Monday, April 9, 2018

The new phone book's here!.....the new phone book's here!

As you, my readers, are well aware, we "financial people", accountants, actuaries and economists tend to get really excited about things that most regular folks just don't care too much about.  As financial people, we go to work day after day, make calculations, check and recheck our work, and sometimes for decades at a time, determine, with little or no fanfare, that everything, seems to be chugging along just fine.  We review reports, statistics, financial statements and documents that validate, confirm and bless the notion that our investments are solid, our businesses are well run and all is indeed right with the world.  This work, for lack of any better explanation as to why we do it, gives meaning to our lives.



That said, occasionally, we run across a document like the just released 2017 Financial Stability Board's  (FSB)"Global Shadow Banking Monitoring Report" (catchy title), which, to put it plainly, gives us a reason to get up in the morning.  That's right....

The new Financial Stability Board Report is here!

To professionals like us, this document is so fascinating that, like a great detective novel, we just can't put it down.  We can't wait to see how this "whodunit?" ends.  I consider this and other FSB work to be an essential road map for every investor, manager, economist, government, Central Banker and, neigh dare I say, every household on the planet, to use as an essential guide describing what's about to happen to us, and with proper interpretation, help us assess our financial future.

Let me also be clear, this document is not for everybody.  It's is not nearly as much "fun" as the Black Panther, Kardashian Tweets or watching the seemingly endless parade of White House firings du jour. That's real entertainment!  But, also knowing full well that some of my readers might not be as interested as I am about, or truly understand the importance of, this document, nor might they have the requisite time available to fully analyze these 100 pages of technical jargon with references to the thousands of pages of prior reports, related studies and additional jargon, I want to be clear that, as always,  I'm here to help.

I had previously reviewed and commented on the content of the 2016 Report (2015 Data) in my post "The Sum of All Fears...." but like a great mini series, the saga continues and the plot thickens.

The value that I hope today's exercise brings to the table for my readers is that together, we can painstakingly figure out what all of this complex nonsense really means, why it's happening and how it can directly impact us......we will do the heavy lifting together.  We will also try our best to explain this mess in everyday, easy to understand language.  Of course, if you are an economist, student, banker, investor, rich "dude" or member of your neighborhood investment club and want to check/verify my work or disagree with my thoughts/conclusions, I've posted links to the reams of source material below for your further review.  Have at it!.... and see if you can come to different conclusions.  Feel free to send comments/criticisms or additional thoughts/references to me at:

Deep.Throat.IPO@Gmail.com.

Finally, since this post is 1.) Much more in depth than what I've posted in the past, and 2.) What we're about to discuss is so grueling, complex, inexact and mind-numbing, and 3.) The world has come to believe that anything written with more than 240 characters is boring, irrelevant and just not worth the time, I've written this post in a new format.  I've included  a short "One-Line Executive Summary" (in Red) along with "Executive Summary Bullet Points" at the beginning of every new concept/section, along with instructions to skip ahead if you don't want to get bogged down in the detail.

OK.....(deep breath....exhale....).......here we go....


The 2017 Financial Stability Board (FSB) Global Shadow Banking Monitoring Report 

One-Line Executive Summary:

Global Financial Assets (Loans and Equity) have increased dramatically over the last few years.  Most of the increase is a result of Chinese Monetary Policy on both the Chinese Mainland and Offshore Custodial Money Financial Centers (CMFCs).  This accumulation and concentration constitutes a significant global, systemic financial risk. 

Executive Summary Bullet Points
  1. The Report covers data up to end-2016 from 29 jurisdictions. (including Luxembourg for the first time).  The data from these economies and financial centers represent the economic activity related to more then 80% of global GDP.
  2. Global Financial Assets (Loans & Equity) for these jurisdictions have increased to US$340 Trillion as of 12/31/16, up from US$321 Trillion as of 12/31/15.  (Note that when these reports were published the data was more that a year old.  Further, we have no reason to believe that the trends described have not continued to accelerate.)
  3. Annual compound growth of these assets has been roughly 6% since 2011,  about twice the growth rate of global GDP.
  4. During 2016, these assets also grew as a share of total Reporting Group GDP (from 523% to 540% of GDP).
  5. The concentration of assets in "Non-Bank" OFI's (Other Financial Intermediaries) has increased to US$99 Trillion, or just under 30% of total Financial Assets.  OFI's comprise all financial institutions that are not banks, insurance companies, pension funds, public financial institutions, etc.      
  6. OFI Assets have increased at an annual compound rate of roughly 9% since 2011, roughly 3x the growth rate of Global GDP.
  7. Shadow Bank Assets.....a subset of OFI Assets which by definition are subject to instability and "runs" amount to US$45 Trillion at the end of 2016, up an astounding US$11 Trillion from 2015.  
  8. Asset Growth, specifically OFI Assets has been concentrated in both China and what I'll refer to as "Custodial Money" Financial Centers or CMFCs.  A CMFC to be defined as a Financial Center where the Asset Value(s) in the Financial system bear little relationship to the GDP of that particular domicile.  i.e.) The CMFCs are holding and "playing with somebody else's money".  The domiciled assets of the Caymans, Luxembourg, Hong Kong, Ireland, Netherlands, Switzerland, Singapore financial systems, which I've defined as CMFC "Custodial Money", have expanded much more rapidly than asset levels in the rest of the world.
  9. Combined Chinese and CMFC "Custodial Money"   (as defined above) Financial Assets have increased by US$11 Trillion (to US$104 Trillion) from 2015 to 2016.  These assets now represent roughly 1/3rd of the all of the Financial Assets (wealth) on the planet.  OFI Assets, for the same jurisdictions, increased US$8 Trillion for the same period, comprising the lion's share of the total US$11 Trillion increase.  OFI Assets in these jurisdictions now represent nearly half (44%) of all OFI Assets on the planet.     
  10. The Executive Summary of the Report concludes with four (4) Recommendations summarized as follows. 1.) Enhance the system-wide oversight of shadow banking.  2.) Authorities are encouraged to seek further granularity on cross-border interconnectedness between banks and non-banks. 3.) Authorities should supplement flow of funds data, where needed.  4.) Authorities should closely monitor and share information and, where possible, data on emerging financial stability risks that are growing quickly and may become concerning.
  11. Author's Note: Based on the rapid growth of these asset classes (and their curious domicile) in relation to Global GDP, the above described FSB recommendations seem quite similar to Captain Edward John Smith's well thought out, calmly delivered instruction to his crew to "try to carefully and accurately measure all the seawater that's pouring in from those gigantic iceberg holes in the hull."
Remember if you hate gory details ONLY READ THE RED "One-Line Executive Summaries" and Executive Summary Bullet Points


Non-Executive Gory Details Begin Here - Feel Free to skip ahead to "So where is all of the CMFC money coming from?" if you don't want to deal with the details....

So let's take a look at what the FSB refers to as the "macro-mapping" of the worlds Financial Assets.  The 2016 and 2015 Charts below illustrate the amounts and types of institutions where the increase in assets is concentrated.




When we compare the above charts, the increase in both non-bank assets (MUNFI) and Shadow Bank Assets jumps off the page.  With a few offsets, we see that the entire $11 Trillion MUNFI increase is due to Shadow Bank Assets which are substantially comprised of "Assets Subject to Runs".

