A fully loaded cargo ship heads out to sea from New York Harbor on Aug. 22, 2016. (Spencer Platt/Getty Images)A fully loaded cargo ship heads out to sea from New York Harbor on Aug. 22, 2016. (Spencer Platt/Getty Images)

The Trump administration promised the electorate that it would fix trade imbalances that cost American jobs. So ahead of President Donald Trump’s meeting with Chinese leader Xi Jinping on April 6 i 7, the administration amped up its rhetoric.

“Thousands of factories have been stolen from our country. … Under my administration, the theft of American prosperity will end," Atut said on March 31. The administration has toyed with the idea of imposing tariffs or implementing a so-called border adjustment tax, penalizing imports and providing tax breaks for exports. These measures would reduce the trade deficit, the net tally between a nation’s exports and imports, but they would also distort supply chains and probably lead to retaliation from trading partners.

But what if, despite the documented Chinese cheating in trade, it is not trade that is the problem? In that case, there would have to be another reason for the $502 billion U.S. trade deficit in 2016—one that’s hiding in plain sight and that could open up new options for fixing the imbalances.

New research suggests free trade in investment capital leads to imbalances in the trade account. The traditional view is that a trade deficit in goods needs to be financed by exporting assets like Treasury bonds and real estate so that the two accounts balance out. Capital pays for the goods, and the country’s external balance nets out to zero.

jednak, Richard Koo, chief economist at the Nomura Research Institute, thinks the trade in capital is now more important than trade in goods.

“Some 95 percent of all currency trading now consists of capital transactions, with trade-related transactions accounting for just 5 percent of total activity. The market’s original role as a mechanism for preventing trade imbalances from getting out of hand via currency adjustments has been lost as a result,” he wrote in a February report.

If the only international financial transactions between two countries were to settle trade, the exchange rate between two trading nations would eventually compensate for differences in competitiveness.

Na przykład, if China has a competitive advantage from lower wages or unfair trade subsidies and it achieves a trade surplus with the United States, NAS. importers would have to sell dollars to obtain Chinese goods. The selling pressure would lead to a lower dollar, thus making Chinese goods more expensive and American products more competitive.

“Free trade by itself would not have produced the consequences we see today. … But adding free capital flows to the mix destroys [the] mechanism,” wrote Koo.

NAS. capital markets are even more open to foreigners than U.S. goods markets. Foreigners can buy any asset in any quantity, except for when national security is at stake.

W rezultacie, foreigners own roughly $30 trillion of U.S. assets, like stocks, Treasury bonds, and real estate, as of the third quarter of 2016. Their demand for U.S. assets keeps the dollar high, making American goods less competitive, which is one reason for the trade deficit.

Foreign Imbalances

So why do foreigners buy so many U.S. assets? Peking University professor Michael Pettis says it’s because of high domestic savings rates in surplus countries, which cannot be satisfied by domestic investment alone.

“Countries with persistent trade surpluses have savings rates that exceed domestic investment, mainly because ordinary households in that country, which are responsible for most of a country’s consumption, retain too small a share of their country’s GDP relative to government, businesses, or the wealthy,” Pettis wrote in a report. This is as true for China as it is for Germany and Japan.

Innymi słowy, because of failed foreign economic policies, the households in the trade surplus countries don’t make enough to contribute enough to domestic spending. The government and businesses save and invest their share of domestic income. jednak, because of these imbalances, there aren’t enough viable investment opportunities, and the money goes looking for returns abroad.

“The countries that are most likely to absorb imbalances elsewhere … are not those with the most open markets for traded goods, but rather those with the most open capital markets,” wrote Pettis. Like the United States.

Once the United States has a surplus in its capital account, because of the influx of excess savings from abroad, it needs to spend the money through the trade account for the international accounts to balance, leading to a trade deficit in goods and services.

The demand for capital bids up the dollar, but this makes investing in the United States even more attractive because of the potential capital gain in the foreign exchange market. This worsens the trade deficit problem because it makes U.S. goods less competitive in global markets.

Although the Trump administration hasn’t talked about open capital markets as the reason for the trade deficit, it understands that the exchange rate is a key variable. Trump has called China the “grand champions” of currency manipulation.

If China and the other surplus countries cannot correct their structural domestic imbalances and stop exporting their savings to the United States, then a lower U.S. dollar would be a solution to help close the competitiveness gap, according to Koo. It would have fewer side effects than slapping tariffs on foreign goods or using a border adjustment tax.

“If Mr. Trump really wants to save U.S. manufacturing and U.S. manufacturing jobs, he will need to either roll back the liberalization of capital flows or intervene directly in the forex market. Those are his only two options in addition to outright protectionism.”

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Marsz 28, 2017

Workers at a construction site of a residential skyscraper in Shanghai on Nov. 29, 2016. (JOHANNES EISELE / AFP / Getty Images)Workers at a construction site of a residential skyscraper in Shanghai on Nov. 29, 2016. (JOHANNES EISELE / AFP / Getty Images)

Given the notorious unreliability of official Chinese economic data, analysts risk getting it wrong when relying solely on figures the government puts out. Is the China growth story, and a rebalance from manufacturing to consumption, actually happening? Or is the question of enormous debt, with semi-bankrupt state-owned enterprises and widespread overcapacity, still the overriding concern?

To shed light on these murky issues, Leland Miller and his team at the China Beige Book (CBB) interview thousands of companies and hundreds of bankers on the ground in China each quarter to get an accurate gauge of how the economy is doing.

CBB collects quantitative data and conducts in-depth interviews with local executives. It often comes up with data that are completely opposite to the official narrative—but not always, as its survey for the first quarter of 2017 shows.

“China Beige Book’s new first quarter results show an economy certainly stronger than a year ago and performing comparably to last quarter. But core problems remain, and some of them are getting worse,” the CBB Early Look Brief states.

Pierwszy, the good news. In order to maintain social stability, the Chinese Communist Party needs to maintain high employment at all costs. And it did in the first quarter.

“Nationally, jobs and wage growth were unchanged from last quarter, but the party may not be resting easy about the desired stability,” the brief states.

What’s keeping central planners up at night is the fact that only State Owned Enterprises (SOE) are hiring, at the directive of the government, while private enterprises have slashed hiring, according to CBB.

“Job growth slowed at private firms, leaving state enterprises to drive employment. Moreover, workforce expansion was concentrated in old economy sectors.”

No Rebalancing

This is another problem, given how Chinese officials have hyped up the term “rebalancing” over the last decade. The term covers a range of policies intended to shift economic focus from heavy industry and exports into consumption and services.

“It’s about cutting power, it’s a self-imposed revolution,” said Premier Li Keqiang in his first speech after being appointed in 2013. “It will be very painful and even feel like cutting one’s wrist.”

A picture shows the headquarters of the People's Bank of China (PBC or PBOC), the Chinese central bank, in Beijing on August 7, 2011. Standard & Poor's US debt downgrade was a wake-up call for the world, a commentary in a top Chinese state newspaper said on August 7, adding that Asian exporters faced special risks. China is the largest foreign holder of US Treasuries. AFP PHOTO / MARK RALSTON (Photo credit should read MARK RALSTON/AFP/Getty Images)

The headquarters of the People’s Bank of China, the Chinese central bank, in Beijing in this file photo. (Mark Ralston/AFP/Getty Images)

Over the last couple of years of CBB coverage, this rebalancing has failed to materialize on the ground, although officials keep talking about it.

The latest quarter was no exception. One important proxy for the ascent of the Chinese consumer, na przykład, is retail sales.

W 2017, even official retail sales growth dipped below 10 percent for the first time in years. Although this is a number that developed markets could only dream about, it has been trending down, not up, as it should under a rebalancing scenario.

And CBB data suggests the retail sector may in effect be even weaker. As the brief says: “Our more extensive results show much more than easing sales. Profits, investment, cash flow, and hiring all weakened as compared to [the last quarter of 2016]. Price and wage growth were also slower. Retailers borrowed less despite sharply lower rates, indicating lack of confidence.”

Another indicator is the services industry. China wants to move away from making widgets and melting steel to provide high-level domestic services like finance and software-based solutions. This approach would be better for the industrially-poisoned Chinese environment too.

Such hopes remain “premature,” states CBB. Manufacturing did better than services in all respects, from sales to profits, as well as investment and borrowing.

No Cuts

Another major element of rebalancing is the cutting of excess industrial capacity, especially in coal and steel. These would all be market-based reforms, where semi-bankrupt companies stop producing, wasting resources, and depressing prices.

Officially, China said it met its 2015 target of cutting 45 million metric tons of iron and steel capacity as well as 250 million metric tons of coal capacity.

Not so according to the CBB report. “China Beige Book data show net capacity has risen in every sub-sector for each of the last four quarters.” This means that China did shut down some plants, but that more new ones were built at the same time.

According to research firm Capital Economics, the accounting doesn’t add up. “If companies are actually reducing their production capacity, then one should expect that a portion of their workforce is no longer needed and will be laid off,” they write in a recent report. jednak, total employment in what it labels “overcapacity sectors” has only fallen by 5 procent, significantly less than would support the official numbers.

