The Chinese bubble

The End of the Communist Dynasty

By Craig Tindale

Steve Keen's Debt Watch,

3 June, 2012

There is a crisis of confidence unfolding in China that is likely to end in a full scale capital flight and a disorderly collapse in both economic and political cohesiveness. The lowering of the reserve requirements for Chinese banks, while reported in the media as a loosening of credit, is more likely an early sign of capital flight. Similarly reflective of this, are the large increases of gold purchases by Chinese citizens who have few diversification options away from the RMB.

China’s wealth is concentrated abnormally within an elite 1% of high net worth individuals. This 1% command up to $5 USD trillion dollars in wealth. If these elite should rush the doors to move their wealth out of the country using the multitude of avenues that exist to evade Chinese capital controls, then the Chinese banks may face the biggest bank run in history.

The problem is that while the propaganda machine might control the minds of the masses, the wealthy elite are virtually immune to thought control and are likely to be the best informed and have the means to be the first to leave. Reserves are mostly tied up in USD and treasuries cannot be liquidated for fear of raising the value of the RMB. Along with further eroding trade surpluses, this means a capital flight by the elite occurring with massive insolvency in the credit market could vaporize the Chinese liquidity in what will seem like an economic Cat 5 hurricane.

The Chinese economy is in the final stages of largest Ponzi scheme ever devised. Minsky outlined three distinct phases in the credit cycle: In the first phase known as the hedge phase; economic actors borrow money to invest in order to create goods to sell for profit. In the second stage, the speculative phase, more economic actors join the economy, borrowing money to invest in assets in the expectation that these assets will rise in value. In the last stage, known as the Ponzi stage, economic actors borrow in the hope that conditions will improve. This borrowing is designed to avoid insolvency during what is perceived or hoped to be a short to medium term setback in economic conditions.

Some may argue that the Minsky market driven instability hypothesis is not suited to China and that they are chiefly a centrally planned state controlled economy. This reflects a fundamental misunderstanding of Minsky’s work. The Western economies’ attempt to centrally plan economic activities from the consumption end, the state based capitalism that China has become known for attempts to centrally control the economy from the production side.

The Chinese production economy cannot be seen in isolation from the consumption economies of the West; debt based consumption provided the umbrella under which the Chinese miracle grew. When the GFC collapsed Western debt based consumption reacted by providing the last line of Minsky Ponzi financing via government bail-outs. Governments faced with banking collapse chose keep the system going by transferring debt from private hands to those of the taxpayers.

The Chinese, faced with a massive collapse in export income, chose to keep the economy functioning by stimulating the economy with massive capital works and lending. In both cases the government was the provider of the last line Ponzi financing to keep the economy rolling.  Now that this Ponzi financing has been near exhausted in both the West and the East, profound collapse is the only logical outcome.

Whereas the Minsky moment in Western economies comes by way of over-enthusiastic private borrowers, the instability in China is potentially more virulent in that its source is an over-enthusiastic government: the former relying on the solvency of borrowers and the later relying on the solvency of the state.  Some argue that while the Chinese state remains solvent, no matter how many empty buildings exist they can continue the game.  The question then is – Are they solvent and how long can they remain that way? The exponential growth in Chinese debt and mal-investment and the very unlikely return of Western demand means the system will become insolvent in the short to medium term.

The number of investors who have suffered losses due to widespread fraud is growing exponentially and the list of those that have racked up substantial losses includes some of the leading investors in the world.  This list of investors includes investment legends like Anthony Bolton one of Europe’s most well-known fund managers, legendary investment icon John Paulson have been the victims of fraud, the scale of which has never been seen in economic history.

Bolton came out of retirement in 2009 specifically to invest in China and his investments have turned into a complete disaster. In fact, Bolton was forced to offer an apology for his companies poor performance after losing 28.9% of its nearly 430M pound capitalization in the last six months of 2011 Anthony Bolton apologises for China fund’s poor performance. Rampant fraud was evident right at the core of his investment difficulties. This appears to have reached epidemic proportions right across the Chinese corporate landscape, so much so that Bolton has been forced to turn to private investigators after investors in Fidelity’s China fund suffer losses of 21%.

Bolton wasn’t the only one. The legendary investor John Paulson is being sued by his investors after losing $462M of his 23B fund investing in Sino Forest Paulson Fund Sued Over Sino-Forest Losses. The Sino Forest debacle was kicked off with a 19 page report issued by Carson Block of Muddy Water Sino Forest Report. This report didn’t mince words and came out form the start comparing the company to Bernie Madoff’s Ponzi scheme.

“Like Madoff, TRE is one of the rare frauds that is committed by an established institution.  In TRE’s case, its early start as an RTO fraud, luck, and deft navigation enabled it to grow into an institution whose “quality management” consistently delivered on earnings growth.”  
 
