Needless to say, China’s construction and “investment” binge manifestly does not meet these criteria in the slightest. It was funded with credit manufactured by state-controlled banks and their shadow affiliates, not real savings.
It was driven by state-initiated growth plans and GDP targets. These were cascaded from the top down to the province-, county- and local-government levels—an economic process that is the opposite of entrepreneurial at-risk assessments of future market-based demand and profits.
China’s own GDP statistics are the smoking gun. During the last 15 years fixed-asset investment—in private business, state companies, households and the “public sector” combined—has averaged 50% of GDP. That’s per se crazy.
Even in the heyday of its 1960s and 1970s boom, Japan’s fixed-asset investment never reached more than 30% of GDP. Moreover, even that was not sustained year in and year out (they had three recessions), and Japan had at least a semblance of market pricing and capital allocation—unlike China’s virtual command-and-control economy.
A CREDIT-DRIVEN MADHOUSE
The reason that Wall Street analysts and fellow-traveling Keynesian economists miss the latter point entirely is because China’s state-driven economy works through credit allocation rather than by tonnage-toting commissars.
The Gosplan is implemented by the banking system and, increasingly, through China’s mushrooming and metastasizing shadow-banking sector. The latter amounts to trillions of credit potted in entities that have sprung up to evade the belated growth controls that the regulators have imposed on the formal banking system.
For example, Beijing tried to cool down the residential real estate boom by requiring 30% down payments on first mortgages and by virtually eliminating mortgage finance on second homes and investment properties. So between 2013 and the present more than 2,500 online peer-to-peer lending outfits (P2P) materialized—mostly funded or sponsored by the banking system—and these entities have advanced more than $2 trillion of new credit.
That’s right. A new $2 trillion credit channel erected virtually overnight.
The overwhelming share went into meeting “down payments” and other real estate speculations. On the one hand, that reignited the real estate bubble—especially in the Tier I cities where prices have risen by 20% to 60% during the last year.
At the same time, this P2P credit eruption in the shadow-banking system has encouraged the construction of even more excess housing stock in an economy that already has upward of 65 million empty units.
In short, China has become a credit-driven economic madhouse. The 50% of GDP attributable to fixed-asset investment actually constitutes the most spectacular spree of malinvestment and waste in recorded history. It is the footprint of a future depression, not evidence of sustainable growth and prosperity.
Consider a boundary-case analogy. With enough fiat credit during the last three years, the United States could have duplicated China’s cement-consumption spree and built 160 Hoover Dams on dry land in each and every state.
That would have elicited one hellacious boom in the jobs market, gravel pits, cement-truck assembly plants, pipe and tube mills, architectural and engineering offices and so on. The profits and wages from that dam-building boom, in turn, would have generated a secondary cascade of even more phony “growth.”
But at some point, the credit expansion would stop. The demand for construction materials, labor, machinery and support services would dry up; the negative multiplier on incomes, spending and investment would kick in; and the depression phase of a crack-up boom would exact its drastic revenge.
In fact, that’s exactly the kind of crack-up boom that has been underway in China for the last two decades. Accordingly, it is not simply a little overdone, and it’s not in some Keynesian transition from exports and investment to domestic services and consumption. Instead, China’s fantastically overbuilt industry and public infrastructure embodies monumental economic waste equivalent to the construction of pyramids with shovels and spoons and giant dams on dry land.
When the credit pyramid finally collapses or simply stops growing, of course, the pace of construction will decline dramatically. In turn, as we suggested above, the collapse of its construction boom will leave the Red Ponzi riddled with economic air pockets and negative spending multipliers.
THE MOTHER OF ALL MALINVESTMENTS
Take the simple case of the abandoned cement-mixer plant pictured below. The high wages paid in that abandoned plant are now gone; the owners have undoubtedly fled, and their high-living extravagance is no more. Nor is this factory’s demand still extant for steel sheets and plates, freight services, electric power, waste hauling, equipment replacement parts and on down the food chain.
And, no, a wise autocracy in Beijing will not be able to offset the giant deflationary forces now assailing the construction and industrial heartland of China’s hothouse economy with massive amounts of new credit to jump-start green industries and neighborhood recreation facilities. That’s because China has already shot its credit wad, meaning that every new surge in its banking system will trigger even more capital outflow and expectations of FX depreciation.
Moreover, any increase in fiscal spending not funded by credit expansion will only rearrange the deck chairs on the Titanic.
Indeed, whatever borrowing headroom Beijing has left will be needed to fund the bailouts of its banking and credit system. Without massive outlays for the purpose of propping up and stabilizing China’s vast credit Ponzi, there will be economic and social chaos as the tide of defaults and abandonments swells.
Empty factories like the one pictured above—and China is crawling with them—are a screaming marker of an economic doomsday machine. They bespeak an inherently unsustainable and unstable simulacrum of capitalism where the purpose of credit has been to fund state-mandated GDP quotas, not finance efficient investments with calculable risks and returns.
