Workers distribute packs at S.F. Express in Shenzhen, China, on Nov. 11, 2013. Private companies in China have stopped to invest in further expansion in 2016. (ChinaFotoPress/ChinaFotoPress via Getty Images)Workers distribute packs at S.F. Express in Shenzhen, China, on Nov. 11, 2013. Private companies in China have stopped to invest in further expansion in 2016. (ChinaFotoPress/ChinaFotoPress via Getty Images)

Previously the engine of relatively efficient growth, it looks like the private sector has given up in China. Investment by private companies went negative in June and decreased another 0.6 percent in July. That’s right, negative growth month over month, something completely unfathomable during the boom years of above 20 percent growth just a few years ago.

“We believe private [investment] slowdown is more structural this time, dragged by weaker investment return and falling business confidence amid limited reforms and deregulation. Strong State Owned Enterprise (SOE) investment is unlikely to fully offset the weakness, instead, it could create more excess capacity and deteriorate capital returns,” the investment bank Morgan Stanley writes in a note.

For the first half of 2016, private investment is only up 2.4 percent over the year. This is worrying because the private sector is responsible for most of China’s real economic development and relatively efficient capital allocation. 

The government will try to coopt the private sector into spending through monetary and fiscal policies.

— Viktor Shvets, global strategist, Macquarie Securities

To balance the decline in private investment, the state used SOEs as countercylical fiscal policy instruments. SOE’s share of investment in fixed assets rose 23.5 percent compared to the first half of 2015. Because of inefficient investments from years prior, overcapacity, and mounting defaults, Morgan Stanley thinks this is ill advised. 


(Morgan Stanley)

(Morgan Stanley)

Morgan Stanley notes that private companies are avoiding sectors such as mining and steel, which are plagued by overcapacity. But they also cannot invest in the service sector as they please because of high entry barriers and too much regulation.

Private investment outside of manufacturing—read services—declined 1.1 percent in the first half of 2016 over the year, compared to 15 percent growth in 2015. SOEs, on the other hand, boosted investment in services 39.6 percent.

So much for a successful rebalancing to services, which has been considered a linchpin of the effort to reform the Chinese economy. It’s happening, but at the behest of the state.



(Morgan Stanley)

(Morgan Stanley)

Overall, there just aren’t enough good investment opportunities around and the borrowing costs for private firms are as high as 15 percent, much higher than the return on assets. Unlike their state-owned counterparts, private companies actually try to be profitable—and they don’t see profits in China’s slowing economy.

In addition, the lack of progress in the much-touted reform agenda hurts business confidence and financial visibility. Zhang Qiurong, who owns a specialty paper business told the Wall Street Journal: “The economic outlook is really grim. You have to survive, that comes first.”

Mr. Zhang’s feelings are reflected in the China Economic Policy Uncertainty Index, which has been increasing steadily in 2016, almost reaching the record levels of uncertainty seen during the last handover of Communist Party leadership in 2012.

The economic outlook is really grim. You have to survive, that comes first.

— Zhang Qiurong

The result of the uncertainty? Companies are stashing money at the bank and just won’t spend and invest it. 

“Despite loads of liquidity pumped into the market, enterprises would rather bank the money in current accounts in the absence of good investment options, which is in line with record low private investment data,” Sheng Songcheng, head of statistics and analysis at the People’s Bank of China said earlier this year. Cash and short-term deposits at banks grew 25.4 percent in July.

To counter concerns of crashing private investment in China, the regime promptly announced private-public partnership (PPP) investment programs worth $1.6 trillion and spanning 9,285 projects, first reported by Xinhua on Aug. 15.

“The government will try to coopt the private sector into spending through monetary and fiscal policies,” says Viktor Shvets, global strategist at Macquarie securities.

The problem is that this strategy is unlikely to work. 

“The impact of PPP on China’s investment growth is likely to be limited, considering the small share of PPP projects in execution (less than 0.5% of total [investment]), the still low participation ratio by private investors … International experience shows that private financing of public investment entails large fiscal risks in the absence of a good legal and institutional setup,” writes Morgan Stanley. And a good legal and institutional set-up is not what China is known for.

If the PPP and short-term monetary and fiscal stimulus won’t work, China actually has to deliver on reforms to get the private sector to spend again. 


Read the full article here

Rescuers help recover valuables from a damaged home after an earthquake hit Lushan County in Ya'an City, southwest China's Sichuan province on April 21, 2013.  (STR/AFP/Getty Images)Rescuers help recover valuables from a damaged home after an earthquake hit Lushan County in Ya'an City, southwest China's Sichuan province on April 21, 2013.  (STR/AFP/Getty Images)

No matter how much politicians and Western observers want the Chinese economy to run on services and forget about manufacturing, we are a long way away from it.

Case in point: In order to keep GDP from collapsing entirely in the second quarter, Chinese state enterprises boosted overall fixed asset investment to 9.6 percent growth over the year while investment by private companies languished at 3.9 percent.

Private investment is the lowest it has been in decades and the divergence between state and private is also striking.



“State Owned Enterprises (SOE) continue to invest in the overcapacity industries, which suffer from slower growth in production,” writes the investment bank Natixis in a note.

Mining, steel, and oil are all sectors dominated by SOEs and ill-equipped for the current economic downturn.

“The commodity sectors in general experienced contraction in production, these are sectors that SOEs have invested heavily in,” writes Natixis.

The private sector can easier respond to changes in the economic landscape and has expanded production in new technology goods like electronic cars and robots.

Another outlet for the surge in new credit in the first quarter ($712 billion in newly created loans) was real estate. Construction is another classic outlet of state-directed stimulus, so real estate investment jumped 7 percent in May, the fastest rise in 14 months.

But it’s not only the banks which are lending to SOEs, the government is also directly involved in infrastructure spending. It has set a deficit target of 3 percent for 2016 and is on its way to meet it.



Like all stimulus, this won’t last forever, though.

“State sector spending may remain strong for another couple of quarters as the delayed impact of earlier policy easing continues to feed through but it is likely to begin slowing by the end of this year. The continued deceleration of private sector investment means the risk is growing that as policy support wanes, the economy could face another downturn,” the research firm Capital Economics writes in a note.

