September 23, 2017 02:16 pm CDT
Here it Comes
By Briton Ryle, Wealth Daily


Friday May 15, 2015.

Remember this date, because it may well mark the beginning of the end for the 30-year Chinese growth cycle. 

It's pretty well known that China has created a huge amount of debt as it has gone into hyper-drive developing its manufacturing sector and adding infrastructure to support the urbanization and modernization of its emerging economy.

We've seen the Chinese government pump its economy with the biggest stimulus ever in the wake of the financial crisis. It poured over a trillion dollars into its economy to stave off a slowdown.

We've seen it cut reserve requirements for banks so they will lend more to support the real estate market. And we've seen it raise those requirements when real estate prices start getting out of hand.

All the while, the total amount of debt in China continues to grow. Total bank debt in China has grown from $14 trillion in 2008 to around $30 trillion today. At the same time, China's money supply has doubled. After all, if you're gonna pump out more loans, you have to actually have the money to, um, give to people.

I know this may sound like what's been happening here in the U.S., but there is an importance difference: It's starting to sound like China is actually giving money away...

Last Friday, China's Finance Ministry, banking regulator, and central bank issued a joint directive that banks should keep making loans to local government projects — even if these borrowers are unable to make payments on existing loans.

Yeah, you read that right: China's banks are being "asked" by a communist government to make loans to corrupt local governments when there's a pretty good chance those loans won't be repaid...

These local governments will even be allowed to "restructure" some of their debt by exchanging loans for a type of municipal bond that will have a capped interest rate.

The assumption here should be pretty clear: These bonds are backed by the Chinese government. If the local governments can't pay (likely), the Chinese government will (also likely).

Can This End Well?

It's pretty important to remember that China is a communist country. All politics are local, they say, so the mandates and five-year plans agreed upon by China's communist leaders get put into action by the local governments.

We need more roads, say the communists in Beijing, and local party leaders borrow money, select contractors, skim some cash off the top for themselves, and get the roads built.

No shocker there — local officials are always pretty good at graft, no matter the political system.

But communism is special. And Chinese communism is especially special. Because you've got a few men planning the fate of 1.4 billion people. So they can say, hey, we're gonna need a six-lane highway between these two towns because eventually 600 million farmers are gonna move to these towns and they're going to need to get back and forth.

So the local official goes to the bank, says I need a loan for a six-lane highway, the bank says okay, and they build the highway. Never mind that these 600 million farmers don't want to move, and even if they did, they'd be loading up the ox instead of the Ford that took Jed and his family to Beverly Hills. And so there are miles of barely used highway in China.

Or even better, maybe the Boys from Beijing say oh yeah, we're gonna need big apartment buildings for these 600 million farmers to live in when they move to the big city. Do the math — it looks pretty good. We can build a 20-story building with eight apartments per floor — that's 160 apartments pulling in $800 a month, so we'll be making $128k a month and $1.5 mill a year. We'll get this thing paid off in five years.

Bank says sweet, 8% a year for doing nothing is great. The local official says awesome, I'm gonna skim a cool million off this job. The Boys in Beijing say nice job — the building looks great.

But then not enough people move in. There's not enough cash to pay the loan, the local official can't get new money to build the next building, and the bank is suddenly in violation of reserve requirements. The whole Chinese economy grinds to a halt...

china ghost town

China did something virtually unthinkable

And that's what's been happening. I'm sure you've heard about the ghost towns in China, built in anticipation of residents that have yet to show up. These ghost towns are funded with loans that may never get paid back. And it's a problem because China needs to keep building, spending, and growing.

$3.5 Trillion

It's estimated that local Chinese government debt stands at $3.5 trillion.

To put that in perspective, the bribery/kickback scandal that sent Brazil into political chaos and crushed shares of state-run oil company Petrobras (NYSE: PBR) was less than $4 billion in bribes.

We haven't seen anything like China's loan problem...

And the thing is, because China's economy is basically closed, there are no checks and balances on monetary policy there.

If a U.S. bank lent too much and it looked like it wouldn't get paid back, investors would sell the stock, sell the bonds, pull their money out, and the bank would collapse. But market forces can't be brought to bear on Chinese banks in the same way.

China can keep printing money, keep renegotiating bad loans, and keep lending as long as it wants to. I won't be surprised if China's communist party simply writes off all the bad debt and gives newly printed money to China's banks.

You may think our Fed has gone off the rails, but it's nothing compared to the financial experiment the Chinese are conducting. We all better hope nothing goes wrong...

Until next time,

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Briton Ryle

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