. You sell it to an intermediate company who on-sell it in China. From the Western perspective you pay a few per cent for access. From the Chinese perspective – this is just a gentle form of looting.
A normal business – especially a State Owned dinosaur run by bureaucrats – would collapse under this scale of looting. But here is the key: the Chinese SOEs are financed at negative real rates. A business – even a badly run business – can stand a lot of looting if it is (a) large and (b) funded at negative real rates.
Those negative real rates are only possibly because there are copious bank deposits available at negative real rates to State controlled banks.
When you have copious funds at a negative cost a lot of investments that look stupid under some circumstances suddenly look sensible. US Treasuries look just fine. Don’t think the Chinese are going to stop holding Treasuries. The Treasuries yield far more than they pay the peasants. The Chinese make a positive arbitrage on holding low rate US bonds.
The reality is: the banks and SOEs – that is to say, those party members that control them – get paid4-5% to borrow money !!, which they can then use to run industries that make a lot more money. As long as the system lasts. Which it does only as long as price-inflation numbers stay high and economic growth remains robust. And that’s where things are starting to go wrong.
Problem no. 1: slowing growth. From Reuters:
China’s annual economic growth could fall below 7 per cent in the second quarter if weak activity persists in June, an influential government adviser was quoted on Wednesday as saying. The forecast by Zheng Xinli, a former deputy director of the Chinese communist party’s policy research office, is among the most bearish by any government and private sector economists.
“GDP growth in the second quarter could fall below 7 per cent if there is no significant improvements in economic data for June,” the overseas edition of the People’s Daily quoted Zheng Xinli, now deputy head of the China centre for International Economic Exchanges (CCIEE), a top government think-tank, as saying.
China’s industrial output growth usually outpaces GDP growth by 3-5 percentage points, the newspaper cited Zheng as saying. China’s industrial output rose 9.6 per cent in May from a year earlier, picking up slightly from a three-year low of 9.3 per cent stuck in April.
Problem no. 2: falling inflation. From Zarathustra at Also Sprach Analyst:
China’s CPI inflation continued with its downward trend in May.
The headline consumer prices index inflation fell to 3.0% yoy in May, lowest reading since June 2010, down from 3.4% yoy for the previous month, and below market expectation of 3.2%. On a month-on-month basis, CPI fell by 0.3% in May, down from a fall of 0.1% in the previous month.
Just as mentioned before, we are seeing sharply lower food prices in May, which fell by 0.8% on the month in May, while on a year-on-year basis, food prices inflation is down to 6.4%. Non-food prices increased by 1.4% compared to a year ago, while it remained unchanged on a month-on-month basis
Problem no. 3: liquidity. Zarathustra again:
[..] … while we have had no doubt about the willingness of the Chinese government to maintain growth, we have had serious doubt about the ability of the government to actually spur growth when necessary. Perhaps following paragraphs will not be the thing that bulls want to read the most. China is in a liquidity trap, just like everyone else in the world. That’s according to Dong Tao of Credit Suisse.
This is not a usual thing to be heard regarding to China. After all, the popular definition of liquidity trap is more or less that interest rates are already close to zero such that there is no way to be lowered, and there is indeed much room to cut interest rates across maturities. So it seems, at first glance, to be absurd to claim that China is in anywhere close to a liquidity trap.
But we did talk about debt deflation. We firmly believe that this is, if not already happening, will soon happen. In a debt deflation scenario, debtors will be rushing to pay down debt (or else they are defaulting), and the economy is not interested in taking on more debt. In that scenario, cutting interest rates alone will indeed have very little positive impact on lending. We are probably not quite near a liquidity trap, but sooner or later, we believe we will get there.
Dong Tao of Credit Suisse (one of the very few sell-side China economists that we actually care what they say) believe that China is in a liquidity trap:
However, we believe that a cut in the lending rate will only have limited impact in stimulating investment. We believe China is in a liquidity trap. With a low interest rate environment, further cuts in interest rates may not get much of an additional impact. Today’s problem in China is not about funding cost or bank liquidity, but demand for loans for real businesses.
As companies in the real businesses struggle with surging costs, over-capacity, and weakened demand, the incentive to conduct real investments is low. It would take some structural changes to jump-start the momentum of investments in the private sector, instead of just through easing monetary policy.
Problem no. 4: money supply. And there we get to our definition of inflation: as shrinking money supply and velocity of money. Ambrose Evans-Pritchard:
Growth of the world money supply has dropped to the lowest level since the financial crisis of 2008-2009, heralding a severe economic slowdown later this year unless authorities rapidly take action.
