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China's Macro Pawns

Heaven is high, and the Emperor is far away. But his malinvestment bubble isn't...
IMAGINE, if you will, a small, isolated hamlet where the daily round proceeds in harmony with the gentle rhythm of agriculture, writes Sean Corrigan of Diapason Commodities at the Cobden Centre.
Ground is tilled, seed is sown, crops are harvested, dried, threshed, and milled, each in their due season. In the lush, green meadows a little higher up the valley cows are impregnated before their calves are led docilely off to slaughter – both for their meat and for their cheese-making stomach enzymes. The kine turn the sweet grass which covers the pasture into much-needed fertilizer for the arable lands and, twice daily, milking takes place according to its own timeless routine.
Into this bucolic idyll now intrudes an ambitious village headman who has heard that he can further his own lot in life if he erects a series of shrines to the glory of the Emperor who is honourably busying himself with the mandate of heaven, far away in the stately pleasure dome of his Celestial Palace. Work begins at once, employing both those locals who have too little to do and, in due course, attracting itinerant labourers to the village.
Since the business of shrine building produces nothing tangible of itself – no new stands of millet or of teeming paddies of rice, no additions to the lowing herds of cattle – it is necessary that all those set to constructing them be given a share of the existing produce of the land
Thus, the biddable farmers are constrained to eat less heartily of the fruits of their own labours so that the community's meritorious contribution to the cult of the Emperor may better be advanced. Not wishing to be seen as grasping, those toiling to break the rocks and pile up the cairns which constitute the sacred monuments are also persuaded that they, too, should forego the immediate enjoyment of the entirety of their daily wage and should also set some of it aside as their own offertory act.
So as to recognise the sacrifice each has made – a propitiation which each fully expects will earn him a future reward in something a little more material than the Emperor's gratification alone, though from whence exactly none can truly say – the village scribe diligently records the size of each implicit donative against the name of its pious contributor in his scrolls (implicit since each has already been used up as surely as if they were burned in some great communal hecatomb). Slowly then and at no little personal cost in denial, if not outright privation, this local register of deeds grows longer, keeping as it does a tally on the mounting sum of savings being laid down by the dutiful and the diligent.
Imagine then, the consternation which ensues when, one fine spring morning, a courier rushes into the market square and, gathering his breath, proceeds to read out the latest proclamation from an imperial capital so far removed from their daily experience that few in the village have any firm conception of either its extent or its location. The Most Venerated Prince has decided, the messenger declares, that the count of the shrines being dedicated to the royal personage is become too large and that His Highness' most farseeing haruspices and horoscopists have persuaded Him that it is unseemly for an earthbound divinity such as He to be seen to rival in this way the worship of the true Immortals in all their celestial splendour.
Henceforth, all such construction is to be halted and no more oblations are to be made in His most blessed name. No one, the herald continues, is to 'save' any further, upon pain of exciting both the Emperor's awful displeasure and the thunderous anger of the Sky Gods whom He, too, serves in his turn. Instead, each must consume up to the very limit of his income and entertain no further thought of laying in a store against a future already so lavishly provisioned for.
But, goes up the cry, where will we, His Majesty's most loyal temple builders, earn our bread, if the farmers do not continue to set aside our due portion? Are we, too, to follow the plough tomorrow? And, if so, who will grant us the lands, the tools, the skills to enable us to do so? All we have to hand are these well-used chisels and thrice-repaired picks. All we otherwise possess is a certain facility in the mason's art. Surely these will not now serve to fill our empty bellies and still the crying of our hungry children?
And, for our part, how will we achieve any measure of recompense for the manifold portions already foregone, howl the farmers who have come to realise that their 'savings' are nothing but an empty twirl of the calligrapher's brush, that they represent no bounty – present or prospective – to see them through their dotage or to pay their daughters' dowries? Indeed, beyond a sterile list of claims to ownership of the many useless piles of now deconsecrated rubble, to what has all their devout abstinence amounted, they wonder. Will these bring forth butter or bread on which to spread it? Will it give us flax for our wives to spin into clothing, or hide to keep us shod, they quail?