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Every economy has themes. For the Chinese economy, the only theme up until recently was rapid growth. First because of exports, then because of investment in infrastructure and factories.
The Chinese economy of 2016 has many different themes. One theme is an unprecedented economic slowdown, reflected in official numbers and much worse in unofficial estimates. But then there is the theme of rebalancing. The old economy of manufacturing, investment, and exports is slowing down but the new consumer and services led economy is supposed to take over the baton.
With official sector data notoriously unreliable, China analysts get conflicting messages and don’t know which theme is actually happening. To shed light on this murky situation, Leland Miller and his team at the China Beige Book (CBB) interview thousands of companies and hundreds of bankers in China each quarter to get an accurate gauge of the themes prevailing in the Chinese economy.
Led by rising layoffs at private firms, first quarter job growth took another notable hit.— China Beige Book

CBB collects data from thousands of Chinese firms every quarter including some in-depth interviews with local executives. 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.
Labor Weakness
The most interesting finding of this quarter’s report is that the labor market is finally reflecting the weakness in the general economy. This hasn’t been the case throughout the slow-down, which started in the second quarter of 2014 according to the CBB data.
“Led by rising layoffs at private firms, first quarter job growth took another notable hit, sliding to a new four-year low. Expectations of future hiring have also taken a dive,” states the report. Only 23 percent of respondents said they were hiring, with 15 percent of companies said they are firing. China has announced it will lay off millions in the moribund steel and coal sectors of State Owned Enterprises (SOE). However, the CBB survey indicates it was mostly private companies which didn’t want to hire more workers.
Only 28 percent of the companies said they will hire in the near future. Another interesting development is the slowing growth in the country’s supply of skilled and unskilled labor. The constant flow of rural workers to the cities dramatically increased productivity over the last 20 years and provided China with a low-cost labor advantage. However, many analysts now estimate that the Lewis Turning Point has been reached and China’s working age population is declining. The CBB report confirms this thesis, as only 33 percent and 24 percent of the companies reported growth in skilled and unskilled labor.
The good news: Profit growth stabilized overall and didn’t further deteriorate compared to last quarter, although the report notes this may be due to cost cutting and layoffs.
Old Economy
Capital expenditure increased at only 33 percent of companies, a record low in the 5-year history of the CBB. Again it was private companies leading the way here, whereas SOEs tried to budge the trend. Another part of the old economy—manufacturing—continues to deteriorate, especially when compared to the first quarter of last year. Only 42 percent of companies reported revenue gains, which technically means the sector is in recession. 
Collectively, our data show that that firms first stopped borrowing, then cut spending, and now are becoming allergic to hiring. — China Beige Book

Most notable here is the textile sector, which has lost competitiveness due to higher wages. As a consequence, multinational companies relocate their production elsewhere in Asia or even back to the United States. The number of companies reporting gains crashed by 31 percentage points to only 24 percent compared to last year.
The last part of the old economy, the manufacturing export sector, is also very weak, with only 27 percent of companies reporting revenue gains.
The CBB cautions that any kind of monetary easing, like the Reserve Requirement Ratio cut earlier this year, is not having its intended effect. Only 16 percent of companies say they are borrowing money. Again, contrary to the People’s Bank of China’s (PBOC) easing effort, interest rates at banks and shadow lenders increased, presenting an interesting paradox. The central bank eases credit conditions, firms do not wish to borrow, and yet interest rates are on the rise. Unfortunately, the CBB doesn’t explain this phenomenon but succinctly summarizes the current state of affairs like this: 
“Collectively, our data show that that firms first stopped borrowing, then cut spending, and now are becoming allergic to hiring.”
The PBOC has been cutting reserve requirements but the CBB days it didn’t help much (Natixis)
So what about the new economy? Services, consumption, retail?
“Revenue growth in retail and services each slowed again in the first quarter, a rebuke to those analysts who optimistically repeat the mantra of ‘two-tiered economy’ in lieu of compiling relevant data.” So no, at least for now, even though e-commerce companies reported gains.
The worst performers in retail were textile and furniture and appliances. The China watchers who speculated the home furnishing section would take a hit because of a slowdown in property were right. 
Services presented a mixed picture, with 47 percent of firms saying their revenues increased, which is down from 48 percent compared to a year ago and not enough to take over from the old economy.
Within the service sector, China shows a remarkable similarity to the United States: The strongest subsector was healthcare.
As for the property market, residential is still under pressure but commercial property showed a rebound compared to the last quarter.
“Talk of a property rebound was also accurate only on the surface, in light of sharp differences by city size, region, and commercial (soaring) or residential (plunging) orientation,” the report states.
With respect to the official data rebound in prices and record volumes of used homes transacted in residential real-estate, the CBB survey poses more questions than it answers. Or maybe we should just trust the data on the ground and not the officially reported ones, as Andrew Kollier of Orient Capital pointed out: “I don’t trust the official figures of a rebound because

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The good news first. The slowdown in the Chinese economy and lower commodity prices mean more money for the consumer in the West.
“What happens to the overall world economy depends on whether the boost to income and spending of the consumer will outweigh the hit to the income and spending of the producers,” says Diana Choyleva, chief economist of Lombard Street Research.
While mining companies like Anglo American PLC and commodity traders like Glencore PLC are suffering, consumers are enjoying lower prices, especially regarding gasoline.
U.S. disposable income has gotten a boost from low commodity prices (St. Louis Fed)
But while consumers in the European Union have spent most of it according to Choyleva, consumers in the United States are staying put because a big chunk of their savings is tied up in the stock market.
“The longer financial market volatility continues, the more likely it is that the American consumer will continue saving the real income gains and not spend them,” says Choyleva.
Good for China
The same is true for China. Take money away from the producers and put it in the consumer’s pocket. A devaluation of the currency could help this process, says Choyleva.

“An open capital account and weaker currency will produce higher domestic interest rates. It’s exactly what China needs in order to move toward higher consumption,” she says. Because most of Chinese household savings are in interest bearing deposit accounts within the banking system, higher rates mean higher income and thus higher consumption.
Lower Chinese investment by producers and the government, on the other hand, would enable Western businesses to pick up the slack and increase business investment.
Given where debt-to-GDP is at the moment, it actually has at most one or two years to do the wrong thing before it blows up.— Diana Choyleva, Lombard Street Research

As for higher import prices because of a weaker currency, Mrs. Choyleva says this is nothing to worry about because China doesn’t actually import a lot of consumer good but rather commodities needed for investment.
Bad for China
However, it looks like Western central banks aren’t letting China get away with this strategy. “It would have been much better for them to let the currency go in a one-off fashion. But of course, that would be like a red rag to the bull; whether it’s the Japanese bull or the American bull,” says Choyleva.
The Bank of Japan has recently reiterated its aggressive stance on monetary easing and even told China to implement stricter capital controls to stem capital outflows and prevent a depreciation.
“We are in the midst of a currency war. It’s quite clear that if every major central bank in the world tries to devalue its way out of trouble, no one will succeed, unless of course, we find life on Mars,” says Choyleva.
It has in the past, when its run into these hurdles, tried to go through one last, great surge of lending.— Evan Lorenz, Grant’s Interest Rate Observer

Evan Lorenz of Grant’s Interest Rate Observer thinks a sharp Chinese devaluation would definitely make in onto the U.S. election agenda in 2016.
“It would be a political catastrophe right now. We’re in the middle of a U.S. election right now. China has already become an election issue. I have to imagine that the Republican front-runner Donald Trump is going to make China headline news until the election in November should they devalue 10-15 percent. That may lead to trade sanctions or some problems for China down the line,” he says.
Ugly for China
Evan Lorenz has a more pessimistic view on the whole China rebalancing story. “It does seem like China’s overinvestment bubble is starting to pop with bad repercussions for China and the rest of the world,” he says.
He says China has a massive debt problem (240 percent of GDP officially), which is impossible to solve without dramatically slower growth. The regime has recently set a target of 6.5 percent to 7 percent, but Lorenz thinks this won’t be achievable.

