China: Engineers Build – Economists Devalue

I’m at a loss to explain what happened in the Chinese money system the past few weeks. Yes, the tip of the iceberg was the Wealth Management Products that matured in June. And yes, it’s likely that things will cool down for a bit. But the guys at Deutche Bank see more trouble ahead.

We would expect to see clearer indications of more cash flow problems across different industrial sectors in China in the near future.

There are only two possibilities for what has happened in China’s funding markets. 1) A mistake was made, or 2) it was deliberate. The evidence tells me this was deliberate. The tripling of short term borrowing rates could have been avoided. But why would China try to derail its economy? The idea that the Chinese leaders chose to choke off credit to the shadow banking system and precipitate a funding crisis is hard to accept. I’ve been struggling to come up with an explanation. Possibly this chart provides an answer:

The composition of the Chinese Politburo has changed remarkably. For the past twenty years the leaders in China were mostly engineers (in this case engineers = technocrats). What do engineers like to do? They build things. And that is exactly what China has has done for the past two decades. It built cities that no one lives in. It built highways, rail lines and airports that are not used. It changed the course of rivers with huge dams, in the process it uprooted millions and changed the climate. There is no precedent for what China has done the past few decades.

Building all of the stuff that China has constructed has proven to be a huge stimulus to the domestic economy. The raw materials that China consumed to build out the country fueled the global commodities boom. Damn near every nation on the globe benefited while China’s engineers/politicians built things.

As of 2013, the composition of the leadership in China has changed dramatically. The engineers are gone. Today the leadership is comprised of Economists and Lawyers. Economists only look backward and opine on what has happened, they rarely have a vision of the future. Lawyers, are always cautious, and are more likely to say “No”, than “Yes”.

The following data sets must have those lawyers and economists at the Politburo losing sleep at night. China has been completely out of whack with the rest of the world when it comes to building stuff:

An economy that relies on 50% fixed investment for growth is going to stumble sooner or later. For China, with a $7Tn economy, it means that every 12 months another $3.5Tn of “stuff” has to get built. The new Chinese leaders have ten-years to leave their mark on history. They must understand that the 50% fixed investment that has fueled China’s growth the past 2o years is now a busted model. If they have grasped this reality, then they also understand that they must act quickly to change things around. If a transition is inevitable, it’s better to get it over with in the first three years of the new leadership. That way the last three years would have a chance of proving them right, and ensuring their place in history. What better way to transform an economy than to precipitate a recession? And what better way to precipitate a recession than to raise interest rates and destroy wealth?

If the Chinese economists and lawyers are not going to build things at the pace of the past, then something else has to fill the bucket. The only thing that I can see is the $3.5Tn of reserves. How that hoard of cash could be used without creating other problems is not clear to me. But those Chinese lawyers and economists are going to try to figure out ways to do just that.

If things unfold as I suspect, and the foreign currency reserves are used to prop up a sagging economy, then it will trump anything that Bernanke and his Taper Talk have done to global interest rates.

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