Trumped! A Nation on the Brink of Ruin... And How to Bring It Back

by David Stockman

  CHINA’S MASSIVE WHITE ELEPHANT—1.4 BILLION TONS OF STEEL CAPACITY

  Stated differently, even at the peak of recent financial bubbles in London, NYC, Miami or Houston they did not build such monuments to sheer economic waste and capital destruction. But just consider the case of China’s mammoth steel industry.

  Annual production grew from about 70 million tons in the early 1990s to 825 million tons in 2014. Beyond that 12X gain, it is the capacity build-up behind the following chart below that tells the full story.

  To wit, Beijing’s tsunami of cheap credit enabled China’s state-owned steel companies to build new capacity at an even more fevered pace than the breakneck growth of annual production. Consequently, annual crude-steel capacity now stands at nearly 1.4 billion tons, and nearly all of that capacity—about 65% of the world total—was built in the last 10 years.

  Needless to say, it’s a sheer impossibility to expand efficiently the heaviest of heavy industries by 17X in a quarter century. And especially so when, as outlined below, China’s long-run sustainable demand for steel is on the order of 400 million tons, or one-third of its current capacity.

  Indeed, what actually happened is that China’s aberrantly massive steel industry temporarily created a significant increment of demand for its own products.

  That is, in order to build up 1.4 billion tons of capacity, it needed massive amounts of plate, structural and other steel shapes that go into blast furnaces, basic-oxygen-furnace works, rolling mills, fabrication plants and iron-ore loading and storage facilities. It also needed enormous amounts of plate and other steel products to expand shipyards where new bulk carriers were built and also for the huge amounts of equipment and infrastructure used at the iron-ore mines and ports.

  That is to say, the Chinese steel industry has been chasing its own tail, but the merry-go-round has now finally stopped. For the first time in three decades, steel production in 2015 was down 2–3% from 2014’s peak of 825 million tons and is projected to drop to 750 million tons next year, even by the lights of the China miracle believers.

  MASSIVE MALINVESTMENT AND AN EPIC IMPENDING MARGIN CALL

  In short, the flip side of the China’s giant credit bubble was the most massive malinvestment of real economic resources—labor, raw materials and capital goods—ever known. Effectively, the countryside pig sties have been piled high with copper inventories and the urban neighborhoods with glass, cement and rebar towers that can’t possibly earn an economic return, but all of which has become “collateral” for even more “loans” under the Red Ponzi.

  So China has been on a wild tear heading straight for the economic edge of the planet—that is, monetary terra incognita—based on the circular principle of borrowing, building and borrowing, and then even more building and borrowing. In essence, it is a giant rehypothecation scheme where every borrower’s “debt” becomes the next investor’s “asset.”

  Local city and county governments, for example, have meager incomes, but vastly bloated debts based on the collateral of stupendously overvalued inventories of land—valuations that were established by earlier debt-financed sales to developers.

  Likewise, coal-mine entrepreneurs face not only collapsing prices and revenues, but also soaring double-digit interest rates on shadow-banking loans collateralized by overvalued coal reserves. Shipyards have empty order books, but vast debts collateralized by soon-to-be-idle construction bays.

  So too, commodity speculators have collateralized massive stockpiles of copper and iron ore at prices that are already becoming ancient history.

  So China is on the cusp of the greatest margin call in history. Once asset values start falling, its pyramids of debt will stand exposed to withering performance failures and meltdowns. Undoubtedly the regime will struggle to keep its printing press prosperity alive for another few months or quarters, but the fractures are now gathering everywhere because the credit rampage has been too extreme and hideous.

  It is downright foolish, therefore, to claim that the U.S. economy is decoupled from China and the rest of the world. In fact, it is inextricably bound to the global financial bubble and its leading edge in the form of Red Capitalism.

