China Crisis Repeating a Familiar Pattern For the Last Time

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Back in 2014, I wrote The Logic of Strategy: Yuan Devaluation and the Road to Trade War after reading Luttwak's book on how to contain a rising China. Luttwak's book has proven prescient. Beyond the arguments in the book itself, it fit the template of my macroeconomic model for China. I anticipated a weaknening Chinese economy, followed by a credit crunch and currency devaluation. Whatever path was taken, it seemed the U.S. and China were headed for a political, military, economic and currency confrontation.

One of the main reasons I wrote this blog over the years was to provide an alternative view on China. The standard narrative was China taking over the world. The yuan would challenge the dollar for reserve currency status, China's private economy would boom, reform would unleash the talent of the Chinese people and eventually, the U.S. would be pushed out of the Pacific either willingly or unwillingly. Events took a very different turn, and the Western narrative on China even contradicted what Chinese officials were publicly saying in the daily papers. A theme that would return in Brexit and Trump, through to today. The mainstream/establishment thinking glued to its own narrative rather than observing the facts on the ground. Great volatility and profit was and is still available to those paying attention.

A brief and truncated history of China's post-2008 economy

The yuan devalued in 2008, as covered in this post from 2013: Chinese Yuan Could Devalue 50% Or More (the title was a think piece, not a target). Instead of letting the market take its course, China did what it got accolades for doing in 1997: it did not join in the broader wave of currency depreciation. As a result, it may have helped arrest the 2008 downturn. The Chinese markets, emerging markets and many commodities would bottom in November 2011 (certainly on a relative basis). The U.S. economy experienced a shallow recession. And along with central bank action across the globe, the world's economy returned to a slow path of growth. Or not, depending on if you adjust for debt. Either way, the bill is coming due.

China never experienced healthy growth out of the crisis. It launched major infrastructure projects such as the national high-speed rail and citywide subway systems. It is possible to walk to most, if not all, major Chinese cities by taking a subway to the train station. However, this growth ended in 2011 and came with a run-up in debt. The stimulus was 40 percent of GDP in 2008 and was force fed through banks. Distortions were all over the place (such as SOEs borrowing at low rates from banks and loan-sharking at double-digit interest to private developers). The country experienced a real estate downturn as stimulus faded in 2011. In January, the real estate market was smoking. The WSJ ran an article titled: Real Estate Rage Erupts in Hangzhou. The rage was a fight breaking out among people trying to buy new apartments. By September, a new form of rage was setting in. Home buyers in Shanghai angry at massive price drops, smash offices

August 2011 was a volatile time for global markets. Europe's sovereign debt crisis was in full swing, the U.S. Congress was threatening to enforce a hard debt limit, one that would have terminated the U.S. government's ability to spend beyond its means. Gold would peak later that year. Emerging markets failed at their 2007 high. The global impulse created by central banks and China stimulus was over. There were hints that yuan depreciation could follow: Chinese yuan depreciation coming soon? By December, banks were selling dollars to halt the yuan's relatively minor slide: Devaluing the renminbi. It was a little late as devaluation pressure lifted by spring, but in July, investors were still shell shocked: Chinese hoard dollars. A credit growth cycle was underway though, one that wouldn't end until 2014.

As for the acute crisis, China saw falling real estate prices from June to Decemeber, with some currency depreciation into the early second quarter.

In 2014, China stimulus ran out. Resource investors and companies ignored the Chinese government's repeated warnings that there would be no repeat of the 2008 stimulus. The big blog post for that year was China Real Estate Rage Is Back; Ghost Cities Everywhere; Offshore Yuan Plunges; Talk of Falling Real Estate Prices Across China. By October, it was Liaoning Sounds Warning on Chinese Economy. The real estate development model looked busted. Local governments relied on real estate for GDP growth as traditional commodity-related industries went into recession. There was a real threat of the entire country tipping into recession should the decline in real estate be repeated elsewhere. Credit guarantees were blowing up left and right. Trust and bond defaults shook the notion that the government would always step in to prevent any default. Globally, the U.S. dollar bottomed in June and began a major bull market that appears unfinished. In November, crude oil began a plunge that would not end until 14 months later. Emerging markets would fail at their 2007 for a second time.

China would not escape with modest currency depreciation this time. In August 2015, it allowed the yuan to find its market price, far lower than the high of 6.04 in late 2013. The currency impact of this round would last until early 2017, with USDCNY touching 6.96 and threatening to break 7.00. It would cost China $1 trillion of its reserves. Global equity prices wouldn't bottom until early 2016 along with commodity prices. Bonds would peak around the time of the U.K.'s Brexit vote. The dollar would spike following President Trump's election. The crisis was acute for China, natural resources and currency markets.