The relentless growth of China’s aluminum production is just one more example. It now exceeds US output by 10X. So, when China’s construction and investment binge finally stops, there will be a huge decline in industry wages, profits and supply-chain activity.
But the mother of all malinvestments sprang up in China’s steel industry, as we outlined above.
And that’s where the pyramid-building nature of China’s insane fixed-investment spree comes in. China’s humungous iron and steel industry is not remotely capable of “rationalization” as practiced historically in the developed-market economies. Even Beijing’s much ballyhooed 100–150-million-ton plant closure target is a drop in the bucket—and it’s not scheduled to be completed until 2020 anyway.
To wit, China will be lucky to have 400 million tons of true sell-through demand—that is, ongoing domestic demand for sheet steel to go into cars and appliances and for rebar and structural steel to be used in replacement construction once the current one-time building binge finally expires.
For instance, China’s construction and shipbuilding industries consumed about 500 million tons per year at the crest of the building boom. But shipyards are already going radio silent and the end of China’s manic eruption of concrete, rebar and I-beams is not far behind. Use of steel for these purposes could easily drop to 200 million tons on a steady-state basis.
By contrast, China’s vaunted auto industry uses only 45 million tons of steel per year, and consumer appliances consume less than 12 million tons. In most developed economies autos and white goods demand accounts for about 20% of total steel use.
Likewise, much of the current 200 million tons of steel that goes into machinery and equipment, including massive production of mining and construction machines, rail cars and the like, is of a one-time nature and could easily drop to 100 million tons on a steady-state replacement basis.
So it’s difficult to see how China will ever have recurring demand for even 400 million tons annually, yet as I indicated above that’s less than one-third of its massive capacity investment.
In short, we are talking about wholesale abandonment of a half billion tons of steel capacity or more—that is, the destruction of steel-industry capacity greater than that of Japan, the European Community and the United States combined.
Needless to say, that thunderous liquidation will generate a massive loss of labor income and profits and devastating contraction of the Chinese steel industry’s massive and lengthy supply chain. And that’s to say nothing of the labor-market disorder and social dislocations that will occur when China is hit by the equivalent of dozens of burned-out Youngstown’s and Pittsburgh’s.
And it is also evident that it will not be in a position to dump its massive surplus on the rest of the world. Already trade barriers against last year’s 110 million tons of exports are being thrown up in Europe, North America, Japan and nearly everywhere else.
This not only means that China’s half-billion tons of excess capacity will crush prices and profits, but, more importantly, that the one-time steel demand for steel industry CapEx is over and done. And that means shipyards and mining equipment too.
VANISHING ORDER BOOKS IN CHINA’S GIANT SHIPBUILDING INDUSTRY
That is already evident in the vanishing order book for China’s giant shipbuilding industry. The latter is focused almost exclusively on dry-bulk carriers—the very capital item that delivered into China’s vast industrial maw the massive tonnages of iron ore, coking coal and other raw materials.
But within in a year or two most of China’s shipyards will be closed as its backlog rapidly vanishes under a crushing surplus of dry-bulk capacity that has no precedent, and which has driven the Baltic shipping-rate index to historic lows.
Still, we now have the absurdity of China’s state shipping company (COSCO) attempting to compensate for the loss of dry-bulk carrier orders at state-owned shipyards by ordering 11 massive containerships. Yet it can’t possibly need this new finished-goods shipping capacity since China’s year-to-date exports are down 20% and will be heading lower as the global economy eventually succumbs to outright recession:
China’s waning appetite for raw materials have come around to bite the country’s shipbuilders, raising the odds that more shipyards will soon be shuttered.
About 140 yards in the world’s second-biggest shipbuilding nation have gone out of business since 2010, and more are expected to close in the next two years after only 69 won orders for vessels last year, JPMorgan Chase & Co. analysts Sokje Lee and Minsung Lee wrote in a January report. That compares with 126 shipyards that fielded orders in 2014 and 147 in 2013.
Total orders at Chinese shipyards tumbled 59 percent in the first 11 months of 2015, according to data released Dec. 15 by the China Association of the National Shipbuilding Industry. Builders have sought government support as excess vessel capacity drives down shipping rates and prompts customers to cancel contracts. Zhoushan Wuzhou Ship Repairing & Building Co. last month became the first state-owned shipbuilder to go bankrupt in a decade.
It is not surprising that China’s massive shipbuilding industry is in distress and that it is attempting to export its troubles to the rest of the world. Yet subsidizing new builds will eventually add more downward pressure to global shipping rates—rates that are already at all-time lows. And as the world’s shipping companies are driven into insolvency, they will take the European banks that have financed them down the drink, as well.
Still, the fact that China is exporting yet-another downward deflationary spiral to the world economy is not at all surprising. After all, China’s shipbuilding output rose by 11X in 10 years!
MADNESS IN THE AUTO ZONE TOO
Nor is the loss of its own tail the only market shrinkage facing China’s core steel industry. Even more fantastic has been the growth of China’s auto-production capacity. In 1994, China produced about 1.4 million units of what were bare-bones Communist-era cars and trucks. Last year it produced more than 23 million mostly western-style vehicles, or 16X more.