  WHY THE CHINA BUBBLE IS GLOBAL

  Bubble vision’s endlessly repeated mantra that China doesn’t matter because U.S. exports to it account for less than 1% of GDP is a non sequitur. It does not require astute observation, for example, to recognize that Caterpillar did not export its giant mining equipment just to China; massive amounts of it went there indirectly by way of Australia’s booming iron-ore provinces—that is, until the global CapEx bust was triggered by two years of crumbling commodity prices. Caterpillar’s monthly retail sales reports, in fact, are a slow motion record of this unprecedented crash.

  Overall, Caterpillar’s global retail sales posted a massive 16% drop at the end of 2015 compared to the prior year—a result tied for the worst annual decline since the financial crisis. And that came on top of the 12% decline the prior year, another 9% drop in 2013 and a 1% decline in 2012.

  Moreover, four consecutive years of declines is not simply a Caterpillar market-share or product-cycle matter. Its major Asian rivals have experienced even larger sales declines. Komatsu is down, for example, by 80% from its peak sales levels.

  In the heavy-machinery sector, therefore, the global CapEx depression is already well underway. There has been nothing comparable to this persisting plunge since the 1930s.

  Likewise, the United States did not export oil to China, but China’s vast, credit-inflated demand on the world market did artificially lift world oil prices above $100 per barrel, thereby touching off the U.S. shale boom that is now crashing in Texas, North Dakota, Oklahoma and three other states. And the fact is, every net new job created in the United States since 2008 is actually in these same six shale states.

  Indeed, the rot that was introduced into the global economy by the world’s convoy of money-printing central banks extends into nearly unimaginable places, owing to the false bubble prices for crude oil, copper, iron ore, aluminum, nickel and countless other raw materials that were temporarily inflated by the global credit boom.

  Indeed, the deformation spread like a tidal wave across the entire planet. Notwithstanding a 33% increase in oil exports last year, Iraq is now so broke, for example, that it is petitioning the IMF for a bailout. Yet as recently as a year ago plans were proceeding apace to build the world tallest building at its oil-country center at Basra.

  That right. The Bride of the Gulf now has tin cup in hand and is heading for an IMF rescue. The monstrosity below will likely never be built, but it does succinctly symbolize the trillions that have been wasted around the world by lucky reserve-owning companies and countries during the false boom that emanated from the Red Ponzi.

  The planned Bride of the Gulf building in Basra, at a height of 1,152 meters would outdistance even the Jeddah Tower being built in Saudi Arabia.

  Similarly, U.S. exports to Europe have tripled to nearly $1 trillion annually since 1998, while European exports to China have more than quintupled. Might there possibly be some linkages?

  In short, there is an economic and financial train wreck rumbling through the world economy called the Red Ponzi. In all of economic history there has never been anything like it. It is only a matter of time before it ends in a spectacular collapse, leaving the global financial bubble of the last two decades in shambles.

  So forget the orderly-transition myth. What happens when the iron-ore ports go quiet, the massive copper stockpiles on the pig farms are liquidated, the coal country turns desolate, the cement trucks are parked in endless rows, the giant steel furnaces are banked, huge car plants are idled and tens of billions of bribes emitted by the building boom dry up?

  What happens is that giant economic cavities open up throughout the length and breadth of the Red Ponzi.

  Industrial profits as a whole are already down 5% on a year-over-year basis, but in the leading sectors have already turned into re
d ink. In a few quarters China’s business sector, in fact, will be in the throes of a massive profits contraction and crisis.

  Likewise, tens of millions of high-paying industrial and construction jobs, and the consumer-spending power they financed, will vanish. Also, the value of 65 million empty apartment units that had been preposterously kept vacant as a distorted form of investment speculation will plunge in value, wiping out a huge chunk of the so-called savings of China’s newly emergent affluent classes.

  So where are all the promised new consumers of services supposed to come from? After Peak Debt and the crash of China’s vast malinvestments, there will be no surplus income to recycle.

  Most importantly, as the post-boom economic cavities spread in cancer-like fashion and the crescendo of financial turmoil intensifies, the credibility of the regime will be thoroughly undermined. Capital flight will become an unstoppable tidal wave as the people watch Beijing lurch from one make-do fix and gimmick to the next, as they have during the stock market fiasco of the past two years.

