In the midst of an intense global economic slowdown that began in 2008, China's
economy amazingly appeared to be unaffected. Defying the world-wide real estate
collapse, China's GDP grew by an impressive 8.7% in 2009. Fueled initially
by a $586 billion stimulus package, China would end up plowing and additional
$20 trillion dollars into a fixed asset bubble that was designed to produce
the government's desired GDP print.
Perhaps inspired by the movie "Field of Dreams", the Chinese government believed
in the adage "If you build it, they will come". And for the next 6 years China
built empty cities in spades. New construction remains mostly unoccupied to
this day; estimates are that 52 million homes are vacant and 90% of those empty
units were purchased strictly for investment purposes.
Apartments were snapped up as investments by the nation's wealthy upper and
middle classes, then sat empty as the owners failed to find tenants who could
meet the pricey rent.
Investors sat on massive mortgages on unoccupied real estate holdings and
home prices began to fall when loans from the shadow banking system started
to dry up. This caused the Chinese authorities to quickly search for another
bubble to create; one in a more convenient and easily manipulated asset class.
If the average citizen could no longer afford to buy a house why not try to
create a wealth effect by putting equities in a perpetual bull market?
Substituting empty cities for brokerage accounts with little capital, on-line
Chinese lenders set up margin accounts with the same fervor as U.S. sub-prime
mortgage lenders in 2006. In addition to conventional brokerage accounts, 40
online lenders helped arrange more than 7 billion yuan worth of loans for stock
purchases in the first five months of 2015. Lending volumes surged 44% from
April to May alone.
China's margin finance problem quickly reached epic proportions. Margin trading jumped
thirtyfold over the past three years on the Shanghai stock exchange.
Chinese margin debt has risen 123% year-to-date, reaching a new record of 2.3
trillion yuan ($370 billion) on June 18.
However, some analysts believe the real amount of money borrowed by Chinese
investors is likely to be much higher. The amount of shadow margin financing,
which includes umbrella trusts and stock-collateralized loans, in the mainland
stock market could easily be double or triple that of the balance of conventional
margin financing taken through brokerages.
In addition, unlike other major international stock markets, which are dominated
by professional money managers, retail investors account for around 85% of
Chinese trading.
For a brief moment it was a magical solution to combat the failed real estate
bubble. The Shanghai Composite started 2015 at 3,234 and hit 5,023 on June
4th--a 150% surge from the preceding 12 months, before plunging to 3,800 where
it sits today.
But the market is still far from trading at a discount valuation. Despite
the recent carnage, Shanghai shares are trading at 57 times earnings. That's
down from the June price to earnings ratio of over 100, but it's still 3x higher
than the PE ratio of the S&P 500.
The totalitarian regime is making daily policy modifications in a desperate
attempt to stem the fall. But, interest rate reductions by the People's Bank
of China (PBOC), cuts in reserve ratio requirements and relaxations in margin
trading rules have done little to calm investors so far.
Brokerage firms and fund managers have now vowed to buy massive amounts of
stocks aided by a direct line of liquidity from the PBOC, which is directly
monetizing securitized loans from China Securities Finance Corporation (China's
state-backed margin finance company.)
The nation is also trying to coerce corporate officials to buy back their
own shares to a great degree. But with China's questionable accounting practices
and stocks prices completely decoupled from fundamentals, this is a little
like asking Jim Jones to drink his own Kool Aide. In addition, China has promised
to investigate "malicious" shorting of stocks (basically banning short selling
unless you want to be a guest in the communist government's prison system)
and has banned selling of shares outright from any shareholders that own at
least a 5% stake in a company.
And, to make matters even worse, over 50% of stocks in the primary Shanghai
Exchange are in a trading halt. Just imagine how much further down the stock
market would be if these shares were allowed to freely trade. Given all this
it is a travesty to believe there is actually a stock "market" in China any
longer. Perhaps the Chinese government will be able to manipulate stocks from
going down much further but it will be powerless to prevent the ultimate collapse
of its phony economy.
The current debacle in China is actually much worse than the U.S. equity collapse
in 1929 and the Japanese economic bubble in 1989. Despite what the Carnival
Barkers on Wall Street are saying, the Chinese economy is now suffering from
the evaporation of the wealth effect. New Chinese millionaires, bolstered by
their newly found stock market wealth, had been fueling the consumption economy
that was supposed to supplant its export-driven growth model.
After a stock-market rout that has erased about $3.2 trillion in perceived
value, car sales in June were down 3.2% month over month. This is the first
such decline in over 2 years and refutes the claim that China is still growing
at the fictitious 7% growth rate the government has sought to produce.
Once the darling of the Keynesian utopian dream, a booming China spoke to
those who believed that the power of a command and control economy was far
more effective than the power of the free market.
As the Chinese communist economic regime begins to unravel, the bubble in
the belief that a small group of central planners can make better decisions
than millions of people acting freely in their own self-interest should burst
along with it. And the current massive bubble in the credibility of Central
Banks to save every market should suffer a welcomed blow as well.
The Chinese are communists masquerading as capitalists. They have no idea
what a free market is; instead they have layered an artificial equity bubble
on top of a manufactured real estate bubble. And now are busily trying to command
both bubbles to perpetually float.
Make no mistake, China is by no means alone in their disdain for free markets
and its willingness to create a facade of prosperity at all costs. The governments
and central banks of Japan, Europe and the United States have also eviscerated
the price discovery mechanism in all asset prices. What we have left are worldwide
asset bubbles floating on top of synthetic economies, which has somehow caused
-- in lobotomized fashion -- a universal confidence in governments to borrow
and print our way to everlasting prosperity.
These Potemkin central banks will be able to erect only hollow economies built
with counterfeit money. Therefore, you must build a strategy that will profit
from the inevitable fate of these economies, which is intractable inflation
and a protracted depression...at least until governments embrace the power
of free markets once again.
