The People’s Bank of China cut the reserve requirement for Chinese banks by 50 bps on Tuesday, supposedly freeing up ¥1trillion in the banking system. The head of the central bank also promised to reduce mortgage rates by 50 bps on new loans and to push banks to reduce some existing mortgage rates by 50 bps.
They caught some short-sellers by surprise and sparked a bit of a rally in the yuan but not much else. They tried the same thing in February.
These rallies mean nothing in the longer term. Too many people were expecting China to roll-over and die (economically) in the short run when the decline is going to take some time. Think of China as a terminally ill patient that sometimes still experiences lucid days; we’re not yet at the point of death throes. For all intents and purposes, China’s demise is inevitable.
Deflation
$6.8 trillion has been wiped out of Chinese equity since 2021 while $18 trillion has been lost in housing. The Chinese people have responded by cutting spending which is why I don’t believe retail sales are positive at roughly 2% year-over-year. The nation has been swallowed by the Paradox of Thrift where people choose to save rather than spend. The result has been a massive decline in small companies that cater to retail and dining. This is disastrous because private enterprise employs 80% of the Chinese workforce and 90% of new jobs according to Harvard’s Kennedy School.
Declining retail and restaurants negatively impact banks because real estate is largely funded by bank loans. Economists have been imploring Xi for two years to create a bailout package to restore consumer confidence and domestic spending. Instead, local governments are taxing and applying fees to everything imaginable to close their revenue gaps.
Xi Jinping’s economic policies are not aimed at restoring consumer spending nor does he support industries in demand by Chinese consumers. Instead, he favors industrial process investment and exports that accumulate dollars. For example, China is pushing electric vehicles to bring producer’s costs down through scale in order to dominate global markets. It’s a mercantilist strategy at its core.
I wrote a series of pieces earlier this year where I express my belief that China is running out of US dollars. Here’s a link to the first piece in the series: https://geovestadvisors.com/has-china-run-out-of-dollars/ If I’m right, it explains Xi’s choices for economic policy because a mercantilist policy allows China to stockpile dollars while a consumer policy forces the People’s Bank of China make dollars available for the importation of consumer items.
China has hundreds of millions of urban retirees surviving on the equivalent of $425 a month while rural retirees can receive as little as $25 per month. Calls for bigger payouts by economists fall on deaf ears. If you’ve followed Xi’s policies, his focus has always been the future and retirees represent the past. Xi is attempting to restore the Marxist policies of Mao and Mao allowed tens of millions of Chinese people to starve to death. I don’t expect Xi to be any more compassionate with retirees.
The Wall Street Journal has reported that Zhu Hengpeng, formerly the Deputy Director of the Institute of Economics at China’s Academy of Social Sciences, disappeared in April and has not been seen since. Zhu, who’s specialty is healthcare economics and elder care, made the mistake of criticizing Xi’s policies in a private chat group. Liu He is also believed to be in some trouble following an analysis where he pushed for more consumer stimulus to fix the economy. Fortunately, Liu is very high profile.
The Chinese people aren’t dumb; they have figured all of this out which is why the trends of “lying flat” and competition over who can spend less for food are growing. Lying flat means doing as little as possible to survive. It means eschewing marriage and career.
Chinese youth unemployment is back to 18.8% after going through a revision of methodology that reduced this number. Keep in mind that China is experiencing a dramatic increase in worker retirement which should benefit youth hiring but it’s not happening because the economy is in a state of collapse.
The chart below of housing prices only goes to January 2024 and things have gotten worse since the beginning of the year. Will reducing mortgage rates by 50 bps make enough of a difference to reverse this trend? NO WAY!!!!
The next chart came from ZeroHedge last week and points to deflation in a nutshell. It’s China’s M1 which is the most liquid portion of money supply. It is collapsing. This is why it’s virtually impossible for retail sales to be positive; money is not changing hands in China.
Keep in mind, this chart is collapsing despite the PBOC adding roughly 25% to the monetary base in 2023 to bail out local governments. It’s full-fledged deflation in China but as a command economy, they can prevent the collapse from becoming a rout for some time. This means that they will be able to continue catching careless short-sellers from time-to-time until they are out of tricks.
Impact on Banks
Without reflection, we go blindly on our way, creating more unintended consequences, and failing to achieve anything useful – Margaret Wheatley
Over the past decade, China’s “net interest margin” at its banks has dropped from 2.5% to 1.5%. NIM is the spread between rates charged on loans and the interest paid to attract deposits. This level of profitability can work if credit quality is very good and credit charge-offs below 1%. If I had to guess, bad loans are many times that 1.5% profit margin these days although not being realized due to pressures from Beijing.
When we consider that China is largely capitalized with debt and that private companies are presently out of favor with Chinese leadership, we can logically expect much of the debt shown below to turn negative before long. The chart only goes through the end of 2022, so we can assume more debt has been accumulated by private companies.
Interestingly, look at the Covid period between 2020 and early 2022 where there was a massive spike in borrowing to replace the lost cash flow from having the economy shut down. It wasn’t just corporations, young people also borrowed aggressively during this time to pay for necessities as they endured the lockdowns and loss of wages. Just one more way that Xi destroyed the Chinese economy.
The more time goes by, the more those loans will move from current to non-performing. When we combine this understanding with the low profitability of Chinese lending products, the Chinese banking system is going to experience a horrendous meltdown. Presently, it’s being kept aloft by the aforementioned Paradox of Thrift that has Chinese consumers foregoing consumption in order to save more money. Yet, even with Chinese consumers paying down loans and saving, M1 continues to decline. Those savings are preventing banks from needing to liquidate bad loans but for how long?
The question now becomes whether Chinese banks will lend out this money and the capital unlocked from the 50 bps decline in the reserve ratio? Or will they continue to limit new loans to ride out these rough times? My guess is that the decline in the reserve requirements will produce negligible loan growth. Again, it’s why Chinese M1 is deeply negative.
Conclusion
Concentrated power is not rendered harmless by the good intentions of those who create it – Milton Friedman
The Chinese government executed another short-squeeze, one of many as the value of Chinese financial paper has declined over the past decade. It has declined for both cyclical reasons and because Xi has managed the Chinese economy about as bad as humanly possible – but don’t comment on his mismanagement if you live in China unless you want to disappear in the back of a police van.
This short-squeeze means nothing, nor does cutting a half point from mortgage rates. Optimism for the future of China is the worst form of wishful thinking at this point because decline is inevitable. But inevitability doesn’t mean that you can try to profit from China’s problems without consequence.
For now, global central banks are on China’s side because they don’t want to create a contagion; China represents potential global financial contagion far worse than 2008. When it happens, I expect the US dollar to spike as we learn that China has run out of greenbacks. With the dollar trading at the bottom of its recent range and the yuan trading just above ¥7 to the buck, the time for a Chinese collapse is not at hand.
Furthermore, copper is trading above its recent range and that tells us that this global deflationary risk is presently subdued. My next piece will focus on the value of the dollar and how I believe it will hover at current levels for at least another month. I will also write about what I perceive as attempts by global central banks to protect the fragile banking systems of Europe and China by keeping those currencies elevated versus the buck.