  In short, China will eventually crash into economic and civil disorder when the Red suzerains go full retard with governance by paddy wagons, show trials, brutal suppression of public dissent and a return to Chairman Mao’s gun barrel as the ultimate source of Communist Party power

  Self-evidently, the Maoist form of rule did not work. But what is now becoming evident is that Mr. Deng’s printing press has a “sell by” date too.

  RED PONZI LURCHING

  The specious notion that the rules of Beijing can deliver a soft landing has been refuted time after time in recent months by spasms of disorder and dysfunction. These events and symptoms are intensifying, and self-evidently can’t be patched over with expedients and new credit infusions indefinitely.

  One night in February 2016, for example, the red-chip casino took another one of its patented 6.5% belly flops. In fact, more than 1,300 stocks in Shanghai and Shenzhen fell by 10%—the maximum drop permitted by regulators in one day—implying that the real decline was far deeper.

  That renewed carnage was the worst since, well, the prior 6% drop in late January. It also meant that the cumulative meltdown from the June 2015 stock market high was pushing 45% or nearly $4 trillion.

  Moreover, this red-chip mayhem did not come at an especially propitious moment for the regime, as the Wall Street Journal explained:

  It comes at an awkward moment for the Chinese government, which is hosting the world’s leading central bankers and finance ministers starting Friday. China has been expected to use the G-20 meeting to address global anxiety about its economy and financial markets. Worries about China’s economic slowdown and the volatility of its markets have weighed on investment decisions around the world.

  But if we are remarking on “awkward,” here’s awkward. The G-20 central bankers, finance ministers and IMF apparatchiks who descended on Shanghai in late February should have taken an unfiltered, eyes-wide-open view of the Red Ponzi fracturing all about them, and then made a petrified mad dash back to their own respective capitals. There was nothing more for the G-20 to talk about with respect to China except how to get out of harm’s way, fast.

  In fact, China is a monumental doomsday machine that bears no more resemblance to anything that could be called stable, sustainable capitalism than did Lenin’s New Economic Policy of the early 1920s. The latter was followed by Stalin’s gulag and it would be wise to learn the Chinese word for the same, and soon.

  The regime is in a horrendous bind because it has played out the greatest credit spree in world history. As we indicated above, this cycle of undisciplined, debt-fueled digging, building, spending and speculating ballooned its collective debt balance by a 60X gain in debt over just two decades in an “economy” that has no legitimate honest financial markets, no legal system and no tradition of bankruptcy and financial discipline.

  Its banking system that functions as an arm of the state, cascading credit down from the top in order to “print” an exact amount of GDP each month on the theory that anything that can be built should be built in order to hit Beijing’s targets.

  If an economy and its ruling regime were an animate being you could call it a “fatal addiction” and be done with it. These folks are on the deadliest strain of financial heroin known to mankind and have no chance of surviving; it’s a dead economy walking.

  Look no further than the hideous debt gains reported for the early months this year. Total social financing rose at a $6 trillion annualized rate, or by 55% of GDP. And that was on top of the tottering $30 trillion debt tower it already had.

  By now China’s businesses—especially the giant state-owned enterprises—are drowning in excess capacity and unpayable debt that amounts to upward of 180% of GDP (compared to 70% in the United States). But never mind. New loans to the business sector were up by 73% over the prior year.

  Worse still, it is evident that a high share of the lunatic rate of credit expansion in early 2016 was devoted to paying interest on the existing monumental debts of China’s businesses and so-called local-government financing vehicles.

  Even the Beijing authorities concede that more than 60% of new debt issuance in recent years has been used to pay interest. They are chasing their tail ever more furiously; they are strapped on to a debt whirligig they can’t and won’t get off . . . until it finally explodes.

