China is a kleptocracy of a scale never seen before in human history. This post aims toexplain how this wave of theft is financed, what makes itsustainable and what will make it fail. There are several Chinaexperts I have chatted with – and many of the ideas are notoriginal. The synthesis however is mine. Some sources do not wantto be quoted. |
The macroeconomic effects of the Chinese kleptocracy and themassive fixed-currency crisis in Europe are the dominantmacroeconomic drivers of the global economy. As I am trying acomprehensive explanation for much of the world's economy in lessthat two thousand words I expect some kick-back. China is a kleptocracy. Get used to it.
I start this analysis with China being a kleptocracy – acountry ruled by thieves. That is a bold assertion – but I amgoing to have to assert it. People I know deep in the weeds (thatis people who have to deal with the PRC and the children of the PRCelite) accept it. My personal experience is more limited butincludes the following: (a).
The children and relatives of CPC Central Committee membersare amongst the beneficiaries of the wave of stock fraud in the US, (b). The response to the wave of stock fraud in the US and HongKong has not been to crack down on the perpetrators of the stockfraud (so to make markets work better). It has been to make Chinese statutory accounts less available to make it harder todetect stock fraud . (c).
When given direct evidence of fraudulent accounts in the USfiled by a large company with CPC family members as beneficiariesor management a big 4 audit firm will (possibly at the risk totheir global franchise) appear to sign the accounts knowing fullwell that they are fraudulent. The auditors (including and arguablyespecially the big four) are co-opted for the benefit of Chinesekleptocrats. This however is only the beginning of Chinese fraud. China is amafia state – and Bo Xilai is just a recent publicmanifestation. If you want a good guide to the Chinese kleptocracy– including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.
China has huge underlying economic growth from moving peasants intothe modern economy Every economy that has moved peasants to an export-orientatedmanufacturing economy has had rapid economic growth. Great Britainindustrialized at about 1 percent per annum. It was slow becauseall the technology needed to be invented for the first time. Duringthe 19th Century US economic growth – once started –ran about twice the rate of the UK. They copied the technologywhich was faster than inventing it.
Later economies (eg Japan,Malaysia, Thailand, Korea) went later and faster. As a general rulethe later you industrialized the faster you went – as theease of copying went up. In the globalized internet age copyingforeign manufacturing techniques and seeking global markets iseasier than ever – so China is growing faster than any prioreconomy. This fast economic growth – which would happen in a more openeconomy – is creating the fuel for the Chinese kleptocracy.
The one-child policy drives massive savings rates The other key fuel for kleptocracy is a copious supply of domesticsavings to loot. The reason Chinese savings levels are so high isthe one-child policy. In most developing countries the way that people save is they havemultiple children hopefully to generate a gaggle of grandchildrenall of whom are trained to respect their elders. Given most peopledid not live to old age if you did you became a treasured (and wellcared for) family member.
This does not work in China. Longevity in China is increasingrapidly and the one-child policy results in a grandchildpotentially having four grandparents to look after. The "fourgrandparent policy" means the elderly cannot expect to belooked after in old age. Four grandparents, one grand-kid makesabandoning the old-folk looks easy and near certain.
Nor can the elderly rely on a welfare state to look after them.There is no welfare state. So the Chinese save. Unless they save they will starve in old age.This has driven savings levels sometimes north of fifty percent ofGDP. Asian savings rates have been high through all the keyindustrializations (Japan, Korea, Singapore etc). However Chinesesavings rates are over double other Asian savings rates –this is the highest savings rate in history and the main cause isthe one-child policy.
Low and middle income Chinese have very limited savings options The Chinese lower income and middle class people have extremelylimited savings options. There are capital controls and they cannottake their money out of the country. So they can't invest in anyforeign assets. Their local share market is unbelievably corrupt. I have looked atmany Chinese stocks listed in Shanghai and corruption levels aresimilar to Chinese stocks listed in New York.
Expect fraud. What Chinese are left with is bank deposits, life insuranceaccounts and (maybe) apartments. Bank deposits and life insurance as a savings mechanism in China Bank deposits rates are regulated. You can't get much differentfrom 1 percent in a bank deposit.
Life insurance contracts (a hugesavings mechanism) are just rebadged bank deposits –attractive because the regulated rate is slightly higher. This is a lousy savings mechanism because inflation has beenbetween 6 and 8 percent (but is now lower than that and is fallingfast). At almost all times (except during the height of the GFC)the inflation rate has been higher – often substantiallyhigher – than the regulated bank deposit (or life insurancecontract) rate. In other words real returns for bank accounts are consistentlynegative – sometimes sharply negative.