When we examine the types of institutions that actually have custody of these assets as well as the growth these asset classes held by these custodians over the last few years we conclude that the the higher risk OFI Asset Classes have been growing at a rate roughly 3x Global GDP, to nearly $100 Trillion at the end of 2016.  Unfortunately, we'll have to wait another year for the 2017 figures, but I'd imagine that the trend has continued.























As described earlier and in Exhibit 2-3 below, we see that there is significant new asset concentration in both CMFCs and China.   Financial Assets expressed as a ratio of GDP are substantial in the Caymans (KY),  Luxembourg (LU), Ireland (IE), Netherlands (NL), Hong Kong (HK), Switzerland (CH) and Singapore (SG), generally nearing, or well in excess of 1000% of GDP for these reporting jurisdictions.



Now let's look at the composition of the Financial Assets in these reporting jurisdictions in relation to the world.  We see that roughly a third (31%) of the world's Financial Assets and nearly half (44%) of the world's OFI Assets are concentrated in these eight (8) jurisdictions.  These jurisdictions represent only 18%  of the worlds GDP.  If we remove China from the discussion we see that  US$51 Trillion (15%) of Total Assets and US$33 Trillion (33%) of OFI Assets are held by institutions on the remaining seven (7) CMFCs.  These seven (7) CMFCs contribute only 3% of the world's GDP.












































Am I wrong or wasn't the world's economic activity chugging along pretty well, even before $104 Trillion in Financial Assets and the related leverage magically showed up in these secretive, opaque financial centers? 

So where is all of the CMFC money coming from?

One-Line Executive Summary:

Because of opaque CMFC banking rules, it is impossible to tell with certainty, but these jurisdictions which have traditionally been sanctuaries for hedge fund, oligarch, cartel, tax avoidance/cheat and various forms of questionable/secretive money, have increased Financial Asset Balances to the point where the aforementioned traditional sources of funds are insufficient to justify the huge increase.  The only plausible explanation is that much/most of this "money" is being created, through various vehicles, by the Chinese Government.  

Executive Summary Bullet Points
  1. In 2014 PWC produced an excellent white paper/study entitled "Where do you Renminbi?" sponsored by the Grand Duchy of Luxembourg, which describes the flow and expansion of Chinese Investment into the world's various CMFC financial systems. 
  2. Chinese Money Center Banks (Bank of China, China CITC, China Construction Bank, ICBC China, etc.)  have set up prominent beach-head operations in the CMFCs with presumably significant assets under management.
  3. There have been thousands of Chinese owned offshore Shell Companies created to facilitate movement of wealth from the mainland.  Many of these vehicles were created to hold wealth generated by IPOs and Bond issues on US Exchanges as well a Private Equity Investment.  (See Alibaba 424(b)4 - pg. 250-251 as an example)  These businesses invest primarily in US/EU/HK/etc. Financial Assets and Real Estate.
  4. There is tremendous political pressure to make things look better than they actually are with no "pants on fire" mechanism to catch and correct bad data.  The favorable is trumpeted, while the bad news is buried, glossed over or omitted all together.  There's more "bad data", defined as data that doesn't match or balance with other published data, out there than ever before.

Non-Executive Gory Details Below - Feel free to continue on to "Silly Numbers and 'Bad Gauges' "  if you don't want to deal with this....

Over the last few months I've occasionally given a quick, informal, one question quiz to a few investors and economists I am fortunate enough to be acquainted with.  They are all aware, at least at some level, of the rapidly increasing money in the Caymans/Caribbean and CMFC's.  My question was  "Where is all of this offshore money coming from?"  The usual response was a momentary pause followed by an answer something like "US Hedge funds and asset appreciation....I guess...".

I would have thought the same thing until I started digging into it.  The FSB estimates that hedge fund assets in the Cayman Islands are roughly US$3.2 Trillion, or roughly 45% of total US$7.3 Trillion Financial Assets domiciled in the Caymans.  The point is that there are trillions of dollars in these mysterious assets located in CMFCs where the real origin and ownership of these assets is impossible to determine.     

Just for fun, lets take a look at the "Balance of Payments" for China over the last few years.  There's all sorts of complex, technical jargon involved here (Economists love technical jargon....) but the map below describes what has happened from 2013 thru 2016.  Here are the bullet point concepts for you non economists out there:
  1. Businesses around the world Sell to (Export) or Buy from (Import) to Businesses in China.  Chinese businesses, of course, do the same with the rest of the world.  
  2. All these transactions are accomplished in a designated currency.  So Businesses exchange stuff for "Money" causing "flows" of each.  
  3. Businesses also make Investments in Assets in China.  These Investments are referred to as "Foreign Direct Investments" (FDI).  Of course Chinese businesses invest funds in other countries as well.  This is referred to as "Outbound Foreign Direct investment" OFDI, again creating flows of money.  Simply put, businesses and investors are exchanging "money" for ownership interest in overseas assets.  
  4. Of course transactions within the border of every country take place in the local currency.
  5. Businesses either buy/sell (Import/Export) goods and services (the "Current Account") or they make investments or sell off investments (the "Financial Account").  The sums of the "Current Account" and the "Financial Account" add up to the "Balance of Payments".  It's the sum of "stuff" and "ownership interests" coming into or going out of a country. 
  6. Therefore, the value of Exports and the value of FDI (Money coming in) increases the Balance of Payments (BoP) and the value of Imports and OFDI (Money going out) decreases the Balance of Payments.
  7. In theory, the grand total of every Country's Balance of Payments (BoP) should be zero.  i.e.) Given Country A & Country B; Country A's Exports are Country B's Imports and Country A's FDI is Country B's OFDI.   Simply put, the world should "balance". 
Given the above, and applying data from the World Bank we see what China's Balance of Payments relationship with the rest of the world looks like in the map below.  Over the four years from 2013 through 2016, China "gained" US$873 Billion in "Money" and the world "gained" the same amount in "Goods & Services".  China also gained a net US$285 Billion (US$972B - US$687B) in "Money" and the world gained the same amount in net "ownership" of Chinese Assets.  Total "Money" gained by the Chinese during that time, increasing the Balance of Payments is US$1.158 Trillion. 



Now lets look at more World Bank Data below.  The only absurd, ridiculous, impossible conclusion we can draw is that:  "The numbers don't add up".  Let's take a look at the figures in the chart below:























As far as we can tell, Current Account and Financial Account changes reported don't carry forward. There may very well be a good reason for this, perhaps I just don't understand the math.  Perhaps there's something that isn't obvious that the World Bank is just not telling us.  Since I'm not a World Bank accountant I may not have a full understanding of the mechanics of these calculations.  But on the other hand, here's what I see:

For example, China's total reported Current Account + Financial Account Balance at the end of 2012 was US$347 Billion.  If we add Net Exports and Net Inbound FDI we would expect the BoP Account Balance to increase by US$375 Billion, from US$347 Billion, totaling to an ending balance of US$722 Billion in 2013.  In other words, in 2013 the reported Total Account Balance is US$236 Billion, yet the "calculated" balance should have been US$722 Billion.  We seem to be missing US$486 Billion?

We see the same variance in the numbers for the US.  According to the schedule above, over the four year period, the US Balance of Payments should have decreased by US$1.031 Trillion yet the reported balance actually increased by $46 Billion.

