The Bonfire Burns On


“Life invests itself with inevitable conditions, which the unwise seek to dodge, which one and another brags that he does not know, that they do not touch him; but the brag is on his lips, the conditions are in his soul. If he escapes them in one part they attack him in another more vital part. If he has escaped them in form and in the appearance, it is because he has resisted his life and fled from himself, and the retribution is so much death.”

– Ralph Waldo Emerson, “Compensation”

Bonfires are fun to watch, but they eventually burn out. Human folly apparently doesn’t, so we just keep adding to the absurdities. The volume of daily economic lunacy that lights up my various devices is truly stunning, and it seems to be increasing. I shared a little of it with you in last week’s “Bonfire of the Absurdities.” Since it’s a holiday weekend and I was traveling all week, today I’ll just give you a few more absurdities to ponder. And this shorter letter will lighten your weekend reading load.

First, let me thank everyone who took my advice to register early for my next Strategic Investment Conference, March 6–9, 2018, in San Diego. Hundreds of you are now confirmed to attend. I know many more intend to do so. Sadly, we can’t accommodate an unlimited number of you. I can’t say when we will reach capacity, but I hope it is soon. I am in negotiations right now with a very familiar name whose economic views are, shall we say, different from mine. Our idea is to debate those differences in front of an audience. Fireworks will likely ensue. But, to get this to happen, I need some numbers to line up. You can help by registering for the conference now. Click here for more information.

Now, on with the absurdities.

Leverage, American Style

When I asked my “kitchen cabinet” of friends for instances of the absurd, Grant Williams sent a monumental slide deck. I guess I should have expected that, as the absurd is one of his specialties. My computer almost melted trying to download the deck, but it finally finished and was worth the wait. Here is just one example of craziness.

This chart is straightforward: It’s outstanding credit as a percentage of GDP. Broadly speaking, this is a measure of how leveraged the US economy is. It was in a sedate 130%–170% range as the economy industrialized in the late 19th and early 20th centuries. It popped higher in the 1920s and 1930s before settling down again. Then came the 1980s. Credit jumped above 200% of GDP and has never looked back. It climbed steadily until 2009 and now hovers over 350%.

Absurd doesn’t do this situation justice. We are mind-bogglingly leveraged. And consider what the chart doesn’t show. Many individuals and businesses carry no debt at all, or certainly less than 350% leverage. That means many others must be leveraged far higher.

Now, the usual economic pundits tell us that the situation is safe and under control and that we all have plenty of cash and cash flow to be able to handle this load of debt. Worrying about debt is so 1900s, they say. And they may have a point, in that many of us are able to use debt in responsible ways. But how about that $1.2 trillion in student debt?

While lending has been a very lucrative business in recent decades, it’s hard to believe it can last. At some point we must experience a great deleveraging. When that happens, it won’t be fun.

Against the Crowd

“Contrarian” investors believe success lies in going against the crowd, because the crowd is usually wrong. That is often a very good assumption. My own experience suggests one small adjustment: Pay attention not to what the crowd says but to what it does. Words are cheap.

This next chart is a prime example. We see here the amount of cash held by Merrill Lynch clients from 2005 to the present, as a percentage of their assets. The average is about 13%.

Of course, people hold cash for all kinds of reasons that don’t necessarily reflect their market outlook. Nor does this chart tell us how their non-cash assets were allocated. The pattern is nevertheless uncanny. In 2007, as stock indexes reached their peak, cash holdings were well below average. They rose quickly as the crisis unfolded, peaking almost exactly with the market low in early 2009.

In other words, at the very time when it would have been best to reduce cash and buy equities, Merrill Lynch clients did the opposite. And when they should have been raising cash, they kept their holdings low. I don’t think this pattern is unique to Merrill Lynch’s clients; I suspect we would see the same at most retail brokerages. Market timing is hard for everyone.

The disturbing part is where the chart ends. Merrill Lynch client cash allocations are now even lower than they were at that 2007 trough. Interest rates are much lower, too, so maybe that’s not surprising. Central banks spent the last decade all but forcing investors to buy risk assets and shun cash. This data suggests it worked. But whatever the reason, investor cash levels suggest that caution is quite unpopular right now. So if you consider yourself a contrarian, maybe it’s time to raise some cash.

Michael Lewitt’s latest letter came in this morning. He began with the marvelous Ralph Waldo Emerson quote that I used at the beginning of this letter, and then he helpfully contributed this list of absurdities:

Anyone questioning whether financial markets are in a bubble should consider what we witnessed in 2017:

• A painting (which may be fake) sold for $450 million.
• Bitcoin (which may be worthless) soared nearly 700% from $952 to ~$8000.
• The Bank of Japan and the European Central Bank bought $2 trillion of assets.
• Global debt rose above $225 trillion to more than 324% of global GDP.
• US corporations sold a record $1.75 trillion in bonds.
• European high-yield bonds traded at a yield under 2%.
• Argentina, a serial defaulter, sold 100-year bonds in an oversubscribed offer.
• Illinois, hopelessly insolvent, sold 3.75% bonds to bondholders fighting for allocations.
• Global stock market capitalization skyrocketed by $15 trillion to over $85 trillion and a record 113% of global GDP.
• The market cap of the FANGs increased by more than $1 trillion.
• S&P 500 volatility dropped to 50-year lows and Treasury volatility to 30-year lows.
• Money-losing Tesla Inc. sold 5% bonds with no covenants as it burned $4+ billion in cash and produced very few cars.

This is a joyless bubble, however. It is accompanied by political divisiveness and social turmoil as the mainstream media hectors the populace with fake news. Immoral behavior that was tolerated for years is finally called to account while a few brave journalists fight against establishment forces to reveal deep corruption at the core of our government (yes, I am speaking of Uranium One and the Obama Justice Department). In 2018, a lot of chickens are going to come home to roost in Washington, D.C., on Wall Street, and in the media centers of New York City and Los Angeles. Icons will be blasted into dust as the tides of cheap money, cronyism, complicity, and stupidity recede. Beware entities with too much debt, too much secrecy, too much hype. Beware false idols. Every bubble destroys its idols, and so shall this one.