You might ask why people save with sharply negative returns. Butthen you are not facing starvation in your old age because of the"four grandparent policy". Moreover because of theunderlying economic growth (moving peasants into a manufacturingeconomy) there are increasing quantities of these savings everyyear. This is the critical point – the negative return tocopious and increasing Chinese bank deposits drives a surprisingamount of the global economy and makes sense of many things insideand outside China. The Chinese property market as a savings mechanism Chinese people have very few savings mechanisms.
The major ones(bank deposits and their life-insurance contract twins) have sharpand consistently negative real returns. Beyond that they have property. Bank deposits have sometimes 5 percent negative returns. If you got1 percent negative returns from property – well – youwould be doing well. Buying an empty apartment and leaving it emptywill do fine provided you can sell the property at some stage inthe future.
It is commonplace amongst Western investors to view the see-throughapartment buildings of China as insane. And they may be a poor useof capital. But from the perspective of the investors – wellthey look better than bank deposits. Negative returns on bank deposits and the Chinese kleptocracy Most Chinese savings however are not invested in see-throughapartment buildings.
Bank deposits still dominate. The Chinesebanks are the finest deposit franchises in human history. They canborrow huge amounts at ex-ante negative real returns. And those deposits are mostly lent to State Owned enterprises. The SOEs are the center of the Chinese kleptocracy.
If you manageyour way up the Communist Party of China and you play your politicsreally well may wind up senior in some State Owned Enterprise. Thisis your opportunity to loot on a scale unprecedented in humanhistory. Us Westerners see the skimming arrangements. If you want to sellkit (say high-end railway control equipment) to the Chinese SOE youdon't sell it to them. You sell it to an intermediate company whoon-sell it in China.
From the Western perspective you pay a fewpercent for access. From the Chinese perspective – this isjust a gentle form of looting. And it is not the only one. The SOEs are looted every way untilTuesday. The Business insider article on the spending at HarbinPharmaceutical is just a start.
The palace pictured in Business Insider would make Louis XIV of France (the Sun King) proud. This palaceshows the scale (and maybe the lack of taste) of the Chinesekleptocracy. A normal business – especially a State Owned dinosaur run bybureaucrats – would collapse under this scale of looting. Buthere is the key: the Chinese SOEs are financed at negative realrates. A business – even a badly run business – can stand alot of looting if it is (a) large and (b) funded at negative realrates.
Those negative real rates are only possibly because there arecopious bank deposits available at negative real rates to Statecontrolled banks. The cost of funds in China and the willingness to hold foreignbonds The Chinese Government (and the banks are part of the governmenteven though they are listed) has access to seemingly unlimited bankdeposits at negative real costs. When you have copious funds at a negative cost a lot of investmentsthat look stupid under some circumstances suddenly look sensible.US Treasuries look just fine. Don't think the Chinese are going tostop holding Treasuries.
The Treasuries yield far more than theypay the peasants. The Chinese make a positive arbitrage on holdinglow rate US bonds. Monetary threats to the Chinese establishment The Chinese kleptocracy – and indeed several major trends inthe global economy – depend on copious quantities of savingsat negative expected rates of return by middle and lower incomeChinese. There are two core threats to this system – one widelydiscussed – one undiscussed.
Inflation (widely discussed) is known to produce riots anddemonstrations in China – and is considered by Westerners tobe bad news for the Chinese establishment. And there are goodreasons why the Chinese riot with inflation – the poor whosave because they are going to starve – get their savingstaken away from them. But ultimately the Chinese establishment like inflation – itis what enables their thievery to be financed. The more serious threat is deflation – or even inflation atrates of 1-3 percent. If inflation is too low then the SOEs –the center of the Chinese kleptocratic establishment will notgenerate enough real profit to sustain the level of looting.
Thesebusinesses can be looted at a negative real funding rate of 5percent. A positive real funding rate - well that is a completelydifferent story. The real threat to the Chinese establishment is that the inflationrate is falling - getting very near to the 1-3 percent range. Low Chinese inflation rates will mean reasonable returns on savingsfor Chinese lower and middle income savers.
Good news for peasantsperhaps. But that changing division of the spoils of economic progress willdestroy the Chinese establishment (an establishment that relies ona peculiar and arguably unfair division of the spoils). The SOEswill not be able to pay positive real returns to support that newdivision of spoils. The peasants can only receive positive realreturns if the SOEs can pay them - and paying them is inconsistentwith looting.
If the SOEs cannot pay then the banks are in deep trouble too. All because the inflation rate is dropping. Maybe they can stop itdropping. The Chinese establishment has a vested interest ingetting the inflation rate up in China. Because if they don't allhell will break loose.
Unless the Chinese can get the inflation rate up expect arevolution. John.
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