“It’s unclear whether it’s going to be 0, 1, 2, or even -1 percent but I do expect lower growth,” he says. The real problem, however, would be for China to inflate another bubble to counter slow growth.
MORE:China Boosts Debt in December, the Market Doesn’t Buy ItChina and Greece Show Not All Debt Is Created Equal
“If the authorities throw money at the problem, forget reform, maybe we will have a short-term relief rally. Given the alarming pace of increase in debt in China, given the investment excesses of the past, given the lack of structural reform in places like Japan and the Euro-area, then it’s very unlikely that this will be a healthy and long term improvement. On the contrary, the fallout from that sort of policy would be much worse,” says Mrs. Choyleva.
“It has in the past, when its run into these hurdles, tried to go through one last, great surge of lending and we saw that around the transition of CCP chairman Xi Jinping in the last Congress of 2012,” says Lorenz.
It seems China is following this “great surge” policy in 2016 as well as it has created more than $1 trillion in total debt financing until the end of February, a new record.
This will not end well, according to Mrs. Choyleva: “China doesn’t have another ten years to be blowing up bubbles and kicking the can down the road. Given where debt-to-GDP is at the moment, it actually has at most one or two years to do the wrong thing before it blows up. The positive take on this is that it still has the funds to clean up the excesses now if it does the right thing.” If it does the right thing.

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Another book written in 2012 that too few people paid attention to. If they had, they could have easily predicted and avoided the current troubles in China. From the inevitable overinvestment, to environmental destruction, to the futility of monetary policy and the chronic lack of innovation, Mark DeWeaver covers it all—in history, in theory, and in modern-day (mal)practice.
The biggest myth he dispels about the Chinese economy is that it’s socialist in name only and run by private enterprises big and small alike.
“Perverse incentives at the local government level continue to be the underlying drivers. Neither extinct nor even endangered, the animal spirits of the Maoist era are still thriving more than thirty years after the introduction of China’s ‘reform and opening’ policy in 1978.”
When ‘numbers produce officials and officials produce numbers,’ as the Chinese say, outright fraud will be an issue as well.— Mark A. DeWeaver

Local Distortion
The local governments in very ordinary terms do whatever they want until Beijing throws the baby out with the bathtub and restricts all investment activity everywhere.
“Booms are led neither by Beijing nor by the private sector, but by local government officials motivated by interests all their own,” DeWeaver writes.
So what are the local government’s, or the local government official’s, interests? No, it’s not like it says in the CCP’s constitution, that a party member should always put the party ahead of personal interests.
In fact, it’s these very personal interests that drove overinvestment in industrial capacity and real estate. The CCP rewards local officials through a tournament system where they compete against other local officials to get the best numbers, be it GDP or otherwise, with devastating results for capital allocation and the natural environment.
“When ‘numbers produce officials and officials produce numbers,’ as the Chinese say, outright fraud will be an issue as well.”
Mark A. DeWeaver
A good example is China’s goal to have non-hydro alternative energy cover 8 percent of installed capacity by 2020. Because the emphasis is on capacity and investment expenditure, 26 percent of China’s wind-power capacity was not connected to the power grid at the end 2010. Many of the wind farms are continuously blasted by sand from the desert, leading to mechanical failures and defects.
This is also the reason why every province and second-tier city in China needs its own airport, regardless of economic viability. “Some ‘image projects’ have no discernible rationale at all aside from creating the impression that officials are getting things done.”
Investment in infrastructure and real-estate generates GDP growth, the stick local officials measure each other against. They use tax breaks, cheap land, low-cost credit (channeled via locally-controlled banks) as well as waivers on centrally imposed labor and environmental regulations to attract private and public sector investment.
The PBOC has many of the same tools as the developed country central banks, but it uses them differently and they generally are less effective as instruments of countercyclical policy.— Mark A. DeWeaver

Because was is no downside for the local officials, at least not until Xi Jinping unleashed his anti-corruption campaign in 2013, capital was misallocated, the natural environment destroyed, and arable farmland converted into unused real estate.
Of course, there is plenty of upside in terms of corruption for the average local official. “Bid rigging is exceptionally easy to get away with because the same officials are often in charge both of inviting bids, in their capacity of transportation department employees, and submitting bids, in their capacity as managers of department-owned construction companies.”
No Central Control
DeWeaver then shows that the much-touted central government control and foresight only has very crude mechanisms to reign in wasteful local government spending.
First of all, most banks, whether central or local are ultimately controlled by the CCP. And it’s CCP officials who benefit most from corruption. “The bankers, whose primary allegiance is to the Party rather than to their institutions, still have little choice but to support local government projects.”
As for the central bank’s ability to manage credit, DeWeaver was way ahead of the curve in noting that the impossible trinity renders the efforts of the People’s Bank of China [PBOC] to control bank lending futile, and describes the process in great detail.
“The PBOC has many of the same tools as the developed country central banks, but it uses them differently and they generally are less effective as instruments of countercyclical policy.”
Innovation: We’ve Been Here Before
The icing on the cake of this book, however, is how DeWeaver deals with the claim that China will one day become a leading source of innovation, a narrative much espoused by consulting firm McKinsey for example.
Proponents of the China innovation story often cite the amount of money spent on research and development as well as the number of patents filed. But, like everything in China, and much like the local government GDP growth targets, these figures are given by the regime.
So the national “Medium- And Long-Term Plan for the Development of Science and Technology” targets R&D expenditure of 2.5 percent of GDP by 2020. Lo and behold, China spent 2 percent of GDP on R&D in 2013 producing little, if any, countable results. The same target goes for patent filings, where China is supposed to be number five globally in 2020. In 2014, it was number one already, without anybody in the world noticing.
“This way of thinking substitutes quantity for quality, just as [with] the targets for steel tonnage during the Great Leap Forward,” writes Weaver.
So it comes as a small surprise that more than half of China’s science and technology R&D funding is wasted on non-research activities like business trips, meetings, and entertainment, according to a recent report by
DeWeaver also notes that this push for innovation is not a new idea. In fact, the sixth five-year plan of 1982 has much the same content than the 11th and 12th five-year plan, other than the specific mention of scientific development.
Much like the Soviets in the 1980s, DeWeaver notes that you can plan to innovate as much as you like; as long as you get the incentives wrong, all you are going to get

