Cracks are opening in the global monetary system

Central bankers have bought growth by sacrificing financial stability

Russell Napier

© AP

While many investors are fretting over what stage of the business cycle we are in, the global monetary system is collapsing — with a whimper initially, but ultimately a bang. The whimper is causing losses for equity investors. The bang will impact global asset prices as much as the end of the Bretton-Woods system or the end of the gold standard.

The system that is ending has no name. It is a system patched together in the embers of the Asian economic crisis, when many countries intervened in the foreign exchange markets to prevent the appreciation of their currencies. The impacts for investors were profound. The roughly $10tn rise in world foreign exchange reserves between 1999 and 2014 resulted in the forced purchasing of US Treasuries. Foreign central bankers owned just 13 per cent of the Treasury market in 1995, but held a third of it by 2014.

This monetary system thus provided a funding holiday for global savers, freeing them to focus on funding the private sector instead. Meanwhile, central bank liabilities increased by $10tn. What could be better for global investors than a monetary system that depressed the global risk-free rate while boosting growth through an explosive rise in the money supply of emerging markets, particularly China? For equity investors the combination of a low discount rate and high growth rate drove prices and valuations higher until 2014.

Since then, though, as foreign exchange reserves have stopped climbing, the job of funding the US government has fallen to savers, not central bankers. Foreign central bank ownership of US Treasuries has fallen from a third five years ago to just under a quarter today. Savers must take up the funding slack, while also buying the Treasuries now being sold by the Federal Reserve. This structural shift in the demand for Treasuries comes as supply is boosted by the Trump administration’s fiscal policy. Savers now have to fund the US government, and to do so they have to either sell other assets or save more. All the movements in asset prices over the past six months bear witness to the huge shift in savings under way, with negative implications ultimately for economic growth. The whimper is evident, but how will the bang look?

Lower growth, lower inflation, lower asset prices and the prospect of declining cash flows will always raise questions about solvency. The global ratio of non-financial debt to gross domestic product is 234 per cent, compared with 210 per cent in December 2007, just before the last credit crisis. If the bang of credit default was possible 12 years ago, how much more likely is it today? For 10 years the growth of debt has outstripped growth in broad money and nominal GDP. Central bankers have bought growth by sacrificing financial stability.

The other side of low growth in world foreign reserves is the low growth in the money supply of exchange-rate targeting regimes. These problems are particularly acute in China, with broad money growth at its lowest in the post-Mao era. The country’s debt-to-GDP ratio is rising at probably the fastest rate ever for a big economy in peacetime. This is the economy that we are told is de-gearing and reflating! It is not, and the burden of the economic adjustment enforced by the end of the growth in its foreign exchange reserves, and hence money supply, will probably be deflationary and will involve debt default. China will probably move to a flexible exchange rate, thus creating the freedom to grow and inflate away these debts. It is that exchange-rate adjustment that will destroy the current global monetary system.
 The key consequence of this collapse will be the destruction of the euro. The expected success of the far-right and far-left in the European parliamentary election in May this year augurs the beginning of the end for the currency union. Both extremes share a commitment to the return of sovereignty to their parliaments that is incompatible with a single currency. That end will come even more quickly with the resultant economic pain from the collapse of the global monetary system, and it is likely to begin with the imposition of capital controls by key eurozone countries.

In the financial, political and social maelstrom of a eurozone dissolution, investors should not expect property rights to be respected. The UK, where democracy and the rule of law will remain largely unchallenged, will become an attractive safe-haven investment for European investors facing increasingly authoritarian regimes and property sequestration on the mainland. Monetary collapses bring social and political ruptures and we now face two such collapses. It would be naive for any investor to assume that “government of the people, by the people, for the people” will survive such ruptures. The risks remain highest in Europe.

Russell Napier is an independent market strategist and founder of the online research platform, ERIC

IMF flags trade war threat and warns of global economic slowdown

Fund revises down growth forecasts to 3.5% this year and 3.6% in 2020

Chris Giles in Davos

The IMF’s revised estimates represent a significant shift for the global economic outlook © AFP

The global economy is weakening faster than expected as trade wars and financial market volatility further undermine the investment climate, the IMF said on Monday at the start of this year’s World Economic Forum in Davos.

World leaders and business titans have converged on the Swiss ski resort, chastened by the recent economic weakness from Asia to Europe, saying that populism and the policies of international conflict are taking their toll on global economic prospects.

Corporate bosses have been left reeling by the rapid change in sentiment that has followed a ratcheting up of trade tensions over the past year and Monday’s news that China’s official growth rate had slowed to its weakest level since 1990.

Alongside the downgrades in the IMF’s growth forecasts, a survey of chief executives by PwC noted a sharp jump in pessimism compared with their almost universal buoyancy a year ago.

The PwC survey showed that almost a third of chief executives believing the global outlook would darken compared with only 5 per cent a year ago. “With the rise of trade tension and protectionism it stands to reason that confidence is waning,” said Bob Moritz, the professional services group’s global chairman.  
The IMF blamed its more pessimistic forecasts mostly on weaknesses in Europe and Japan that slowed momentum in the global economy. It said the biggest downgrades had come in advanced economies where growth was set to drop from 2.3 per cent in 2018, to 2 per cent in 2019 and 1.7 per cent in 2020.
Some of the effects of trade wars had already been felt, the IMF said, which had led to the weakening of global trade growth. More concerning, the outlook could be even worse.
“The true underlying impetus could be even weaker than the data indicate, as the headline numbers may have been lifted by import front-loading ahead of tariff hikes, as well as by an uptick in tech exports with the launch of new products,” the IMF said.
This concern about trade and globalisation was echoed on Monday by the UN’s trade and development body, which reported a 19 per cent fall in global foreign direct investment in 2018 as US companies repatriated funds to take advantage of new tax breaks, pulling money out of the global economy.
These forces led the IMF to revise down its main economic forecasts, with the fund now predicting that the global economy would slow from 3.7 per cent growth in 2018, to 3.5 per cent in 2019 and 3.6 per cent in 2020. The uptick in 2020 was due to expectations that Turkey and Argentina would suffer deep recessions in 2019, before recovering the following year.
The new estimates are 0.2 percentage points and 0.1 percentage points respectively below the IMF’s more recent forecasts in October.