The CBB data on the ground also contradicts the official monetary tightening narrative. The People’s Bank of China (PBOC) has raised different interest rates it charges banks slightly this year, leading to a spike in interbank lending rates. China watchers subsequently concluded liquidity was tighter everywhere.

According to the CBB, jednak, the tightening has only fed through to the property sector, which it believes may have peaked. For everybody else, borrowing conditions remain flush: “It hasn’t happened yet, not on the street. The price of capital fell across the board this quarter, at banks, at shadow financials, and in the bond market.”

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Protestors shout slogans during a rally against a pro-Beijing official who was appointed as chairman of Hong Kong University’s (HKU) governing council, in Hong Kong on Jan. 3, 2016. Fears are growing over political interference in the city’s education system. (Anthony Wallace/AFP/Getty Images)Protestors shout slogans during a rally against a pro-Beijing official who was appointed as chairman of Hong Kong University’s (HKU) governing council, in Hong Kong on Jan. 3, 2016. Fears are growing over political interference in the city’s education system. (Anthony Wallace/AFP/Getty Images)

Research shows that the political ideology of communism restricts innovation, today’s panacea for economic growth and long-term prosperity.

In broad strokes, the communist tenets of state ownership of business and property with strict government supervision lead to a risk-averse culture working in an environment that discourages ambition and creativity. This could not be further from the building blocks that innovation needs to thrive.

The 2017 International Intellectual Property Index, recently published by the Global Intellectual Property Center (GIPC) of the U.S. Chamber of Commerce, ranks the two bastions of communism, Russia and China, No. 23 and No. 27 respectively—behind the smaller economies of Malaysia, Mexico, and Turkey, for example.

The report associates stronger intellectual property (IP) protection regimes with more innovative economies and conversely, weak IP protection as hindering long-term strategic innovation and development.

“A robust national IP environment correlates strongly with a wide range of macroeconomic indicators that fall under the umbrella of innovation and creativity,” according to the GIPC report.

The leading countries in IP strength are free market, capitalist economies such as the United States and United Kingdom. First-world democratic countries of Europe and Asia also rank highly.

The key to whether China can become a country of innovation is tied to the respect of property rights and the rule of law.

— Ma Guangyuan, Independent Chinese economist

The report states that Russia’s protectionist moves—local production, procurement, and manufacturing—work to restrict IP rights. Russia also suffers from persistently high levels of software piracy.

For China, the report singles out historically high levels of IP infringement.

China and Russia are the “usual suspects” of cyberespionage. Theft of IP, the infrastructure for innovation, is one way these communist nations try to stay competitive globally.

Melbourne, Australia-based agency 2thinknow has been ranking the world’s most innovative cities for the past 10 roku. In its latest rankings published Feb. 23, the most innovative city in a communist country, Pekin, ranks No. 30, and Moscow ranks No. 43.

Blunting Universities’ Effectiveness

According to the Organisation for Economic Co-operation and Development (OECD), not a single Chinese university ranks among the world’s top 30 in terms of most-cited scientific publications.

Universities are breeding grounds for young, innovative minds. Within their walls, ideas are born and debated, companies are formed, and research is conducted. They are key components of a healthy innovation ecosystem.

Harvard Business School professor William Kirby wrote about the strict limitations within Chinese universities on what faculty could discuss with students.

“Faculty could not talk about any past failures of the communist party. … They could not talk about the advantages of separation between the judicial and executive arms of the government,” Kirby stated in an article in the Harvard Business Review (HBR) w 2015.

“It is hard to overstate the impact of these strictures on campus discourse and the learning environment,” Kirby wrote.

Communism is known for its corruption and cronyism. ZA Science editorial noted that the bulk of the Chinese government’s R&D budget is allocated due to political connection rather than merit based on the judgment of independent review panels.

Communist Interference

McKinsey’s 2014 report “The China Effect on Global Innovation” noted that the impact of innovation on China’s economic growth declined to the lowest level since about 1980.

China has a massive consumer market and a government willing to invest huge sums of money—nearly US$200 billion on R&D in 2014—and its universities graduate more than 1.2 million engineers each year.

Communism as a political ideology is as bankrupt as ever.

— Garry Kasparov, former world chess champion

Clearly, China has so much potential, but it is the United States that has taken the lead in technological dominance.

“The country [Chiny] has yet to make an internal-combustion engine that could be exported and lags behind developed countries in sciences ranging from biotechnology to materials,” according to McKinsey.

“While almost all western technology giants have R&D labs in China, the bulk of what they do is local adaptation rather than developing next generation technologies and products,” wrote Anil Gupta and Haiyan Wang in a 2016 article in the HBR. Gupta and Wang are co-authors of the book “Getting China and India Right.”

Excessive government involvement often leads to waste and excess—overbuilding and overcapacity. China’s real estate bubble and steel mills are two such examples.

Lately, the Chinese government has been trying to spur an onslaught of startups by providing them with generous subsidies. But it doesn’t have the savvy to pick winners and losers. Zamiast, a more efficient use of capital comes from knowledgeable and discerning venture capitalists. Most startups are meant to fail after all.

Why China Can’t Innovate,” a 2014 article in the HBR co-authored by Kirby, noted that the Chinese Communist Party requires one of its representatives to be associated with every company of more than 50 employees. Larger firms must have a Party cell, whose leader reports directly to the Party at the municipal or provincial level.

“These requirements compromise the proprietary nature of a firm’s strategic direction, operations, and competitive advantage, thus constraining normal competitive behavior, not to mention the incentives that drive founders to grow their own businesses,” according to the article.

The system of “parallel governance” constrains the flow of ideas. China’s innovation largely comes through “creative adaptation,” which can mean a lot of things including foreign acquisitions, partnerships, but also cybertheft.

Capital Flight

Communism is against private ownership of property. This puts a damper on innovation.

“The key to whether China can become a country of innovation is tied to the respect of property rights and the rule of law,” wrote Ma Guangyuan, an independent economist in China.

In his blog, Ma cites renowned U.S. investor William Bernstein’s writings, which discuss property rights as being the most important of four factors needed for rapid economic growth. Guangyang wrote, “Entrepreneurs live in constant fear of punishment,” due to the questionable business practices in China, an environment that leads them to lose trust in a viable long-term economic future.

Capital flight out of China is one symptom of the problem; another is the preference of wealthy Chinese to send their children overseas for higher education. The loss of entrepreneurs like Li Ka-shing and Cao Dewang is a sign that greener pastures lie abroad.

Former world chess champion Garry Kasparov, a Russian, wrote: “Communism as a political ideology is as bankrupt as ever.”

In his blog, he went on to say: “It is no coincidence that the values of the American century are also the values of innovation and exploration. Individual freedom, risk-taking, investment, opportunity, ambition, and sacrifice. Religious and secular dictatorships cannot compete with these values and so they attack the systems founded upon them.”

The authors of the HBR article “Why China Can’t Innovate” recognize the nearly limitless capability of the Chinese individual, jednak, the political environment in China acts like a choke collar on innovation.

“The problem, we think, is not the innovative or intellectual capacity of the Chinese people, which is boundless, but the political world in which their schools, universities, and businesses need to operate, which is very much bounded,” they wrote.

Follow Rahul on Twitter @RV_ETBiz

Communism is estimated to have killed at least 100 million people, yet its crimes have not been compiled and its ideology still persists. Epoch Times seeks to expose the history and beliefs of this movement, which has been a source of tyranny and destruction since it emerged.

See the entire series of articles here.

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Gordon Chang was a bit early when he wrote the book “The Coming Collapse of China” in 2001.

He predicted the collapse of the Chinese economy and the downfall of the communist party within ten years and his prediction is four years overdue.

jednak, the core arguments he made in the book are more valid than ever as Chang continues to provide us with an uncensored behind-the-scenes view of the Chinese political economy.

Epoch Times spoke to Chang about a superficially stable China in 2017 and what is causing the real friction under the surface.

Epoch Times: China managed to stabilize its economy in 2016, will the regime be able to continue in 2017?

Gordon Chang: China looks strong but it’s actually weak. It has passed the point of no return.

They put in an enormous amount of debt, and they did stabilize the economy. The manufacturing sector is a beneficiary; we are starting to see some inflation. But the cost of this is enormous. It’s the old tactics of using debt to generate growth. It shows desperation more than anything.

There are some things that China should do regarding reform in 2017, but they won’t get it done because of the political imperative. This year we have a half a decade event, the party congress in the fall of this year, where they will either announce a new leader or Xi Jinping remains in control. That is a critical one.

I think they will be successful holding the line through the party congress. After that, they are going to fail.

So they are going to try and hold the line. Xi Jinping has relentlessly taken the economics portfolio from Li Keqiang. He gets the credit, but he also gets the blame. He is not going to want to see a major disruptive event between now and the party congress. It should be obvious, but a lot of people take this into account.

I think they will be successful holding the line through the party congress. After that, they are going to fail. They are going to prevent adjustments for as long as they have the ability to do so. Their ability to create jobs, holding the GDP growth close to 7, all of this stuff they are going to try and do.