And yes, that wasn’t the half of it. China has gone nuts building auto plants and distribution infrastructure. It is currently estimated to have upward of 33 million units of vehicle-production capacity. But demand has actually flattened and will likely head lower after temporary government-tax gimmicks—which are simply pulling forward future sales—expire.
The more important point, however, is that as the China credit Ponzi grinds to a halt, it will not be building new auto capacity for years to come. It is now drowning in excess capacity, and as prices and profits plunge in the years ahead the auto industry CapEx spigot will be slammed shut. too.
Needless to say, this not only means that consumption of structural steel and rebar for new auto plants will plunge. It also will result in a drastic reduction in demand for the sophisticated German machine tools and automation equipment needed to actually build cars.
Stated differently, the CapEx depression already underway in China, Australia, Brazil and much of the emerging markets will ricochet across the global economy. Cheap credit and mispriced capital are truly the father of a thousand economic sins.
HERE COME THE PADDY WAGONS
The worst thing is that just as the Red Ponzi is beginning to crack, China’s leader is rolling out the paddy wagons and reestablishing a cult of the leader that more and more resembles nothing so much as a Maoist revival.
As Mr. Xi said while making the rounds of the state media recently, its job is to
reflect the will of the Party, mirror the views of the Party, preserve the authority of the Party, preserve the unity of the Party and achieve love of the Party, protection of the Party and acting for the Party.
The above proclamation needs no amplification. China will increasingly plunge into a regime of harsh, capricious dictatorship as the Red depression unfolds. And that will only fuel the downward spiral that is already gathering momentum.
During the first eight months of 2016, for example, China’s export machine has buckled badly. Exports are now down 20% year over year and show no signs of reviving.
Likewise, local economies in its growing rust belt, such as parts of Heilongjiang, in far-northeast China, have dropped by 20% in the last two years and are still in free fall. Coal prices in those areas have plunged by 65% since 2011 and hundreds of mines have been closed or abandoned.
The next picture below is epigrammatic of what lies behind the great Potemkin village that is the Red Ponzi.
While pictures can often tell a thousand words, sooner or later the numbers are no less revealing. The fact is, no economy can undergo the fantastic eruption of credit that has occurred in China during the last two decades without eventually coming face-to-face with a day of reckoning. And a Bloomberg analysis of the shocking deterioration of credit metrics in the nonfinancial sector of China suggests that day is coming fast.
THE COMING DEBT-SERVICE CRUNCH IN THE BUSINESS SECTOR
Overall interest-expense coverage by operating income has plunged dramatically, and virtually every major heavy industrial sector of the Red Ponzi is underwater with a coverage ratio of less than 1X.
But that’s not the half of it. What is evident from the following Bloomberg data below is that the overwhelming share of this year’s massive new corporate borrowings are being allocated to pay interest on existing debt because debt service is not being covered by current operating profits.
Firms generated just enough operating profit to cover the interest expenses on their debt twice, down from almost six times in 2010, according to data compiled by Bloomberg going back to 1992 from nonfinancial companies traded in Shanghai and Shenzhen. Oil and gas corporates were the weakest at 0.24X, followed by the metals and mining sector at 0.52X.
The People’s Bank of China has lowered benchmark interest rates six times since 2014, driving a record rally in the bond market and underpinning a jump in debt to 247 percent of gross domestic product. Yet economic growth has slumped to the slowest in a quarter century and profits for the listed companies grew only 3 percent in 2015, down from 11 pe
rcent in 2014. “We will likely see a wave of bankruptcies and restructurings when the interest coverage ratio drops further,” said Xia Le, chief economist for Asia at Banco Bilbao Vizcaya Argentaria SA in Hong Kong.
Massive borrowing to pay the interest is everywhere and always a sign that the end is near. The crack-up phase of China’s insane borrowing and building boom is surely at hand.
Another warning sign of this dead end is found in the “payables stretches” now happening throughout the Red Ponzi. Struggling under $30 trillion of unpayable financial debt accrued during what amounts to a historical heartbeat of frenzied borrowing, China’s businesses are now coping with the inexorable morning-after deflation by means of a time-tested maneuver of last resort.
To wit, they are attempting to pay their bankers by stiffing their suppliers.
As shown below, payables now average an incredible 192 days in China’s business system. And that’s why its whole house of cards is likely to collapse with a bang, not a Beijing-managed whimper.
At some point, this daisy chain of billions of unpaid claims will far exceed even the capacity of China’s state-deputized bankers and its growing fleet of paddy wagons to keep in line.
Indeed, this surge in payables has two untoward implications. The first is that the myth of Beijing’s capacity for omniscient and unfailing economic governance will be shattered. All along, it has been a case of mistaken identity—a failure by Wall Street propagandists of “growth” to understand that doling out trillions of credit through a state-controlled banking system merely funds recordable spending and delivers fixed assets; it does not generate efficient growth or sustainable wealth.
Trumped! A Nation on the Brink of Ruin... And How to Bring It Back Page 35