The IMF report painted a fragile picture of the world economy at a time when leaders have become more focused on domestic matters. It called for greater international co-operation to give business more confidence to invest in the future.

Gita Gopinath, the new IMF chief economist, said: “The downward revisions are modest. However, we believe the risks to more significant downward corrections are rising.”

“The cyclical forces that propelled broad-based global growth since the second half of 2017 may be weakening somewhat faster than we expected in October . . . While this does not mean we are staring at a major downturn, it is important to take stock of the many rising risks,” she added.

One specific risk highlighted by the IMF was that Britain would exit the EU without a negotiated agreement — a no-deal Brexit. The fund said this outcome was a “rising possibility” that could have negative spillovers across Europe.

As China reported its weakest growth since 1990, the IMF predicted the slowdown could be steeper than expected, which Ms Gopinath said might “trigger abrupt sell-offs in financial and commodity markets as was the case in 2015-16”.

The fund also expressed concern about the budgetary position of Italy, which is suffering from weakness in its banking sector. “A protracted period of elevated [Italian bond] yields would put further stress on Italian banks, weigh on economic activity, and worsen debt dynamics,” the IMF said in its report.

The fund called on countries to resolve trade tensions and for a smooth Brexit, all of which are more difficult because the US and UK administrations will be absent from Davos due to mounting domestic crises.

“The main policy priority is for countries to resolve cooperatively and quickly their trade disagreements and the resulting policy uncertainty, rather than raising harmful barriers further and destabilising an already slowing global economy,” Ms Gopinath said.

Warning to Investors: Powell Is No Greenspan

Despite the similarities in the setup, Jerome Powell’s Federal Reserve will be less accommodative than Alan Greenspan’s was in 1999 following a spell of slowdown worries

By Justin Lahart

Former Federal Reserve Chairman Alan Greenspan in 2016.
Former Federal Reserve Chairman Alan Greenspan in 2016. Photo: saul loeb/Agence France-Presse/Getty Images

The 2019 playbook for the stock market is looking a bit like the playbook from 1999. This time, though, the Federal Reserve might not cooperate.

Stocks have found their footing lately and a lot of that has to do with the central bank. In response to worries that the economy will face more formidable headwinds this year than last, the Fed seems to have dialed back its plans to raise rates, and Chairman Jerome Powell has said that mild inflation allows the central bank to take a flexible approach toward setting policy. Since hitting a 20-month low in late December, the S&P 500 is up about 10%.

How powerful the economic headwinds are is anyone’s guess. While the combination of slowing growth overseas, fading tax-cut and spending stimulus and the cumulative effects of the Fed’s rate increases suggest the economy should slow, that hasn’t shown up in the hard data. Some survey-based measures have softened, such as the Institute for Supply Management’s manufacturing report and Duke University’s quarterly poll of chief financial officers, but that may have more to do with the tumult in stocks and weakness abroad than the U.S. economy.

If not a repeat, the situation at least rhymes with what was happening around the start of 1999. Back then, markets still were recovering from the Russian debt crisis—an event that had precipitated the collapse of hedge fund Long Term Capital Management, pushed survey-based measures lower and led the Fed to cut rates three times in the fall of 1998.

Not long into 1999, it was clear that the economy wasn’t in such dire straits as feared, yet the Fed didn’t start taking back its rate increases until late June, helping fuel a massive rally in stocks. A big reason for the delayed response: Inflation was cooling, and Fed Chairman Alan Greenspan argued that technological advances were boosting productivity, allowing economic growth to accelerate without price pressures.

But the drop in inflation wasn’t really about productivity, notes Robert Barbera, co-director for the Center for Financial Economics at Johns Hopkins University. Rather the slowdown overseas had sent the dollar up, import prices down and oil prices to multidecade lows.

Unemployment kept falling and stocks reached skyward, but it wasn’t until inflation reasserted itself that the Fed started tightening the screws. In early 2000, the dot-com bubble burst and that was that.

Mr. Powell seems unlikely to confuse overseas weakness and a booming economy with a productivity miracle. Nor, if stocks start to stage a 1999-style rally, would he likely be as sanguine on the market risks as Mr. Greenspan. Indeed, 2013 Fed-meeting transcripts released last week show that Mr. Powell worries about what can happen when investors take on too much risk. “It’s worth remembering the power of another financial shock to damage the economy,” he said, according to the transcripts.

And for investors, it is worth remembering that somebody other than Alan Greenspan is in charge of the Fed.

Quantitative Brainwashing

By Jeff Thomas

We’re all familiar with the term, “quantitative easing.” It’s described as meaning, “A monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.”

Well, that sounds reasonable… even beneficial. But, unfortunately, that’s not really the whole story.

When QE was implemented, the purchasing power was weak and both government and personal debt had become so great that further borrowing would not solve the problem; it would only postpone it and, in the end, exacerbate it. Effectively, QE is not a solution to an economic problem, it’s a bonus of epic proportions, given to banks by governments, at the expense of the taxpayer.