"Be still, you wretches!" comes the haughty retort of the imperial mouthpiece.
"His Most Elevated Puissance has become aware that the world is out of balance, that Yin does not match Yang, that there is too much investment in tomorrow and not enough indulgence here today. This must cease forthwith!
"What is it to Him if you did not fashion mills to grind your corn or locks to render navigable your streams – and so increase the size and richness of your coming reward – but instead you sought to curry the royal favour by erecting rough-hewn altars to His cult on every rutted cart track and every dusty crossroads? The time has come, His most learned astrologers have ruled, to eat your way to wealth and for those who have hitherto laboured in what they misguidedly took to be His service to do the same for you farmers in your own homes. His mages, in their unfathomable wisdom, have determined that this way, and this way only must be followed: that the erstwhile builders will hew your wood and carry your water, they will sweep your paths and carry in the tapers to light your rooms at night. In short, they shall come to share your table openly with you and, in so doing, will ensure that it straightways will groan under the weight of all that greatly augmented whole that will instantly appear to be laid upon it."
It was realized – if grudgingly – that this arrangement would not be entirely without merit: the farmers were used, after all, to feeding the temple builders and this way they would at least be free to devote more of their energies to higher order tasks and less to menial ones in return. Nevertheless, it came as a rude awakening to one and all to realise that where they thought they had been piling up the riches with which to ease their lives in future, all of their sacrifice had availed them naught and they would have to start again from their beginnings, poorer if hopefully wiser.
No word was said as to what the scribe should do with all those carefully guarded scrolls, now rendered utterly worthless by dint of the Imperial whim. The man himself was cautious enough quietly to make his exit, long before he could be blamed for what he had only wrought at the behest of his masters.
Okay, so folksy analogies aside, we have to confess that not every 'investment' laid down in modern China is a folly; that not every plant operates far short of its capacity; that not all 'profits' are an artefact of hidden subsidies, false accounting, the shameless exploitation of captive savings, and a vast monetary influx, as in our little parable.
Nevertheless, in far too many instances this has indeed become the case. Moreover, the situation is far more fraught than was that which prevailed in our simple village economy because the scribe's register of 'savings' there have as their actual counterpart the liabilities of the financial system. These, as we know, are not simple transactions recorded between two directly consenting counterparties, but are the nodes in a web of a myriad of subsequent interdealings whose complexity is beyond comprehension and whose strands comprise the means of circulation of goods and services everywhere they would go within the economy.
Thus, it is all well and good to declare by way of some sort of macroeconomic truism that we 'need' less investment and we 'need' more consumption and that the Kuznetsian Y will remain unchanged if C rises and I falls in a like manner and in the same timeframe, but that exquisitely interconnected, ever-evolving meta-organism which is an economy cannot be reduced to such a trivial game of adding more of one thing here and taking away some of another there as if we were simply hanging baubles on a Christmas tree.
For a start, the ability to consume must be in some way linked to the fact of having completed a prior act of production, whether we look at how one acquires an 'effective' demand upon such product or how one gains access to the requisite supply. Where that linkage is broken, as when credit creation or money printing tries to circumvent this necessary order of precedence, the consequences are always invidious and usually pernicious, to boot.
Secondly, each particular action, whether of consumption or production, is only sustainable – ie, can be undertaken without unduly limiting the future possibilities for either its repetition or amendment – to the extent that it is integrated into the greater whole of all such actions, a condition which implies not just the instantaneous, but the intertemporal coherence of intentions.
Thirdly, each is dependent not only on the shifting sands of individual subjective preference, but its commission typically depends on the purposeful employment of both specific human skills and a dedicated, non-versatile endowment of capital.
Fourthly, much as the curvature of spacetime gives rise to the gravitational effects on a mass which then curves that same spacetime, each action cannot fail to effect changes in the milieu in which all subsequent actions must be planned and carried out. Thus, in this most Heraclitan of worlds, all is flux, meaning that not even the most bolted down, immovable hunk of plant or machinery should ever be confused with 'capital' per se (that would be to commit the same kind of error of association as is entrained in Marx/Ricardo's labour theory of value and its 'cost of production' school among the resource analyst community).