Read the full article here

James Gorrie chose to start his book “The China Crisis” with a quote, a Chinese proverb.
“Men in the game are blind to what men looking on see clearly.” Written in 2012, the nadir of China’s power and popularity in the world, the book could not have a more fitting opening.
Everybody, except for maybe human rights activists, thought growth in China would continue forever, that the Chinese regime had somehow invented a new economic model far superior to everything else history has ever seen.
Gorrie did not think so. He set out to prove to the reader that almost every mainstream assumption about China’s economic power and political system are naïve at best and flat out wrong at worst.
Now at the beginning of 2016, the tapes of global stock markets are painting China Crisis in red ink almost every trading day. And although more people are seeing clearly now, this is a good opportunity to revisit a book written with the right ideas at the right time, weaving history, economic theory, and up to date examples together to offer a compelling case for a China in crisis.
What’s Wrong
By now, most people know that China’s GDP numbers “are first and foremost political propaganda tools, not economic tools, as they are in the West,” according to Gorrie.
Since the middle of 2015, we also know China indeed ran into trouble for manipulating its currency for decades, as Gorrie pointed out.
We also know the government and the Communist Party are “corrupt in every way possible,” as highlighted by the ongoing anti-corruption campaign.
Eventually, as China loses its tight grip on Xinjiang and Tibet and the internal situation deteriorates, the CCP will lose all ability to control China as a whole.

Most people also know about inefficiencies in the old economy, the overcapacity, and some people are waking up to the immense debt bubble China created.
But “The China Crisis” goes far deeper than that, explaining important and often underestimated issues, like the moral degradation of society, the tragedy of the commons (think of the destruction of natural resources), the inability to produce enough food, as well as the political inability to reform, even when absolutely necessary.
“The China Crisis” also explains how this will lead to massive civil unrest (already happening) and eventually a collapse of the whole corrupt Chinese political system and economy, as well as its impact on the rest of the world.
It’s the Party Stupid
Unlike some other economists who apologize for human rights abuses in the name of economic development, James Gorrie says the Chinese Communist Party is at the heart of all problems in China, not just the economic ones.
“The country and its people experienced enormous tragedies borne of the unbelievably damaging and misguided economic and development policies made exclusively by the Chinese Communist Party leadership,” he writes.
The “tragedy of the commons,” still happening today is a great example. Gorrie explains how the corrupt incentive structure of the CCP encourages economic actors to overuse and downright destroy common property such as farmland, rivers, lakes, oceans, and air.

The abuse and destruction of nature in general and the conversion of farmland for industrial uses in particular have led to a situation where China is dependent on food imports to feed itself, and Chinese people cite food shortages as the biggest threat to their well-being.
Natural destruction is just one side of the unsustainable economic model of overinvestment and credit expansion. Gorrie notes that China’s practices of stealing technology and market share in global trade through underhanded means have hit a brick wall and don’t provide the economy with the juice anymore to keep it going.
China’s Beijing model “is instead a process or policy of Cannibal Capitalism… The various parts of the economy—rather than synergistically growing and expanding the GDP and wealth-creating processes of a nation—actually feed upon one another, destroying the wealth-creating factors in the economy through waste, neglect, graft, and corruption at the highest levels,” Gorrie writes.
The Collapse
The Beijing model is also thoroughly unbalanced, making a few corrupt CCP cadres better off at the expense of the middle class. The unequal distribution of income in a slowing economy, as well as the decline in traditional Chinese values due to CCP campaigns, will eventually lead to social unrest doing away with the CCP empire altogether.
Gorrie offers an account how it could play out, which does not include reform from within the CCP, which he deems to be improbable if not impossible.
Food shortages, as well as social dissent because of land grabs or unemployment, may lead to riots so numerous that CCP cannot control them despite the use of the army.
One or several of China’s renegade provinces such as Xinjiang and Tibet may declare independence, and China will increase its sabre rattling toward Taiwan and Japan, possibly drawing the United States into a regional conflict.
Capital will start leaving the country through Hong Kong, which sounds eerily familiar in 2016. Gorrie thinks wanton selling of treasuries by China may also crash the U.S. bond market, something that hasn’t happened in 2015 despite more than $500 billion of foreign exchange reserves sold by China.  
“Eventually, as China loses its tight grip on Xinjiang and Tibet and the internal situation deteriorates, the CCP will lose all ability to control China as a whole,” writes Gorrie.
As a new “anti-ccp” leader emerges and transitions China towards democracy, the rest of the world will suffer from a dollar collapse brought about by Chinese selling, as well as a collapse of world trade, with widespread bankruptcies starting with the financial sector.
So far the U.S. bond market is holding up well, although the crash in European banks in 2016 so far should give us some pause. But then again, China is not officially in crisis yet.

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Until now, most of the action has been taking place overseas, far away from American shores. But in an interconnected global economy and financial system, the China crisis is already impacting the United States and will soon impact you too—both positively and negatively.
Financial markets reacted first. China’s stock market is down 22 percent this year. Japan is down 14, Germany 16 percent, all of them extending their slump from 2015.
Relatively speaking, the United States is doing well—the S&P 500 is only down 9.3 percent. But even America won’t be able to save itself from the contagion of a Chinese economy on the edge of the abyss.
Growth in China has slowed to a number much lower than the official 6.9 percent. Capital is leaving the country by the hundreds of billions of dollars every month, the stock market is crashing, and the currency depreciating.
The Ghost of 1997
“There are worries about a rerun of [the 1997 Asian financial crisis] of a series of competitive devaluations,” says Sherle Schwenninger, director of the World Economic Roundtable at the think tank New America Foundation.
Whether competitive or not, almost all emerging market currencies from the South African Rand to the Turkish Lira and the Chinese renminbi are falling against the dollar, exacerbating a problem which started in China in late 2014.
Schwenninger says if emerging market currencies fall in value, dollar debt increases in value, which makes it harder for companies and countries to pay it back. And it’s not just China that has lots of it, $870 billion according to the Bank of International Settlements.   
Those two factors together, China and commodities, are both stimulative for the world economy and a central part of the adjustment to get away from the post crisis distortion.— Charles Dumas, Lombard Street Research

“The larger amount of corporate dollar debt is held by Asian economies and the Western exposure ripples through London Hong Kong and European banks. … The Hong Kong banks are heavily exposed to China’s state owned enterprises,” says Schwenninger.
“Deutsche Bank is a perfect example. They are knee deep in all that stuff,” says Jeffrey Snider, chief investment officer of Alhambra Investment Partners. Deutsche Bank shares are down 39 percent this year, a little more than the shares of Swiss bank Credit Suisse (-35 percent), which Snider says invested too much in its Fixed Income, Currencies and Commodities (FICC) division, or everything that is suffering right now. As a comparison, U.S. bellwether JPMorgan Chase & Co. is only down 13 percent.   
But the banks aren’t just exposed to corporate debt from Asia. The China slowdown has wreaked havoc among energy and commodity traders and producers alike.
Commodity Carnage
“There are systemic linkages to the international financial system. Major commodity firms may end up defaulting in 2016. This is coming to play out in the coming months as more and more cracks are appearing in the commodity complex,” says John Butler, head of wealth services at Gold Money.