But, of course, we shouldn’t be surprised that governments have passed off a massive redistribution of wealth from the taxpayer to their pals in the banking sector with such clever terms. Governments of today have become extremely adept at creating euphemisms for their misdeeds in order to pull the wool over the eyes of the populace.

At this point, we cannot turn on the daily news without being fed a full meal of carefully- worded mumbo jumbo, designed to further overwhelm whatever small voices of truth may be out there.

Let’s put this in perspective for a moment.

For millennia, political leaders have been in the practice of altering, confusing and even obliterating the truth, when possible. And it’s probably safe to say that, for as long as there have been media, there have been political leaders doing their best to control them.

During times of war, political leaders have serially restricted the media from simply telling the truth. During the American civil war, President Lincoln shut down some 300 newspapers and arrested some 14,000 journalists who had the audacity to contradict his statements to the public.

As extreme as that may sound, this practice has been more the rule in history than the exception.

In most countries, in most eras, some publications go against the official story line and may very well pay a price for doing so. But, other publications go along with the official story line to a greater or lesser degree and are often rewarded for doing so.

It should come as no surprise, then, that media outlets often come to report the news in a less than accurate manner.

Mark Twain is claimed to have said, “If you don’t read the newspaper, you’re uninformed. If you do read the newspaper, you’re misinformed.” Quite so.

Still, only fifty years ago, much of the then “Free World” enjoyed a relatively objective Press. Even on television, reporters such as Walter Cronkite, Huntley and Brinkley, etc. presented the news in a bland manner. It wasn’t very exciting, but at least it was relatively balanced and, to this day, most people who were around then still have no idea as to whether reporters like Walter Cronkite were liberal or conservative. Although he was a committed Democrat, he never allowed that to significantly colour his reporting.

But today, we have a very different corporate structure as regards the media. The same six corporations hold the controlling interest of over 80% of the media. And those same corporations also own a controlling interest in the military industrial complex, Wall Street, the major banks, Big Pharma, etc.

What we’re witnessing today is media having been transformed into something more akin to a three-ring circus than journalism of old. This is no accident.

The present travesty that is the 21st century media, is journalism in name only.

So, why should this be so?

Well, as it happens, people tend not to like governments dominating their lives – simple as that.

And yet, the primary objective of any government is to increase its size and power as rapidly as the populace will tolerate it. The only reason that they rarely do this quickly, is that they can’t get away with it. Like boiling a frog, it takes time to lull the populace into submission, bit by bit.  
Once having had enough time to do so, there comes a point at which the government becomes woefully top-heavy, as well as unworkably autocratic. At such times, all that’s necessary to make people rebel is an economic crisis.

Such is the case in much of the world today – the EU, the US, Canada, etc.. Even in their arrogance, the powers that be have to be aware that they’re right at the tipping point. An economic crisis would almost certainly push the situation over the edge.

When truth threatens to undermine machinations for self-aggrandizement, individuals tend to obfuscate in order to delay the inevitable fallout. Governments are no different.

So it was that, in 1999, the largest banks entered into a massive lending scam that would most certainly collapse within a decade. However, before putting the scam in place, they arranged for a “bailout” by the government, which would effectively pass the bill to the taxpayer, while the banks themselves simply increased their own wealth massively.

Of course, QE, as massive as it was, was a mere Band-Aid solution. All those involved (big business and the government) understood that it would hang like a sword of Damocles over the economy until it inevitably came crashing down – a fate far worse than if QE had never been implemented.

And so, for those entities to have invested into the domination of the media was, in fact, essential. Had they not done so, it’s entirely likely that, with a free press, the man on the street would, by now, have figured out that he’d been hoodwinked.

Thus do we see the journalistic equivalent of Quantitative Brainwashing, in which the inevitable realization is delayed for as long as possible.

And, in order to make sure that the public do not figure out what’s been done to them, the news reporting becomes Orwellian in its endless repetition of a false narrative.

It is, however, true that, “You can’t fool all of the people all of the time.” Eventually, the Band-Aid peels back to reveal an infection that’s far beyond what had been generally perceived. It then falls away in layers, as increasing numbers of people become aware that they’ve been scammed – that the media is entirely corrupt and that the media’s owners – big business - have, with the enthusiastic compliance of the government, robbed them on a wholesale basis.

Historically, that’s when the jig is up. What happens then is a matter of historic record.

miércoles, enero 23, 2019



Ukraine’s Crumbling Economy

The country’s persistent economic strife is veering toward crisis.

By Ekaterina Zolotova         

Ukraine is in internal disarray. Driving the disarray is its deteriorating economic situation. While poor economic conditions predate the 2014 revolution, the subsequent Russia-backed insurgencies and annexation of Crimea exacerbated the underlying economic problems and forced Ukraine to attempt a rapid reorientation toward the West. Ukraine staved off potential disaster in December when the International Monetary Fund, as part of its four-year assistance program, approved a new $3.9 billion standby loan, $1.4 billion of which has been disbursed. (Ukrainian government debt is now approaching 70 percent of gross domestic product.) But the program is just a Band-Aid. This year will be a serious test for Ukraine, as millions of citizens – already hurting from the current conditions – will feel the pinch of economic reforms mandated by Ukraine’s creditors.
Rising Prices, Plummeting Conditions
Although some official statistics paint an artificially rosy picture, by almost any metric the economic situation in Ukraine is in danger of becoming critical. According to the U.N. resident coordinator in Ukraine, while 4 percent of the Ukrainian population lives below the national poverty line (defined as 75 percent of the median income), some 60 percent live below the subsistence minimum. Ukraine’s social policy minister noted that between 2014 and 2017, poverty in Ukraine rose from 8 percent to 55 percent. Improvements in the economy can more often be traced back to bureaucratic siphoning of budget funds to prop up entrepreneurs than to any actual improvements among the general population.