This was also the point at which China ran out of political room. Eventually, the U.S. dollar was always going to break under the stress of the global economy. It was becoming too large for the Federal Reserve to control. It likely reached that point sometime in the early 2000s with China's entry into the WTO. At some point, America was going to say no more. Moreover, as China ran up its debt-to-GDP, the risk that the currency would devalue was rising. How unfortunate would it be if at the moment China needed to devalue most, the United States was ready to launch a trade and currency war?

Starting in mid-2015 and again in early 2016, China launched yet another round of credit stimulus following the implosion of the stock market bubble. Much of the stimulus would flow into real estate. By June 2016, Reform Can Wait: 4 Trillion Stimulus All Over Again as SOEs Pour into Land Market and also Ministry of Finance Owned Cinda Real Estate Becomes Land King. The government tried kicking SOEs out, but in February 2017, I posted SOEs Ordered Out of Land Market, Again

In October 2017, the green light for a national deleveraging is given by the National Congress. 19th National Congress: Deleveraging Will Have No Negative Effect on GDP

In summer of 2018, there was a report showing a speculative takeover in housing, beyond anything seen previously. Speculators Take Over Chinese Housing MarketBy September 2018, Fresh Reports of Real Estate Rage Signal Turn in Chinese Housing Market. China's economy has been slowing into 2019. Baoshang Bank failed and the Bank of Jinzhou needed a bailout, tying the story back to Liaoning 5 years earlier as laid out in China Credit Growth and Risk of Financial Crisis

China's stock market would decline in 2018 along with the rest of the world. Emerging markets experienced a failed breakout and fell below their 2007 high for a third time. They would recover this level in early 2019. They failed for a fourth time today, August 5, 2019.

The yuan has started depreciating again and broke the all-important former "line in the sand" of USDCNY 7.00. A simple overlay of prior events suggests the currency could depreciate for another 12 to 18 months, and that's if the magnitude is similar. As I recently discussed, the prior downturn saw trusts and a few bonds default. This time a bank has failed and another required a bailout. There is a trade war threatening even greater U.S. dollar pressure than the market alone creates. China has now been named a currency manipulator. Events have moved full circle back to the Logic of Strategy.
Whichever path is chosen, the economic and geostrategic paths will line up. An economic crisis in China will add the economic component to the emerging geostrategic China policy. A geostrategic decision to confront China economically would set in motion an economic crisis that would propel the strategy forward since China would respond in kind. The decision to halt rare earth exports to Japan and the widespread anti-Japanese riots of recent years already show how China will respond. A major confrontation from the U.S. would require an even larger policy response. Luttwak lays out some possible policy choices, starting with small ones such as banning technology transfers in a limited area such a military or telecom. I fully expect that were a Chinese crisis and devaluation to accompany another recession in the United States, the push for tariffs would find a bipartisan majority in the House and Senate.

Yuan devaluation is inevitable as soon as China enters a serious financial crisis. If the government refused to devalue, the nation would go through a 1930s style deflationary Great Depression. China is unlikely to allow the market to take the yuan lower in a panic collapse like a replay of 1997. At some point, it would announce a large devaluation designed to end the selling and the crisis. This will be called a political act in the United States (those who understand the economics will nonetheless spot the political opportunity) and the political push for protectionist policies will be too attractive to be ignored. The United States will retaliate with sanctions and the world will follow. This will put even more pressure on the Chinese economy and lead to a massive rise in nationalist sentiment (either that or anti-CCP sentiment, so expect the CCP to redirect it into nationalism). A chill wind will blow across the Pacific that will last a generation or more.
I was wrong about the 2014 crisis turning into a major global downturn. Whether central bankers arrested it or not, it terminated in early 2016. The signs of a 1937 event were there, but there was not follow through. I'm always open to the possibility I could be wrong again, but I don't think the next cycle will be similar. If I'm right, I believe we have arrived at the base camp of Everest. What I've written about over the past 8 years or so, had led up to the moment. The preparation is done. The main event is here. If I'm wrong, then I'm wrong about how it ends because I don't expect another stimulus out of China. It's too late, the political, economic and financial situation around the world won't allow for another coordinated kick of the can. We are crossing the event horizon into a new future for China, the United States, and the world order.

The Long Goodbye

This blog was started with the intention of writing about Chinese stocks, believe it or not. It turned into a meta joke over time as that is one of the least discussed topics on the blog. Perhaps there is another couple of years of activity on this subject, but I sense the end is beginning for this blog. It will finally be time to get a new address (maybe on a whole new planet) and a new topic that is years in the making. Already, my long portfolio is increasingly filled with junior gold and cryptocurrency miners. In the end, the biggest emerging markets of the next 10 to 20 years might be right at home.