Energy and commodity producers world-wide were counting on China to keep on growing 7 percent every year indefinitely and invested hundreds of billions to expand supply.
Once demand for commodities started slowing in China, prices for copper (down from $4.5 to $2.12 per pound since Jan. 2011) and iron ore (down from $180 per ton to $38 per ton since 2011) crashed. China is not alone responsible for the decline in the oil prices (West Texas Intermediate is down to $31 from a little over $100 in 2011) but this trend is also hurting producers and the banks who underwrote the loans to energy companies.
“People were holding oil and copper and other things not because of good fundamentals but because they thought the returns there would be greater than in Treasurys and German government bonds. A lot of that money has come out of the market. Hedge funds have been delevering and liquidating their positions in the China growth story. You had the rush of money out, which creates a contagion effect,” says Schwenninger.
I think the idea is that you feel so smart and so wealthy because of appreciating asset prices that you are led to consume more. I think the empirical evidence for this wealth effect is very, very slight.— James Grant, Grant’s Interest Rate Observer

“There is a lot of bad collateral out there, there is a lot of junk debt that has been overvalued and it is going have to be written down,” says Butler.
Shares in British commodity trading companies like Glencore PLC is down 62 percent over the last year. The mining company Anglo American PLC is down 68 percent and announced it would fire tens of thousands of its work force.  
Multinational Impact
Even if U.S. banks for once are not exposed to the epicenter of the crisis, the fact that three large sectors of global multinationals (banks, commodities, and energy) are on the defensive means it has an impact on the earnings of U.S. multinationals as well.
“American multinationals who depend on global markets are going to be hurt competitively, and we have seen that show up,” says Schwenninger. Apple Inc. is down 11 percent in 2016, partly due to a bad earnings report, which blamed China for weak iPhone sales.
Apple’s share price year-to-date (Google Finance)
“We are coming off four or five quarters of negative earnings growth,” says Snider, who also believes the market has lost faith in central banks to fight off a global crisis. “It’s the idea of transitory. It’s all short term, don’t worry about it,” he says has been the mantra of global central banks the market has believed in so far, but not anymore. “The fact it has dragged on over a year, the idea of transitory and temporary weakness is no longer plausible.”
So how does this affect you? Unless you own a lot of stocks in general or the weak sectors in particular or you work for a shale gas producer, the whole China slow-down could actually have a positive effect on the consumer.
We are coming off four or five quarters of negative earnings growth.— Jeffrey Snider, Alhambra Investment Partners

It’s the exact opposite of

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Despite the efforts of investment bank analysts, the market just doesn’t buy the 14.4 percent increase in debt financing in the Chinese economy in December.
Theoretically, an increase in debt means higher growth, says Goldman Sachs: “Today’s figures suggest the overall policy stance remained supportive in December, which provided support to growth.”
Or according to Everbright Securities’s chief Economist Xu Gao: “China can use its savings to boost economic growth as long as it wants.”
So why is the Shanghai Composite down 3.55 percent to 2900, a level last seen in 2014? Why is the Dow Jones down 2 percent in early Friday trading?
Because boosting debt by 14.4 percent means very little in the deflationary Chinese economy.
“Chinese growth in recent years has been of extremely low quality. Productivity has only accounted for 5.7 percentage points of growth since 2008, with the rest coming almost entirely from investment. The result is that debt has soared to 282 percent of GDP,” writes Andrew Lees of Macro Strategy.
The amount of new debt China needs to generate a unit of GDP growth. (Macquarie)
In other words, increasing debt and pouring the money into ineffective investment projects is counterproductive, at least according to the Academy of Macro Economic Research. It estimates the country wasted $6.9 trillion from 2009 to 2014.
If you waste money and don’t generate a return, you get lower and lower returns and at one point the debt will be impossible to pay back.
“You reach a peak level of debt, people will not be borrowing beyond that point,” says professor Steve Keen of Kingston University in London and author of “Debunking Economics.”
According to Macquarie research, China now needs to $3-4 in debt to create only $1 in GDP growth.  “Unless there are significant structural shifts, China requires more than $2 trillion incremental debt to generate 5-6 percent nominal GDP growth.”
Well, according to the latest data, it looks like they are at least trying.  

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Last time around in the third quarter, the China Beige Book’s survey of thousands of companies provided a glimmer of hope for the Chinese economy. It painted a picture of stability, rather than collapse.
In the fourth quarter of 2015, this is no longer the case.
The results “tell a story of pervasive weakness, national sales revenue, volumes, output, prices, profits, hiring, borrowing, and capital expenditure all weaker on-quarter,” the report states.
China Beige Book (CBB) collects data from thousands of Chinese firms every quarter including some in-depth interviews with local executives. Although the CBB does not give definitive growth numbers, it logs how many companies increased their revenues or for how many sales declined. 
Example: The number of companies reporting an increase in profits was the lowest since records began at only 37 percent; 22 percent of companies reported a fall in profits. Even the services sector, a bright spot during last year’s quarter took a hit.
Some policy choices simply will not work … It’s past time the ‘stimulus mafia’ rethinks its Pavlovian responses. Reform or bust.— China Beige Book

