- Can we top “the most boring financial crisis in history”?
- Moody’s downgrades China: Moody’s isn’t telling even half the story
- When to expect the next Chinese devaluation (bad for stocks, good for gold)
- Housing: Existing home sales down, ditto for stuff to fix those homes
- Lights Out: Reader feedback on Koppel’s dire cyberattack scenario
A few years ago, Europe was — in the words of our fearless leader Addison Wiggin — “the most boring financial crisis in history.”
Spanish unemployment, Italian bank scares, the endless negotiations over Greek bailouts (those are still going on this very week!)… it was too much.
The crisis reached its worst point in the late summer-early fall of 2011. But Americans hardly noticed. Here at home we were obsessed with a debt-ceiling showdown. Once the showdown was resolved, Standard & Poor’s made the unprecedented decision to strip Uncle Sam of his pristine AAA credit rating.
That should have been cause for global investors to dump U.S. stocks and pile into gold. But because Europe was experiencing a far worse meltdown at the time, hot money sought “refuge” in U.S. stocks. Gold, meanwhile, topped out at $1,900 and began its long climb back only 18 months ago.
We mention all this as prologue to the very boring news that Moody’s just cut China’s credit rating… and we suspect the outcome for U.S. stocks and gold will be quite different from 2011.
“While ongoing progress on reforms is likely to transform the economy and financial system over time,” said Moody’s, “it is not likely to prevent a further material rise in economywide debt, and the consequent increase in contingent liabilities for the government.”
The downgrade was only one notch, from Aa3 to A1. But it’s a fateful step Moody’s hasn’t taken with China since November 1989 — when the Berlin Wall was falling, Back to the Future II was the big box-office draw and Milli Vanilli lip-synced to the top of the charts with “Blame It on the Rain.”
The trouble in China is deeper than Moody’s lets on, according to our own Jim Rickards.
In an instance of prescient timing, the new issue of Rickards’ Strategic Intelligence arrived in readers’ inboxes yesterday, hours before Moody’s issued its Chinese downgrade. “China has multiple bubbles,” Jim wrote, “and they’re all getting ready to burst.
“The combined Chinese government and corporate debt-to-equity ratio is over 300-to-1 after hidden liabilities, such as provincial guarantees and shadow banking system liabilities, are taken into account.”
Let’s dive into just one of those liabilities — the “wealth management products,” or WMPs, owned by many middle-class Chinese. We’ve described them before, but they’re worth revisiting.
“Picture this,” says Jim. “You’re a middle-class Chinese saver and you walk into a bank. They offer you two investment options. The first is a bank deposit that pays about 2%. The other is a WMP that pays about 7%. Which do you choose?”
Over the last decade, Chinese investors have sunk $12 trillion into these WMPs. “Here’s how they work. Proceeds from sales of WMPs are loaned to speculative real estate developers and unprofitable state-owned enterprises (SOEs) at attractive yields in the form of notes. The problem is that the borrowers behind the WMPs can’t pay their debts. They’re relying on further bubbles in real estate or easy credit from the government to meet their interest obligations.
“What happens when a WMP matures? Usually the bank customer is encouraged to roll over the investment into a new WMP. What happens if the customer wants her money back? The bank sells a new WMP to another customer and then uses those sales proceeds to redeem the first customer.”
If that sounds to you like a Ponzi scheme, it is.
Recently a woman who bought a WMP from her bank was asked by a Bloomberg reporter if she was worried about the credit quality of the loans backing her WMP. “No, not at all,” she replied. “If anything goes wrong, Beijing will bail us out.”
But wait, there’s more: There’s also debt racked up at the provincial level.
Jim recalls a trip he took to Nanjing a while back. “I met with provincial Communist Party officials who took me on a tour of a massive multicity construction project with office parks, skyscrapers, apartment buildings, hotels, recreational facilities and transportation links for each of the cities. It was all empty.”
As Jim is fond of reminding us, China’s “ghost cities” aren’t about building for the future. They’re about providing jobs in the present. “China needs to find jobs for the millions of workers arriving from the countryside looking for work. Failure to generate those jobs could result in social instability, riots and attacks on the legitimacy of the ruling Communist Party of China.
“When we returned for tea in the provincial officials’ offices, I asked how they expected to repay the debt used to fund the construction. The head official answered matter-of-factly, ‘Oh, we can’t repay it. Beijing will have to bail us out.’”
But Beijing’s capacity to offer bailouts to everyone who needs them is constrained by something called “the impossible trinity.”
“The rule,” Jim explained here in late 2015, “is that a country cannot have an independent monetary policy, an open capital account and a fixed exchange rate at the same time.”
In the case of China, that means it can pull off two of the following three things at once, but not all three…
- A monetary policy independent of the Federal Reserve
- A system that allows investors to move their money in and out of the country quickly
- An exchange rate pegged to the U.S. dollar.
China tried to pull off the impossible trinity in 2015, and it wasn’t working. The People’s Bank of China ended up devaluing the yuan relative to the U.S. dollar twice — a shock one-time devaluation in August and a stealth devaluation over several weeks in December. Both devaluations threw global markets into turmoil and took a wrecking ball to U.S. stocks.
Fast-forward to mid-2017: China’s debt problem is even worse, but the government is using paper clips and rubber bands to hold everything together. And Jim says it’ll work — but only for a few more months.