The problem with Sino Forest was that most of the forests the company claimed as assets simply didn’t exist.  Rather than being a few isolated cases, these examples signal an epidemic of systemic fraud and corruption that pervades entire Chinese economy.  This systemic fraud directly correlates to Minsky’s final Ponzi phase: cheap credit, floods the economy, eventually exhausting useful ways it can be utilized. This, together with the lack of systemic controls that accompany cheap credit, initially causes mal-investment into projects that will never return enough to service their debt. Then, having exhausted all reasonable avenues of mal-investment, large amounts get siphoned into the hands of criminal opportunistic economic agents who game the system.

In December another Chinese stock research firm Citron came out with this report Qihoo : Fraudulent Financials,Terminal Business, Or Both….You Decide. Citron maintains price target of $5. In late February 2012 they submitted this report to the SEC Citron Reports to Securities and Exchange Commission. Australian, John Hempton of Bronte Capital, famous locally for uncovering the Astara Trio Capital Ponzi scheme, has been instrumental in uncovering a long list of Chinese frauds including: Longtop Financial Technologies, Universal Travel Group, China Media Express, and China Agritech

A few weeks ago, Boshiwa Holdings the  licensee and manufacturer of Harry Potter related toys plunged 42% on news that its auditor had quit. In late February Puda Coal raised a $100M from US investors based coal assets that were never there: A Fraud Went Undetected, Although Easy to Spot.

What is China’s response to this plague of fraud in Chinese US listed stocks? They intend to make it very difficult for the Big 4 to continue to work in China ‘Big Four’ auditors brace for big changes in China. In the case of Longtop Financial, Deloites, the firms’ auditors have been unable to provide the SEC with any documentation about the collapse for fear of breaking China’s state secrecy laws.

These frauds are extremely sophisticated and have gone undetected by the large audit firms. They are not just the result of a series of independent events undertaken by similarly dishonest business people acting alone. Rather, a recent report suggests they are part of a systemic network of agents acting inside and outside of China whose main purpose is to perpetuate investment fraud on a scale never seen before in economic history.

One of the central players in uncovering Chinese investment fraud research is the firm Muddy Waters who recently published a white paper entitled Frauducation Part I: in this paper the author outlines how Chinese businessmen are taught and sponsored by experts, who sponsor and coach fraudsters in subjects like falsifying records, accounting, assets and  the various methods needed to pull off  grand frauds. When a character like John Paulson gets taken for nearly half a billion there is a lot of motivation on the criminal side to get things right

The fraud school’s assistance went well beyond providing document and accounting templates. The fraud school provided a network of “friendly” auditors that would help the companies get through the initial due diligence processes. The fraud school also helped companies game the due diligence process by providing the companies with contact information of suppliers and customers to give to potential investors. The suppliers and customers were frauds – the school hired them merely to play a role and answer questions according to the script. (Source: Muddy Waters)

Fraud is central to the Chinese system, it has emerged via virulent mutation of the ancient tribute system.  In the past, these tribute systems reflected an ancient form of private regulatory order. In the past there was often a limited basis for the rule of law to govern transactions. Throughout Chinese history, trade relied on systems of tribute to ensure secure business and political outcomes.

These old systems were still essential throughout Asia up until only a few decades ago because, transacting parties could not rely on the rule of law to ensure the security of terms governing a transaction. In China this has evolved into government sponsored systemic corruption with Western motivations of greed and criminality. It infects every level of the private and public sector.

A small piece of it was exposed recently in the “Bo” scandal, where there are reports of it infecting the families: Not only the Bo Lai family but even to the highest level of government- up to and including the family of Propaganda Minister, Liu Yunshan .Who 16 elder retired  elder statesmen petitioned to have sacked

Rather than being seen as isolated incidents, these examples reflect a cultural meme, a way of doing business that represents the standard operating procedure for a large segment (if not all) of the Chinese economy.

The epidemic of fraud sits like a structural element across both the private and government sector further magnifying the mal-investment caused by the massive credit expansion. For example: The high speed rail project  audits reveal millions have been siphoned toward corrupt contractors and government officials. This amount merely represents the siphoning on the core budget and doesn’t reflect the extra costs loaded by each of the contractors.

Take for example Hollysys, the provider of signalling and control systems for many the Chinese high speed train projects. This company managed to earn `154M (2009)-175M(2010) with a trifling $3.1 M in capital equipment. Their explanation for this is they outsource all manufacturing, which is a little odd since they have such massive buildings, covering hundreds of acres and $24M in inventories.

On its website, the company boasts of over 40 major projects covering everything from Nuclear Power station instrumentation to cutting edge high-speed rail. All of these projects combined require no more than $3.1 million in capital equipment? In a country where corruption is evident at every level, the corruption apparent in the high-speed rail project was even too much for the Chinese system to carry. China’s Communist Party has expelled a once-powerful former railways minister accused of serious corruption, state-run media report.