Inflation is becoming a pernicious problem. While the official inflation rate has been around 10 percent since last June, Ukrainian research and media firms suggest it’s much higher. Vesti-UA reported the prices of 87 percent of consumer staples have increased. Info-Shuvar reported that the price of potatoes doubled since the beginning of November, and Obozrevatel said that such increases were not limited to potatoes. According to the State Statistics Service, the price of onions has increased by 115 percent, cabbage and carrots by 60 percent and beets by 30 percent (compared to the same time last year). Bread, flour, semolina and bacon have seen price hikes between 14 and 17 percent, while the prices of beef, fish and sausage have reportedly increased between 9 and 11 percent.


Other consumer goods and services are feeling the effects of inflation, too. Public transit fares have risen by 26 percent. Cigarette prices are up 16 percent, and antibiotics cost around 10 percent more than they did a year ago. Looming largest, however, are natural gas price increases. The IMF has mandated that Ukraine cut natural gas subsidies if it wants to remain in good standing. Ukraine has resisted; still, starting May 1 the price of natural gas is slated to increase by 15 percent, and beginning in 2020 it will be sold at market rates. (Due to previous price hikes, Ukrainians are now paying roughly 40 percent of the market price for gas. In 2015, they paid only 12 percent.) At the same time, the volume of natural gas in Ukraine’s underground storage facilities has fallen to 43 percent of capacity. Ukrainians should prepare to pay more for this key commodity or fall back on the coal industry.

Reports suggest that deepening poverty and fear of increasing military activity are prompting a new wave of migration as Ukrainians seek better economic conditions elsewhere. This is not a new phenomenon: According to the IMF, between 2 million and 3 million Ukrainians work abroad, while the government estimates that 3.2 million Ukrainian citizens are living abroad permanently. (The U.N. estimated that in 2017, roughly 6 million Ukrainians were living abroad in total.) The IMF has said the increase in the number of Ukrainian emigrants is becoming a domestic political issue. One opposition party leader said that “poverty makes Ukrainians [want] to work abroad, sometimes people have to work in terrible conditions and with old equipment.”

The increased migration has resulted in long queues at the Uspenka checkpoint, on the Ukraine-Russia border near occupied Donetsk. Eyewitnesses said there were more than 200 cars queued up to enter Russia – though apparently, it’s possible to purchase a better place in line for 2,000 Russian rubles ($30). Details on this specific outflow are sparse, and at least some of the increased traffic may be a result of people returning to Russia after Christmas, which the Orthodox world celebrated Jan. 7. It remains to be seen if the situation will stabilize in the coming days.
Government Inaction
It’s hard to know whether the Ukrainian government’s inability to tackle these problems is a symptom or cause. Either way, Kiev is increasingly unable to support its citizens. The government needs cash to pay off the foreign loans it took out in 2014-2015, valued at roughly $17 billion. (Coincidentally, that’s about the value of the country’s entire gold and foreign currency reserves, which total $17.7 billion.) The bulk of these repayments are due in the second half of 2019, just as natural gas subsidies are slashed, prices are climbing and elections are held.

Meanwhile, Kiev has increased military spending, a political necessity considering that the government has made the threat of Russian aggression a key campaign talking point. In December, Interfax reported that the government planned to increase spending on the army in 2019 by 16 percent – for a total of about $16 billion. Funding for the defense and security sectors will top 5 percent of GDP. (In 2017, only 5 countries spent a greater percentage of their GDP on the military.) Russia is a real threat to the government. But so are elections – and they go a long way to explaining why President Petro Poroshenko, who after 2014 promised to “live in a new way,” now touts the slogan, “Army, Language, Faith.”

What this boils down to is that Ukrainian authorities – whether pro- or anti-Russia – will need an infusion of cash in 2019. Oligarchs have money, but they’re not going to spend it on Poroshenko. (Instead, they may throw their own hats into the ring this election cycle.) The IMF remains a key option for the president. Decisions on the next tranches of the standby program will be made in May and November this year. They will hinge on Ukraine’s ability to slash its budget, reduce inflation while maintaining a flexible exchange rate, privatize state-owned businesses and increase natural gas prices. Ukrainian citizens won’t be happy with these reforms, and it won’t be easy for presidential candidates to appeal to the population while staying on good terms with the IMF.

Pursuing one of these imperatives necessarily hinders the other, which puts Ukraine in the unenviable position of having to choose between choices that are all bad.

Bull in the China Shop

By John Mauldin

The production of souls is more important than the production of tanks.... And therefore I raise my glass to you, writers, the engineers of the human soul.

Joseph Stalin, 1932

[Our purpose is] to ensure that literature and art fit well into the whole revolutionary machine as a component part, that they operate as powerful weapons for uniting and educating the people and for attacking and destroying the enemy, and that they help the people fight the enemy with one heart and one mind.

Mao Zedong, 1942

Art and literature is the engineering that molds the human soul; art and literary workers are the engineers of the human soul.

Xi Jinping, 2014

This week’s letter focuses on China’s economy. We’ll look at some numbers showing the challenges China faces, but they don’t explain something important. The way China will meet those challenges is going to be substantially different than we would see in the West. So I want to start with a little context.

When European Central Bank President Mario Draghi promised to solve the financial crisis with “whatever it takes,” central bank policy was his only tool. Xi Jinping has a vastly larger toolbox. It is hard for us in the Western world to understand that. Xi not only has every tool a top-down government can have, he has experts to wield them, all of whom are 100% aligned with his goals.