Liquidity Lost

The next absurdity is absurd because it is so obvious, yet many don’t want to see it. Too bad, because I’m going to make you look. This comes from Michael Lebowitz of 720 Global. It’s the S&P 500 Index overlaid with the Federal Reserve’s balance sheet and the forecast of where the Federal Reserve intends to take its balance sheet.

As I noted above, the Fed and other central banks have practically forced investors into risk assets since 2008. You can see the relationship very clearly in this chart. The green segments of the S&P 500’s rise occurred during quantitative easing programs. Correlation isn’t causation, but I think we can safely draw some connections here.

Ample low-cost liquidity drives asset prices higher. That’s not controversial. It makes perfect sense that the withdrawal of ample low-cost liquidity would also impact asset prices in the opposite direction.

The Fed has even given us a schedule by which it will unwind its balance sheet. Michael’s chart gives us a sense of how far the S&P 500 could drop if the Fed unwinds as planned and if the relationship between liquidity and stock prices persists. Either or both of those could change; but if they don’t, the S&P 500 could fall 50% in the next few years.

At the risk of repeating myself, I think it is borderline dysfunctional for the Fed to be raising interest rates and at the same time experimenting with reducing its balance sheet. Where’s the fire? Seriously, we waited for four years, deep into the recovery, before the Fed found enough intestinal fortitude to begin to timidly raise rates. And now they think they have to proceed at warp speed? I just don’t see this ending well.

What would be really absurd, I submit, would be to see this data and then somehow convince yourself that stock prices can keep climbing or even merely hold steady as the prime mover that drove them higher moves in the opposite direction.

Mobbing the Exits

Another peculiar wrinkle in the situation today is that many investors see all these warning signs but think they can keep riding the market higher and hedge against losses at the same time. It doesn’t really work that way. However, it’s easy to see why people think they can get away with it. Wall Street firms have rolled out all kinds of volatility-linked products that purport to protect you from sudden downside events.

In various ways, most of these products are linked to the Volatility Index, or VIX. Volatility has been persistently low as the market has risen in recent years. That has made it cheap to buy protection against a volatility spike. However, it’s not clear if the sellers of this protection will be able to deliver as promised.

My friend Doug Kass has been concerned about this for some time. He believes the risks of a “flash crash” are rising, and those who think they are hedged may learn that they are not. He shared this Morgan Stanley graphic of how many VIX futures contracts would have to be bought to cover a one-day market drop.

Between hedgers, dealers, and ETP sponsors, a one-day 5% downward spike in the S&P 500 would force the purchase of over 400,000 VIX futures contracts. This was in October, and the figure has probably risen more since then. Doug isn’t sure a market under that kind of stress can deliver that much liquidity.

 Every market downturn seems to expose the vacuity of some new, sophisticated hedging product. In 1987 it was “portfolio insurance.” Whatever the particulars, the schemes all purport to let investors ride the market higher without taking on meaningful downside risk. That is not how hedging works. I suspect the various VIX-linked products will disappoint buyers when the unwind occurs.

Doug also shared what will be the final graph for this week and observed, “This is the dreaded alligator formation, and the jaws always close.” It’s just a matter of time. It could take another year and get even sillier, but when that gator snaps its jaws shut, a lot of people will get bitten. I personally think the bubble in high-yield debt, accompanied by so much covenant-lite offerings, will be the source of the next true liquidity crisis.

The amount of money available to market makers to use to maintain some type of order in a falling high-yield market is absurdly low. Investors in high-yield mutual funds and ETFs think they have liquidity, but the managers of those funds will be forced to sell into a market where there is no price and there are no bids. Oh, the bids will show up at 50% discounts. Distressed-debt funds and vulture capital will see opportunities, and they will be there. Talk about blood in the streets.

And with this list of fun topics on Thanksgiving weekend, I will leave you to your ruminations.

Home for Christmas, then Hong Kong

Other than a brief trip here and there – and who knows what will slip into the schedule – I will be home for most of December. This Thursday Shane and I fly to Tulsa to see my newest granddaughter, Brinlee Porter, who will be brought into the world by her mother Amanda on Tuesday. Amanda’s sister Abigail and another granddaughter are staying with us this weekend and will return to Tulsa tomorrow.

Shane and I will be in Hong Kong for the Bank of America Merrill Lynch conference in early January. That trip will be made even more fun because Lacy Hunt and his wife JK will be there with us. We are going to take an extra day or two and be tourists. I’ve been to Hong Kong many times but have never really gotten out of the business district. Well, Louis Gave did pick me up in his old-fashioned Chinese junk and took me around to the other side of the island to the yacht club, where we had dinner. The water got a little choppy, and I got a little seasick, so I was grateful for the car ride back. But it was really quite a beautiful outing. I very much like Hong Kong.

One of the things that I will be doing in Hong Kong is getting some new dress shirts. My workouts the past year or so have focused a lot more on my shoulders and shrugs, and I have actually added a full inch to my neck size. I have literally only one shirt that I can (barely) button to be able to wear a tie with. I have been waiting for the Hong Kong trip, because you can get a custom shirt made in just a few days, remarkably cheaply. I’m not sure that will mean I’ll be wearing more ties, but at least I will be able to do so comfortably when the need arises.

Lugano, Switzerland, was beautiful. We were with my associate Tony Courtney, and he drove us to the Lake Como area for lunch on Sunday, negotiating all the switchback roads to the accompaniment of his playlist of James Bond movie tunes, which, while appropriate, also affected his driving style. I was glad when we got to the restaurant and could sit still and breathe deeply. But it was fun. And the weather was marvelous.

