The upcoming credit crunch in China is no secret.
China has $ 1 trillion or more in bad debt waiting to explode. These bad debts permeate the economy.
Some are hired by the Chinese provincial authorities who are trying to circumvent the spending limits imposed by Beijing. Some are direct business loans on bank balance sheets. Some are foreign dollar-denominated debts owed to foreign creditors.
The most dangerous type of debt involves a chain of insolvent companies buying debt from each other.
A single $ 100 million advance can be transferred from one company to another in exchange for a new promissory note, used to extinguish an old unpayable promissory note. Repeated enough times, the $ 100 million can be used as a front to support $ 1 billion or even $ 2 billion in bad debt.
These kinds of accounting tricks will land you in jail in the United States, but it’s an accepted practice in China as long as the CEO of the company is a “Princeling” (a politically connected Communist Party insider descended from the old guard. ) or an oligarch willing to pay bribes.
This state of affairs has existed for years. The question investors keep asking is, “How long can this last?” How long can the garland continue to operate to cover up a sea of bad debt and make the Chinese economy appear healthy?
Well the answer is the Ponzi probably won’t last any longer. Even compliant Chinese regulators are starting to expose bad loans and the banks that cover them. So the good news is that China is starting to tackle the problem. The bad news is that if China takes its bad debt consolidation seriously, its growth will slow significantly, as will global economic growth.
This is bad news for the global stock markets.
Essentially, China is faced with a dead-end dilemma. On the one hand, China has driven growth over the past eight years with excessive credit, wasted infrastructure investments, and Ponzi schemes like wealth management products (WMPs).
Chinese leaders know this, but they have had to keep the growth machine in gear to create jobs for millions of migrants coming from the countryside to the city and to maintain jobs for the millions more already in the cities. .
The Chinese Communist leadership knew that a day of judgment would come. The two ways to get rid of debt are deflation (which results in write-offs, bankruptcies and unemployment) or inflation (which results in purchasing power theft, similar to a tax increase. ).
Both alternatives are unacceptable to communists because they do not have the political legitimacy to endure unemployment or inflation. Either policy would cause social unrest and unleash revolutionary potential.
The Tiananmen Square protests and the 1989 massacre did not start as a freedom movement, although they are remembered in the West as well. It started out as an anti-inflationary protest, and that’s how the Communists remember it.
Instead of these nasty extremes, China’s leaders are trying to go a middle course with gradual financial reform and gradual limits on the shadow banking system. I have already predicted that this gradual policy would not work because the credit situation is so extreme that even modest reform would slow the economy down too quickly for comfort.
This is exactly what happened.
China has already turned around and eased its financial reforms. It works in the short term but only worsens the credit bubble in the long term.
China may soon resort to a combination of debt consolidation and maxi-devaluation of its currency to export the resulting deflation to the rest of the world. When that happens, perhaps later this year in response to Trump’s new trade war with China, the effects will not be confined to China.
A shock maxi-devaluation of the yuan will be the gunshot heard around the world as in August and December 2015 (both times US stocks fell more than 10% in a matter of weeks). Trade and currency wars are far from over.
Prepare for more volatility and decline in US stocks.