I used the “Bull in a China Shop” pun for this letter’s title to create an image in your mind. A bull tears up the proverbial china shop because it can’t comprehend the porcelain is expensive, easily broken, and hard to repair. It perceives the shelves as threats to its own freedom and so tries to escape, destroying them in the process. But that won’t unlock the door, so the bull stays stuck.

Similarly, many in the West misunderstand China and react counterproductively, breaking things and still not solving the problem.

The Stalin, Mao, and Xi quotes above have a common theme. “… engineers of the human soul.” Mao venerated Stalin, and Stalin’s books sold massively in China. Now Xi Jinping frequently quotes or alludes to Mao and Stalin. “Socialism with Chinese characteristics” has been the case since Deng Xiaoping.

I spent a few hours with Mark Yusko here in Puerto Rico this week. Mark is a good friend and every time I hear him talk about the opportunities he has found in China, it makes me want to get my checkbook and fly to Shanghai or Guangdong. The country has enormous investment opportunities, and an atmosphere where entrepreneurs can create almost anything they envision.

However, you must realize this comes with a level of government intrusion unfathomable to us in the West. In the US, we’re debating the data collected by corporations like Facebook and Google. Their Chinese equivalents are encouraged to collect such data and share it with the government. Moreover, in every interview that I have heard, the overwhelming majority of Chinese simply don’t care, at least not publicly.

These same Chinese companies will extend their practices along the One Belt, One Road initiative, and where do you think that data will end up? By the way, OBOR is a brilliant strategy from the Chinese point of view.

Source: Gavekal

Xi Jinping is intent on having China once again recognized as an equal global superpower and, at some point, even the leader. The Chinese leadership are all students of Chinese history. They know where they came from, and want to regain what they consider their proper place. They are playing a long game—decades long.

China is investing at least as much in artificial intelligence, robotics and Big Data as the West is, much of it controlled, directly or indirectly, by the Chinese military. So when US and European military planners get, let’s just say, nervous about China’s growing capabilities, it is not without reason.

China fully intends for the Yuan to be a global reserve currency. One requirement for that status is willingness to run trade deficits. It is no accident China’s large trade surpluses are beginning to dwindle. That is a feature, not a bug. It is by design.

As for intellectual property and patent rights, the Chinese are rapidly creating their own. China graduated 4.5 million, not counting software developers, mathematicians and other scientists. The vast majority of artificial intelligence patents filed last year were Chinese. Their interest in protecting that property is replacing the former practice of stealing the IP shirt off your back.

But China faces numerous challenges, too. Simon Hunt, who has been going to China for 25+ years and knows the country better than any non-Chinese person I’ve ever met, put it this way.

What should be clearly understood is that China’s economy is facing multiple changes in its structure. They include:

- Exporting companies relocating overseas because of rising domestic costs and American tactics (which won’t reduce the total imports, just the origination of those imports!)

- A shrinking labour force.

- A focus on high-tech

- The need to build infrastructure to accommodate the migration of another 150 million from the countryside to the urban community [in addition to the almost 300 million that have already moved in the last 40 years, in the largest single migration in human history]

- The need to focus development on the lower-tiered cities and rural villages

- Whilst continuing the process of deleveraging the economy.

I talk often about how big China is and how fast it is growing. Often I mention it is the world’s second-largest economy after the US. I may have to modify that practice soon.

Standard Chartered Bank said this month China will likely become the world’s biggest economy at some point in 2020, using nominal GDP and purchasing power parity. Gentle reader, 2020 is next year. This isn’t the far future.

Now, this won’t be the end of the world. It is simply math. GDP growth is a function of the number of workers and their productivity. China has more workers (as in four times more) who are getting more productive. At some point, their large numbers outweigh the higher productivity we have in the US and Europe. This is inevitable.

And that rise won’t happen without some hiccups. I noted last week in Something Wicked This Way Comes that the US and Chinese economies are co-dependent in ways we can’t change quickly. Problems in either country will hurt the other, and both currently have problems.
Demand Pulled Forward

The 2008 financial crisis and recession hit China hard, as it did everyone else. Not every country responded like China did, though. Most couldn’t do what China did because they lacked either the financial resources or the political ability. China had both, and so launched a stimulus program of mind-boggling proportions. Beijing compelled local governments and state-owned enterprises to take on massive debt for giant infrastructure projects, huge capacity expansions, and pretty much anything else they could imagine that would put people to work and bolster public confidence. Yes, they built ghost cities.

(Incidentally, the classic ghost city was in Mongolia, literally vacant for a time but now well on its way to being fully occupied or bought. Long game and deep pockets, indeed.)

Not coincidentally, China has doubled its debt relative to GDP since the beginning of the century, and the bulk of that was after 2009.

But it’s how they grew that debt I find amazing. We must remember that the Chinese economy is managed from the top down. The Chinese government is very aware of how its shadow banking system operates. Half of the total debt is from the nonfinancial (i.e., shadow banks) sector. And while Simon Hunt talks about deleveraging, when I talked with him what he really means is that the Chinese government is trying to move from Wild West shadow banking to more traditional bank financing. Central bankers sometimes accompany private bankers to meet loan-seeking businesses. Chinese characteristics, indeed.

In my research for this letter I came across several mentions that China is planning to move another 150 million rural citizens to urban areas, many into so-called second-tier cities. Only in China can a second-tier city have five million people. And people moving from the country into the city becomes far more productive in terms of GDP. And China is beginning to focus on upgrading the infrastructure and the rural cities as well.

As the entire world will come to realize in the middle of the next decade, the debt which financed that infrastructure does have a carrying cost. Even in a top-down economy. Yes, much of it is internal but our first concern is China’s enormous amount of dollar-denominated debt. Here’s Christopher Balding with the numbers:

According to official data, short-term debt accounted for 62 percent of the total [of almost $2 trillion in debt] as of September, meaning that $1.2 trillion will have to be rolled over this year. Just as worrying is the speed of increase: Total external debt has increased 14 percent in the past year and 35 percent since the beginning of 2017.