Nor should it be considered to have any meaningful degree of 'permanence' simply because of its physical durability: function is what matters, not form and, moreover, it should never be forgotten that the true function of capital is to produce positive net income, not the things which we (mostly) trade onwards to others in order to assure receipt of that income. Indeed, we would do better to disembody our conception of capital entirely and to view it solely as a collection of property rights (including the primal right of self-ownership) from whose use we aspire to generate that net income over time and whose composition we must constantly adjust to fit the ever-changing circumstances in which it must be employed and which its very employment also alters.
Finally, in our intimately financialized economy, each one of our undertakings leaves its own trail of obligations given and received, each of which pathways of itself forms the foundation for yet other layerings of promise and contractual delivery. Thus, were our hamfisted attempts at puppeteering to cause a certain critical level of disruption to the operation of and – perhaps more importantly – the faith in one of these trackways, a cascade of failure could all too easily result turning as we Austrians like to say, an initiating monetary problem into a real one.
Thus, it borders on the facile to presume to re-arrange the pawns on the macroeconomic chessboard by lifting them off and putting them back, one by one and regardless of the actual progression of the game, but it is an exercise which not even the grandest of grandmasters could accomplish to orchestrate the march of the pieces from one such position to another not only while they are all moving at once but, indeed, doing so according to their individual expressions of will and, moreover, while they are simultaneously changing not only their own shapes and capabilities for movement, but redrawing the very dimensions of the board as they do.
China – or should we rather say, the individual Chinese – would undoubtedly be better off in an environment where more room was allowed for the 'spontaneous order' of consumer sovereignty under property rights to emerge and less was reserved for the corrupt gaming of central diktat, but to avow this is not to assume either that the transition will be seamless, much less painless, nor to accept that it can be so ordained simply by exchanging one set of fiats and public choice manoeuvrings for another.
But, never underestimate the penchant of the crude Keynesians for patent nostrums, state worship, and the elevation of hidden-cost collectivism to a guiding principle. Thus it is that, among the encomia for reform, we hear such idiocies as the following, oft-parroted, Cargo Cult wishfulness:
"[China should] Reform the Hukou system through creating a path for rural migrants to gain affordable housing and social services in urban areas. This could unlock much more consumer spending because, at the moment, some 270 million migrants who lack access to these services are forced to save hard to pay for their families' education, healthcare and housing, etc..."
...which is to imply nothing less than if the migrants themselves do not have to save, no-one else will either since the tutelary welfare state is, after, all a Tooth Fairy!
In the present vogue for voicing the previously inexpressible – presumably as part of the strategy to persuade the diehards that change is an unavoidable imperative – one of the New Men of the reform movement, Fang Xinghai, ex-Shanghai, World Bank, and Stanford, warned that many small banks were horribly over-reliant on wholesale sources of funding – to the tune of no less than 80% in some cases, Fang alleged – thus making them highly vulnerable to a run and of then acting as the 'triggers' in a possible asset price 'cascade'.
To say such things openly is indeed to peer into Pandora's Box. Total Chinese banking assets currently stand at some CNY147 trillion, around 2.5 times GDP. As such, they have doubled in the past four years of increasingly misplaced investment and frantic real estate speculation, adding the equivalent of 140% of average GDP – or, in Dollars, $12.5 trillion – to the books. For comparison, over the same period, US banks have added just less than $700 billion, 4.4% of average GDP, 18 times less than their Chinese counterparts – and this in a period when the predominant trend has been for the latter to do whatever it takes to keep commitments off their balance sheets and lurking in the 'shadows'!
Indeed, the increase in Chinese bank assets during that breakneck quadrennium is equal to no less than seven-eighths of the total outstanding assets of all FDIC-insured institutions! It also compares to 30% of Eurozone bank assets (which are broadly unchanged over our chosen horizon, but which do represent an even more scary 320% of GDP and, in many cases dispose of worryingly scanty tangible equity ratios, q.v. below).