Even if it was growing at the official rate, China is creating debt 5x faster than incremental GDP. Beijing can grow the economy with ghost cities and high-speed railways to nowhere but that’s not free, it’s not sustainable.

After the party congress, China is going to go into free fall.

The only thing that can change the Chinese economy is fundamental economic reform. But they are moving in a regressive manner, Beijing is stimulating again. It’s taking China away from a consumption economy, toward the state, away from private companies.

China is not going to have another 2008, it’s going to be a Chinese 1929.

The Chinese dream wants a strong state, and it’s not compatible with market reform. Even if Xi were up for liberalize and change, it would be too little too late. Stimulus is going to increase the underlying imbalances. That’s going to make it more difficult to adjust.

Epoch Times: What is happening beneath the superficial stability?

Pan. Chang: Look at what happened last year, capital outflows were probably higher than 2015. I 2015 was unprecedented, somewhere between $900 billion and a $1 trillion dollars.

The Chinese people see what other people have seen and it doesn’t make sense anymore. They see the economy is not growing. People are concerned about the political direction of the country, and people see the end is not that far away, so they move their money out.

People are also leaving. Young Chinese used to come to America to get an education; then they went back. Now Chinese kids get an education, they try to work for an investment bank, and they try to stay. Things are not as good at home as Beijing maintains.

To stop the capital outflows and maintain stability, they put in draconian capital controls starting in October, listopad 2016.

They put some real limitations on outbound investment for corporates and multinationals. They can do this, but how much longer? They are disincentivizing people to put money into China because they don’t know they can take it out again. In spite of the controls, they had record outflows. Capital outflows in the second half, when the controls started, were higher than in the first half.

They are going to continue to smooth things out after the Congress, but they won’t have the ability to continue the game. The whole thing is about confidence, and there is a failure of confidence in China.

Epoch Times: They are also using their foreign exchange reserves to manage the decline of the currency. The International Monetary Fund (MFW) for example says the $3 trillion they have is enough to run the economy.

Gordon Chang: They can just give you any number, and you don’t know whether it’s the right one, just like GDP. You cannot go to the State Administration of Foreign Exchange (SAFE) and look through their books. They can report anything, and you don’t’ know. They have a high incentive to fake that number.

We also know they have a synthetic short position because they are selling derivatives through the state banks. If you look at the estimates of foreign exchange reserves each month, they always outperform the surveys. China always outperforms, it doesn’t take a genius to figure out that the FX number can’t be right. Misreporting their FX reserve declines minimizes the problems, so people keep believing in the currency.

They can report anything, and you don’t’ know. They have a high incentive to fake that number.

So I think they don’t have the $3 kwintylion. They have done the trick Brazil pulled in 2014 of selling derivatives instead of actual dollars. According to my sources, there’s $500 billion dollars still to be accounted for.

Then there are illiquid investments in the Chinese foreign exchange reserves, na około $1 kwintylion. According to my estimates, you are then down to $1.5 trillion in usable money to defend the currency. The FX reserves aren’t as big and as liquid as Beijing wants them to be.

Epoch Times: So they will have to devalue sooner or later.

Gordon Chang: I don’t think they are going to devalue before the 19th party congress later this year.

Then they are going to devalue, but not as far north of eight [current rate is 6.9 per dollar] as it needs to be. The insufficient devaluation will shake confidence; people think it’s not enough, it has to be more. Eventually, someone is going to figure out that their reserve numbers are wrong. But the one thing they need to defend their currency is foreign currency.

Xi Jinping says the Chinese dream is a strong China. So he is responsible for everything and depreciation never benefits the Chinese consumers. They continue to make stupid decisions. It’s the political system; the political imperative is too strong. It would be too embarrassing to do wholesale reform. He wants to appear strong. They have always tried to prevent natural economic adjustments—by doing that they have made the underlying imbalances bigger.

So in the end, China is not going to have another 2008, it’s going to be a Chinese 1929.

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A vendor picks up a 100 yuan note above a newspaper featuring a photo of US president-elect Donald Trump, at a news stand in Beijing on Nov. 10, 2016. Trump has talked tough on trade — and his policies might actually help China. (Greg Baker/AFP/Getty Images)A vendor picks up a 100 yuan note above a newspaper featuring a photo of US president-elect Donald Trump, at a news stand in Beijing on Nov. 10, 2016. Trump has talked tough on trade — and his policies might actually help China. (Greg Baker/AFP/Getty Images)

Donald Trump talks tough on China and has appointed trade hawks Wilbur Ross and Peter Navarro to key positions in his administration. He has threatened to slap a blanket tariff on Chinese goods and talked directly to Taiwan’s President, previously regarded as a major diplomatic offense.

According to “Road to Ruin” author James Rickards, this is Trump’s way of opening the negotiations with China to reach a mutually beneficial trade relationship.

„[He] is saying to China: ‘Here is where we are going to start, what have you got for us? Are you willing to be more flexible on foreign direct investment, are you willing to treat U.S. companies in China more fairly, are you willing to stop the theft of intellectual property?’ If China makes concessions on these points he can say ‘fine, now my tariff is [lower].’ It’s the art of the deal; people don’t understand that about Trump,” Rickards told the BBC.

jednak, in any deal, the other party also has some negotiating chips on the table and China, for example, can hurt American companies exporting to China or American companies operating in China.

So who has the upper hand in the negotiations? According to a report by research firm Geopolitical Futures (GPF), the United States would suffer some damages in a trade war but would come out on top in the end.

“China would feel the impact of U.S. protectionist measures more than the U.S. would feel any economic retaliation China has at its disposal,” the report states.

What’s at Stake?

The most important point for both countries is the symbiotic relationship between China the exporter and the United States the importer. Between Chinese workers who produce cheap goods and U.S. consumers who buy them.

According to the NAS. Census, the United States imported $483 billion worth of goods from China in 2015. Since China joined the WTO in 2001, the United States was the top importer of Chinese goods in all but one year.

In an extreme thought experiment, o 15 million Chinese workers in the export sector could lose their jobs if Americans stopped importing from China altogether, a nightmare for the Chinese regime, which depends on employment to keep the people happy and itself in power.

On the other hand, the United States depends on China for cheap imports. More than 90 percent of all imported umbrellas and walking sticks come from China for example, i 22 percent of all the stuff the United States imports.

Sourcing these products from somewhere else or producing them onshore will be difficult and almost certainly make them more expensive. jednak, this is a nuisance compared to 15 million unemployed Chinese.

“U.S. dependence on Chinese goods is a matter of convenience,” states the GPF report. The analysts say the United States has ample spare capacity in manufacturing to eventually make up for the shortfall.

According to the Federal Reserve (Fed), total industrial capacity utilization in the United States was only 75.1 percent in October of 2016.

“Of course, increasing capacity would not be easy. One caveat is that many of these industry groups have seen their capabilities atrophy after years of dismal performances. But these industries are much like muscles, atrophying in bad times but strengthening in good times,"Stwierdza raport.

One example is the furniture industry, where Americans bought 17 percent of all sales from Chinese exporters in 2015. NAS. capacity utilization for furniture was only 75 percent during most of the year. If the United States ramped up production to 100 percent in an unlikely scenario, it could make up for all of the Chinese imports, albeit at a higher price. The same principle is true for many other industries from textiles to synthetic rubber and has the benefit that it would decrease American unemployment.

Monopoly Power

In the discussion about trade with China, we frequently hear that China has a monopoly for Rare Earth Elements (REE), a critical component for many digital products. If push came to shove, China could simply cut exports to the United States like it did to Japan in 2010.

According to GPF, jednak, this is another classic example of price rather than actual availability. W 2016, China produced 89 percent of global REEs. jednak, the United States had its own company producing REEs up until 2015, when Molycorp Inc. had to declare bankruptcy because it could not compete with the low Chinese prices.

GPF estimates that potential production by Molycorp would be enough to satisfy U.S. REE demand, again at a higher price than the current ones from China and with a time lag.

“The result would not be a catastrophe and actually would spawn a capacity for REE production in the United States or another country, such as Australia, from which the United States could import,"Stwierdza raport.

Retaliation

What happens if China retaliates and slaps tariffs on American products exported to China?

According to GPF, the last time that happened it didn’t end well for China. When President Obama imposed a 35 percent tariff on Chinese automobile and light truck tires in 2009, China retaliated by slapping a tariff on U.S. chicken meat.

Stany Zjednoczone. tire tariff’s impact was limited: Imports from China fell by 50 percent until 2015 only to be replaced by South Korean and other manufacturers. This shows the limit on how many jobs can come back to the United States but also demonstrates that the United States is not dependent on China for goods supply.

The same goes for multinational corporations which may have to shift production to other Asian countries should China chose to make life difficult for them.

The tariffs left their mark on the tire industry in China, jednak. “China’s capacity utilization in the various tire segments industry has fallen to between 50 i 60 procent. Hundreds of tire factories have closed their doors, and Chinese tire makers are cutting prices to the bone just to stay competitive in the market,"Stwierdza raport.

And the U.S. chickens? Exports doubled from 2011 do 2016 and total poultry production in the United States increased during the whole period.