I spoke to a number of Swiss money managers and family offices while I was at the conference, and I can tell you there was not a sense of complacency. They were all very nervous and not quite sure what to do – not unlike many of my readers. We took an informal poll, and a majority of the attendees felt that the Swiss National Bank’s balance sheet would top $1 trillion in less than a year. They are goosing it in order to keep a lid on the Swiss franc. Interestingly, 65% of the attendees felt that the SNB should not be buying US equities (it now owns more than 3% of Apple, for instance); and while this audience earns their keep by managing money for mostly non-Swiss clients, they were all concerned about the continued strength of the Swiss currency and wondering how long it can remain so strong.

Still, one way or another, we will all Mudadle Through. And as I hit the send button, I am noticing one of the anomalies of my life in a high-rise in what is essentially downtown Dallas (although technically the locals call it Uptown). The high-rise apartment building some 100 yards away from me has a pair of nesting red-winged hawks that have lived there for the last two or three years. The male actually landed on my balcony once, and I’ve often thought about putting out some meat to see if I could attract him back, as seeing him up close is magnificent. The weather is perfect, and I see as I glance out that the pair are doing an aerial dance. I think I’ll walk out on the balcony with a book and just watch. You have a great week!

Your enjoying the little things in life analyst,

John Mauldin

In Peru’s Deserts, Melting Glaciers Are a Godsend (Until They’re Gone)

Accelerating glacial melt in the Andes caused by climate change has set off a gold rush downstream, letting the desert bloom. But as the ice vanishes, the vast farms below may do the same.


VIRU, Peru — The desert blooms now. Blueberries grow to the size of Ping-Pong balls in nothing but sand. Asparagus fields cross dunes, disappearing over the horizon.

The desert produce is packed and shipped to places like Denmark and Delaware. Electricity and water have come to villages that long had neither. Farmers have moved here from the mountains, seeking new futures on all the irrigated land.

It might sound like a perfect development plan, except for one catch: The reason so much water flows through this desert is that an icecap high up in the mountains is melting away.

And the bonanza may not last much longer.

“If the water disappears, we’d have to go back to how it was before,” said Miguel Beltrán, a 62-year-old farmer who worries what will happen when water levels fall. “The land was empty and people went hungry.”

In this part of Peru, climate change has been a blessing — but it may become a curse. In recent decades, accelerating glacial melt in the Andes has enabled a gold rush downstream, contributing to the irrigation and cultivation of more than 100,000 acres of land since the 1980s.

Yet the boon is temporary. The flow of water is already declining as the glacier vanishes, and scientists estimate that by 2050 much of the icecap will be gone.

A 30-year-old photograph taken from a nearby location was placed on the path to the Pastoruri glacier in Áncash, Peru, showing how far the ice has retreated. Credit Tomas Munita for The New York Times 

A family harvesting flowers in the foothills of the Cordillera Blanca in Peru. Credit Tomas Munita for The New York Times 

An irrigation running through the desert south of Trujillo, Peru. Accelerating glacial melt in the Andes has allowed more than 100,000 acres of land to be brought into cultivation since the 1980s. Credit Tomas Munita for The New York Times

Throughout the 20th century, enormous government development projects, from Australia to Africa, have diverted water to arid land. Much of Southern California was dry scrubland until canals brought water, inciting a storm of land speculation and growth — a time known as the “Water Wars” depicted in the 1974 film “Chinatown.”

Yet climate change now threatens some of these ambitious undertakings, reducing lakes, diminishing aquifers and shrinking glaciers that feed crops. Here in Peru, the government irrigated the desert and turned it into farmland through an $825 million project that, in a few decades, could be under serious threat.

“We’re talking about the disappearance of frozen water towers that have supported vast populations,” said Jeffrey Bury, a professor at the University of California at Santa Cruz who has spent years studying the effects of glacier melt on Peruvian agriculture. “That is the big picture question related to climate change right now.”

A changing climate has long haunted Peru. One past civilization, the Moche people, built cities in the same deserts, only to collapse more than a millennium ago after the Pacific Ocean warmed, killing fish and causing flash floods, many archaeologists contend.

Now dwindling water is the threat. While more than half of Peru sits in the wet Amazon basin, few of its people ever settled there. Most inhabit the dry northern coast, cut off from most rain by the Andes range. While the region includes the capital, Lima, and 60 percent of Peruvians, it holds only 2 percent of the country’s water supply.

The glaciers are the source of water for much of the coast during Peru’s dry season, which extends from May to September. But the icecap of the Cordillera Blanca, long a supply of water for the Chavimochic irrigation project, has shrunk by 40 percent since 1970 and is retreating at an ever-faster rate. It is currently receding by about 30 feet a year, scientists say.

Farmers along the 100-mile watershed that winds its way from the snowcapped peaks to the desert dunes say they are already feeling the effects of the change.

The retreat of the icecap has exposed tracts of heavy metals, like lead and cadmium, that were locked under the glaciers for thousands of years, scientists say. They are now leaking into the ground water supply, turning entire streams red, killing livestock and crops, and making the water undrinkable.

Workers harvesting asparagus in the sand south of Trujillo, Peru. Credit Tomas Munita for The New York Times

Temperatures in this area have risen sharply, leading to strange changes in crop cycles, farmers say. Over the past decade, corn — which since precolonial times was grown only once a year in the mountains — can now be harvested in two cycles, sometimes three.

That would be a windfall, said farmers like Francisco Castillo, if it were not for all the pests that now thrive in the warmer air.

For Mr. Castillo, who plants corn and rice near the Santa River in Chimbote, it was a worm that became the scourge for him and neighboring farmers. It suddenly started devouring their crops in the early 2000s.

Then, last year, came the rats.

“This wasn’t a place you had rats before,” Mr. Castillo said.

For Justiniano Daga, a 72-year-old farmer, the breaking point for his cotton crops came when red ants ate away the buds. This year, he has decided to plant sugar cane instead and move some of his production to higher altitudes where it is colder.

“But the pests will arrive there, too,” as temperatures keep rising, Mr. Daga said.