External debt is no longer a trivial slice of China’s foreign-exchange reserves, which stood at just over $3 trillion at the end of November, little changed from two years earlier. Short-term foreign debt increased to 39 percent of reserves in September, from 26 percent in March 2016.

The true picture may be more precarious. China’s external debt was estimated between $3 trillion and $3.5 trillion by Daiwa Capital Markets in an August report. In other words, total foreign liabilities could be understated by as much as $1.5 trillion after accounting for borrowing in financial centres such as Hong Kong, New York, and the Caribbean islands that isn’t included in the official tally.

So, China could owe non-Chinese lenders as much as $3.5 trillion, much of it in USD which are more expensive to acquire than they used to be. This is why a trade war is so threatening to China. Revenue from exports to the US helps pay that debt.

So that’s one problem, but the internal debt is not exactly benign. Yes, a state-dominated economy like China’s can deal with debt in its own currency. It has many ways to extend and pretend. But they have limits and don’t work forever. It has to be worked off.

Job Jitters

Leverage is fun. It lets you do things you otherwise couldn’t. Deleveraging is the opposite of fun because you must do things you would rather avoid. This is a particular problem for the Chinese government, which must keep a large population fed, housed, and otherwise content. Thus the drive to improve the conditions or move 150 million people from the poverty of rural China to the cities.

Beijing has many tricks up its sleeve but China’s labor market has its own Dynamic.

From my friends at Gavekal Dragonomics, written by Ernan Cui:

China’s job market is proving to be an early casualty of the US-China trade conflict. Layoffs in manufacturing accelerated over the second half of 2018 as US tariffs fell into place, and job losses have now matched the pace seen during the economic slowdown of 2015-6. But the situation is arguably worse this time, as the service-sector employers that previously absorbed many laid-off workers are now being squeezed by tighter regulations. Government officials are trying to adjust and soften policies to help employment, but the outlook for household income and consumer spending in China in 2019 is clearly worsening.

Consumer spending had already slowed in 2018, but most of the deterioration came from a decline in auto sales. [Which still total 27 million cars sold.] That was largely the result of the end of several years of favorable policies that had front-loaded vehicle purchases; spending on services and other consumer goods actually held up fairly well. But China looks to be headed for a more broad-based slowdown in consumer spending in at least the first half of 2019. The employment components of the PMI surveys, both for manufacturing and non-manufacturing sectors, started to deteriorate sharply in September. These are decent leading indicators of household income growth (see chart), so a further slowdown in income and consumption in the next couple of quarters is almost guaranteed.

Now, we should note that Chinese economic data is questionable in the best of circumstances. The last thing Beijing wants is to give the public rigorous data proving how hopeless its job-hunting is, or how unlikely its income is to grow. Fortunately, we have alternative sources like Gavekal, China Beige Book, and others with on-the-ground presence and access to non-government data.

Gavekal in their broad-based research found an amazing data point, too. The graph below shows an index of Chinese internet searches for the word “layoff.” Notice where it is now compared to 2008 and other recent economic slowdowns.

Now, this doesn’t mean Chinese employers are actually conducting layoffs.
It means people are looking for information on the topic, and I think it’s fair to call that a sign of worry. What is causing this concern? Do Chinese workers see something that bullish Western analysts are missing?

Credit Intensity

Economic weakness is relative. Like anything else, coming down from a level to which you are accustomed is hard, even if you land in a place that isn’t so bad in absolute terms.

Assuming (for discussion’s sake) the official numbers are right, China’s GDP growth has been around 4% at worst going all the way back to the 1980s, and usually much higher. The US has struggled to achieve anything near that. So a decline from the 6.9% growth seen in 2017 to, say, 6%, is a big deal to the Chinese. And that’s what the government apparently expects. Reuters reported on January 11 that in March the government will announce a 2019 growth target goal in the 6-6.5% range… and China always hits the target. Funny how that works.

Here in the US we would celebrate 4% growth. (I think by the end of 2019 we may be wishing for even 2% growth.) In China, they will hit the proverbial panic button at anything south of 6%. Look for the government to respond with even more debt and infrastructure spending to try and stimulate the economy and maintain growth in the 6% range.

The problem is, like a medicine to which the body adapts, debt is no longer having the same kind of effect. An IMF study last year measured China’s “credit intensity” over time.

Source: IMF

I’m sorry that picture is fuzzy—it’s that way in the original, too. Here is how they explain it.

However, over the last five years, domestic nominal credit to the nonfinancial sector has more than doubled, and the domestic nonfinancial sector credit-to-GDP ratio rose to about 235 percent of GDP as of end-2016. 2 During this period, the efficiency of credit expansion has increasingly deteriorated, pointing to growing resource misallocation. In 2007-08, about RMB 6½ trillion of new credit was needed to raise nominal GDP by about RMB 5 trillion per year. In 2015-16, it took more than RMB 20 trillion in new credit for the same nominal GDP growth.

So in less than a decade, the amount of debt needed to produce a given impact on GDP more than tripled. I’ve cited data from Lacy Hunt showing a similar trend in the US but it’s nowhere near that magnitude.

That tells us something important: In the next downturn, slowdown, or whatever you call it, Beijing may not be able to borrow its way out of the hole. Or if it does, the amounts could be astronomically high.

But absent debt stimulus, what else can they do? As noted, Xi Jinping has many tools. Some are more pleasant than others. I seriously doubt he has any way to restore growth to what everyone wants without massive adjustments (i.e., more debt). And it will be painful not just for Chinese, but Americans, too.