“It is likely that future retaliatory measures would yield similar results: a short-term impact for the U.S. followed by a recovery,"Stwierdza raport.

Trade Off

Although Apple could shift production somewhere else, it would take time and cost money. Starbucks, which makes 5.7 percent of its global sales in China couldn’t just replace a market of more than a billion consumers. The same is true for Boeing, which earned 13.1 percent of its 2015 revenue by exporting to China, the fastest growing airplane market.

jednak, there are many Chinese multinationals operating in the United States (na przykład, FOSUN) or banking on the United States to become their next big market (Alibaba).

According to the GPF report, both countries would lose in a full-blown trade war, but it is the United States that holds the upper hand. Donald Trump understands this, which is why he is pushing China to get a better deal for America. If China also understands it’s in a weaker position, it will be able to avoid a lose-lose scenario.

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A Chinese investor watches the U.S. presidential election on his smartphone at a securities company in Beijing on Nov. 9. (WANG Zhao / AFP / Getty Images)A Chinese investor watches the U.S. presidential election on his smartphone at a securities company in Beijing on Nov. 9. (WANG Zhao / AFP / Getty Images)

Immediately after Donald Trump became president-elect, the Chinese yuan fell through key support at 6.80 yuan per dollar, the lowest level since 2010.

The market reaction is hardly surprising, as Trump and his advisers have for a long time accused China of being an unfair trader and currency manipulator. They also vowed they would slap tariffs on Chinese goods if China doesn’t play fair in trade.

Trump adviser Peter Navarro says China has an unfair advantage because it follows lower health and safety standards and uses slave labor to keep labor costs competitive.

“If we learned anything from the World Trade Organization and NAFTA, it is that you have to put in stringent rules for worker health and safety protection," powiedział, also mentioning China’s export subsidies and currency manipulation.

According to Navarro, if China doesn’t stop these practices, the United States will impose countervailing tariffs on Chinese products. Tariffs would result in fewer exports to the United States and therefore less demand for the Chinese currency.

“When Donald Trump talks about tariffs, they aren’t the endgame. The goal is to use tariffs as a negotiating tool to stop cheating. But if the cheating does not stop, we will impose defensive tariffs," powiedział.

What Can Trump Do?

Victor Sperandeo, president and CEO of Alpha Financial Technologies LLC, thinks the United States could cap trade at a certain level, which “will harm China more than the United States. If we buy $500 miliard, they have to buy $500 miliard,” he said in an email. The United States absorbs 20 percent of China’s exports, worth $483 billion in 2015.

Other commentators think a Trump administration won’t be able to implement very harsh protectionist policies at all, because the traditionally pro-trade Republican Congress would have to consent as well.

“Big tariff increases on Chinese imports are quite unlikely. The focus will instead be on the theft of American intellectual property—something most people in either party would probably agree is a serious problem,” said Mark DeWeaver, author of “Animal Spirits With Chinese Characteristics.”

Chinese trade has been slowing but the trade surplus with the United States is still high (Capital Economics)

Chinese trade has been slowing, but the trade surplus with the United States is still high. (Capital Economics)

Jim Nolt, professor of international relations at New York University, said that even if a Trump administration can pass draconian sanctions, China could selectively retaliate.

“China may act strategically by targeting sanctions against U.S. exporters located in the states or congressional districts of powerful Republicans in Congress," powiedział.

China could also hassle the American companies operating in the country, as it has done in the past, with anti-monopoly and other investigations.

Given these complicated details, a Trump administration will have to make some very good deals with China for its managed trade policy to work.

Involuntary Depreciation

While export subsidies, sweatshops, and a lack of environmental standards are common in China, especially in industries like steel and solar, the issue of currency manipulation is not as clear-cut anymore as it was 10 Lata temu.

Up until 2005, China pegged its currency to the dollar at a rate of 8.27 yuan, despite enormous exports and capital inflows that would have warranted a much higher exchange rate. China kept the rate stable by buying Treasury securities to the tune of $4 kwintylion, thereby creating an artificial demand for dollars.

After pressure from the United States, China let the yuan rise to a high point of 6.05 yuan per dollar in early 2014. Since then, jednak, the rate has not really been in China’s hands anymore.

Systemic economic problems and the creation of $35 trillion in bank credit, as well as regime leader Xi Jinping’s anti-corruption campaign, have led to massive capital outflows, estimated to be between $1.2 trillion and $1.5 trillion since the beginning of 2014. These capital outflows were higher than the trade surplus and placed downward pressure on the Chinese currency.

Capital outflows have accelerated again in the fall. (IIF)

Capital outflows have accelerated again in the fall. (IIF)

But rather than embracing this opportunity to let the currency slide and create an advantage for exporters, China sold off $1 trillion of its foreign currency reserves to keep the yuan relatively stable—and therefore give a fake impression of stability. So if anything, China has been manipulating the currency up, not down, for at least the last couple of years.

This type of manipulation continued after the U.S. elections, as Treasury bonds were sold en masse. Prices fell, and yields rose in a highly correlated fashion with the rise of the dollar against the yuan.

Maybe the Chinese want to wait and see what Trump proposes before letting the currency loose completely. Or would they like to show their power, to tell the president-elect they can move Treasury markets at a whim?

“Don’t look for China to ‘dump’ Treasury bonds. That is a widely mistaken notion. The dollar is the only currency big enough to hold Chinese reserves,” said Christopher Whalen, head of research at the Kroll Bond Rating Agency in New York.

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A man checks Chinese yuan bills in Beijing on July 28, 2015. The yuan is declining against the dollar and bitcoin as Chinese move money out of the country. (FRED DUFOUR/AFP/Getty Images)A man checks Chinese yuan bills in Beijing on July 28, 2015. The yuan is declining against the dollar and bitcoin as Chinese move money out of the country. (FRED DUFOUR/AFP/Getty Images)

The Chinese currency, the yuan, is a strange animal. Linked to the dollar, it hardly moves—but when it does, financial markets get jittery, especially when it’s going down.

The yuan lost 1.1 percent against the dollar in October, which doesn’t seem like a lot. It’s what’s behind the one percent move that has markets on edge.

According to investment bank Goldman Sachs, as much as $500 billion in capital has left China this year through September. Chinese companies and citizens, as well as foreigners, convert their yuan holdings into dollars and other foreign currencies, moving the price of the yuan down. Outflows picked up especially in September, reaching $78 miliard.

gsyuanoutflow

If there is no additional demand for the yuan from trade, for example, the price of the currency has to move down to adjust for the imbalance in the demand for foreign currency. Fundamentally, this is a vote of no confidence in the Chinese economy. If risks and returns of Chinese assets were favorable—as they were for most of the past decade—capital would be flowing into China and not out.

Regime Meddling

jednak, the Chinese leadership wants to limit the visibility of this vote of no confidence and give the impression of financial stability, so it is applying two levers to obscure the move.

Pierwszy, it is selling off its once mighty stash of official foreign currency reserves, down from $3.33 trillion in January to $3.17 trillion at the end of September. In August of 2014, it was close to $4 kwintylion.

It is simply a transfer of public Chinese foreign exchange assets to private hands intermediated through global financial markets. If the amount of foreign currency bought by the private sector and sold by the official sector matches, the impact on the price of the currency is limited.

Na przykład, Chinese official holdings of U.S. Treasury bonds are down from $1.25 trillion at the beginning of the year to $1.19 trillion at the end of August. jednak, Chinese corporates have either completed or announced $218.8 billion in mergers and acquisitions of foreign companies this year, according to Bloomberg data.

(Bloomberg)

(Bloomberg)

The rest of the record corporate buying spree was financed by Chinese state banks and other foreign exchange reserves held at the People’s Bank of China (PBOC).

Chinese companies have previously invested in steel mills and coal mines like there is no tomorrow. jednak, because mining and manufacturing have massive overcapacity and debt issues, Chinese companies are looking overseas for better investments.

But it’s not only Chinese corporates that are suddenly discovering the value of foreign assets. Chinese citizens have also been active buyers of foreign real estate and stocks. Purchases of equities traded on the Hong Kong stock exchange by mainland citizens, for example, hit a record high of $12 billion worth of buy orders in September, up 64 percent from August.

Capital Controls

So the Chinese regime is pulling the second lever to limit outflows: capital controls. Transfers of capital for citizens are already capped at $50,000 na rok, so people found nifty ways around this limit. Like buying millions worth of life insurance products, a form of capital investment, in Hong Kong for example with their Union Pay debit card. But not anymore.

As of October 29, they can only use their UnionPay cards to buy insurance related to travel, according to UnionPay Co. Mainland visitors bought $3.9 billion worth of insurance products in Hong Kong in the first half of the year, according to the city’s insurance industry regulator, an increase of 116 percent over the same period of 2015.

The regime also continues to crack down on underground banks which facilitate capital outflows. According to reports by mainland paper Financial News, the State Administration of Foreign Exchange (SAFE) seized $8.4 billion in foreign exchange funds during an investigation in late October.