When we look at the "World" it's even more confusing.  As I mentioned earlier, the World's Exports should equal the World's Imports.  Outbound FDI should equal Inbound FDI.  There should be no "balance".  The total of both trade flows and capital flows should be zero.  According to the World Bank, when we add up the data provided by individual governments, we see that, in aggregate, they must be Exporting more than they are Importing and they are investing in other countries more than other countries are investing in them.  The US$1.446 Trillion overstatement in four years is a material deviation, effectively making things seem much better than they actually are.  Unfortunately, Central Bankers are presumably basing policy decisions on these overstated figures.   

When working with several hundred reporting entities/governments I'd expect that the data might be a bit rosy.  That's human nature.  The "good stuff" is always highlighted and the "bad stuff" is either omitted or minimized in the discussion.  There are obvious political motivations and incentives for producing puffed up stats, yet there's no mechanism to catch errors/misrepresentations and correct them.  As a World Bank accountant, when reams of massaged data come across your desk, what can you do?  Do you get on the phone and call "liar liar pants on fire"?....no, you add the data up and publish it as is.  Like so many financial functions in the world today, as a World Bank Accountant, you do what you are told.

How can this happen?  I remember back in my days at the University of Wisconsin, I had an Intermediate Level Accounting Professor who emphasized that on any exam, no matter how brilliant a student's analysis was, he/she would get absolutely no credit for his/her answer if the journal entry didn't balance. 

Perhaps, and this is just a guess, the World Bank economists and bookkeepers never took that accounting class at the University of Wisconsin.  If my former professor was running the World Bank today when these governments handed their work in, he would have kicked it back to them with a lot of red marks and notes in the margin and given them all a big fat goose egg for their efforts.  The red lines and notes would say "DOES NOT BALANCE!!"  He'd refuse to publish the data, or if he did, he'd at least footnote it saying he doesn't believe a word of it.

Silly Numbers and "Bad Gauges" 

One-Line Executive Summary:

There are so many inconsistencies and non-sensical metrics being reported now, whether it be in individual company financial statements or official Government Statistics that the world's Central Bankers are increasingly more likely to make horrific policy mistakes.  Political pressures combined with a willful regulatory ambivalence has created a sunshine, lollipops and rainbows financial view in a "pants on fire" world, which, at some point, will prove to be unsustainable.

This next section is a tough read.....if you don't feel up to it and are reading the Executive Summaries only.....scroll on down to "The RMB....the Giant 'Effing' Panda in the Room...."

So now that we've taken a look at the World Bank Data above and concluded that it might have some inconsistencies, let's take a look at the data from the IMF.  Perhaps the IMF can add some insight.  I've attached a chart showing the "World's" Imports vs. Exports below.   The official Data Set we're analyzing is the DOTS (Direction of Trade Statistics - BM.GSR.GNFS.CD - Imports/Exports of goods and services comprise all transactions between residents of a country and the rest of the world involving a change of ownership from nonresidents to residents of general merchandise, non-monetary gold, and services. Data are in current U.S. dollars.)

Interestingly, these statistics are reported to the dollar....so they must be extremely accurate.  The more precise the number, the more believable it's deemed to be.  As an aside, my Accounting Professor also mentioned that he'd prefer to have no financial information rather than "bad" financial information.  His rationale was that "in our profession, we can refuse to make a decision if we have no information.....on the other hand, we can easily be fooled into making a bad decision if we have bad information..."

The chart below compares the world's IMF reported Exports of "Goods, Services and Primary Income" to Imports of same.










When we examine the chart and the underlying data we see that:
  • In 1990 the world was much less interconnected, with only about US$5 Trillion in total imports/exports.
  • Back in 1990, the difference between Exports and Imports was "only" a few hundred billion dollars, not too much in the grand scheme of things.
  • Reported Exports have always been greater than reported Imports.
  • By 2014, Global Exports had increased nearly 6x to US$28.1 Trillion.  The "Gap" between reported Exports and reported Imports had increased to more than US$4.9 Trillion. In other words the "World" was reporting that it was exporting nearly US$5 Trillion more than it was importing in 2014.  As a point of reference US$5 Trillion is roughly the GDP of Japan, the world's third largest economy by nominal GDP.  Unless some of the governments/countries reporting have located some extraterrestrial trading partners and have crafted intergalactic trade agreements, this, of course, is not possible. 
  • The difference between reported Exports and Imports has been growing steadily and has settled in with Exports exceeding Imports to the tune of roughly US$4 Trillion per year over the last few years. 
  • IMF Exports reported are equal to the World Bank Exports reported.  (US$ 24.548 Trillion in 2016),  However, IMF Imports reported (US$20.150 Trillion) are much less than World Bank Reported Imports ( US$23.963 Trillion).     
Being concerned about this disparity in the data, since US$ 4 Trillion+ a year isn't exactly a rounding error, I noticed a "Chat Button" conveniently located on the IMF website, reminiscent of what I've become accustomed to when inquiring about why my Amazon order arrived without the socks or boxer shorts I had ordered. So I thought I'd give the "Chat Button" a try.  As an aside, I think it's absolutely awesome that all I had to do is click a button and I'd have immediate 24x7 access to a world renowned economist who could immediately answer all of my questions.

I clicked the button and submitted what I considered to be a carefully crafted paragraph outlining the concerns I had described above.  In less than a second, I received not one but three AI generated possible responses.  The only response that had anything to do with my question is posted below.  The other two responses seemed to be generated because my question had the words "Import" and/or "Export" in the question.

Here's the IMF's "Official" Response:

Why do the exports of country A to country B not equal to the imports of country B from country A in the Direction of Trade Statistics (DOTS) dataset?


It is sometimes assumed that corresponding export and import data between partner countries should be consistent. That is, the exports from Country A to B should be equal to the imports of Country B from A, after taking into account the insurance and freight costs under the generally observed case that Country B imports are valued on a cost, insurance, freight (c.i.f.) basis. The DOTS estimation system uses this assumption in cases where one partner has not reported data.

However, notwithstanding the inclusion of insurance and freight in imports c.i.f., it should be noted that there are several complications that can cause inconsistency between exports to a partner and the partner
s recorded imports f.o.b., or between imports free on board (f.o.b.) from a partner and the partner
s recorded exports. The principal reasons for inconsistent statistics on destination and origin for a given shipment are differences in 1) classification concepts and detail, 2) time of recording, 3) valuation, and 4) coverage, as well as 5) processing errors.

Well...there you have it!  From the IMF canned response we learn a couple of things:
  • Enough people have asked this question that they've actually developed a canned response to it.
  • The IMF is aware of the significant difference/disparities, as evidenced by this, although insufficient, well crafted response.
  • The IMF is apparently attempting to explain away a US$4 Trillion a year disparity (roughly 1/5th of US GDP) with 1.) Classification (which should offset), 2.) Timing (Which should correct in the next period), 3.) Valuation (probably a significant error), 4.) Coverage (Doubtful.... all major economies are all reporting), and 5.) Processing Errors (US$4 Trillion of Processing errors?  Really?)  
Now that we've identified a US$4 Trillion a year confusion/anomaly in the Import/Export figures let's take a look at the World's Balance of Payments data, again per the IMF.  The chart below illustrates what we get when we add up the reported Balance of Payments (The Financial Account PLUS the Current Account) for all IMF reporting countries.  Note also that the actual figures are again reported to the nearest dollar.
