The Chavimochic project, which lies just north of where the Santa River meets the Pacific Ocean, is a crown jewel of Peruvian agriculture and civil engineering.

The government aimed to create industrial-scale agriculture in Peru’s northern deserts through a sprawling system of locks and canals. The idea’s supporters promised profits through exports to markets in North America, Asia and Europe, where the fruit seasons were reversed.

The first phase of the project started in 1985 with a 50-mile canal that irrigated a valley and brought a large hydroelectric plant, providing electricity to residents. In the early 1990s, Peru began a second phase, which irrigated two more valleys and created a water treatment plant that served 70 percent of the surrounding population.

The ruins of the Temple of the Sun, built by the Moche people, whose civilization collapsed more than a millennium ago after the Pacific Ocean warmed, killing fish and causing flash floods. Credit Tomas Munita for The New York Times

Blueberries in the region grow to five times their normal size. They are shipped to China, where they are prized. Credit Tomas Munita for The New York Times

A team of glacier researchers walking in Cordillera Blanca, Peru. The temperature at the site of the glaciers rose between 0.5 and 0.8 degrees Celsius between the 1970s and early 2000s. Credit Tomas Munita for The New York Times

All told, more than 100,000 acres of desert were brought into cultivation.

“Years ago, if I gave you a plot of land here, you’d have said, ‘What do I do with this?’ ” said Osvaldo Talavera, a spokesman for the water district. “Now you’d say, ‘Do you have another plot for me?’ ”

Among the investors was Rafael Quevedo, a wealthy Peruvian landowner who began snapping up arid tracts after studying desert hydroponic techniques in Israel. His proposition was simple: With enough water and fertilizer, asparagus could be grown directly in the sand — and at yields per acre far higher than in the United States because Peru has no cold season and more days of sun.

“We’ve started a new chapter in the history of cultivation,” said Mr. Quevedo, who runs a farming company called Talsa.

Blueberries on a sandy hillside here grow to be five times as big as a normal-size blueberry before being sent to China, where they are prized for their size. A form of white asparagus, favored by Europeans, is grown by burying the stalks in sand. A reservoir was created out of a dune. More than 8,000 tons of produce grows here every year.

Yet at the headwaters of the Santa River, in the mountain city of Huaraz, César Portocarrero, a Peruvian climatologist, sees problems afoot for those downstream.

The temperature at the site of the glaciers rose 0.5 to 0.8 degrees Celsius from the 1970s to the early 2000s, causing the glaciers of the Cordillera Blanca to double the pace of their retreat in that period, Mr. Portocarrero said. Several times a year, he and other scientists would make brutal hikes into the glacial valleys, where they found entire sections of the icecap gone. One part of an exposed glacier revealed fossils of dinosaur footprints.

Sand dunes near agricultural lands in Viru Valley, Peru. Credit Tomas Munita for The New York Times

A 2012 study by scientists from the United States and Canada showed that water flow in the Santa River was falling, and that at current rates, the river could lose 30 percent of its water during Peru’s dry season.

“Each year there is less water; each day there is less water,” Mr. Portocarrero said.

When Odar Gómez headed to Chavimochic to look for work in 1997, he was only the third person to do so from his impoverished mountain town, where many eked out a living with the subsistence farming of corn.

It was the start of a wave of migration from the mountainside to the coast set off by the arrival of the water.

One coastal town, Viru, went from a population of 9,000 in the 1990s to 80,000 today. Another, Valle de Dios, was an empty desert canyon until it was invaded by squatters in the early 2000s. The new arrivals were mainly agricultural workers and transformed it into a full-fledged town with a pharmacy, a grocery store and a mechanic’s garage.

Mr. Gómez began to work at Talsa, and he headed to the mountains on weekends to recruit others to join him.

“Now in my village you have empty homes where whole families have left,” he said. “People are coming from the Amazon. Chavimochic was our salvation.”

The town of Valle de Dios, which was an empty desert canyon until it was invaded by squatters in the early 2000s. Credit Tomas Munita for The New York Times

Support staff members for a research team rested at the base of a glacier after hiking from their base camp. Credit Tomas Munita for The New York Times

A shepherd with his flock in the Cordillera Blanca, some 14,000 feet above sea level. Credit Tomas Munita for The New York Times

The water has also transformed life on the coast.

About a decade ago, a Danish-Peruvian operation installed running water and electricity in the town of Huancaquito Alto, where the business was employing many residents in its packing plant. The town of 2,500 now has a municipal cleaning system that employs trash collectors.

“This was all grassland,” said Edgar García, a member of the town council, pointing at a new public plaza that was opened last year.

Mercedes Beltrán grew up in San Bartolomé, which was barely a village, with only three families. Her grandfather fished from a traditional reed raft. “There was no market, we bartered between ourselves,” she said.

Now her family plants asparagus for the American market, benefiting from competition between buyers that keeps prices high, she said.

Even the slightest reduction in the flow of the Santa River causes alarm here. The hydroelectric plant now provides power to 50,000 people; treated river water supplies 700,000 people.

“In years to come, we will be fighting over water,” said Mr. Gómez.

The government has struggled to offer solutions. One proposal would try to capture rain runoff from the Andes during the wet season in a large dam. But construction on the dam was led by Odebrecht, a Brazilian construction company that admitted to paying $800 million in bribes throughout Latin America.

The dam is now “completely paralyzed,” with few signs that it will be starting again soon, said Miguel Chávez Castro, the director of the project.

Meanwhile, planners here continue to push for more irrigation. They are now eyeing desert tracts farther to the south for a new 80-mile canal that would, at least for now, supply another 50,000 acres of desert with water.

But Mr. García, the council member in Huancaquito Alto, is not taking any chances. He has refurbished an old well used by his father to hold water in the days before this area was irrigated, and he is building a new one near his asparagus fields.

“Because of this water, our children have been able to go to university,” he said. “But if there is no water from the Santa River, that all changes.”

