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“Panics do not destroy capital. They merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”

John Stuart Mill

Commentary & Analysis
Mr. Xi Jinping’s Deflation

Today’s short story starts with China’s investment overhang…or malinvestment for lack of a better term…

In the chart below from Morgan Stanley, it suggests China hasn’t changed much, i.e. it is still trying to keep growth alive through its tried and true capital investment model.

The chart above reveals each new dollar invested has a decreasing stimulative impact on GDP; i.e. the efficiency of capital employed in China has fallen dramatically. Is it a classic case of malinvestment?

“Malinvestment is a mistaken investment in wrong lines of production, which inevitably lead to wasted capital and economic losses, subsequently requiring the reallocation of resources to more productive uses. Austrians believe systemic malinvestments occur because of unnecessary and counterproductive intervention in the free market, distorting price signals and misleading investors and entrepreneurs. For Austrians, prices are an essential information channel through which market participants communicate their demands and cause resources to be allocated to satisfy those demands appropriately. If the government or banks distort, confuse or mislead investors and market participants by not permitting the price mechanism to work appropriately, unsustainable malinvestment will be the inevitable result.”


Given the secular decline in both consumer demand and globalization itself, recent attempts by the Chinese authorities to revive its capital investment growth model (stimulate exporters), evidenced by another massive surge of credit, seems likely to fail.

Source: Leto Postcripts, Criton Zoakos

[Note: The G-7 is concerned; but the latest pronouncements suggest our heroes don’t believe much can be done on a coordinated basis. It brings to mind the “rats scurrying off a sinking ship” analogy. If trade growth continues to plummet there is little doubt trade tensions and currency manipulations will grow.]

…it would be silly to try to predict China’s political future, or suggest there will be some major crisis, but there is a roadmap for Leninist party states past. China is approaching a critical stage…

“…revolution and seizure of power →transformation and mobilization of society → consolidation of state power and extension over all aspects of society → extraction of resources and capital from society for state purposes → bureaucratization and “Brezhnevization” of state power → adaptation and limited pluralism to cope with stagnation and ossification → ?”

David Shambaugh, China’s Future

…the case for increasing pluralism anytime soon does seem on the horizon given the massive malinvestment and increasing authoritarian rule by Chinese President Xi Jingping…

“Since Xi Jinping came to power at the Eighteenth CCP Congress in November 2012, the reign of the Conservatives has continued. Xi has proven to be a very anti-liberal leader and he has overseen an even greater intensification of the repression evident since 2009. There has been an unremitting crackdown on all forms of dissent and social activists; the internet and social media have been subjected to much tighter controls (see chapter 3); Christian crosses and churches are being demolished; Uighurs and Tibetans have been subject to ever-greater persecution; hundreds of rights lawyers have been detained and put on trial; public gatherings are restricted; a wide range of publications are censored; foreign textbooks have been officially banned from university classrooms; intellectuals are under tight scrutiny; foreign and domestic NGOs have been subjected to unprecedented governmental regulatory pressures and many have been forced to leave China; attacks on “foreign hostile forces” occur with regularity; and the “stability maintenance” security apparatchiks have blanketed the country. A swath of intrusive new regulations and laws concerning national security, cyber security, terrorism, and nongovernmental organizations have been drafted and enacted. China is today more repressive than at any time since the post-Tiananmen 1989–1992 period.”

“Many members of Jiang Zemin’s factional network, and a rising number of Hu Jintao’s, have been brought down—yet none of Xi’s own princeling associates have been touched.”

“The regime’s repression is symptomatic of its deep and profound insecurity.”