The above shows us yet another level of confusion.  In theory, when we add all of the World's reporting countries/economies Balance of Payments up, the "balance" should be zero ($0) or close to it.  Surpluses should offset deficits.  Debits should equal credits.  Yet, over the last few years we see that the "world" is somehow running at a net surplus of roughly US$1 Trillion.  (2013-$1.115T, 2014-$1.215T, 2015-$911T, 2016 $933T)

Again, the net result here is that these figures make the finances of some reporting entities look a bit better, or perhaps significantly better than they actually are.  Moreover, it doesn't seem likely that governments would be over-reporting deficits or under-reporting export or investment growth.  CEOs, Government Officials and Politicians tend to shape the numbers to look better than they are.  It's in their DNA.

I'll be the first to admit that I have a tremendous advantage over world renowned economists when asking these simple straight forward questions.  First, I doubt that very many people actually bother to download World Bank or IMF data, dump it into an Excel spreadsheet and parse it out and compare it in their spare time.  The refutable presumption is that everything is accurate.  If there's some secret, simple explanation for the above described inconsistencies, that every world renowned economist is aware of, it would be great to hear what it might be. 

Moreover, since I'm just an insurance agent in Cleveland I have the luxury of being able to ask these questions with no career repercussions.  I'm not afraid to look silly.  I will not be laughed at or ostracized if I missed something obvious.  My career will not be impacted since I dare to ask simple questions about something I don't fully understand.  I consider it an intellectual advantage to feel comfortable enough in my own skin to ask what many might think is a stupid question.  If I'm wrong and these are indeed stupid questions, my life will continue unchanged.

On the other hand, if I were running the World Bank or the IMF and I didn't truly understand what was happening....well.....I can imagine there might eventually be some fallout at some point.


The RMB.... the "Giant Effing Panda" in the Room....


Related image
Here's a picture of my good friend Nancy Effing with her Giant "Effing" Panda.

For all of my troll friends out there who, after seeing this picture, have just jumped on the Internet and done all sorts of time-wasting research, immediately determining that this is NOT a picture of someone named "Nancy Effing"....don't worry..... I know.

It's actually New York Congresswoman Carolyn Maloney, and you trolls believe you are now poised, locked, loaded and ready to accuse me of being a liar and charlatan for posting this "Effing" picture.  Before you do so, let me point out that this is what we, in America, refer to as a "joke".

One-Line Executive Summary:

The Chinese government has dramatically increased both its global presence and national wealth by managing International Financial transactions through its dual, On-shore(CNY)/Off-shore(CNH) RMB currency mechanism/scheme, to the Rest Of The World's (ROTW)  financial detriment.

Executive Summary Bullet Points
  1. The primary currencies for international settlement on our planet are the US$ (42% of transaction volume), Euro (31%), Pound (7%), Yen & Canadian Dollar (2% each).  i.e.) Roughly 84% of all international trade and investment is settled in these currencies.
  2. As of February 2018, only 1.56% of all international currency transactions are settled in RMB
  3. Total RMB in circulation (M3) is just short of US$26 Trillion.  China's M3 is roughly US$12 Trillion greater than (nearly double) US M3.
  4. Total "Offshore" RMB (CNH) available for International transactions is currently RMB 1.15 Trillion (US$ 182 Billion), actually declining from its peak of RMB 1.85 Trillion in 2015.  This total represents roughly 0.7% of all RMB in circulation.
  5. Primary offshore RMB depository markets (90% of all offshore RMB) are Hong Kong, Singapore, Taiwan, London, Luxembourg and Macao.      
  6. By managing the global supply/inventory of the RMB and consequently the exchange rate, the Chinese Government has been able to generate US$ Trillions of additional compensation for net exports as well as  purchase US$ Trillions of EU/Western/Offshore Assets at a significant discount. Simultaneously, the CCP has been selling Mainland (RMB Denominated) Assets to EU/Western/Offshore Businesses and Investors at a grossly inflated price.
  7. The RMB is the only currency issued by a major economy that does not float.  China is the only major economy in history to be able to pull this off.
  8. It's absolutely brilliant.
If you'd prefer not to go through the gory details....feel free to scroll down to "The Cartels"

As far as international settlements go, despite the huge size of the Chinese economy and their global presence in both trade and finance, the RMB(CNY) is a nearly irrelevant currency.  Currently, (as of February of 2018) only 1.56% of all international transactions are settled in RMB.  The chart below illustrates the trend from December of 2015 to December of 2016.  RMB settlement preference is actually declining. The primary currencies for international settlement are the US$ (42%), Euro (31%), Pound (7%) and Yen (4%) Roughly 84% of all international trade and investment is settled in these currencies, followed by the Canadian Dollar, Aussie Dollar, Hong Kong Dollar and the RMB(CNY) at about 2% each. 
 






















When we compare global settlement transaction volume to total RMB in circulation we see a stark contrast.  While RMB settlements are relatively small and declining, China's M3 is increasing dramatically.

When we examine the FRED graphic below we see that China's M3 (Red Solid) in circulation has nearly doubled in the last five (5) years to US$25 Trillion, nearly tripling in the last eight (8) years.  During the same time frame, by comparison, US M3 (Blue Solid) has increased 40% and 50% respectively to roughly US$14 Trillion.  One might wonder why the Chinese would need so much currency (US$10 Trillion more than the US) to run their smaller economy?

On the other hand, these are absolutely brilliant folks.  They are economic chess masters.  They know what they are doing.  When I attend University graduation ceremonies here in the States, as I do from time to time, I can't help but notice that most of the cum laude (or better) names announced in the math, science, business, finance and engineering disciplines are Asian sounding names that are difficult for me to pronounce without my wife's assistance.  These are wonderful, smart, talented, multilingual kids who are capable of quickly doing really difficult math and grasping complex concepts (that I would likely struggle and bumble through) with ease.  Of course "American" sounding names still dominate the English Lit, Sports Management and Film Making degree designations, so we've got that going for us.  Anyway, that said, I'm pretty sure the folks running the Chinese economy have a firm handle on this chess game and know exactly what their next moves are going to be.  They are seeing the board three moves ahead while the world's naive financial rookies are playing the equivalent of economic Tiddlywinks.

On the other, other hand, could it be that our devilishly clever US Leadership is actually the puppet master here?   Could it be that, through a carefully crafted, diversionary media campaign, we've been able to convince the world that our government is no longer the Reagan era Shining City on the Hill but is actually run by dithering, dysfunctional Twitter-heads, who get their security briefings and economic information by watching Fox News, spend inordinate amounts of time firing henchmen, (allegedly) obstructing justice, while playing golf with lobbyists and Russian Oligarchs, occasionally resorting to bedding aging porn stars for entertainment, when in reality our leaders are cold, cunning, calculating geniuses of  high moral fiber who understand every aspect of this situation and have financial countermeasures locked, loaded and ready for deployment to save our souls?  Could it be that this is indeed a truly brilliant trap, concocted by the Deep State to protect us from Communism, spread Democracy and eventually, by shear coincidence, accidentally usher in an American era of  world economic domination?  That's one hell of a media campaign.  If true, it's absolutely diabolical.