Published NPL ratios are reassuringly low and, as a result, earnings seem wonderfully robust, but it simply defies belief to accept either of these at face value, given that we know the Chinese leadership itself is terrified at the state of the nation's finances.
It is for this reason, as much as any other, that we will believe all the brave talk about capital account liberalization and exchange rate reform when we see it. It would be simply too dangerous for a country stuffed to the gunnels with Ponzified finance raised against a plethora of underproductive assets and overpriced properties. If the PBOC wants to see its $3.7 trillion reserve stash evaporate amid a flirtation with becoming the 1997 Thailand of the current decade, we suggest it proceeds to abolish its controls at its earliest convenience.
It is too early to be justifiably pessimistic and too tempting to let scepticism shade into cynicism, but no-one can readily deny that the implementation of all these much-vaunted reforms will not take place without a struggle: too many losers will be created, who must either be compensated or else outweighed in influence by the new winners who emerge.
Take the relaxation of the one-child policy. We already harbour some doubts about just how much pent-up Maternal Instinct there exists in a nation of increasingly professionalized, materially better-off women (a group for whom the indisputable global precedent is that they voluntarily rein in their fertility) whose dream of owning a suitable home in which to raise the first, much less the second, child is ever less realizable thanks to China's soaring property prices.
On top of this, it has already been admitted by the ruling National Heath and Family Planning Commission that the policy will be left largely to the discretion of lower levels of government to enact, that "there will not be a unified timetable" in recognition of the fact that "preparations or conditions might not be mature in some regions".
We might suspect that Hukou reform will be seen to require a similar, locally-sensitive and hence inherently piecemeal enactment. Shame about all that 'consumption' we might have to forego among those looking forward to cracking open a bottle of Maotai the minute they receive their state pension booklet.
Then there is the ingrained habit which will be hardest of all to break: namely that the facilitation of shrine building – sorry, 'investment' – is the raison d'être of being a local government official. Take the report from this week's, post-Plenum edition of First Financial News which pointed out that the joint spending plans of ten Chinese provinces amounted to a stupefying CNY40 trillion – or 80% of nationwide GDP! Clearly they did not get the latest memo from Chairman Xi.
Before leaving the topic of China, there is just one other faint concern to address; viz., the demotion of the previously ubiquitous champion of reform, Premier Li, almost to the status of Unperson as his superior, President Xi, conversely, has undergone a veritable apotheosis in recent weeks.
Though not quite airbrushed from the May Day balcony shot, Li has been obviously and humiliatingly relegated to the inside pages of late, having conducted such pressing duties as entertaining the Romanian PM on the sidelines of a conclave of central and eastern European leaders in the throbbing heart of Uzbekistan and of chairing a State Council meeting whose agenda read like the trailer for an edition of the BBC's consumer affairs programme Rogue Traders at which our man set his face firmly against the evils of counterfeiting and the future sale of 'shoddy' goods. (There goes the Chinese Mittelstand, we are tempted to observe).
Though much has been made of the significance of the newly-instituted Central Leading Committee for the Comprehensive Deepening of Reform (don't you just revel in the wilder flights of Socialist Newspeak?) and of its possible role in stymieing the local cadre-friendly NRDC, there is a growing suspicion that Li himself will not be selected to head it. If such whispers have any merit to them, this would mean that Xi's thirst for personal power has already come at the expense of the better co-ordination of the reform push.
Watch this space.

Stalwart economist of the anti-government Austrian school, Sean Corrigan has been thumbing his nose at the crowd ever since he sold Sterling for a profit as the ERM collapsed in autumn 1992. Former City correspondent for The Daily Reckoning, a frequent contributor to the widely-respected Ludwig von Mises and Cobden Centre websites, and a regular guest on CNBC, Mr.Corrigan is a consultant at Hinde Capital, writing their Macro Letter.

See the full archive of Sean Corrigan articles.

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