China is a country that is essentially a directly funded fiat system, whereas in a traditional fiat funded system the state prints money to directly purchase goods and services. Here, the Chinese system achieves the same outcome by lending with little prospect of repayment.  A system that perpetually rolls over debts does not constitute a credit based money system. Whether they are corporations or individuals, many of state affiliated economic agents simply cannot default because the lender is unwilling to foreclose on an influential political player. If you cannot pay you can simply ring the party to arrange a rollover the balance.

The funds are effectively fiscal stimulus carried out government-controlled intermediaries, state and local governments, who then spend these funds on projects dreamt up by corrupt local politicians. These projects are built with borrowed money by various state aligned economic agents. These agents have little hope of repaying the debts incurred. This in turn means that the debts are roll over when they fall due. In reality the State is simply printing money, spending it and then at some point writing it off. This is being done at a speed and scale never before seen in human history.

Jim Chanos the famous hedge fund investor who foresaw the subprime crisis described the entire Chinese economy as “1000 times worse than Dubai”. In 2008, when the world experienced the GFC, China doubled down and simply spent their way through via massive credit stimulus. When China’s massive export markets shrank due to the Western debt crisis the Chinese elected to convert their economy from an export based one to a construction based economy.  Meanwhile, the Western media perpetuates the myths of China’s supposed ascent to displace the US as being the world largest economy.

The problem is that the Western economies never recovered and the Chinese have had to continue their massive growth purely based on constructing roads, bridges, airports, dams and various other construction based infrastructure

If one starts with the official economic statistics and works down through the accounting, taxation, banking systems and then across Chinese industry, there is rampant fraud, poor reporting and outright propaganda at every level. The Chinese economy is largely a central government budgetary system of fiscal spending; each local government submits spending plans to central party authorities, who in turn recommend expenditure up the line.

In 2008 in order to counter the shock of the GFC the Chinese Communist Party (CCP) engaged in massive stimulus programs just as the West did. The difference though was in the way the stimulus was delivered. In Australia, stimulus was delivered as government spending. This is traditionally known as fiscal stimulus where the government borrows money to spend on projects like the new fibre optic NBN Network. In China, though the stimulus was delivered much less traditionally; the increase in expenditure was delivered through banks who were encouraged to offer massive amounts of debt to provincial governments, state owned and sponsored owned enterprise.
The impetus for the stimulus might have been centrally planned, but the spending was decentralised. Provincial governments in China are not able to issue bonds, so state owned investment vehicles borrow the money, often using state gifted real estate collateral as security. The reality is that the majority of these investments, do not or will not pay a return anywhere near that required to make debt repayments. These projects born of corruption, nursed by self-serving bureaucracy fail to thrive due to the defective financial DNA.

Provincial credit expanded at a rate of +35% of GDP per annum and many of the loans needing to be rolled over, with no prospect of serviceability. For this lunacy to continue, what is primarily a construction economy must build more infrastructure this year than last and more again next year and the year after into perpetuity. If these projects had no chance of becoming solvent going concerns in the past, then new projects are even less likely to repay their lenders in the future. In this environment of manic overproduction, elite capital at some point will panic and run for the exits.

To a large extent the Chinese propaganda machine has captured an unquestioning Western media;, the meme that China is the next rising super power and will shortly overtake the US is a part of this propaganda story. Westerners imbue their view of China’s future with cultural qualities that have simply never been reflected in historical fact. In fact, programs like the one child policy reflect the opposite

If the projects in 2009 and 2010 cannot pay adequate returns to service debt then what hope do the new projects have? Furthermore, due to the epidemic of corruption throughout China’s public and private sector, the projects rarely reflect good value for money. This places the entire Chinese economy in Minsky’s last phase of expansion: The Ponzi phase, where lending is perpetrated in the hope that conditions will improve and with little hope of repayment.

In the West debt is to be freely given but even at its worst it is done on some basis of return. When an economic system loses its way, to the extent China has done, the tension it creates on a society becomes unbearable. When the eventual day of reckoning comes and the ability to expand debt is exhausted, then the physics of complete collapse come into play.

A bleak harsh reality will descend on a political system that’s run out of options. One unique feature will come the fore: That China uniquely spends more on internal security than external defence.  China will at once face a great leap backward forcing a military coup and the effective end of CCP rule. Whether the military can hold the country together through a Soviet style collapse is anyone’s guess. One outcome could see the wealthier provinces seeking independence, however it ends it will be the end of a dynasty that started with Mao.

China will not be be the world’s biggest economy this century.  It will falter, due to its demographic arthritis and debt explosion. The denouement of its corruption will pull it down like no other collapse in history. China will shortly have “interesting times.”

Craig Tindale is the Vice President of the Centre for Economic Stability, Professor Steve Keen’s non-profit research initiative.