David Shambaugh, China’s Future

…a wrong turn here by China’s leaders can threaten, or at least postpone, China’s development into a normally functioning modern state…

“The key issue for nations like China at this stage of development is not just the economic growth model and its declining efficacy, but precisely the relationship between economics and politics. For economies to transition up the added-value ladder, break through the developmental ceiling, and make the kinds of qualitative transitions necessary to become truly modern and developed, political institutions must be facilitative. They must cease being ‘extractive’ states and become what scholars Daron Acemoglu and James Robinson describe in their insightful book Why Nations Fail as “inclusive states.” This requires tolerance— even facilitation— of autonomous actors within society.”

David Shambaugh, China’s Future

…more muddling through decreases the chance China will escape the “middle income trap” which has plagued developing economies in the past? Just and FYI: The theory of convergence so talked about by emerging market mutual fund salesman is more the exception than the rule. [Does anyone remember the acronym BRICs?] …the probability of “Japanification” of the Chinese economy is rising. Consider the similarities…

“During the 1980s it appeared Japan as the Creditor Superpower was going to gobble up the world with their powerful export machine and massive current account surpluses rolling in. Then a little thing called the US stock market crash in 1987 changed the game. Dollar credit flowed from the global system triggering an improvement in the US current account balance (first gold box left in chart below) which was followed by a US recession. This came as the Japanese yen was appreciating in value, thanks to the G-7 Plaza Accord to pressure the yen higher because of all those Japanese exports.

“The litany:

  1. Japan’s very hot stock market broke in 1989.
  2. Then its extremely over-priced real estate bubble started its collapse (remember when the Imperial Palace in Tokyo was worth more than the entire state of California).
  3. Japanese authorities did all they could in the form of stimulus to try to keep air in the bubble.

a. They pumped more money into the stock and property markets in order to revive the wealth effect for domestic consumers.
b. They subsidized export companies to keep exports flowing (but the world’s major consumer—the US economy—was entering recession and not there to buy).
c. They lowered interest rates to zero.
d. They continued massive fiscal stimulus by building infrastructure across the country.

“But, it didn’t work. The massive dislocations caused by artificial channeling of credit within the Japanese economy in order to focus almost entirely on building a global export machine created the malinvestment that has taken years to work off precisely because the Japanese economy was so imbalanced—production versus consumption. Attempts to change this model were scant at best; instead they kept morbid companies alive, and forced its consumers to save thanks to artificially low interest rates. “

Jack Crooks, “The Japanese-China Parallel: Eerie and Scary Combined,” Forex Journal July 2010

At the very least, we would expect another wave of deflation to flow out of Asia. Directly impacting the emerging markets in terms of trade through falling commodity prices and leading to another flow of capital from the periphery (developing world economies) to the center (developed world economies); it would be a negative reinforcing feedback loop for the emerging markets (risk off and possibly contagion)…

The deflationary impact to the developed world from China would be more implicit (as the brunt of falling commodities prices has already been discounted to a large degree) seen through falling final goods and material prices. Interestingly, despite negative interest rates in Japan and Europe, those countries should receive their fair share of money flow from Asia because increased deflation will push up real yields in both places; i.e. nominal yield minus inflation rate.

But given the estimated $3 trillion emerging market dollar denominated debt, the dollar will likely win the global money flow game: 1) a risk bid for the world reserve currency; and 2) yield on the premise the Fed will be the only major world central bank to hike in 2016.

So, to summarize potential takeaways:

  1. Increased Chinese stimulus will most likely increase deflationary pressures down the road.
  2. Increased repression and external belligerence (Can you say: South China Sea?) from Chinese President Xi will likely prolong the downturn in the Chinese economy.
  3. Despite the excitement about oil being back at $50 per barrel, the global macro environment may not be a fertile backdrop for a continued run in commodity prices.
  4. The currency order under this scenario: Dollar is most favored; other developed economies second; commodity currencies third; emerging market currencies last

Editor’s Note: I am preparing a detailed special report and specific trading/investing ideas as related to the scenario summarized in today’s missive; along with a voiced-over PowerPoint presentation. It will be used as a promotion for our new service: Key Market Strategies. I should have that available early next week.