“Both manufacturing and services performed poorly, with revenues, employment, capex, and profits weakening in each. The popular rush to find a successful manufacturing-to-services transition will have to be put on hold for a bit,” the report states.
So even if the companies don’t say how much profits increased or decreased, the CBB sample provides an accurate snapshot of where firms are headed on aggregate.
“This is one quarter, it’s not yet a trend. But the data are interesting and different enough to raise at least  a yellow flag right now,” says Leland Miller, president of CBB.
The price level also changed for the worse. Whereas growth slowed down throughout the year, prices were flat to stable. Not this quarter. “Gains in input prices, sales prices, and wages all hit the lowest levels CBB has ever recorded,” the report states. “For the first time, it looked like firms were encountering genuinely harmful deflation.”
Falling prices, whether it is commodities, real estate, or wages, indicate there is too much supply. Falling prices resulting from gains in productivity aren’t bad. It’s bad if they fall because of oversupply, which makes servicing debt a lot harder.
So the last man standing is the labor market, long known to be the most important factor influencing the decision makers in Beijing. If the CBB analysis is true, the situation is also far worse than expected.
As a reminder, reliable employment data is notoriously hard to come by and maybe the most unbelievable of all of the official data out of China. The official unemployment rate has hovered around 4 percent (4 percent to 4.3 percent to be precise) for the last 10 years.
“Job growth took a pronounced hit, while labor supply (both skilled and unskilled) became less available. … If labor market weakness persists, Beijing will feel increasing pressure to ramp up its policy response,” the report states. Judging from the fiscal deficits China started to run this year, it may already feel the pressure, as 16 percent of companies surveyed fired people.  
The mining sector also suffered, with more firms reporting decreases in revenue rather than increases.
Stimulus Doesn’t Work
CBB, however, finds both monetary and fiscal stimulus don’t work, as two classic outlets for government spending (transportation and transportation construction) had profits disappear and revenues plunge. The shipping industry fared the worst, with more companies reporting a drop in revenues rather than an increase.
On the monetary side, China cut interest rates six times this year, but CBB says the credit transmission mechanism is broken, because companies don’t want to borrow. “The share of firms borrowing hit a record low of 14 percent, despite a lower cost of borrowing from banks,” the report states. Over the four years of the survey’s existence, the percentage of firms that said they were borrowing money fell by two-thirds.
This is “good for restructuring, bad for short-term growth.” Not surprisingly, the number of firms reporting an increase in capital expenditure also fell to a record low.
In financial markets, the CBB report shows a remarkable decline in appetite for credit, as yields rose to 9 percent and issuance halved compared to the third quarter. Safer bank loans yield less compared to last quarter, where riskier non-bank loans yield more. A classic case of selective lending only to safe creditors who don’t need any money.  
Real estate was more or less stable, residential construction even showed an increase in firms reporting gains.
Another relative positive was retail spending which increased at 46 percent of the firms, but the increase was lower than last quarter’s. So the consumer is not dead, but it’s also not coming to the rescue as policy makers would have you believe.  
As Epoch Times reported recently, the regime is stimulating on all fronts to stem the tide. But CBB is not too optimistic it will work out and urges the regime to really reform the economy.
“Some policy choices simply will not work. … It’s past time the ‘stimulus mafia’ rethinks its Pavlovian responses. Reform or bust.”
About the China Beige Book: The China Beige Book™ uses quantitative and qualitative data to track on-the-ground sentiment as it changes from quarter to quarter across China’s industries, key sub-sectors, and regions. The quarterly report regularly surveys over 2,100 firms and 160 bankers across China, in addition to conducting in-depth interviews with C-suite executives throughout the country.

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China is growing fond of currency baskets. After the International Monetary Fund added the yuan to its reserve currency basket, China decided it wants to use a basket to track the exchange rate of its currency, rather than just the U.S. dollar. 
This opens the door to further yuan depreciation, not to increase growth, but to prevent mass unemployment. 
China has tracked the movement of the dollar until 2005, when the People’s Bank of China started to adopt a softer peg, but still kept the exchange rate under close control. This summer, the PBOC almost abandoned the peg and devalued the yuan, much to the surprise of the market. Since then it has gradually managed the decline against the U.S. dollar and that’s where the new basket comes in.
Like the IMF’s special drawing rights (SDR) basket, the trade weighted index of the PBOC is an empty basket. It just provides a reference to the value of the Chinese yuan compared to the currencies of its most important trading partners.
The U.S. dollar expressed in Chinese yuan. Down means yuan appreciation (Google Finance)
Under normal circumstances this is hardly worth mentioning. The U.S. dollar index or DXY is exactly the same and nobody ever thought it strange.
These baskets help to gauge policy makers whether their currency is over or undervalued against its most important trading partners. In the case of the Chinese currency for example, the yuan isn’t much overvalued compared to the U.S. dollar, but more so against other currencies.
The Chinese yuan compared to several global currencies (SLJ Macro Partners)
The Chinese Foreign Exchange Trade System (CFETS), which is part of the PBOC and calculates the basket, said as much in its original press release: “Therefore, the renminbi is a relatively strong currency among the major international currencies.”
Mark Williams, chief economist of Capital Economics says: “Because of the link to the strengthening dollar, the renminbi has appreciated significantly in trade-weighted terms. Yet any sustained weakness in the renminbi relative to the dollar tends to be interpreted as ‘devaluation’ and trigger market concerns.”
Yes, the mini devaluation in August did not even reach 3 percent and yet financial markets across the world went haywire at the end of the month.
Since the IMF added the renminbi to its SDR basket, the PBOC let the yuan drop for seven consecutive days as of Dec. 15, the biggest devaluation record, again very much under the scrutiny of the media and financial markets.
 The yuan dropped another one percent against the dollar since Nov. 16, the day China was all but certain it would get the approval for the SDR.
If China wants to significantly devalue against all of its major trading partners, it will have to devalue even more against the dollar, which only makes up 26 percent of the basket and has been rising against other big currencies like the euro or the yen, taking the yuan with it on its rise.  
The renminbi expressed valued against the new CFETS indext and a BIS index (Goldman Sachs)
Because “the authorities have increasingly drawn public focus to the renminbi’s performance on a trade-weighted-index basis rather than simply against the U.S. dollar, it reinforces the likelihood of moderate depreciation versus the U.S. dollar, should the broad U.S. dollar continue to strengthen,” Goldman Sachs writes in a note.
In other words, according to Goldman Sachs, it gives Beijing an excuse to say, “Our currency is very overvalued and we need to depreciate, especially against the U.S. dollar.”
Analysts at Macquarie think the yuan could weaken as much as 5 percent against the dollar in 2016. Most analysts, however, believe the yuan is about 15 to 20 percent overvalued on a trade weighted basis. With the new excuse in the form of the basket, this makes are larger devaluation against the dollar more likely.  
Why They Are Doing It
Why is China going to great lengths to justify devaluing its currency not just against the U.S. dollar but also against the currencies of its major trading partners?
Many analysts believe it’s because China wants to boost growth through exports. This, however, is unlikely.
“They were at the peak which was just a few years ago. Their net exports were 8 percent of GDP. Now it’s just a couple of percent of GDP,” says Richard Vague, author of “The Next Economic Disaster.” Net exports contribute almost nothing to GDP growth.
According to World Bank data, the share of total exports of GDP has been declining to 22.6 percent in 2014 from 25.5 percent in 2011. So what is all the fuss about?
China’s and the world’s share of total exports as a percentage of GDP (World Bank)
Trade still significantly contributes to employment in China.
“China is so much about jobs as opposed to profits, it is very important for the government to maintain jobs,” says billionaire investor Wilbur Ross of WL Ross & Co.  
It’s especially important to maintain jobs when the economy is slowing down and labor costs are becoming less competitive. In this respect, 2015 was a complete disaster:
“From January to November 2015, China’s exports of labor-intensive products contracted by 6 percent year on year while exports of hi-tech products were flat. China’s processing exports, which are built on low labor costs, fell 10 percent, while China’s ordinary exports increased by 2 percent,” investment bank Macquarie writes in a note.
According to a report by the Bundesbank, employment from exports was still 80 million people in 2009 (or 10.2 percent of total employment) down from 99 million in 2007 (12.9 percent of total employment).
Although the report was released in 2014, the data from 2009 is a bit dated and also reflects the fall in employment because of the financial crisis.
According to a report by the George Washington University, more than 20 million people lost their jobs in Chinese coastal areas after the financial crisis—the main reason China started its infrastructure and investment program, which provided work but also produced massive overcapacity.
Exports picked up shortly after for a couple of years but have been declining for the last five months in 2015.  
Because investment spending is