This fall — the date isn’t yet set — China’s Communist Party will hold its every-five-years National Congress. President Xi Jinping will use the occasion to consolidate his power. Jim says Xi is in position to become the most powerful Chinese leader since Mao Zedong — and maybe since the emperor Shunzhi in 1644.
“With so much at stake for Xi, investors can be sure that no one in China will be allowed to ‘rock the boat’ before October,” Jim explains. “The currency should remain stable against the U.S. dollar at least until then in order to avoid acrimony with the United States.”
But then all hell will break loose, for the reasons Jim’s described here before.
China’s foreign exchange reserves have already shrunk from $4 trillion to $3 trillion. Of that remaining amount, about $1 trillion is tied up in illiquid investments (like ghost cities) and another $1 trillion will be needed for all those bailouts. That leaves only $1 trillion left to defend the yuan-dollar peg.
A few months ago, Jim figured China’s forex reserves would be exhausted by the end of this year. But the aforementioned paper-clip-and-rubber-band solutions have bought a little more time — maybe till mid-2018.
“This leaves only one way out for China,” says Jim: “a maxi-devaluation of the yuan. A drop of 20% against the dollar would be viewed as sustainable.” Likely impacts: A U.S. stock market correction of greater than 10% and a flight to safety in gold.
Yes, there’s a way to play it, and not with complicated options strategies, either: “If you make the right moves now, you can earn huge returns even as Chinese credit and currency crash and burn.”
We’ll reserve that recommendation for paying subscribers of Rickards’ Strategic Intelligence. Subscribe here and we’ll send you a copy of Jim’s latest book, The Road to Ruin… and you’ll get immediate web access to the current issue with the full China story.
It’s another “meh” day in the markets. The major U.S. stock indexes have barely budged. Ditto for gold.
Earnings season is limping to a close, and Lowe’s whiffed this morning — a remarkable feat for a retailer whose wares are mostly immune from “the Amazon effect.”
The only economic number of note is existing home sales — down 2.3% in April. That’s not as big a disappointment as the drop in new home sales yesterday, but it’s a disappointment nonetheless.
Traders are waiting for the “minutes” from the Federal Reserve’s meeting three weeks ago, whereupon they will analyze the document for clues about future interest rate policy in the same manner as a witch doctor analyzes entrails…
“Are these power outages lasting awhile or do they seem like glitches?” a reader writes after yesterday’s episode on the possibility of a cyberattack taking out the power grid.
“I ask because I run a dealership and today, no bad weather or overload on power, all of a sudden, power out for a few seconds, and then directly back on. I may be a little paranoid, but you mentioned Nashville, and we are about an hour and a half south of Nashville.
“Again, probably nothing, but this is a true threat and can be done from anywhere.”
“You can’t turn off the electricity in the USA with a switch,” writes a skeptic. “The grid has too many parts, and though they are interconnected, they can be disconnected and operate on their own.
“It’s true that if you damage enough things, such as transmission lines or large transformers, you could black out some fairly big areas, but not the whole grid, and not for very long.
“The electrical grid is not just one thing. It’s hundreds of things that can be connected together or not. There are many, many companies and power plants that provide power to large and small areas that can be isolated from other companies and still go on running.”
“Like many others, I have read Mr. Koppel’s very disturbing book.
“‘Our’ Congress — after being made completely aware of the dangers involved and the relatively modest cost involved in hardening the grid against such threats — has consistently voted NOT to take any action.
“This fact is even more astonishing given the relatively low cost of (1) hardening the grid and (2) taking action to stockpile the various hard-to-replace elements of the grid such as large power transformers that require very long lead times to manufacture and transport to where they are needed. Indeed, if compared with the cost of a year’s operations in Afghanistan — or the cost of a few dozen ‘FUBAR-35’ fighter aircraft — the cost of hardening the U.S. power grid is almost trivial. Again, we are looking at a truly existential threat to the survival of this nation, but nobody, apparently, cares.
“I contacted my own ‘representative’ in Washington. His staff, first of all, had no clue about any of this and, after some discussion, opined that they did not consider this issue to be at all ‘important’ — and why was I ‘bothering’ them with such nonsense?
“As an experiment, try calling up your local ‘representative’ in Congress and see what kind of response you get. I think that you will be amazed/appalled at just how ignorant/unconcerned they are about this issue. And yes, they really DON’T CARE if we die. They, on the other hand, have very nice, government-provided bunkers that they will be staying in while the rest of us scramble for food, medicine and some semblance of public order after the grid goes down.”
“Concerning the miscalculations of the Canadian Mint,” a reader writes on another topic yesterday, “purchasers of their coins also received free shipping.
The face value is a $20 coin of the realm, which will buy $20 worth of goods in much the same way as a $20 paper bill. So investors are in reality losing nothing — almost as if they had gone to their bank and exchanged four $5 bills for a $20. The coins did make a rather nice gift for the grandkids, though.”
The 5: According to one news story we saw… when the coins were first issued in 2011, some Canadians tried to spend them. Not that many merchants were willing to take them…
Best regards,
Dave Gonigam
The 5 Min. Forecast
P.S. Did you play it? This morning Zach Scheidt told readers of Contract Income Alert they were in line to collect an 80% gain on a play they entered just over a year ago. And they didn’t even have to call their broker or log onto their account!
How did they do it? All they needed was a nine-digit code with which they could “unlock” the kind of interest rates you can’t possibly get from a CD, a Treasury bond or even a high-dividend stock.
And all you need is $1,000 to get started. Here’s the whole story.