He added: “We have to get our wells ready. Sure, it’s like going back in time, but what can we do?”

Luis Puell and Andrea Zarate contributed reporting.

Will President Xi Jinping Let Markets Decide China’s Future?

 China currency

China’s twice-a-decade Communist Party congress wrapped up on October 26 with party head and President Xi Jinping claiming a place alongside revolutionary leader Mao Tse-tung in the pantheon of modern Chinese heroes. In addressing the congress, Xi focused on contradictions the party faces in steering China toward a brighter future, much as Mao highlighted “class contradictions” decades earlier.

But the party gathering did little to clarify how the leadership plans to handle the challenges simmering within the world’s second-largest economy, and especially within its chaotic financial system.

Franklin Allen, an emeritus Wharton professor of finance, and a professor of finance and economics at Imperial College in London, questions Xi’s appetite for painful reforms that are needed to rebalance China’s economy away from its longtime heavy reliance on construction investment and exports. “Xi has established tremendous political power. Now the question is how much of that he will turn into economic reforms,” Allen says. For now, Xi seems to prefer using his “One Belt, One Road Initiative,” to expand Chinese supply chains and market access, as well as its geopolitical influence, across the developing world. In the meantime, on the domestic front, “I would not be surprised if there was slow and gradual reform.”

The outlook for reforming China’s developing financial markets and the banking system remains obscured, in part, by a lag in the timing for key appointments such as a successor for Zhou Xiaochuan, longtime head of the People’s Bank of China. Some newly appointed party leaders, including Xi’s close economic adviser Liu He, are thought to support more market-oriented reforms.

Will Financial Reforms Be Smothered?

But the overall tone of the congress in backing stronger Communist Party involvement in the economy and businesses is worrying some longtime China watchers. “I am fearful that the party conservatives will prevail over the economic and financial reformers after the party congress,” says Pieter Bottelier, a visiting scholar of China studies at Johns Hopkins School of Advanced International Studies (SAIS) in Washington, D.C.

He sees a direct conflict between the party’s priorities and those favoring more aggressive financial reforms. Xi’s landmark three-hour speech at the outset of the congress “showed the top priority of the party is no longer economic development and growth but consolidation of the party power, party prestige and party control of everything,” Bottelier says.

With the economy still growing at an annual pace of over 6% and financial markets seemingly on an even keel, Xi’s team can claim to have weathered the post-2008 financial crisis with few major hiccups. But rising levels of corporate, banking and government debt have prompted the International Monetary Fund to raise the alarm. Estimates of the ratio of non-performing loans to total lending in the banking sector range as high as 35%. Most economists and banking analysts say the real level is likely much lower.

China has seen worse: in the late 1990s many of the biggest banks were technically insolvent, buried in mountains of debt from many years of financing defunct state-owned enterprises (SOEs). The government successfully rescued most of the banks, shifting the unrepayable loans into asset management companies and recapitalizing the banks. If need be, it can do it again, analysts say. But such bailouts only treat the symptoms of deeper dysfunctions within the economy that will hinder economic growth as the economy matures.

Why Such High Debt?

To understand the urgency of the problem it’s necessary to grasp why debt levels are so high and are rising so rapidly, what the risks are of failing to resolve the issues, and what unexpected triggers could unleash a wider, more damaging financial crisis with potential global implications.

“A lot of people see the debt itself as the problem. I see the debt more as the symptom of the deeper underlying problem which is misallocation of credit and resources,” says Julian Evans-Pritchard, China economist for Capital Economics. In other words, money is going not to the best opportunities with the greatest potential returns, but to the state-owned companies or government projects with the strongest political leverage. “The reason for that is the role of the state in the economy and the large role of the state sector in many parts of the economy.”

The level of debt in the Chinese economy skyrocketed after Beijing unleashed record amounts of stimulus — at least 17.5 trillion yuan ($2.6 trillion) — to help fend off the worst impact of the 2008 financial crisis. That credit binge has not yet been fully digested. In the years since, the level of debt surged further, much of it as “off balance sheet” lending by so-called shadow banks that operate outside the state-dominated formal banking industry.

The shadow banks play a key role in directing financing to China’s dynamic and fast-growing private sector. Such companies are the real driving force behind the country’s ascent as a global trading power and are the main creators of jobs, but are generally shunned by the state banks, which exist mainly to funnel support to state-owned enterprises.

Moody’s Investor Service estimates that the size of shadow bank lending has more than doubled since 2012, growing more than 20% in 2016 to reach 64 trillion yuan ($10 trillion), or about 86.5% of China’s GDP. The category spans a wide array of funding sources, including wealth management products, entrusted loans, finance company loans, pawn shop loans, online peer-to-peer lending, consumer credit companies and microcredit, among others.

The IMF estimates that risky corporate loans amount to 15.5% of total corporate loans of Chinese commercial banks. CLSA, a brokerage and investment group, put the non-performing loan (NPL) ratio at 15%-20% in 2016. The official government figure was 1.74% at the end of June 2017, unchanged from March. The wider figure for total NPLs plus “special mention” loans that are vulnerable to adverse economic conditions but still being repaid was 3.64% as of the end of June, according to the China Banking Regulatory Commission.

Louis Kuijs, a China expert and head of Asia Economics at Oxford Economics, estimates the level of problem loans including bank loans, shadow banking lending, and local and central debt at about 14% of China’s GDP.

But estimates of the total amount of debt in the economy go much higher, up to 280% of GDP as of the end of 2016, says Evans-Pritchard. The ratio of debt to GDP has improved recently thanks to a pickup in economic growth fueled by still more stimulus that has fired up property prices and other asset prices. But it’s bound to deteriorate again as activity slows. “We figure debt levels are high. Not only are they high, but the main thing that is concerning is how quickly they’ve risen,” he says.