The latest data show that the real M1 money supply – cash and overnight deposits – for China, the eurozone, Britain and the US has been contracting since the early Spring. Any further falls risk a full-blown global recession. [..]
The world money data collected by Simon Ward at Henderson Global Investors show that real M1 for the G7 economies and leading E7 emerging powers peaked at 5.1pc in November and has since plunged to 1.6pc in April. The data explain why commodity prices are falling hard, with Brent crude down to a 16-month low of under $97 a barrel.
China’s money data are falling at the fastest pace since records began. The gauge – six-month real M1 – gives advance warning of economic output half a year ahead. “Europe needs to start quantitative easing [QE] immediately and China must ease policy,” said Mr Ward.
The shrinking money supply is a global issue. It it proof that the inevitable debt-deleveraging is continuing, or you might say has taken off for real. Inevitable because the mountain of debt from our recent past needs to deflate. It makes no difference what governments and central banks try to stop this process.
China could be hit harder than just about any other country by this. It needs a high economic growth, of some 7% of more, or the engine will roll off the rails. And the powerful and wealthy party members need a high rate of price inflation to keep their kleptocratic scheme alive.
Obviously, it doesn’t look like either will be there. China depends on exports, and they are falling, on the back of the ongoing and worsening global crisis. Getting the Chinese people to increase their consumption levels is of course not very likely when their prospects become less sunny.
The government can try to get the inflation rate up by pumping more money into the economy, but it’s hard to see any reason why the Chinese would go out and borrow it. By and large, what they would want to spend, they already have in savings. They’re not Americans yet, certainly not in that regard. More infrastructure investment? There are limits there too.
So it would look like China is caught in a trap. John Hempton again:
The Chinese kleptocracy – and indeed several major trends in the global economy – depend on copious quantities of savings at negative expected rates of return by middle and lower income Chinese.
There are two core threats to this system – one widely discussed – one undiscussed.
Inflation (widely discussed) is known to produce riots and demonstrations in China – and is considered by Westerners to be bad news for the Chinese establishment. And there are good reasons why the Chinese riot with inflation – the poor who save because they are going to starve – get their savings taken away from them. But ultimately the Chinese establishment like inflation – it is what enables their thievery to be financed.
The more serious threat is deflation – or even inflation at rates of 1-3 per cent. If inflation is too low then the SOEs – the centre of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 per cent. A positive real funding rate – well that is a completely different story.
The real threat to the Chinese establishment is that the inflation rate is falling – getting very near to the 1-3 per cent range. Low Chinese inflation rates will mean reasonable returns on savings for Chinese lower and middle income savers. Good news for peasants perhaps.
But that changing division of the spoils of economic progress will destroy the Chinese establishment (an establishment that relies on a peculiar and arguably unfair division of the spoils). The SOEs will not be able to pay positive real returns to support that new division of spoils. The peasants can only receive positive real returns if the SOEs can pay them – and paying them is inconsistent with looting.
If the SOEs cannot pay then the banks are in deep trouble too. All because the inflation rate is dropping. Maybe they can stop it dropping. The Chinese establishment has a vested interest in getting the inflation rate up in China. Because if they don’t all hell will break loose.
Unless the Chinese can get the inflation rate up expect a revolution.
“Maybe they can stop it dropping”. Well, I don’t think they can. I don’t see how. It looks like China can print money, but no-one wants it anymore. Indeed, former stimulus has led to overcapacity, so there’s no point in doing even more. As CCB International Securities analysts Banny Lam and Rocky Zhang recently wrote:
“Today, China’s manufacturing industry, and by extension the entire economy, is suffering from massive overcapacity in both infrastructure and industrial production causing prices to plunge, utilization rates to fall, profits to decline and the number of bad bank loans to rise.”
It’s not possible, for obvious reasons, to pinpoint when all this will reach critical mass. What we can say, though, is that the harder Europe falls, the harder China will. China is not some miracle story, it’s simply just another part of the insane global credit bubble machine we’ve all thought was making us rich. We know better now, or should at at least, and the Chinese soon will too.
That will in all likelihood lead to fierce battles between the politburo, the party members and the Chinese triad mafia on the one hand, and 1.3 billion citizens on the other. Not a pretty prospect.
Whichever faction takes over power in October may decide to go looking for some Lebensraum in places like Siberia, and send 1 or 2 or 10 million of the 1300 million people they have, abroad. Not a pretty prospect either.