Yes!  Yes!... now the absurd, ridiculous daily news diarrhea all makes sense.  It's clear now that what we're seeing in the media everyday is all an elaborate, brilliantly concocted ruse.  Someday, it will eventually be revealed that, behind closed doors, the US Government is a well oiled bipartisan machine and the righteous standard bearer of Democracy, immune to the influence of Special Interests, lobbyists and kickbacks.  Behind closed doors the White House and Congress are in lockstep, united in the common goal of protecting and fostering the American Dream.  We will find that our government is totally on top of all of this and ready to spring into action.  It will be revealed that Apple, Walmart and Amazon are all CIA sponsored shell entities, products of the Deep State, created and designed to supply the American consumer with cheap phones, sneakers and plastic junk at a huge discount while taking terrible advantage of the hard working Chinese people.  A billion Chinese people are working their fingers to the bone for pennies so that we can sit on our overstuffed couches and watch NASCAR on our big screen TVs....Mabel! git me another Budweiser!  Hell Yeah!  God Bless America! 

Now, some of my American readers may have read the last two paragraphs and thought "Yeah man.....that's what I'm talking about.... MAGA Baby!"  For those of you that have reacted in this manner, I'm sorry to say that this is what we economists refer to, once again, as a "joke".

Back to business......

When we modify the previous FRED graphic to compare M3 Growth for relative PGDP/GDP the contrast is even more dramatic. (PGDP or "Productive GDP" which is described as “GDP excluding all of the over-building, non-productive excess capacity and accounting games created simply to hit the arbitrary, CCP mandated GDP growth target"  See:  The Sum of All Fears....and Michael Pettis exceptional "Bridges to Nowhere..." and GDP Growth doesn't mean what you think it means
























When we compare GDP Growth (dashed Red for China and dashed Blue for the US) we see that the amount of GDP created per unit of money is decelerating as we'd expect.  As money/debt creation outpaces GDP, the money is used to service existing debt, fund bubbles and generally kick the can down the road.

Using my predefined, random walk PGDP (Green Line) constant of roughly 0.66 (est.) we can calculate that the actual value of (PGDP) created per unit of money (M3) in a centrally planned economy, decelerates even more vigorously.  Presumably, the "can kicking" and "bubble blowing" accelerates at the same pace.

With the M3 growth described above we'd think that the Chinese economy would be experiencing both significant CPI inflation and an erosion of the exchange rate.  Interestingly, in defiance of economic principles, that hasn't happened.  The chart below illustrates this impossible phenomenon.



When we examine the above, despite the dramatic growth in M3 (blue line) we see that the exchange rate (green line) has remained relatively constant (within a range of 6.25:1 to 6.75:1) with no detectable relationship to M3, since 2010.  The reported CPI cost of living index (red line) has actually declined.  Generally, all else being equal, as the money supply increases you'd expect inflation and a weaker currency.  Again, if the Chinese were operating as a market driven economy and a floating currency, the above chart would not be possible.

In my own, albeit simplistic, way of thinking, we can explain away the CPI relationship with 1.) Price Controls.  2.) CCP mandated production/supply constraints, and 3.) Magical sampling/reporting methods by the NBS, all designed to show that, as always, everything going on in the Chinese economy is just fine.

So let's take a look at the "Effing" root cause of something that, in my mind, is much more important, specifically because it impacts every man, woman and child on the planet.....wait for it....yup....I'm of course referring to the exchange rate of the "Effing" RMB.

In a nutshell, the value of all that is China, is calculated based on on a "fake" exchange rate.  Because the RMB value (supply/demand) is based on a tiny offshore sliver of the total amount of currency in circulation, we are faced with the proposition that virtually every economic relationship/conversion between the "Rest of the World" (ROTW) and China is based on a manipulated currency.

Think of it like this: a currency is a commodity, like oil for example.  Today, let's say that the supply and demand for oil are in equilibrium.  A buyer is willing to pay a specific price ($X) for a barrel of oil.  If tomorrow, some enterprising entrepreneur announces that he/she has invented a process which, for about a third of the cost, could turn sea water into high grade crude oil, the supply of oil would become nearly limitless overnight and the price or "value" of oil would of course plummet....perhaps to roughly 1/3 of $X, based solely on the "new" cost to convert sea water to crude oil.  "Drilled" oil and all of the extraction infrastructure would become worthless.  Of course, in the real world, our hypothetical entrepreneur would immediately find himself with a price on his head and the target of an all-out OPEC, Russian, US Big Oil manhunt......but I digress.

So we've already established that dump truck loads of "Onshore" RMB have been printed/created over the last few years.  Carrying through on our Crude Oil metaphor, think of the "Onshore" RMB (CNY) as the inaccessible underground reserves of Crude Oil that we know are there, but can't be accessed.  We think of the "Offshore" RMB (CNH) as the immediately usable Crude Oil in the system which is priced based on current accessible supply/demand availability.  What if the vast reserves of RMB suddenly became available and hit the market?   Or to continue the metaphor, what if we could immediately convert sea water (The Onshore CNY) to Offshore CNH?  What would happen to the exchange rate?

Now, let's think about the RMB the same way we think about our oil example above.  Right now, the only value the RMB has to the "Rest of the World" (ROTW) is to facilitate trade and investment with China.  Today, the dual currency system makes the value and amount of currency in circulation on the mainland (the "Reserves") irrelevant to the ROTW.  Like Oil, what matters to the ROTW in terms of supply and demand is the accessible amount of RMB available to settle transactions with China.  The smaller the supply, the higher the "cost" and "value" the RMB has i.e.) the exchange rate.

Printing money is easy....and it's fun!  Everybody gets rich!  But let's take a look at what's happened with the "Offshore" RMB, the RMB (or CNH) that the rest of the world must use to transact business with China.  Unlike the Dollar, Euro, Pound and Yen, which can be converted to most currencies (and back) instantly, almost anywhere in the world (except mainland China) there are only a few places on the planet that the CCP allows RMB (CNH) to hide.  In the chart below, we see that the RMB located in clearing centers around the world has been declining.  Total "Offshore" RMB (CNH) available for International transactions is roughly RMB 1.15 Trillion today, actually declining from it's peak of RMB 1.85 Trillion in 2015.  This RMB 1.15 Trillion total represents roughly 0.7% of all RMB in circulation, down from about 1.6% in 2015.  What we're witnessing is "Offshore" tightening and the loosest "Onshore" money since the Post WWI Weimar Republic.  (Slightly exaggerated for dramatic effect)




As we see below the RMB that either "escapes" from China or is "released" by the PBOC finds its way to just a few financial centers.  90% of all offshore RMB reserves are housed in Hong Kong, Singapore, Taiwan, London, Luxembourg and Macao. 



When we look back at the first graphic in the post (The Big Map), we recall that over the four (4) year period from 2013 thru 2016 that the the net Balance of Payments increase from China's foreign transactions should have been US$1.158 Trillion. Now let's see what's happening to all of that foreign currency that should be coming into China's coffers.  I've borrowed a great graphic below from Brad Setser and the Council of Foreign Relations which raises a few questions.  Since, because of SAFE rules, mainland commercial banks don't hold significant FOREX and have in fact been reducing FOREX balances for the last few years. (See Victor Shi,  Financial Instability in China: Possible Pathways And Their Liklihood, MERICS Mercator Institute for China Studies).

All of this FOREX (US$1.158 Trillion) should be showing up on the PBOC Balance Sheet.    But when we look at Brad's chart below, both Foreign Reserves and Assets are declining.  Sure, some of it is probably capital flight.....Chinese elite have come up with all kinds of gimmicks and schemes to convert RMB to Western Assets outside of the SAFE rules....(there's gotta be a  good reason for that don't you think?)