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The real number of China’s GDP growth will remain a mystery. There are some other official numbers, however, which make it very clear China’s model of generating growth through investment has run its course.
After the financial crisis in 2008, China ramped up spending on infrastructure and productive capacity to maintain GDP growth higher than 10 percent. To this day, fixed asset investment—private and public—makes up almost 50 percent of total GDP, or $5 trillion dollars.
This basically means digging up a whole lot of earth and putting nice and shiny things like bullet trains in the resulting whole. What do you need to dig up earth? Right, excavators, tons of them.
In the heydays of investment spending, the country bought almost 50,000 excavators in a single month. Since January 2014, however, this trend is officially over. Excavator sales volumes are down 38 percent for the period spanning January to November 2015, compared to the same period in 2014, according to research by Goldman Sachs.
(Goldman Sachs)
So maybe China now has enough excavators and doesn’t need to buy new ones, but is still using the old ones? No. Excavator utilization hours declined 7 percent in October 2015 compared to last year. This is better than the -50 percent drop in January of 2015, but utilization hours are far off the highs reached in 2011 and 2012.
(Goldman Sachs)
Another important indicator tracking the 50 percent of economic activity is freight railway traffic. It’s down 12 percent from January to November 2015 compared to the same period last year. Locomotive train sales are down 4.6 percent from January to September before recovering a little bit in October.
(Goldman Sachs)
Overall infrastructure spending improved a little bit in November, growing 10.2 percent in November of 2015 compared to a year ago and 9.4 percent in October of 2015. This includes electricity, gas, water, transport, storage, postal, and water conservancy.
Fixed Asset Investment (FAI) in total renminbi and year-on-year growth (Goldman Sachs)
Looking at the longer term trend, this looks like a dead cat bounce, rather like a sustainable bottom. And it comes at a price. China has previously chosen state banks to funnel money into investment projects, boosting bank assets from $10 trillion in 2009 to $30 trillion in 2015.
Since then, loan growth has also slowed down as banks are hitting balance sheet constraints. The last straw is fiscal spending and both the national and local governments have been running fiscal deficits averaging $100 billion for the last three months. Expenditure increased 18.9 percent during January to November 2015 compared to the same period last year.
(Goldman Sachs)
Local governments have also taken full advantage of the debt swap program and ramped up issuance of bonds as well. Goldman estimates local governments and their financing vehicles have issued $620 billion in debt this year.
(Goldman Sachs)
Because the much anticipated shift to a consumer economy remains elusive, China has and is using every method possible to shore up growth: Fiscal spending, interest rate cuts, devaluing its currency and boosting its stock market.
If you were looking for a sign China is getting desperate, this is it.  

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Horace “Woody” Brock of Strategic Economic Decisions is a big fan of infrastructure spending. The economic scholar would have the United States invest $10 trillion in public infrastructure in the coming year.
According to Brock, however, China, has run out of roads to invest it. 
China is different from Russia. In Russia, when you have depressions, workers get drunk.

Epoch Times: China has invested the most in infrastructure of any country during the last decade. Will they have high returns in the future?
Woody Brock: The answer is crystal-clear. When you build roads to nowhere, empty cities, you have a big negative rate of return.
At first, China didn’t do that. Between 1981 and 2005, in my opinion, China brilliantly spent a lot of money, huge infrastructure, but they did it right. When they borrowed, they didn’t build a road to nowhere, there was a new city to go with the road and then there was a train.
They did this for 25 years. As theory says, this should’ve increased productivity and economic growth enormously and it did. Good theory is never wrong.
The regime is terrified of the people.

Epoch Times: But then what happened?
Mr. Brock: Before, you never heard one word about bad debt in China. But you did, starting in 2010. When the global financial crisis happened, China’s export strategy fell apart.

They hoped consumption would go up and investment would fall from 45 percent to 32 percent of GDP. This didn’t work so they had to go back to massive investment spending to keep people working when the export story fell apart.
They had to, because China is different from Russia. In Russia, when you have a depression, workers get drunk. But in China they riot and they hate the Communist Party who are mostly thugs and crooks.
The regime is terrified of the people. That’s why … Xi Jinping is telling banks: “I don’t care if you’re losing money, don’t stop funding these new things. Factories, don’t stop producing widgets. We have to keep people working.”
The regime of China went to its postbox and guess what was not in the postbox? A rent check.

Epoch Times: What’s your take on the current economic slowdown?
Mr. Brock: China is in trouble now and should be in trouble because it built 18 cities you can see through. It has huge debt only now because only now did they not stick to the drill and invest in good things. They didn’t.
They just kept people working. The world is impressed by the fact that China sailed through the Great Recession and kept its GDP going. Drilling holes to nowhere, as Joyn Maynard Keynes pointed out, does keep GDP growing.
But then something happened on January 3, 2013 when the world was in recovery. The regime of China went to its postbox and guess what was not in the postbox? A rent check. That there’s no growth and that was why some regional banks have collapsed.