Rushing the Process

That being the case, now is not the best time for a trade war between the US and China. Yet we find ourselves in one. Let me again give my requisite disclaimer, since I always get letters saying, essentially, “China bad! Must do something!” Yes, China hasn’t played fairly in a number of ways. I get that. We have issues and problems that need resolution. Prior efforts haven’t worked. I get that, too. We have national security concerns about China, totally apart from our trade disputes. Granted on all counts.

It does not therefore follow that slapping tariffs on Chinese imports is the right answer. We have to fix these things, but without shooting our own feet. American and Chinese businesses have spent the last two decades integrating supply chains and developing markets with each other. Every one of us benefits from that integration every single day.

Could we reverse the integration and become less interdependent? Yes, of course. It’s happening already, simply due to technology that is letting production move closer to consumers. That’s a natural process that will continue. Rushing that process, while probably possible, would have a cost.

Last week I mentioned the US microchip companies that in some cases get half their sales from China. Some are one tariff away from being out of business. Gone, kaput. Stock zero, all employees jobless, all their small-business suppliers, bondholders, and bank lenders left to fight over the scraps in bankruptcy court.

This is one of my greatest short-term fears: that the Trump administration’s hardline tactics will push China into recession, which for them is less than 4% growth. The president himself seems to relish the prospect. He’s talked proudly of the way Chinese markets fell due to his policies. Maybe he thinks the threats will make Xi back down. I don’t think they will. We are pursuing a high-risk policy that will have massively negative consequences if it fails.

I titled this letter “Bull in the China Shop” because that is what we need to avoid. Running around breaking things may be satisfying in the moment, but the cleanup isn’t fun at all.

Next week I go to Tampa Bay for two days, then Baltimore for a few hours, then New York on Sunday, and then back to Palm Beach the following Tuesday. My schedule has changed so much in the last 24 hours it is really insane. I don’t even want to write about it, much less see that many airports and train stations. But it is what it is, and comes with the territory.

I had lunch this week with Harry Dent. He has been in Puerto Rico for several years, and bought property here 20 years ago. I always enjoy my times with Harry and now that we are almost neighbors, there will be more of them. I’m finding that I know many people in Puerto Rico and I’m meeting many more. And Shane loves it. What’s not to like?

My editors are going to have problems getting the word count down, so I think I will help them and just go ahead and hit the send button. You have a great week!

Your hoping we get the China issues resolved analyst,

John Mauldin
Chairman, Mauldin Economics

The Clinton-Obama era ends as US Democrats seek a radical new voice

The party owes a debt of gratitude to Donald Trump as it sweeps away a cautious mindset

Edward Luce

Listen carefully and you can hear the retreat of the Democratic establishment. Incrementalism served its purpose: it made Democrats electable again and safe for Wall Street. But it has had its day. The generation of Democrats that downplayed concerns about inequality and embraced global markets is being replaced by a far bolder political voice. No matter who takes the Democratic nomination in 2020, they will speak for a radicalised party in quest of the new New Deal.

They owe a debt of gratitude to Donald Trump. However much resurgent liberals detest America’s 45th president, they can thank him for sweeping away the mindset of systematic caution that has mesmerised Democratic leaders for a generation.

It began with Bill Clinton’s New Democrats in the late 1980s. It ended in 2016 when Hillary Clinton lost to Mr Trump. In between it spanned Al Gore, the losing 2000 nominee, John Kerry, who lost in 2004, and Barack Obama, whose eight-year legacy is now being destroyed by Mr Trump.

Mr Trump has served both as a call to arms and as an example of how establishments can be defeated. On the first, Mr Trump has demolished whatever case remained for the idea that Democrats must forever ready themselves for a promised land of bipartisan amity. In practice, many thought that stance had already been discredited by Newt Gingrich, the take-no-prisoners Republican Speaker of the House during the Clinton years. Others thought the wrecking ball the Tea Party took to Mr Obama’s fiscal plans had finally settled the argument.

No matter how much Democrats tacked to the centre, the rewards for this virtue never came. Republicans simply moved further to the right. Democratic presidents, such as Mr Clinton, created budget surpluses. Republicans, such as George W Bush, duly spent them on tax cuts. Inequality is far worse today than in 1992, even though Democrats held the White House for more than half that time. Median incomes, meanwhile, have barely shifted. The initial anger over the 2008 financial crash was captured by the Tea Party. It is nevertheless hard to believe the self-proclaimed socialist Bernie Sanders would have nearly defeated Mrs Clinton had she not developed such close financial ties to Wall Street.

But it was Mr Trump who changed the weather. He showed that you could bamboozle a hostile establishment and still win an election. Then he switched horses and pursued an aggressive Republican agenda. From tax cuts and deregulation to gun rights and anti-abortion judges, Mr Trump now has Republican lawmakers eating out of his hand. Those who still believed it would be possible to work across the aisle — and who pined for the days of Rockefeller Republicans — were robbed of any remaining force. Mr Trump has done a service for the American left.

Reality has also lent it a helping hand. Regardless of your ideology, today’s numbers paint a stark picture. Ten years into the US recovery, median household incomes are, in real terms, still much what they were they were in 1999. The top one per cent of households own more wealth than the bottom 90 per cent. America’s average life expectancy has started to decline.

Mr Trump has made inequality worse. But he is not its author. The numbers were almost as bleak at the end of Mr Obama’s two terms. So tinkering no longer holds much appeal.