I'd suggest that the reason the PBOC on-balance-sheet FOREX balances aren't increasing as we would expect is really very simple.  The world's FOREX never gets to the mainland in the first place.

Let's take a look at the chart below.  It illustrates what's really happening (hypothetically) when Apple buys a shipment of iPhones from FOXCONN.  Of course the transaction structure is similar whether we're talking about phones, circuit boards, underwear, basketball shoes, or most of the stuff available from Amazon re-sellers or sitting on Walmart shelves.  I've chosen Apple and the other logos for illustration purposes simply because, to me, it's just a little easier to visualize and it explains a lot of the things going on above. 




























So here's the process:
  1. Apple takes delivery of the iPhone shipment and has to pay FOXCONN.  Apple has dollars and FOXCONN wants RMB so it can pay wages, raw material costs, utilities, kickbacks, etc. in China.
  2. Apple has an account at JP Morgan and sends US$ wire instructions.
  3. The Bank of China (FOXCONN's Bank) receives the US$ and forwards the equivalent RMB to  FOXCONN's Bank of China Account on the Mainland.  The Bank of China (Hong Kong Branch) Needs to replace the RMB so they borrow the RMB from the mainland home office.  The Hong Kong branch can now loan out or invest their US$ deposits.
  4. Fortunately there are lots of Caymans, Luxembourg, London, Netherlands, etc. Investment Vehicles with accounts owned by the creme de la creme of the Chinese Elite, who are more than happy to invest in US & EU Stocks, Bonds, Real Estate and businesses.
  5. Because the CCP is able to artificially inflate the value of the RMB by limiting the available supply, they, to borrow a phrase, not only "Buy American"....if this imbalance goes on unchecked, over time, they will actually be able to "Buy America!" (anonymously)....one business, stock, bond and luxury condo at a time.
  6. Again, the only reason this is possible is that the world's Central Bankers and Regulators have allowed the "second biggest" economy to operate in a world where they are able to "assign" a value to the RMB rather than have it float, like every other major currency on the planet.  Authors Note: I put the "second biggest" in quotes since if we restate PGDP (GDP x 0.66) by the "Real" Exchange rate (18:1) we see that China's economy actually drops to 4th on the list, right behind Germany, similar to that little dip the Russian economy took a few years ago when the Ruble crashed.
  7. All things considered, this really is a brilliant, diabolical plan.....of course, again, none of it would have been possible without the help of US, Swiss & EU Investment Bankers, their insatiable thirst for fees and naive Central Bankers who've apparently been asleep at the switch for years.
The above, at least partially, explains: 
  1. The meteoric increase in CMFC money.
  2. Why the US, Japanese and the EU financial systems have operated in a Near-ZIRP environment for nearly a decade and have experienced comparatively anemic "main street" GDP growth with no inflation.  i.e.) The funding has been siphoned off and sent overseas, to boomerang back in the form of asset bubbles. 
  3. It explains why a partially finished apartment in a half vacant building in Beijing "costs" the same as a Park Avenue or Kensington Condo.
  4. It explains why large swaths of New York, Bay Area, LA & Miami Real Estate are owned by Chinese shell companies in all cash deals.
  5. It explains why PBOC FOREX Assets and Reserves are holding relatively steady (or slowly declining) when, as the "factory to the world", these balances should be increasing significantly. 
  6. It explains why eight (8) of the ten (10) largest businesses in China, the "factory to the world", are Banks and Insurance Companies.  (The other two are oil companies.) 
  7. It explains why absurdly run, opaque companies with suspect business models, like Alibaba, Ant Financial, Tencent, Evergrande, Fosun, AnBang, JD.com, HNA, and hundreds (perhaps thousands) of others, even exist in the first place.  These are not the CCP's foray into market driven capitalism....far from it.  These businesses are CCP sponsored vehicles created and designed to convert "monopoly money" into hard Western assets at a discount.   
What can I say.....in Nancy's words....this is a "Effing" mess.....


"The Cartels"

One-Line Executive Summary:

When thinking about what the Chinese Government has been able to accomplish with their RMB "monopoly", limiting the supply in order to control the price (exchange rate), the term "Cartel" seems applicable.  When we think about the context, there are three famous (or infamous) Cartels that immediately come to mind.  They are:  De Beers, OPEC and the Post World War I Weimar Republic.  (Bear with me on the Weimar Republic, it will make sense in a minute.)  De Beers is, by my measure/criteria, the most successful of the three.  OPEC had a great run.  The Weimar Republic....well, not so much.  So the question is:  Is China's dual Onshore/Offshore RMB "monopoly" more like De Beers, OPEC or the Post WWI Weimar Republic? 

Executive Summary Bullet Points

First, I'm not going to spend much time going through the history of De Beers, OPEC and the Weimar Republic herein.  The activities of these organizations and their history has been well chronicled.  I've posted a few links to what I think are some entertaining references to same at the end of this post if you have interest.

1.) The First, and by far the most successful of the three cartels, De Beers, has relentlessly held market prices for diamonds well above cost for more than a century by: 1.) Controlling the global supply of diamonds.  2.) Creating a "Diamonds are forever" intrinsic value. and 3.) The most successful navigation of the worlds geopolitical landscape in modern history.

2.) OPEC was able to control world oil prices quite effectively in the 1970's and 1980's by virtue of access to a restricted, disproportionate supply of cheap, easily extractable crude oil.  Over time, with the world's adoption of new technology and the discovery and development of new, cheap reserves outside of the OPEC umbrella, their ability to control prices has waned. 

3.) The Post WWI Weimar Republic was the first/only significant attempt in modern history where a major economy/government tried to "print" two currencies, to be used for two distinct purposes.  The "Onshore" gold mark backed by and pegged to gold was to be used as the benchmark currency for Germany's internal trade and investment/finance.  The "Offshore" paper mark fiat currency, backed by a nebulous relationship to the gold mark and its fading perception of value, was to be used to repay war debts and reparations.  For a number of reasons, this plan resulted in unprecedented hyperinflation crippling the German economy.  

If you'd like to skip ahead....feel free to scroll down to "The Financial Crime of the Century!"

A Cartel can only function effectively by restricting supply, fostering demand and consequently generating out-sized economic returns on whatever commodity it happens to be "Cartel-ing".

De Beers

With De Beers, there is no question that they've been masterful at creating a timeless brand and an unflinching market for incredible, beautiful, shiny little pieces of carbon.  Two hundred years ago, nobody cared about, owned or placed much value on diamonds.  They were nice little rocks found in South American Streams.  When significant diamond deposits were found in South Africa in the late 1800's De Beers was born.  Over time the firm has been able to convince most of the young men around the world, using catchy slogans, Hollywood Stars and British Royalty wearing sparkling product samples, that it's mandatory to spend a few months of gross wages (at a minimum) on De Beers inventory to prove your love for the woman of your dreams.

As additional discoveries were made and mines were opened in Siberia in the 1950's in Australia in the 1980's, De Beers deftly adjusted their political and marketing strategies to keep the huge additional supply under control and metered into the market profitably.  Expanding demand with "Anniversary", "chocolate" and "Eternity" products to match the volume of smaller/cheaper and discolored stones released into the market, etc. as an example.