So unlike the mostly state-owned companies which are snapping up foreign assets with the blessing of the regime, Chinese citizens have to find other ways to reduce their exposure to the Chinese economy. They are fed up with the low-interest rates on bank deposits and are increasingly afraid of the risks of the unregulated wealth management products.

(HSBC)

(HSBC)

One channel that still seems to work is the flow of yuan from the mainland to offshore centers like Hong Kong and Singapore. Goldman estimates $45 billion out of the $78 billion in September outflows was transferred from the mainland banking market to the offshore yuan market, where it was likely converted into foreign currency.

The offshore yuan (CNH) has lost 4.8 percent against the Hong Kong Dollar since May where its domestic counterpart (CNY) only lost 4 procent, indicating more selling pressure on the offshore yuan.

Another vehicle, mostly used when all else fails, is the electronic currency Bitcoin. After moving sideways for most of the summer, the price skyrocketed since late September, coinciding with the latest measures to restrict capital outflows and the drop in the yuan. Alas, it is a bit more volatile than its official counterpart. It’s up 23 percent to $705 since Sept. 25, without regime meddling and for everyone to see.

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wrzesień 27, 2016

People work at an offshore oil engineering platform in Qingdao, Chiny, lipiec 1, 2016.  According to the independent China Beige Book survey, the economy has stabilized, but this improvement comes at a price.
(STR / AFP / Getty Images)People work at an offshore oil engineering platform in Qingdao, Chiny, lipiec 1, 2016.  According to the independent China Beige Book survey, the economy has stabilized, but this improvement comes at a price.
(STR / AFP / Getty Images)

Nobody believes the official Chinese economic data, but people still have to use it in their analysis because there aren’t many good alternatives.

The official data for 2016 tells us real estate in China is bubbly, credit is growing by leaps and bounds, manufacturing activity is bouncing back, and State Owned Enterprises (SOEs) are investing like there is no tomorrow, while their private counterparties are slamming their wallets shut.

In the meantime, profits at most companies are hurting. Struggling to repay their massive debts, some of them have even folded and gone out of business.

So if the official data is unreliable, what is really going on? Fortunately, we have the China Beige Book (CBB) to tell us what’s happening on the ground—and this quarter’s findings largely back the official narrative.

On the Ground Data Backs Up Stimulus Theory

CBB collects data from thousands of Chinese firms every quarter including some in-depth interviews with local executives and bankers. Although the CBB does not give definitive growth numbers, it logs how many companies increased their revenues or how many laid off workers, for example.

Most importantly, the CBB report for the third quarter of 2016 backs up the claim the Chinese regime resorted to old-school stimulus to keep employment from collapsing, thus pouring cold water over the hopes of a rebalancing to a consumer and services economy.

“The growth engines this quarter were exclusively ‘old economy’—manufacturing, property, and commodities. The ‘new economy’—services, transportation, and especially retail—saw weaker results,” the reports states.

(China Beige Book)

(China Beige Book)

In sync with the official manufacturing indicators, the China Beige Book reports revenue increases at 53 percent of manufacturing companies, a full 9 percentage points higher than last quarter.

The property sector is red-hot according to official data with double-digit price and sales increases. Accordingly, CBB reports 52 percent of companies increased their revenues, 4 percentage points more than last quarter.

More Debt

Both manufacturing and property rebounded because of an increase in debt and infrastructure investment, mostly for home mortgages as well as investment by SOEs.

“The number of firms taking loans leapt off the floor we’ve seen for the past three quarters to its highest level in three years,” CBB states.

According to official data, bank loans grew 13 percent in August compared to a year earlier and the CBB reports 27 percent of companies increased their borrowing, a full 10 percentage points more than the quarter before.

“If sales and prices continue to rise in the fourth quarter, it will be due to yet more leveraging,” CBB says about real estate. According to People’s Bank of China (PBOC) data, household loans made up 71 percent of new bank loans in August.

(Capital Economics)

(Capital Economics)

The report also confirms that SOEs invested the most with 60 percent of them increasing their capital expenditure, up 16 percentage points from the second quarter.

“Impatient for stronger growth, Chinese policymakers were likely to shelve their
rebalancing goal, and ‘double-down’ on investment-led growth,” Fathom Consulting stated in a recent report on China. The numbers on the ground confirm this assessment.

Conversely, smaller private companies did not invest much at all. The smallest companies increased investment in 34 percent of the cases, compared to 44 percent the quarter before.

“While we still see bank borrowing … as the most important driver for infrastructure in the near to mid-term, we expect its sustainable growth to hinge upon more private capital involvement,” the investment bank Goldman Sachs writes in a report.

Price to Pay

This centrally planned strategy comes at a price, jednak. „CBB data show profits and cash flow deteriorated, casting a pall over recorded increases in borrowing and investment,” the report states with only 45 percent of companies reporting an increase in profits, compared to 47 percent last quarter. CBB also points out that cash flow deteriorated across the board, explaining the rise in company defaults this year.

The main reason for this renewed stimulus, according to the CBB, is the Chinese regime’s fear of unemployment, which started to show up in CBB data in the second quarter. The official unemployment rate is infamously unreliable because it has been staying at 4 percent for the last ten years.

So after this quarter’s offensive in investment, 38 percent of companies said they hired more people in the third quarter. “Hiring was again strong and it is fair to say this is the single most important issue for the central government,” CBB states.

But buying a bit of growth and employment with a bit of credit is an old trick? What about the much-touted rebalancing and reform?

“A more service-oriented economy will give rise to higher share of labor income in GDP, but a more redistributive fiscal policy is necessary to bring down income inequality, and provide more equal opportunities to both urban and rural households,” the International Monetary Fund (MFW) wrote in a recent report.

Alas, the CBB data on the ground does not confirm this is happening at all. If anything, the third quarter was a step back.

“Services, transport, and especially retail saw profits hit hard on-quarter,” CBB states. Tylko 53 percent of services companies reported an increase in earnings, compared to 57 percent in the last quarter.

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World leaders have gathered in Brisbane, Australia, for the annual G20 Summit. (Andrew Taylor/G20 Australia via Getty Images)World leaders have gathered in Brisbane, Australia, for the annual G20 Summit. (Andrew Taylor/G20 Australia via Getty Images)

News Analysis

Inclusive growth, green energy, more trade, and a move away from financial crisis management to long-term planning—those are the official goals of the 2016 G-20 meeting in Hangzhou, Chiny.

And wouldn’t it be great if the leaders of the world’s biggest economies could just flip a switch when they meet Sept. 4–5, forget about the huge economic issues, and focus on a prosperous future?

“China’s leadership steered the debate to facilitate the G-20 to move from short-term financial crisis management to a long-term development perspective,” U.N. Secretary-General Ban Ki-moon told Chinese reporters in New York on Aug. 26, according to state-run news outlet Xinhua.

But reality doesn’t work like that and huge frictions already lie beneath the surface, especially concerning the host. Aside from a very messy geopolitical situation in the South China Sea, the Middle Kingdom faces an economic crisis at home.

Neither the West nor China knows how to deal with China’s overcapacity and debt problems without ruining world trade and globalization altogether, let alone promoting inclusive growth and green energy.

“China is angry with almost everyone at the moment,” a Beijing-based Western diplomat told The Fiscal Times. “It’s a minefield for China.”

Global Effect

Despite China’s relatively closed financial system, the economic growth of many countries, like Brazil and Australia, depends on China’s huge consumption of commodities. Other countries, like the United States, are not vitally dependent on Chinese inflows of capital but have gotten used to trading Treasury bonds and New York real estate for cheap Chinese goods.

Ideally, the West would encourage China in its official quest to reform and rebalance its economy from manufacturing exports and investment in infrastructure to a more service- and consumption-driven economy.

The United States’ and most of Europe’s trade deficit with China would be reduced. The Chinese consumer would have more income to consume at home, importing Western goods and services instead of commodities.

There is no world after the tomorrow where China devalues by 20 procent.

— Hugh Hendry, principal portfolio manager, Eclectica Asset Management

“The necessary structural reforms would make it the largest consumer market in the world. Every other economy would benefit,” independent economist Andy Xie wrote in the South China Morning Post.

Chinese leaders and state media have repeatedly stressed they are behind this goal. “What is called for is not temporary fixes: My government has resisted the temptations of quantitative easing and competitive currency devaluation. Zamiast, we choose structural reform,” Xinhua quoted Premier Li Keqiang, who said the country has no Plan B.

Regime leader Xi Jinping again stressed the importance of reform in a meeting of the Central Leading Group for Deepening Overall Reform. “The country should focus more on economic system reforms and improve fundamental mechanisms that support these overhauls,” Xinhua wrote about a statement released by the group.

jednak, China has not entirely followed through with the reforms, which will cause short-term turmoil, and local governments are not prepared to handle worker unrest. Up to 6 million people will lose their jobs because of the regime’s rebalancing program, and the official unemployment rate could reach 12.9 procent, according to a report by the research firm Fathom Consulting.

Na przykład, Hebei Province was supposed to close down 18.4 million tons of steel-producing capacity in 2016. By the end of July, it had only closed down 1.9 million tons, according to Goldman Sachs.