Much of the focus is on who should be the Democratic nominee to challenge Mr Trump. That obviously matters. But the significant point is that the party’s centre of gravity has shifted. Whoever the challenger turns out to be, whether Joe Biden, the former vice-president, Elizabeth Warren, the economic populist, Beto O’Rourke, the sunny optimist, or Mr Sanders, their platform will have to reflect that shift. Stances such as “Medicare for all”, a “Green New Deal”, and public election financing will have to be part of the package. So too will higher taxes.

Attention has also been lavished on Alexandria Ocasio-Cortez, the 29-year-old Democratic socialist and youngest member of Congress. More notable is the respect her ideas, including a top tax rate of 70 per cent, commands among establishment Democrats. “The congresswoman is right,” Lawrence Summers, Mr Clinton’s former Treasury Secretary, said last week. Mr Summers personified the Washington consensus of the 1990s. Like Keynes, however, he says he changes his mind when the facts do. They no longer fit the arc-of-history Democrats used to narrate. “The false doctrines of the neoliberal priesthood are losing their hold,” writes Nick Hanauer, the entrepreneur who made his fortune with Amazon.

America’s left is turning into a factory of new ideas. Some of them, such as a universal basic income, may be questionable. Others, such as breaking up monopolies, are more promising. Either way, for the first time in decades, America’s intellectual energy is now on the left. Some liken the ferment to the “bold persistent experimentation” of Franklin Roosevelt, author of the 1930s New Deal. Doubters compare it with the false dawn of George McGovern, who lost in a 1972 landslide to Richard Nixon. Whichever view proves correct, the Clinton-Obama era is drawing to a close. A new one is just beginning.

Trump’s New Shutdown World

In 2013, Obama tried to maximize the difficulty. OMB is taking another tack.

By Kimberley A. Strassel

A girl outside the shuttered National Museum of African American History and Culture in Washington, D.C., Jan. 2.
A girl outside the shuttered National Museum of African American History and Culture in Washington, D.C., Jan. 2. Photo: andrew caballero-reynolds/Agence France-Presse/Getty Images

This weekend the federal shutdown becomes the longest in history—and yet, and yet, the sky has not fallen. Meet the team that has allowed the Trump White House to hold out for so long, and in the process forever altered future shutdown fights.

Across the street from the Oval Office, an only somewhat merry band of budget lawyers labor on one priority: making this event as painless as possible. That was the order from President Trump when the government closed, and the Office of Management and Budget was ready.

Acting White House Chief of Staff Mick Mulvaney had spent months as OMB director gearing up for a stoppage. Acting Director Russ Vought was all in. And OMB General Counsel Mark Paoletta and his small legal team (those not furloughed) has spent every day since putting out fires.

It’s the opposite of prior shutdown thinking. The Obama White House used a 16-day shutdown in 2013 to punish Republicans for withholding funds, and in the process penalized the nation. The administration immediately furloughed workers and cut pay for private contractors. It shuttered Head Start, suspended money for health care in the District of Columbia, and sealed national parks, including war memorials on the National Mall. Some agencies had carry-over funds that would have allowed them to continue operations; they refused to use it.

Some shutdown pain is unavoidable—and correctly so. Both the Constitution and the Antideficiency Act are clear that only Congress appropriates money, and no one should want the executive branch to flout clear legal requirements. Shutdowns are also wasteful and highlight Washington’s inability to function.

Yet since Mr. Trump “owns” this one, Republicans have an incentive to minimize the suffering. Congressional Republicans helped themselves by last year passing bills that kept most of the government open. As for the rest, it turns out the law provides some useful flexibility—when an administration cares to exercise it.

A series of OMB memos stretching back to 1981 had already established certain shutdown exceptions. Agencies can continue to function as necessary to protect safety and human life and property, as well as in aid of the president’s fulfilling constitutional duties. Those programs that operate under “indefinite” appropriations, including Social Security and Medicare, also continue. The current OMB team has employed some of these doctrines in ways past administrations haven’t but which nonetheless make obvious sense. The Food and Drug Administration, for instance, has on the grounds of safety continued to monitor adverse reactions to medical devices, conduct foreign drug-factory inspections, and watch for outbreaks of food contamination.

Lawyers have scoured other statutes for legal outs. It turns out that Congress’s latest spending bill, the continuing resolution that ended Dec. 21, contained a provision allowing the government to pay certain obligations that came due within 30 days. That’s allowed OMB to rush food-stamp payments for millions of Americans through February. It was the Interior Department’s own reading of prior statutes that allowed it to use entrance fees to keep national parks open.

Then there’s the past OMB legal finding that unfunded agencies can continue providing services that are “necessary” to funded ones or to mandatory services. An easy example: The Social Security Administration and Treasury Department, both technically shut down, must nonetheless process Social Security checks that operate under continuous appropriations.

That’s also why Americans will still get tax refunds. The OMB team dug through Treasury documents and found that long ago the Internal Revenue Service had determined refunds fall under permanent, indefinite appropriations. IRS workers are being recalled from furlough to process them.

Some critics claim these workarounds are “illegal,” but lawyers say the Trump team looks to be on sound footing—especially given these decisions have been approved by career OMB lawyers.

And also because the Trump team continues to nix proposals that fall too close to the legal line.

Yet there are no legal fixes for some truly painful effects—including Friday’s missed paycheck for 800,000 federal workers. And many patches were one-time wonders. There can be no additional payments for food stamps or for the Coast Guard. The pressure on Mr. Trump will only rise from here, and some Republicans are already nervous. Prepare for a lot more talk about national-emergency declarations.

But no matter the immediate outcome, the administration’s “painless as possible” approach has shifted the appropriations landscape. House Democrats will have to confront a new set of political calculations in budget negotiations during the Trump presidency. And future administrations will have a harder time justifying ugly shutdowns, in light of this example. Yet another way the Trump administration has changed Washington.