Under Xi, the government has sought to curb the shadow banking that is a big share of debt and a potential source of financial instability given its tenuous access to funding and lack of regulation. The balance of outstanding wealth management products amounted to 30.1 trillion ($4.5 trillion) yuan, or nearly half of the 64 trillion yuan in total shadow bank loans, at the end of 2016. It had declined by 10% by the end of August 2017 from the end of 2016, according to Fitch Ratings. In late September, the CBRC re-emphasized its determination to tackle the problem, warning that failure to spot and deal with problems would be viewed as a dereliction of duty, Fitch Ratings said in a research note.

Chi Lo, a senior economist at BNP Paribas Investment Partners in Hong Kong and author of several books on China, estimates the share of shadow banking finance in the Chinese system fell from a peak of 37% in 2013 to less than 10% at the end of 2016. But instead of eliminating this murky segment of the financial sector, Beijing needs to regulate it, he says. Evans-Pritchard adds that cracking down on shadow banks helps reduce risks but conversely hurts a trend toward improved allocation of credit, because it cuts off smaller corporate borrowers that have no other source of financing. “Many of these smaller firms have much higher returns on assets. They’re much more efficient than the larger SOEs. It’s not necessarily a positive for credit allocation,” he says.

Notes Wharton management professor Minyuan Zhao, “cleaning up shadow banking is not easy. With economic slowdown, firms, especially small and medium-sized firms, are facing serious financial crunches. Meanwhile, with a disappointing stock market and restrictions on outward financial investment, investors are looking everywhere for higher returns. Without serious reforms, the official banking sector simply does not have the means (or flexibility) to bridge the two sides, although they are sometimes enablers of shadow banking.”

Even if they can count on the government to step in if debts spiral out of control, China’s bigger and more powerful state commercial banks are facing risks of their own. Increasingly, the banks are relying on short-term funding and interbank funding. Growing interdependence between the banks adds to the potential risks from any liquidity crisis, which could ripple throughout the industry and beyond. With growing portfolios of non-performing loans on their books, the profitability of most of the banks is declining, and that erodes their capital bases. Ultimately, the banks may need to turn to the government. Regulators, aware of this trend, are pushing for more “market discipline” in the form of using debt-equity swaps and loan securitization to avoid outright bailouts.

Risks of Crisis Remain

For now, economists are downplaying the likelihood of an immediate crisis. “The banks are taking a gradual approach to the NPL problem by writing them off from their balance sheets or transferring some to asset management companies,” says Rajiv Biswas, Asia Pacific chief economist for IHS Markit. It’s unclear just how long the banks can carry on with such strategies before they will end up having to seek help from the regulators.

In the meantime, Xi’s China must grapple with those contradictions, between state control and market forces; excess supply in many industries — from steel and aluminum to rubber flip-flops and plastic trinkets — and volatile demand; and the tradeoffs between quantity versus quality of growth. So far, the signals from the congress point to an emphasis on continuity and caution.

“The choices are stark. Either they allow distressed large SOEs to fail or reform the SOEs so they operate on a commercial basis. So far there has been willingness to do neither,” notes Marshall Meyer, a Wharton emeritus professor of management.

The government remains committed to its goal of doubling the GDP of 2010 by 2020. Xi’s call to promote Made in China “national champions” and prevent losses of state assets indicated a commitment to protecting the state sector, not to overhauling it to improve its productivity.

Given the huge and to a certain extent hidden amount of debt within the economy, China’s regulators are gambling they can take their time in tackling the problems in the banking sector.

Property prices in the biggest cities, such as Beijing and Shanghai, have risen higher than in the U.S. and even Japan. “If you get a sharp and sustained decline in real estate prices, you will have a whale of problem,” says Bottelier. Much of the local government and corporate debt is tied up in the real estate sector. If prices fall, and they will eventually, “the NPL ratio will shoot up because borrower after borrower will not be able to meet debt payments at much lower real estate prices.”

Adds Wharton’s Zhao: “As of now, most banks in China are not losing sleep because of NPLs. The booming (or bubbly) housing market is propping up a major part of bank assets, and contributed to the high profits some banks enjoyed in the past year or so. Many believe this is not sustainable. Given that the state banks are held hostage by the real estate sector, the government will not easily pop the housing bubble. Instead, it is encouraging the development of rental properties to isolate ownership from affordability issues.”

Meyer points out that “everyone used to say the debt wasn’t serious because it was domestic — it’s not like 1997 when foreign investors pulled out of the Tiger countries leaving behind debt denominated in dollars. Still, there are lots of warnings about local government and SOE debt. Last month, Zhao Xiaochuan warned of a possible Minsky moment [a sudden loss of confidence leading to a financial crisis]. In September, S&P downgraded China.”

No ‘Cold Turkey’

There is no “cold turkey” solution to the debt bubble in China, and China’s regulators will do well to tread carefully as they restore balance to the financial sector, says Chi Lo. Credit growth has been outpacing economic growth for over a decade. A sharp cutback would “crush the economy before the benefits of deleveraging could materialize,” he says. A better option is to use a variety of strategies such as the restructuring of zombie companies, bankruptcies, debt defaults and local austerity measures.

With such a gradual approach, China may manage to avoid the sort of deflationary slump that Japan slipped into when its bubble economy imploded in the early 1990s, ushering in its current era of glacial-paced growth. At the same time, Chinese regulators need to find ways to correct the imbalances and misallocations in credit and other resources that are hindering strong domestic consumption-fueled growth.

Whether they will choose to do so remains unclear: The track record is not encouraging given both the signals from above, and the graft and influence peddling that pervades the economy. Tightening the taps on credit carries risks of its own. “It’s not clear at this stage what the pain threshold is and how willing they are to allow growth to slow,” says Evans-Pritchard of Capital Economics. “I see big tensions in their goals.”

To claim a place alongside Mao and Deng Xiaoping, who initiated the current era of “opening up” China to world markets, Xi needs to go beyond what was promised at the party congress, says Allen. “Xi has followed Mao so far by gaining strong political control. Is he going to do what Deng did to open up China and let the markets decide? If he does, China can grow even faster.”