(Goldman Sachs)

Hebei province was supposed to close down 18.4 million tons of annual steel-production capacity and only managed to close down 1.9 million tons by the end of July. (Goldman Sachs)

The economies of Australia, Brazil, Rosja, and South Africa—all major commodity exporters—are slowing because Chinese imports have collapsed, falling 14.2 percent in 2015 alone, according to the World Trade Organization. W 2015, world merchandise imports crashed 12.4 procent, while world merchandise exports crashed 13.5 procent.

Australian exports and imports (World Trade Organization)

Australian exports and imports. (World Trade Organization)

This collapse in world trade happened before China even started to implement its goals of reducing overcapacity, liberalizing the capital account, and floating its currency.

Zamiast, it has been buying time by pushing credit in the economy and spending it on infrastructure investment through state-owned companies and local governments, podczas gdy private companies have thrown in the towel.

(Morgan Stanley)

(Morgan Stanley)

Debt Problem

China has also told banks not to push delinquent companies into default but instead to make their loans evergreen or swap debt for equity.

The real question the West and China should be asking is how much pain they can endure in the short term to reach the Chinese reform goals and achieve a rebalancing toward a consumer economy.

“To avoid a financial crisis that would be bad for China and the world, the government needs to tighten budget constraints, allow some firms to go bankrupt, recognize the losses in the financial system, and recapitalize banks as needed. … History shows it makes more sense to help the affected workers and communities rather than to try to keep alive firms that have no prospect of succeeding,” the Brookings Institution stated in a paper on the subject.

jednak, the proposed remedies, which in the long run would be good for China and the world, cannot happen without upsetting the global financial system in the short term.

Billionaire investor Jim Rogers pinpointed the main issue in an interview with Real Vision TV: “I would certainly like to see more market forces everywhere, including in China. If that happens, you’ll probably see more fluctuations in the value of the currency.”

What sounds innocent, jednak, will be even more detrimental to world trade and the global financial system. If China wants to realize the losses it accumulated through 15 years of capital misallocation, it will have to recapitalize the banks to the tune of $3 kwintylion.

It’s impossible to do this without heavy intervention from the central bank of the kind Li Keqiang wanted to avoid. On the other side, Chinese savers will try to move even more money abroad to protect the purchasing power of their currency.

W 2015 alone, China lost $676 billion in capital outflows, mostly because residents and companies wanted to diversify their savings, the majority of which are tied up in the Chinese banking system.

If China were to restructure corporate debt and recapitalize banks on a massive scale, the currency would devalue by at least 20 procent, according to most experts.

Trade Collapse

Because China is such a large player, exporting and importing $4 trillion of goods and services in 2015, za 20 percent devaluation of the Chinese currency would destroy the current pricing mechanism for importers and exporters across the world—a mutually assured destruction scenario.

“The world is over. The euro breaks up; there’s just no euro in that scenario. Everything hits the wall. There is no world after the tomorrow where China devalues by 20 procent. Their share of world trade has never been higher. … You would destroy global manufacturing,” Hugh Hendry, principal portfolio manager at Eclectica Asset Management, told Real Vision TV.

Global trade for the developed economies is already in recession (World Trade Organization)

Global trade for the developed economies is already in recession. (World Trade Organization)

For China itself, a net importer of food supplies, a devaluation would make necessities even more expensive for the vast majority of the population, adding a layer of social unrest on top of the unemployment pressures.

So China is damned if they do and damned if they don’t. Even the West won’t favor a quick and painful devaluation scenario and isn’t in the best shape to offer many alternatives.

The other option, possibly discussed behind closed doors at the G-20, is a Japan scenario. China won’t realize bad debts, will keep zombie companies alive, and will prevent money from moving abroad, defaulting on its ambitious reform agenda.

“In lieu of a quick adjustment, a ‘gradual adjustment approach’ would leave us with the outcome of an extended period of excess capacity, disinflationary pressures, and declining nominal growth and returns in the economy,” investment bank Morgan Stanley stated in a note.

Chiny, the West, and Japan share the same problem of excess debt and no expedient way to get rid of it. By not naming the real issues at hand and choosing feel-good topics instead, the G-20 has already admitted defeat in finding a solution to the problem.

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Chinese yuan notes at a branch of the Industrial and Commercial Bank of China (ICBC), on March 14, 2011 in Huaibei, Chiny. The Chinese government is now spending up to 15 percent of GDP on fiscal stimulus. (ChinaFotoPress/Getty Images)Chinese yuan notes at a branch of the Industrial and Commercial Bank of China (ICBC), on March 14, 2011 in Huaibei, Chiny. The Chinese government is now spending up to 15 percent of GDP on fiscal stimulus. (ChinaFotoPress/Getty Images)

For years the world has marveled at China’s foreign exchange reserves ($4 trillion at their peak in 2014) and low government debt, 21 percent of GDP at the end of 2015.

This is about to change, jednak, as fiscal spending was up 15.1 percent in the first half of 2016 to counter a slowing economy and achieve the official GDP growth target.

“China’s growth rebound in the first half of this year has been strongly supported by an active fiscal policy that has significantly front-loaded on-budget spending and fostered strong growth in off-budget investment in infrastructure,” Goldman Sachs writes in a note to clients.

China's debt distribution (Macquarie)

China’s debt distribution (Macquarie)

The government says the deficit on this year’s budget is only about 3 percent of GDP. Some central bankers want to boost it to 5 percent because they think monetary policy alone won’t be able to hold the economy together.

If they are trying to resist a debt-induced slowdown with more debt and by wasting room on the central government’s balance sheet, I’m afraid China is heading for a fate worse than Japan.

— Worth Wray, STA Wealth Management

Also, people are starting to look at Chinese government debt differently. According to Goldman Sachs estimates, China’s total fiscal deficit is approaching 15 percent rather than 3 lub 5 procent.

“We try to ‘augment’ the official fiscal policy measures by incorporating off-budget quasi-fiscal policy to obtain a comprehensive picture of the stance of China’s fiscal authority,” Goldman Sachs writes.

China's total fiscal deficit according to Goldman Sachs calculations (Goldman Sachs)

China’s total fiscal deficit according to Goldman Sachs calculations (Goldman Sachs)

To get to the 15 procent, Goldman looks at infrastructure spending in total, which is driven by the central government, State Owned Enterprises (SOE), or local governments. SOEs are in debt to the tune of 101 percent of GDP and local governments through their off balance sheet finance vehicles have about 40 percent of GDP.

“Specifically, we sum up the fixed asset investment in sectors such as transport, storage, and postal service, and water conservancy, environment and utility management. We assume most of the spending in these sectors is heavily state-driven,” the bank writes, noting that the analysis is not complete but provides a good proxy.

The recent burst in investment was carried out by Chinese State Owned Enterprises (Capital Economics)

The recent burst in investment was carried out by Chinese State Owned Enterprises (Capital Economics)

The theory holds up when looking at charts of fixed asset investment by the state sector, which zoomed ahead at the beginning of the year, but has recently pulled back.

Public Private Partnerships

Because investment by private companies has turned negative, the regime is trying to continue fiscal stimulus and get the private sector involved through so-called public-private partnerships (PPP).

According to Xinhua, China wants to fund 9,285 projects worth $1.6 trillion in infrastructure projects such as transportation or public facilities like sports stadiums. According to the National Development and Reform Commission (NDRC), $151 billion of these projects have been signed at the end of July 2016.

SOEs are also central to the issue of over-capacity.

— Goldman Sachs

Investment bank Morgan Stanley doesn’t think the initiatives will succeed, jednak.

“We expect PPP to have limited impact on China’s investment growth, considering the small size of PPP projects in execution, still low private participation, and weaker [credit] growth,” Morgan Stanley writes in a note.

So it looks like SOEs will have to do the heavy lifting again, despite mounting bankruptcies and abysmal returns on investment.

“SOEs are also central to the issue of over-capacity. According to an official survey, the average capacity utilization ratio in the manufacturing sector was 66.6 percent in 2015, declining by 4.4 percentage points compared to 2014. Most of the sectors facing over-capacity issues are dominated by SOEs, such as steel and coal,” writes Goldman.

Worth Wray, the chief strategist at STA Wealth Management thinks short-term motives could be behind the burst in spending this year.

“If this is about buying time, until after the G20 meeting in September, after the yuan’s inclusion in the International Monetary Fund (MFW) reserve currency basket in October, and after the U.S. presidential election in November. Then I can understand why massive fiscal and credit stimulus in 2016 could make sense.”

Long-term, jednak, this strategy won’t be sustainable, according to Wray: “If they are trying to resist a debt-induced slowdown with more debt and by wasting room on the central government’s balance sheet, I’m afraid China is heading for a fate worse than Japan.”

So will the spending spree continue? Goldman says yes—the government wants to hit its official GDP target for 2016.