Unlike so many other businesses that have come and gone over the last century, De Beers has demonstrated an incredible ability to maintain both margins and market share.  No small feat.  In terms of longevity, profitability and consistency, De Beers may just be the most successful business in history.  Unlike Real Estate, Tulip Bulbs and Dot.com stocks, the De Beers Cartel has, over the last 100 years, proven that the price of diamonds does indeed never go down.  Perhaps diamonds actually are forever!         

OPEC

OPEC/Middle East producers have long been the lowest cost crude oil producers on the planet, able to generate significant margins at virtually any price level.  In short, they drill a hole and oil comes gushing out of it.  Unfortunately (for OPEC) there is also plenty of crude oil on the planet, it's just not as easy to get to as OPEC oil.  Supply, albeit higher cost, has significantly increased over the years, primarily from Russian and US fields and projects.  Improvements in extraction technologies combined with accelerated CAPEX over the last twenty years have brought higher cost fields on-line and producers are reluctant to shut production down even at lower margins.  Reduced margins, as long as the projects are covering variable costs, would seem to be a reasonable sacrifice in exchange for positive cash flow.  The result is that crude prices have reset in a much lower relative range.



There's enough non-OPEC supply on line now that OPEC members have concluded that cutting their own production would no longer have a meaningful impact on global supply.  Even if they were able to drive the price up, higher prices would only further increase non OPEC production/supply, making more expensive projects viable, bringing them on-line.  The graphic below illustrates the number of significant projects which become profitable/viable as oil prices increase.

When we examine the graphic we see that numerous Brazil and US deep water projects and a few US and Canadian shale projects are viable at less than $60/bbl.

Given that these investments are usually operating over a ten to twenty year cycle it's unlikely, again because of cash flow, that once these projects are brought on-line, that they would be shut down for anything other than a long term collapse in demand/price.

When we account for the continuing, forecast reduction in world demand resulting from increased fuel efficiency, alternative energy strategies, and environmental awareness, we can further conclude that there is simply too much infrastructure either on-line or waiting in the wings for OPEC to move prices up over the long term.   OPEC had a great run, but the days of "gas lines" and other than conflict related temporary price spikes, should be over.


The Post WWI Weimar Republic

The Weimar Republic, when confronted with the proposition of having to finance WWI, issued war bonds and adopted a dual currency system to finance the war.  The essence of the plan was that, once victorious, the German government would demand reparations from the defeated Allied opposition, confiscate valuable French resources and pay the money back.  Even the "War to end all wars" had to deal with the bookkeepers and bankers.

At the onset of the war, circa 1914, the the German government, presumably anticipating the inflationary consequences of their pre-war debt levels, abandoned the gold standard and issued two classes of currency, the "gold mark", which could be converted to gold and the "paper mark" which could not.  

Of course, the "winning the war" part of the plan backfired and the German government was put in a position where it was required to pay back both pre-war debt/bonds and unworkable WWI reparations to the Allied governments.  The German government began to "print" their way out of the problem.  In a clever effort to pay war debts, through financial prestidigitation, since the "paper mark" was thought to be just (or nearly) as valuable as the "gold mark" at the time, the German government printed truck loads of paper marks, converted it to foreign currency and used foreign currency to pay their war debts and reparations.  This actually worked pretty well for a few years.  The German government was able to pay debts and reparations until the world's financiers figured out that the supply of paper marks was increasing geometrically and the paper mark soon became worthless.  

This was the first significant attempt, at least that I'm aware of, in modern history where a major economy/government tried to "print" two currencies, to be used for two distinct purposes.  The "Onshore" gold mark backed by and pegged to gold was to be used as the benchmark currency for Germany's internal trade and investment/finance.  The "Offshore" paper mark fiat currency, backed by a nebulously defined convertibility relationship to the gold mark and its fading perception of value, was to be used to pay back war debts and reparations.

As I mentioned, this dual currency plan, much like their "winning the war" plan, didn't go all that well.  There was no mechanism to control the flow of paper marks in circulation and it became obvious, as bankers noticed that German citizens were using wheelbarrows of paper marks to buy loaves of bread, that paper marks had become worthless.  As a footnote, the German government finally paid the last US$94 million installment on the Treaty of Versailles negotiated (and regularly renegotiated) war debt and reparations, in October of 2010, nearly 90 years after the debt was first established.  

Let's look at the convertibility of  paper marks to gold marks.  The chart below describes the relationships.































It's unclear as to exactly how large the German money supply actually was at the time, but according to a white paper by the Richmond Fed, there were roughly 6 Billion marks in circulation in 1913.  From the end of World War I until 1924, the price level rose almost one trillion-fold.  Conventional, simple math would lead us to believe that the related money supply had also grown more than a trillion fold.  To be sure, when you can no longer do the conversion math without a super computer, you're looking at hyperinflation.

Below we see a 50 Trillion mark note. (see conversion table on the graphic above)  This single note, issued in November of 1925 represented more then 8,300 times the number of marks in circulation just eight(8) years earlier.   




Unlike today, rather than simply putting an electronic credit in an account, in 1923 if a Central Bank wanted to increase the money supply geometrically, they actually had to create paper money "notes" to do it.  It became obvious to the world that the mere existence of 50 Trillion notes was evidence  that the German money supply was increasing at unprecedented, uncontrolled levels. Could you imagine being a banker or investor holding, say for example 10 Billion marks of pre-war debt and being presented with this newly printed 50 Trillion paper mark note from the German government in full payment of the debt....and then asked to make change?

At some point through 1919 and 1920 the world started to catch on that the Reichsbank was simply printing money to pay the country's debts and European and US Bankers stopped exchanging foreign currency for paper marks at anywhere near the exchange rates just a year or two prior.  Any foreign banker or investor holding paper marks would soon be holding worthless currency.  Like so many financial events in history, once Mr. Market figures out what's going on, he refuses to play the game, illustrating what can happen to a commodity (i.e. the mark) once the supply becomes unlimited.

The question we need to ask is:  Does the CCP and the RMB today more closely resemble:

1.) De Beers and Diamonds?
2.) OPEC and Oil?
3.) The Post WWI Weimar Republic and the "paper mark"?


The Financial Crime of the Century!

Executive Summary:  Feel free to read this last section in its entirety.

"The only accurate piece of information on the front page of a Chinese newspaper is the date."

I'm not sure when or where I heard this quote the first time.  I wish I could take or give credit for it, or cite the source since it's more relevant today than ever.  But I'm sorry, I can't.  Maybe one of my readers might chime in?

We're taught from a very young age that "lying" is just plain wrong.  It is illegal, at least in theory, to tell lies on a witness stand, in a courtroom or write them in a public document.  We refer to it as mis-representation, perjury or fraud.  There are severe penalties and repercussions, again, in theory, for perpetrating these acts.

First, let me be clear, the dual currency scheme I've described above is absolutely brilliant.  It's also the greatest crime in financial history.  The CCP has devised a system to take advantage of what can only be considered systemic flaws in a market driven world.  The best parallel I can draw is the conniving used car dealer.  The slick car dealer locates all sorts of oil-burning, salvage-title, odometer-rolled-back, "cream puffs" and he/she coaches, motivates and compensates his even slicker team of sales reps to move these sweet rides to naive buyers.  Of course, in their minds nobody is doing anything wrong, the sales reps didn't officially know about the salvage titles or bad odometers.  It burns oil?  Really?  It was in a wreck?  You're kidding?  I had no idea.  The best part of all of it is, even if the slick dealer is caught in a lie, there's no enforceable penalty.  Let the buyer beware.  Gotta move the cream puffs and collect my profit and sales commission!  That's capitalism!