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Top Chinese leaders continue to emphasize the need to clean up “zombie enterprises,” large, unproductive, debt-laden, state-owned enterprises that suck up resources and drag down the economy. On Nov. 4, China’s premier Li Keqiang called for “accelerating the pace of restructuring and consolidating ‘zombie enterprises,’ or have them leave the market.” Liu He, a top Communist Party economic official, also stressed a need to “increase efforts to clear out ‘zombie enterprises’ and effectively resolve overcapacity.”
Due to various complex factors, “zombie enterprises” have become a disease plaguing China’s economy that is very difficult to cure.
For many years, the Chinese economy has been trapped in a vicious cycle: the greater the efforts to resolve overcapacity, the worse the problem becomes.
For example, we have been combating overcapacity in steel, cement, and aluminum for years. Not only did production in these industries not decline, but it increased. Survey data from the National Development and Reform Commission, China’s economic planning agency, indicates that in the first half of 2014, capacity utilization was less than 75 percent in 21 out of 39 industries.
Many emerging industries in China have had the tendency of rushing headlong into massive action. They rushed in because of stimulus policies and within a few years turned shortage into overcapacity.
China’s photovoltaic industry has a serious problem of excess capacity, while the wind turbine industry has excess capacity of more than 70 percent. Most industries with overcapacity problems are very unprofitable. However, with the help from banks or the government, they always find a way to hold on and thus turn out to be a source of chronic disease in China’s economy.
State-Owned Enterprises
Most of China’s “zombie enterprises” share the following features:
1) They are large state-owned firms. These large enterprises have many employees and play an important role in the local economy. In order to maintain stability, the government does not let these companies go bankrupt. But it is difficult to help turn them around, so they maintain the status quo through continuous money infusions from banks or the government.
2) “Zombie enterprises” are mostly found in industries with problems of overcapacity, such as steel, cement, and electrolytic aluminum, used to make capacitors for a wide variety of electrical applications. These industries, on the one hand create a great deal of local GDP; on the other hand, there is no need for them to exist from an economic perspective. But in order to maintain employment, local authorities won’t let them go bankrupt.
3) Most “zombie enterprises” are found in low-level manufacturing. They add little value but add a lot of pollution and emissions.
4) Most of them have received excessive preferential policies and loans, and are often in heavy debt. For example, total liabilities in the steel industry exceeded 3 trillion yuan in August 2014. Eighteen publicly listed steel enterprises had debt ratios exceeding 70 percent.
Corporate Debt
Once the economy starts a downturn and investment slows, the debt burden will cause a range of knock-on problems. We need to realize that these “zombie enterprises” are like landmines that can cause a lot of damage to China’s economy. In the present economic downturn, China’s economy has already entered into a risk cycle.
Risk factors, such as debt, are testing the stability of the economic system. Corporate debt is the number one threat. Since 2012, China’s corporate debt has been above 113 percent of GDP, far higher than the international risk threshold of 90 percent.
In its October 2015 report, the IMF estimated that there is up to $3 trillion in debt accumulated by companies and banks in emerging market countries, with China at the top of the list.
Soaring bad bank loans and corporate debt defaults are related to the current economic cycle. It is also the result of too many “zombie enterprises” soaking up credit.
Credit Crunch
The many “zombie enterprises” have also caused a serious issue of mismatched resources.
Take another look at credit resources. Since the financial crisis, China issued a large amount of credit to resolve financing difficulties of small and medium-sized enterprises (SMEs). China’s M2 money supply, a measure of money that includes saving accounts and similar deposits, is close to 135 trillion yuan. But it is more and more difficult now for many SMEs to obtain bank loans.
China’s corporate financing cost is far higher than Europe’s and America’s because a large number of “zombie enterprises” are hoarding credit. This result is a vicious cycle: the more credit is issued, the tighter the liquidity and the more expensive the financing.
With the government trying to sustain inefficient “zombie enterprises,” competitiveness breaks down. Enterprises take advantage of the government’s obsession with GDP and abuse policies to benefit themselves. Hence China’s economy pursues low-end manufacturing and quick returns. This has created huge obstacles to upgrading the economy.
“Zombie enterprises” must be dealt with; it is the key to optimizing China’s resource allocation, and to realize a true upgrade on the supply-side of the economy. If the government is determined to get rid of the interference from local governments and allows “zombie enterprises” to be eliminated by the market, then entrepreneurialism and competitiveness will take root. The distorted phenomenon of Chinese enterprises rushing into low-end industries in the global industrial chain will naturally go away. And the hidden risk to banks will also be greatly reduced.
This is a translation of Ma Guangyuan’s Chinese article posted to his public WeChat account on Nov. 30, 2015. Ma Guangyuan is an well-known independent economist in China. Ma appears as a financial commentator on China Central Television, and his columns have been published in Financial Times Chinese, Southern Weekly, and elsewhere.

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In light of the yuan devaluation fireworks and the dire state of Chinese companies, Chinese local governments haven’t gotten a lot of headlines recently.
Except for a Dec. 2 Bloomberg report about the expansion of the local government debt swap program to 15 trillion yuan ($2.43 trillion and up from 1 trillion yuan at the beginning of 2015.)
Now we know why. As Chiecon reports, China’s local government debt increased 41.54 percent in 2014, according to data compiled by the 21st Century Business Herald and released on Dec. 3. Local debt data takes a long time to compile, so the finance ministry may have felt the need to act on the year-old data immediately and expand the limit.
The debt swap program simply allows local governments—indebted to the tune of 24 trillion yuan—to swap higher interest bank loans to lower interest bonds. The bonds are also bought by the same banks, but can then be posted as collateral with the central bank, easing their financing constraints.
This exercise not only lowers interest payments of the local governments, but also gives banks the opportunity to pass on the debt to the central bank, easing pressure on their balance sheet.  
By buying local government debt from banks and other financial institutions, the central bank replenishes their reserves and they could start lending to local governments again. Despite a high chance of this money being wasted, it would still go into the economy at first and probably benefit real estate as well. In addition, the central government can exert more control over local governments.
“The central government wants to get a handle on the expansion of credit. The debt swap program gives it a lever to selectively reward or approve of policies of specific local governments,” says Jim Nolt, author of “International Political Economy.”
The local governments desperately need the fresh money, because revenues from land sales have declined along with the slowing economy. According to the report by Chiecon, local governments are hitting centrally imposed debt limits and can’t borrow more. In the chart below, Guizhou for example has a debt limit of 900 billion yuan. 
 The red line represents the assets the local government has securing the debt in relation of the debt limit. In Guizhou’s case, the debt limit is 200 percent of available assets and Chiecon notes it’s very likely the provinces are actually at their limit, if not above. 
Because the debt swap program only lowers interest expense and doesn’t cancel the debt (at least for now), provinces will have very little financial fire power in the near future.
Chiecon: “Unfortunately for local Chinese residents in high debt areas, the local government’s waste of resources through inefficiency and corruption, and the need to channel more and more funds just to repay off old debt, equates to future investment in improving local services…denied.”

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George Soros, the legendary investor who made a billion dollars in a single day often spoke about his theory of reflexivity.
In short, a trade or investment or business decision is reflexive when its cause and effect become the same.
House prices in the United States rose because people got subprime loans to buy houses. The rising prices led to more people borrowing to buy houses which made prices rise even further. Until the music stopped.
It is a profoundly circular system which, like all circular systems, has to collapse eventually.
In the case of China’s overcapacity, this is also true. China invested heavily in infrastructure and production capacity over the last decade, driving commodity prices up.
Rising demand and rising prices then prompted mining and commodity companies in China and elsewhere to invest hundreds of billions in new mines and pits to profit from the trend.
This further increased commodity prices—mines consume resources too—, leading to further expansion projects, thus becoming reflexive in Soros’s sense.
Now the circle has reversed an is spinning backwards. China all but stopped investing in new infrastructure and production capacity because the projects don’t generate a return anymore. 
But this is just the demand side. With hundreds of billions of extra supply online, global commodity producers are churning out more production than ever, pushing prices down to levels not seen since the beginning of the new millennium. China is flooding the world with aluminum and steel.
 As a result of China’s slowing imports and falling prices, commodity producing countries are either in, or teetering on the brink of recession.
Global mining companies like Anglo American Plc, and Glencore Plc, have shifted gears and are laying off people and selling assets. They are facing billions in losses.
In China, the problem of too much debt spent on non-performing projects is much the same. 
 Earlier this year, Australian investment bank Macquarie reported 50 percent of Chinese mining companies cannot even cover the interest expense with their operating profits.
So those companies started to borrow more just to pay their interest expense. 
But it wouldn’t be China if the government didn’t get involved in the process of shaking out bad debts somehow. On Dec. 10, Bloomberg reported China is setting up a state-fund to take on bad debt from the mining sector.

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