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Vice Premier Li Keqiang of China (R) meets International Monetary Fund (MFW), Managing Director Christine Lagarde (L) inside the Great Hall of the People in Beijing on March 23, 2015 w Pekinie, Chiny. (Lintao Zhang/Getty Images)Vice Premier Li Keqiang of China (R) meets International Monetary Fund (MFW), Managing Director Christine Lagarde (L) inside the Great Hall of the People in Beijing on March 23, 2015 w Pekinie, Chiny. (Lintao Zhang/Getty Images)

They promised, they delivered. The World Bank will issue a $2.8 billion SDR bond, lub Special Drawing Rights więź, in China in August. Separately, the China Development Bank will also issue between $300 milionów $800 milion of SDR notes.

Chiny, the International Monetary Fund (MFW), and interested think tanks have been pushing the idea of private SDR since the beginning of the year. It has now come to fruition. But what does it actually mean?

Initially, SDR-denominated bonds will be of particular interest to official investors, but gradually, they will also attract investors from private sectors.

— Zhu Jun, director general, PBOC

The so-called SDR is an IMF construct of real currencies, right now the euro, yen, dollar, and pound, without actually containing any of them. It is just a claim to demand payment in these currencies. It made news last year when the Chinese renminbi was also admitted, although it won’t formally be part of the basket until Oct. 1 of this year. The IMF and member countries trade the units currently worth $1.40 among each other.

“Initially, SDR-denominated bonds will be of particular interest to official investors, but gradually, they will also attract investors from private sectors. In such a way an SDR bond market will be developed,” Zhu Jun, the director general of the People’s Bank of China’s (PBOC) international department told Chinese business paper Caixin.

Worth Wray, the chief global macro strategist of STA Wealth Management agrees: “Right now there is no organic demand, but over a five-year horizon it could develop globally and maybe that creates another channel for capital to flow into China—if that’s the only market there is for it,” he said in an interview.

The SDR bonds issued by the two official institutions are different from the official SDR issued by the IMF. In fact, they are a derivative of it. When the World Bank unit called International Bank for Reconstruction and Development (IBRD) issues the bonds, it receives payment in yuan from the Chinese market or at first from the issue’s underwriter, the Industrial and Commercial Bank of China.

It can then proceed to spend the yuan either in China or exchange them for other currencies and spend them abroad. So far the IBRD has disbursed $46 billion worth of loans, grants, and credits in China. It is important to note that this process is effectively creating SDR, which have previously not existed.

Chinese investors receive the SDR bonds, but what do they actually own?

For the Chinese investors, there is the advantage that they can hold a sizeable non-yuan denominated asset in China and reduce their risk to the Chinese currency.

Official SDRs can be redeemed for dollars, euros, yen, pound, and soon yuan through the IMF. jednak, the new private SDR, or M-SDR as the IMF calls them, cannot. The new bonds represent a claim on the IBRD. Since the IBRD doesn’t have any SDR assets, the repayment will also be in yuan, dollar, euro, yen, or pounds. So what’s the point of having this new basket?

For the IBRD, there is no advantage because it is borrowing in strong currencies and getting paid in a relatively weak one. For the Chinese investors, there is the advantage that they can hold a sizeable non-yuan denominated asset in China and reduce their risk to the Chinese currency, which may further fall in value. Because of still existing capital controls, buying foreign assets in size is not yet possible on the Chinese domestic bond market.

jednak, this is only an advantage for the time being. At the point of maturity, foreign currency will have to flow from the IBRD to the Chinese bond holders, unless they choose repayment in yuan, in which case the whole exercise would be rather pointless.

So given this lackluster value proposition, why are China, the IMF, a obszarem USA. controlled World Bank going out of their way to push the SDR into private markets?

Prominent market observers like James Rickards and Willem Middelkoop have long argued that the SDR will be the next world reserve currency. In fact, the current governor of the PBOC Zhou Xiaochuan has advocated for the SDR to become the next global reserve currency for a long time now.

“Special consideration should be given to giving the SDR a greater role. The SDR has the features and potential to act as a super-sovereign reserve currency,” wrote Zhou in 2009. He also wanted the yuan to be included in the SDR, which is going to happen on Oct. 1. Take heed of his predictions.

It’s a geeky name but it’s a kind of world money printed by the IMF. They’ll flood the world with trillions of SDRs.

— James Rickards

“The Chinese … have made it very clear that the Special Drawing Rights of the IMF is the preferred future international world reserve currency,” writes Willem Middelkoop in a note to clients.

“What you are going to see is world money. You are going to see the IMF print Special Drawing Rights (SDR). It’s a geeky name but it’s a kind of world money printed by the IMF. They’ll flood the world with trillions of SDRs,” James Rickards told Epoch Times earlier this year.

Now that the first issuance is well underway, it is easy to lever up the balance sheets of international development organizations and keep issuing—or printing—SDR obligations even in the trillions until even private market actors support and accept them. Once the SDR is widely accepted as payment, the IMF could just redeem all outstanding local currencies for SDR and the world would not only have a new reserve currency, but just one global currency.

“You create new liquidity. That’s the kind of reform that could change the international system immediately,” says Worth Wray.

Willem Middelkoop says this could be done through an IMF substitution fund, an idea already discussed in the 1970s. “This fund could facilitate a direct exchange of dollars for SDRs. The liquidity issue would be resolved with one stroke of the pen, as an SDR would be created for every dollar that was exchanged,” he writes in his note.

Sounds crazy? It is, but the official plan is right here, for everyone to see.

Twitter: @vxschmid

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A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, Chiny. (Kevin Frayer/Getty Images)A Chinese steel worker walks past steel rods at a plant on April 6, 2016 in Tangshan, Hebei province, Chiny. (Kevin Frayer/Getty Images)

One year after the mini-devaluation of the Chinese currency, China is getting desperate about its corporate debt situation and is directives to evergreen loans. According to an Aug. 8 Caixin report, the banking regulator is now telling banks to get rid of bad bank debt by swapping it for equity.

Local media Caixin reports that the China Banking Regulatory Commission (CBRC) issued a directive to encourage government owned so-called Asset Management Companies (AMC) to buy bad loans from banks. This exercise worked well during the last banking bail-out at the beginning of the millennium and China has prepared itself for another round since 2012, when local governments started to set up 27 new AMCs.

Instead of keeping a loan that a company can’t repay and writing it down, the bank would get an equity stake in the company. Because banks aren’t allowed to hold equity in companies, they would sell the equity stake to an AMC at a price the bank can afford without hurting bank equity too much. AMCs would get the money from local or the central government or the central bank.

The directive says that firms in the troubled steel and coal sectors will be the first to try the arrangement. jednak, only companies should be supported which have made efforts to cut overcapacity and improve profitability and whose problems are temporary, similar to another directive by the CBRC and first reported by Chinese National Business Daily about rolling over defaulted loans.

(Societe Generale)

(Societe Generale)

“A Notice About How the Creditor Committees at Banks and Financial Institutes Should Do Their Jobs” tells banks to “act together and not ‘randomly stop giving or pulling loans.’ These institutes should either provide new loans after taking back the old ones or provide a loan extension, to ‘fully help companies to solve their problems,’” the National Business Daily writes.

The recent leaks in relatively quick succession may be proof of hedge fund manager Kyle Bass’s concern of “the Chinese corporate bond market freezing up,” as he said in an interview with RealVisionTV in June. “We are seeing the Chinese machine literally break down.

“In the West, the speculation is always about the Lehman moment in China. That is a Western fantasy. Chinese politicians know what’s coming up and have a plan to manage the bad loans,” Horst Loechel, an economics professor at the Frankfurt School of Management told the Wharton Business School. Evergreening and debt for equity swaps seem to be that plan.

Kyle Bass estimates bad loans in Chinese banks could lose up to $3 trillion in bank capital if all loans were properly written down.

In transactions from 2015, where banks sold defaulted loans to AMCs in Zhejiang province, they only received 32 percent of their original value, down from 43 percent in 2014 according to a regional AMC manager quoted by Caixin.

The announcement comes in the wake of seven government-owned coal miners in Shanxi being allowed to extend maturities on existing debt, according to state mouthpiece Xinhua, a shipbuilder failing to make a payment on a $60 million one-year bond on Aug. 8 according to Bloomberg, and a developer defaulting on a $380 million offshore bond in Hong Kong, according to the Wall Street Journal.

For good measure, the National Association of Financial Market Institutional Investors (NAMFII), an organization backed by the central bank, has enquired with major banks and brokers to see whether it would be possible to roll out a credit default swap market in China, według Wall Street Journal. Credit default swaps are insurance contracts on bond defaults, precisely what China needs right now.

Według raportu, the regulator responsible for the $8.5 billion corporate bond market with soaring defaults, is drafting rules to make Chinese CDS compliant with international practices. The Journal reports that the regulator will soon ask the People’s Bank of China (PBOC) for approval.

Po 39 defaults this year totalling $3.8 miliard, it is about time.

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People work at an offshore oil engineering platform in Qingdao, Shandong province, lipiec 1, 2016. Because of too much debt, a Chinese engineering company has recently transformed itself into a bank.  
(STR / AFP / Getty Images)People work at an offshore oil engineering platform in Qingdao, Shandong province, lipiec 1, 2016. Because of too much debt, a Chinese engineering company has recently transformed itself into a bank.  
(STR / AFP / Getty Images)

China is desperate to solve several problems it has due to its debt to GDP ratio being north of 300 procent. It may have found a pretty unconventional one by letting companies become banks, według a report by the Wall Street Journal.