Bernie Madoff and the Case for Civil Asset Forfeiture

We’re returning $3.9 billion to victims of his Ponzi scheme.

By Rod J. Rosenstein

       Photo: istock/Getty Images        

Thanks to civil asset forfeiture, the Department of Justice is announcing today the record-setting distribution of restitution to victims of Bernard Madoff’s notorious investment fraud scheme. We have recovered $3.9 billion from third parties—not Mr. Madoff—and are now returning that money to more than 35,000 victims. This is the largest restoration of forfeited property in history. Civil forfeiture has allowed the government to seize those illicit proceeds and return them to Mr. Madoff’s victims.

Why use civil forfeiture instead of prosecution? Not everyone who possesses illegal proceeds can or should be criminally prosecuted. Many criminals transfer ill-gotten gains to relatives or friends, and others use couriers to transport cash. In such cases, civil forfeiture enables the government to recover property when prosecuting the person caught holding it may not be appropriate or feasible.

When the government can establish by a preponderance of the evidence—the same standard that applies to all civil disputes about property—that the assets were obtained through criminal activity, then they may be forfeited.

Asset forfeiture deters illegal activity by depriving criminals of the financial benefits of their wrongdoing. Perhaps more important, the process allows law enforcement to return proceeds to victims. Since 2000, forfeiture has allowed the Justice Department to return more than $4.4 billion of assets to victims. Almost half that was recovered through civil forfeiture, the remainder through criminal forfeiture.

Civil forfeiture is used in a wide range of cases, not just in conjunction with large fraud prosecutions like Mr. Madoff’s. In a recent case, three brothers allegedly stole $110 million from Medicare and then fled to Cuba. They cannot be prosecuted unless they return. But the government used civil asset forfeiture to recover millions of dollars of property they had purchased with the criminal proceeds, which can now be returned to taxpayers.

When no specific victim is identified, the proceeds can be used to fight crime. We recently used civil asset forfeiture to recover more than $48 million from the operators of the Silk Road website, which criminals had used to distribute fentanyl and other deadly drugs. Those funds will go toward efforts to combat crime. In certain circumstances the Justice Department is authorized to transfer forfeited proceeds to local police forces. Money that otherwise would fund more crime is instead used to protect communities.

Some critics claim that civil asset forfeiture fails to protect property rights or provide due process. The truth is that there are multiple levels of judicial protection, as well as administrative safeguards.

First, money or property cannot be seized without a lawful reason. The evidence must be sufficient to establish probable cause to believe a crime was committed. That is the same standard needed to justify an arrest.

Second, if anyone claims ownership of the property, it may be forfeited only if the government presents enough evidence in court to establish by a preponderance of the evidence it was the proceeds of crime, or was used to commit a crime.

Courts apply the “beyond a reasonable doubt” standard only in criminal cases. That high threshold of proof is appropriate when the stakes involve a person’s criminal record and potential imprisonment. But all other lawsuits, no matter how much money is at issue, use the normal civil standard. There is no logical reason to demand the elevated criminal standard in a lawsuit about illicit proceeds.

A third level of judicial protection is that even after the government proves the property is subject to forfeiture, a claimant can get it back by showing that he is an “innocent owner” who did not know about the criminal activity.

About 80% of the time, nobody even tries to claim the seized assets. Most cases are indisputable. When the police find $100,000 in shrink-wrapped $20 bills hidden in a suitcase, usually there is no innocent explanation. In the majority of cases, seized cash is drug money. If police were to return criminal proceeds to a drug courier, criminals could invest in more drugs and create more death and destruction. Civil asset forfeiture saves lives.

To be sure, law-enforcement officers sometimes make mistakes. Accordingly, this summer the Justice Department announced new protections for adoptive seizures, which occur when a federal agency forfeits property originally seized by a state or local authority.

The changes include moving twice as quickly as required by law—within 45 days instead of the mandated 90—to provide notice and opportunity for property owners to challenge seizures. State and local law enforcement will also be provided additional training on the ethics and legal requirements of forfeiture. In addition, attorneys at the federal agencies adopting the seizures must now review each one for compliance with the law. Seizures without a warrant get special scrutiny, just like arrests without a warrant.

As an additional safeguard, Attorney General Jeff Sessions announced last month that the Justice Department will appoint a director of asset forfeiture accountability, who will monitor forfeitures and ensure appropriate protection for property rights.

Civil asset forfeiture is a powerful tool to make victims whole and prevent crime. The Department of Justice will work with local, state and federal law enforcement agencies to use it responsibly. That will allow us to save lives and reimburse victims, while protecting the rights of innocent property owners.

Mr. Rosenstein is U.S. deputy attorney general.

The Real Risk to the Global Economy


A man walks past a display showing bank notes

WASHINGTON, DC – One of the great mysteries of today’s global markets is their irrepressible enthusiasm, even as the world around them appears on the verge of chaos or collapse. And yet, investors may be more rational than they appear when it comes to pricing in political risks. If investing is foremost about discounting future cash flows, it’s important to focus precisely on what will and will not affect those calculations. The potential crises that may be most dramatic or violent are, ironically, the ones that the market has the easiest time looking through.

Far more dangerous are gradual shifts in international global institutions that upend expectations about how key players will behave. Such shifts may emerge only slowly, but they can fundamentally change the calculus for pricing in risks and potential returns.

Today’s market is easy to explain in terms of fundamental factors: earnings are growing, inflation has been kept at bay, and the global economy appears to be experiencing a broad, synchronized expansion. In October, the International Monetary Fund updated its global outlook to predict that only a handful of small countries will suffer a recession next year. And while the major central banks are planning, or have already begun, to tighten monetary policy, interest rates will remain low for now.

Political crises, however sensational they may be, are not likely to change investors’ economic calculus. Even after the greatest calamities of the twentieth century, markets bounced back fairly quickly. After Japan’s attack on Pearl Harbor, US stock markets fell by 10%, but recovered within six weeks. Similarly, after the terrorist attacks of September 11, 2001, US stocks dropped nearly 12%, but bounced back in a month. After the assassination of President John F. Kennedy, stock prices fell less than 3%, and recovered the next day.