  In truth, China’s economy is no more efficient, productive, stable or prosperous than was Stalin’s five-year-plan GDP. The latter, by the way, grew at fully double-digit rates the West envied for more than a decade during the 1930s.

  The only difference is that the Red suzerains of Beijing seem to have learned about the advantages of using a printing press and “bankers” to carry out their central-planning schemes rather than tonnage quotas and commissars; and also that swapping quasi-slave labor in their export factories for IOUs from its customers in the United States and Europe could temporarily relieve the misery and poverty that Mao had consigned to the hundreds of millions trapped in China’s collectivist rice paddies.

  Needless to say, having built a massive Potemkin economy, China’s rulers have no clue about how to contain the incendiary pressures that are now building to the ignition point.

  Indeed, there are no possible economic mechanisms or even viable half-assed statist schemes to stabilize the $30 trillion mountain of debt that sits precariously on its fracturing hothouse economy, or to relieve it of its fatal debt addiction. So Beijing will soon have no alternative but to rule by the brute force of paddy wagons and even firing squads.

  The days during which a giant daisy chain of ever-inflating lending and spending was raising all boats is over and done. There is nothing ahead except a collapsing credit bubble that will be sinking the great Red Ponzi boat and its 1.3 billion passengers—and along with it, a worldwide economy and financial system afflicted with the kind of plenary misrule that was recently brought to Shanghai by the G-20.

  A POTEMKIN ECONOMY BURIED IN CEMENT

  No wonder the Red Ponzi consumed more cement during three years (2011–13) than did the United States during the entire 20th century. Enabled by an endless flow of credit from its state-controlled banking apparatus and its shadow-banking affiliates, China went berserk building factories, warehouses, ports, office towers, malls, apartments, roads, airports, train stations, high-speed railways, stadiums, monumental public buildings and much more.

  If you want an analogy, the 6.6 gigatons of cement consumed by China during 2011–13 was the equivalent of 14.5 trillion pounds. By comparison, the Hoover Dam used about 1.8 billion pounds of cement.

  So in three years China consumed enough cement to build the Hoover Dam 8,000 times over—160 of them for every state in the union!

  Having spent recent time in China, I can well and truly say that the Middle Kingdom is back. But its leitmotif is the very opposite to the splendor of the Forbidden City.

  The Middle Kingdom has been reborn in towers of preformed concrete. They rise in
there tens of thousands in every direction on the horizon. They are connected with ribbons of highways that are scalloped and molded to wind through the endless forest of concrete verticals. Some of them are occupied. A lot, not.

  The “before” and “after” contrast of Shanghai’s famous Pudong waterfront is illustrative of the illusion.

  The top picture on the next page is from about 1990, at a time before Mr. Deng discovered the printing press in the basement of the People’s Bank of China and proclaimed that it is glorious to be rich and that if you were 18 and still in full possession of your digital dexterity and visual acuity it was even more glorious to work 12 hours per day six days per week in an export factory for 35 cents per hour.

  Whether or not this image is precisely accurate as to vintage, by all accounts the glitzy skyscrapers of today’s Pudong waterfront did ascend during the last 25 years from a rundown, dimly lit area of muddy streets on the east side of Huangpu River. The pictured area was apparently shunned by all except the most destitute of Mao’s proletariat.

  But the second picture I can vouch for. It’s exactly what you see from the Peninsula Hotel on the Bund, which lies directly across on the west side of the Huangpu River.

  Today’s Pudong district does look spectacular—presumably a 21st-century rendition of the glory of the Qing, the Ming, the Soong, the Tang and the Han—all rolled into one.

  But to conclude that would be to be deceived. The apparent prosperity is not that of a sustainable economic miracle; it’s the front street of the greatest Potemkin village in world history.

  The heart of the matter is that output measured by Keynesian GDP accounting—especially China’s blatantly massaged variety—isn’t sustainable wealth if it is not rooted in real savings, efficient capital allocation and future productivity growth. Nor does construction and investment that does not earn back its cost of capital over time contribute to the accumulation of real wealth.