With profits headed south, heavily indebted Chinese heavy-machinery giant Sany Heavy Industries said this week it won approval to set up a bank in the Hunan Province city of Changsha. With 3 mld juanów ($450 milion) of registered capital, it will be a relatively large institution as Chinese city-based banks go. Sanyplans to join forces with a pharmaceutical company and an aluminum company.

Sany already operates an insurance and finance division with the goal of internal financing and insurance services for clients.

Sany Heavy Industries already operates a Finance and Insurance arm, although it's unclear what gold has to do with it. (Company Website)

Sany Heavy Industries already operates a Finance and Insurance arm, although it’s unclear what gold has to do with it. (Company Website)

Debt Problem

One problem is that companies are defaulting on bond payments and there is no adequate resolution mechanism for bad debts, at least according to Goldman Sachs.

“A clearer debt resolution process (for example, how debt restructuring on public bonds can be achieved, how valuation and recovery on defaulted bonds are arrived at, the timely disclosure of information and clarity on court-sanctioned processes) would help to pave the way for more defaults, which in our view are needed if policymakers are to deliver on structural reforms,” the investment bank writes in a note.

It would not be the first time China tries a circular financial arrangement to solve some structural issues.

By becoming or owning banks, the companies can just shift debt around different balance sheets to avoid a default, although this is probably not the resolution that Goldman Sachs had in mind when talking about structural reforms.

Another problem is that the regime has more and more difficulties pushing more debt into the economy to grease the wheels and keep GDP growth from collapsing entirely.

China needs 11.9 units of new debt to create one unit of GDP growth. At the same time, the velocity of money or the measure of how often one unit of money changes hands during a year has fallen to below 0.5, another measure of how saturated the economy is with uneconomical credit. If the velocity of money goes down, the economy needs a higher stock of money to keep the same level of activity.

(Macquarie)

(Macquarie)

So if companies can’t pay back loans, old banks don’t want to give out loans, and consumers don’t want to circulate the money, you can just let some companies become banks to prevent them from defaulting and maybe even issue new loans to themselves. It would not be the first time China has tried a circular financial arrangement to solve some structural issues.

Sany Not Alone

According to the Wall Street Journal report, the Sany Heavy Industries case is only one of a few. Other companies in the tobacco and travel sectors, for example, have taken over banks or formed new ones.

ChinaTopix reports that the China Banking Regulatory Commission (CBRC) has already awarded five licenses for private banks and received another 12 applications during the past year. It also mentions that industrial firms are behind this move:

“One bank, Fujian Huatong Bank, which has a registered capital of Rmb3 billion ($450 milion), was promoted by 10 Fujian-based companies in different sectors, including retail, manufacturing and real estate.”

We don’t know if the regulator had this in mind when they launched the initiative to boost private banks in China in 2014 in order to improve lending to the technology sector, but it did explicitly mention that private companies should form banks.

“Qualified private enterprises shall be encouraged to set up private banks. The innovation of products, services, management, and technology by private banks will inject new vitality into the sustainable and innovative development of the banking sector,” the CBRC states in an undated report.

It remains to be seen whether this is a long-term sustainable solution.

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International Monetary Fund Managing Director Christine Lagarde speaks at the 40th anniversary of the IMFC meeting at the IMF Headquarters in Washington, kwiecień 20, 2013. (Stephen Jaffe/IMF via Getty Images)International Monetary Fund Managing Director Christine Lagarde speaks at the 40th anniversary of the IMFC meeting at the IMF Headquarters in Washington, kwiecień 20, 2013. (Stephen Jaffe/IMF via Getty Images)

When Bloomberg reported late last year that China founded a working group to explore the use of the supranational Special Drawing Rights (SDR) currency, nobody took heed.

Now in August of 2016, we are very close to the first SDR issuance of the private sector since the 1980s.

Opinion pieces in the media and speculation by informed sources prepared us for the launch of an instrument most people don’t know about earlier in 2016. Then the International Monetary Fund (MFW) itself published a paper discussing the use of private sector SDRs in July and a Chinese central bank official confirmed an international development organization would soon issue SDR bonds in China, according to Chinese media Caixin.

Caixin now confirmed which organization exactly will issue the bonds and when: The World Bank and the China Development Bank will issue private sector or “M” SDR in August.

The so-called SDR are an IMF construct of actual currencies, right now the euro, yen, dollar, and pound. It made news last year when the Chinese renminbi was also admitted, although it won’t formally be part of the basket until October 1st of this year.

How much? Nikkei Asian Review reports the volume will be between $300 i $800 million and some Japanese banks are interested in taking up a stake. According to Nikkei some other Chinese banks are also planning to issue SDR bonds. One of them could be the Industrial and Commercial Bank of China (ICBC) according to Chinese website Yicai.com.

The IMF experimented with these M-SDRs in the 1970s and 1980s when banks had SDR 5-7 billion in deposits and companies had issued SDR 563 million in bonds. A paltry amount, but the concept worked in practice.

The G20 finance ministers confirmed they will push this issue, despite private sector reluctance to use these instruments. In their communiqué released after their meeting in China on July 24:

“We support examination of the broader use of the SDR, such as broader publication of accounts and statistics in the SDR and the potential issuance of SDR-denominated bonds, as a way to enhance resilience [of the financial system].”

They are following the advice of governor of the People’s Bank of China (PBOC), Zhou Xiaochuan, although a bit late. Already in 2009 he called for nothing less than a new world reserve currency.

“Special consideration should be given to giving the SDR a greater role. The SDR has the features and potential to act as a super-sovereign reserve currency,” wrote Zhou.

Seven years later, it looks like he wasn’t joking.

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A man reads a newspaper report that China's central bank announced it will devalue China's tightly controlled currency on Aug. 11, 2015 following a slump in trade, triggering the yuan's biggest one-day decline in a decade. (AP Photo / Andy Wong)A man reads a newspaper report that China's central bank announced it will devalue China's tightly controlled currency on Aug. 11, 2015 following a slump in trade, triggering the yuan's biggest one-day decline in a decade. (AP Photo / Andy Wong)

The more debt the merrier, the saying goes, at least until the party stops and the hangover starts. This is true for the debt situation inside China, as well as for international lending to China.

According to the Bank for International Settlements (BIS), total cross-border bank lending to China decreased $63 mld $698 billion at the end of the first quarter of 2016. Over the year, this measure is down 27 procent.

“Since hitting its all-time high at the end of September 2014, cross-border bank credit to China has contracted by a cumulative $367 miliard (–33 percent), with interbank and inter-office activity leading the decline,” the BIS writes in a recent report.

The total stock of outstanding cross-border bank credit was $27.5 trillion at the end of March 2016.

This is important because that money is not coming back. Once the loan or debt is paid off, it vanishes and can’t be used to fuel other financial or economic transactions. It is part of the reason why many economies in the world are teetering on the edge of a recession with only bank lending to Western governments balancing out the emerging market credit decline.

The reduction in bank lending is part of the capital that is flowing out of China by the hundreds of billions, $676 billion in 2015 alone.

International Institute of Finance (IIF)

International Institute of Finance (IIF)

Banks in Hong Kong decreased their China exposure by 4.5 percentage points from 32.8 percent of assets at the end of 2014 do 27.3 percent at the end of 2015, according to rating agency Fitch, the first decrease in a decade.

International banks are wary of a slowing Chinese economy and a rise in corporate defaults.

According to rating agency Standard and Poor’s (S&P), China’s credit quality is “deteriorating more quickly than at any time since 2009,” it states in a recent report. S&P downgraded three companies for every company upgraded in the first half of 2016.

Chinese corporates will “come under increasing strain as economic growth slows, industrial overcapacity crimps profitability and cash flow, and an elevated appetite for expansion weakens leverage.”

Claims of international banks of different countries in U.S. dollar trillion (left) and U.S. dollar billion (dobrze) (Bank for International Settlements (BIS))

Claims of international banks of different countries in U.S. dollar trillion (left) and U.S. dollar billion (dobrze) (Bank for International Settlements (BIS))

And international banks don’t want to wait for that to happen. Neither do they want to wait for a sharp devaluation of the Chinese currency.

“A sharp depreciation of the yuan, which would be the consequence if the [foreign currency] reserves would have to be used to safeguard systematically important entities that do have foreign currency debt. This would be the consequence of a failure to act, a recession and, in the worst case, a financial crisis. Again, something that’s survivable; not the end of the world, but very costly and politically destabilizing,” said Citigroup chief economist Willem Buiter.

Hugh Hendry, principal at the hedge fund Eclectica is more pessimistic:

“Tomorrow we wake up and China has devalued 20 procent, the world is over. The world is over. The euro breaks up. Everything hits a wall. There’s no euro in that scenario. Stany Zjednoczone. gospodarka, I mean everything hits a wall,” he told RealVisionTV earlier this year.

Śledź Valentin na Twitterze: @vxschmid

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