Yes, each political crisis is different. But through most of them, veteran emerging-markets investor Jens Nystedt notes, market participants can count on a response from policymakers.

Central banks and finance ministries will almost always rush to offset rising risk premia by adjusting interest rates or fiscal policies, and investors bid assets back to their pre-crisis values.

Today, a conflict with North Korea over its nuclear and missile programs tops most lists of potential crises. Open warfare or a nuclear incident on the Korean Peninsula would trigger a humanitarian disaster, interrupt trade with South Korea – the world’s 13th largest economy – and send political shockwaves around the world. And yet such a disaster would most likely be brief, and its outcome would be clear almost immediately. The world’s major powers would remain more or less aligned, and future cash flows on most investments would continue undisturbed.

The same can be said of Saudi Arabia, where Crown Prince Mohammed bin Salman just purged the government and security apparatus to consolidate his power. Even if a sudden upheaval in the Kingdom were to transform the balance of power in the Middle East, the country would still want to maintain its exports. And if there were an interruption in global oil flows, it would be cushioned by competing producers and new technologies.

Similarly, a full-scale political or economic collapse in Venezuela would have serious regional implications, and might result in an even deeper humanitarian crisis there. But it would most likely not have any broader, much less systemic, impact on energy and financial markets.

Such scenarios are often in the headlines, so their occurrence is less likely to come as a surprise.

But even when a crisis, like a cyber attack or an epidemic, erupts unexpectedly, the ensuing market disruption usually lasts only as long as it takes for investors to reassess discount rates and future profit streams.

By contrast, changes in broadly shared economic assumptions are far more likely to trigger a sell-off, by prompting investors to reassess the likelihood of actually realizing projected cash flows. There might be a dawning awareness among investors that growth rates are slowing, or that central banks have missed the emergence of inflation once again. Or the change might come more suddenly, with, say, the discovery of large pockets of toxic loans that are unlikely to be repaid.

As emerging-market investors well know, political changes can affect economic assumptions.

But, again, the risk stems less from unpredictable shocks than from the slow erosion of institutions that investors trust to make an uncertain world more predictable.

For example, investors in Turkey know that the country’s turn away from democracy has distanced it from Europe and introduced new risks for future returns. On the other hand, in Brazil, despite an ongoing corruption scandal that has toppled one president and could topple another, investors recognize that the country’s institutions are working – albeit in their own cumbersome way – and they have priced risks accordingly.

The greatest political risk to global markets today, then, is that the key players shaping investor expectations undergo a fundamental realignment. Most concerning of all is the United States, which is now seeking to carve out a new global role for itself under President Donald Trump.

By withdrawing from international agreements and trying to renegotiate existing trade deals, the US has already become less predictable. Looking ahead, if Trump and future US leaders continue to engage with other countries through zero-sum transactions rather than cooperative institution-building, the world will be unable to muster a joint response to the next period of global market turmoil.

Ultimately, a less reliable US will require a higher discount rate almost everywhere. Unless other economic cycles intervene before investors’ expectations shift, that will be the end of the current market boom.

Christopher Smart is a senior fellow at the Carnegie Endowment for International Peace and the Mossavar-Rahmani Center for Business at Harvard University’s Kennedy School of Government. He was a special assistant to the US president for International Economics, Trade, and Investment (2013-2015) and Deputy Assistant Secretary of the Treasury for Europe and Eurasia (2009-13). 

Time to Remove Italian Banks from List of Global Worries

Bad loans threat receding as sector finally gets cleanup underway

By Paul J. Davies

Italian Banks´ total bad and doubful debts before loss provisions

Here’s one less thing for global investors to worry about: Italy’s once-tottering financial system isn’t nearly as scary as it was.

About €300 billion ($348 billion) in bad and doubtful loans is still big figure—and almost one-third of Europe’s total—but a banking cleanup through sales, higher provisions and capital injections is well under way. Fears that Italy’s banks could be the source of a wider financial panic are finally fading.

Accelerating economic growth this year and pressure from European supervisors have been carrot and stick for the sector, while government-led bank rescues in the summer—after a long wait—dialed down the risk of systemic collapse.

A string of midsize lenders have launched recovery plans in recent months, including just this week Credito Valtellinese and BPER Banca, after several of Italy’s biggest offenders were persuaded or pushed into dealing with their balance sheets this year.

UniCredit , Italy’s biggest by assets, led the way, raising €13 billion in fresh equity and selling €18 billion in bad loans. It was followed by state-backed recapitalizations or liquidations for Banca Monte dei Paschi di Siena, Italy’s oldest bank, and two smaller but deeply troubled banks from the region near Venice.

The upshot of these actions is that €62 billion of toxic loans are already being cut out of the sector. Meanwhile, UniCredit and Intesa Sanpaolo , Italy’s two largest and strongest lenders, are left with €105 billion of the remaining pile. They will further cut these through sales and work outs and their size means that these loans are now worth just 11% and 13% of total loans respectively.

Those levels are above the European average of about 5% but are much improved. As a whole, the sector wide gross bad-loan ratio, before any provisions, was down to 15% at the end of the second quarter, according to the most recent national data, from 16.5% in summer 2016.

Further, Italy and Europe’s strengthening economy means fewer good loans are turning bad. Intesa said this week that new bad loans in the third quarter were the lowest quarterly inflow since 2007. UniCredit also reported a big decline Thursday and others have this month, too.

Harsh standards from European regulators on the treatment of new bad loans might be delayed after questions over their legal basis, but this doesn’t really matter: Italy’s banks now know they can clean up their act and have got the message that supervisors will find a way to penalize them if they don’t.

In another year’s time, much of the heavy lifting ought to be done and Italian banking will no longer be the threat it has been for too long.