The above described impending financial mess du jour would never have happened if the world's bankers would have required that the RMB absolutely must float before the Chinese could play in the global sandbox.  But the CCP knew full well, again, relentlessly relying on the free trade model which they were taught, oh so well at Western Universities, that the market-driven, used-car-dealer-like Western Investment Bankers could be convinced to make really bad deals for America and Europe if it made them really rich individually.  The CCP set out to create the forced labor camp "factories to the world" which would eventually produce so much output (exports) that the value provided by the intelligent, hard working, woefully underpaid Chinese worker would become indispensable to the ROTW.  The "money" would continue to flow into Chinese coffers, to the point where Chinese Elite could eventually "boomerang" the Greenback as I've described, slowly buying significant chunks of America and Europe anonymously. As long as the Western "money" continues to flow the CCP/PBOC will continue to be able to print money, roll their massive internal debt over and protect the fake value of their currency.  But let's take a look at what happens if/when the ROTW figures out what's happened and the flow of money into China slows, stops or even reverses as a result of, for example, just thinking out loud here...some black swan event......like a trade war.....

You'd expect that the PBOC would do everything in its power to maintain the fake value of the offshore currency.  It's the bedrock of their economic model.  If you are familiar with the NBS data, every press release begins with something like:

"The  (insert fake statistic name) once again exceeded expectations attesting to the solid nature of the economy and the insightful leadership of the party.  Everything is just fine and dandy in China and it always will be."  

Since we are inundated with head fakes, goofy deals, silly numbers and "bad gauges" coming out of China we have to look at other indicators to determine when the inflow might start slowing, or God help us, reversing.  We can only hope that Central Bankers around the globe, rather than blindly focusing on their own country's GDP growth, Unemployment and Inflation Rates, managing their money supply accordingly, understand what's really happening and take measures to insulate their markets and capital from the effects of China's pullback.

In short, the CCP would be doing everything a struggling enterprise might be doing to remain liquid, as they make the successful transition from global lender to....gulp....global borrower.

Here are the things we should be looking for (***** indicates that it's already happening):
  • A continuing reduction the relative amount of offshore RMB deposits available to fund Current Account (Import/Export) transactions. (*****)
  • Reduction of Western exports into China....The Soybean seems to be in the news right now.  About 1/3rd of all US Soybean production goes to China.  So what if a few Chinese citizens go hungry....it wouldn't be the first time that's happened. (*****) 
  • The Chinese try to hold exports steady or increase them.  They need the "money".  So far the White House hasn't mentioned anything about slapping fat tariffs on consumer electronics or phones.  Thank goodness.  (*****)
  • Stricter SAFE enforcement on "unauthorized" capital flight. Authors Note: Capital that can "flee" the mainland is fleeing.  Moreover, Capital is not currently "fleeing" into China.  The declining amount of capital showing up on the mainland is being dragged in, kicking and screaming.  Again, there's a reason for that. (*****)
  • Slowing of Outbound FDI.  There would be fewer announcements and more importantly, fewer completions, of "blockbuster" acquisitions of Western Assets. e.g.) CFIUS and Ant Financial/Moneygram.  (*****)  
  • Less Chinese participation on the buy-side in the debt/treasury markets as well as the winding down of current positions.   When significant capital is pulled from these markets we should be seeing credit markets tightening and interest rates/yields beginning to gap-up. (*****)
  • More borrowing.  Chinese businesses will be looking for increases in both RMB (Dim Sum bonds) issued as well as more "Baba-like" bonds/debt underwritten and hitting US, European and Japanese markets. (*****) 
  • More equity raises.  More attempts at cross border ADR's/IPO's and secondary offerings.(*****)
  • Accelerated Regulatory approval of Western/Mainland dual listings, designed to raise on-shore capital and support Chinese offshore ADR values. (*****)
  • Liquidation/reduction of offshore financial assets (Caymans/Luxembourg/Netherlands/Swiss, etc.) Balances begin to level off or decline.  Effectively using offshore FOREX under Chinese control to protect the RMB.  (TBD)
  • Real Estate Asset prices fall in markets previously preferred by Chinese Investors/Buyers (NYC, LA, San Francisco, Miami, etc.) as a result of less participation from Chinese buyers.  Luxury condos/homes will remain on the market longer. (TBD)  
  • Continued deleveraging, bail-outs or outright seizure of dubious mainland, international serial acquirers. (AnBang HNA, etc.)  I understand there are some large chunks of Deutsche Bank, Hilton and the Waldorf Astoria, flagship properties of HNA and AnBang, up for sale at a discount right now.  (*****)
  • China's Elite will be "strongly urged" to repatriate their FOREX holdings.  As the CMFC money drains from Western markets we'll see a pullback and continuing price pressure on US & European Debt, Equity and Real Estate.  This contraction may already be happening based on recent declines, but since so much of this offshore money is anonymous it's impossible to tell exactly what's happening.  On the other hand.....somebody knows. (TBD)
  • Finally, as the last line of defense, so to speak, we'd expect to see significant declines in PBOC FOREX Balances and Reserves as the RMB depreciates, again in an effort to protect the RMB.  On the other hand, given the number of "bad gauges" out there, taken in the context of the "Front page of a Chinese Newspaper" quip above as well as press releases like the recent "Hey we just found out that our US$37 Trillion of Shadow Bank debt is about twice as much as we thought we had...." PBOC announcement, I'd find it difficult to give much credence to any economic data published with the CCP stamp of approval. (Who knows??)
For you skeptics out there who are questioning everything I've described, if I am indeed wildly wrong and none of this matters, simply ask yourself:  If the Chinese Government were to open up their Capital Account, remove SAFE limitations and make the RMB immediately convertible, like every other major currency, would the RMB remain rock solid at the current exchange rate?  Based on the money supply and debt levels, which way would it go?  Why are SAFE restrictions so tight in the first place?      

That said, we all hope and pray that we will see a slow, measured decline in the exchange rate/value of the RMB to a more reasonable equilibrium.  Cooler heads should prevail.  A reset, moving toward a depreciated RMB value in the 18:1 range would be more in line with what a floating RMB might look like in relation to China's money supply and burgeoning debt levels.  If the Chinese government could accomplish this depreciation over a period of a few years it would be the best possible outcome for everyone on the planet.  Unfortunately, as I've said before in this blog, I doubt everything will go according to plan on these all to predictable, decennial "unwindings".  It never does.

As China transitions from a net lender to a net borrower on the global stage (Yes...you read that correctly....I believe I'm the only blogger/pundit suggesting this transition is on the horizon) it will be painful.   When the global value of the RMB decreases to a third of its current level, the value of any RMB denominated assets are also devalued in global purchasing power terms.  The same amount of RMB will only buy a third of that NYC, LA or London Condo.  That unfinished Beijing Condo in the half empty building will no longer be priced like it's located on Park Avenue.....it will get a more representative DesMoine-esque asking price.  After the forced-pseudo-floating reset of the RMB, the assets of those huge Chinese Banks will be worth a third of what they were worth today.  The value of Chinese exports will also be a third of their current value.  FOXCONN workers will get a huge pay cut in terms of purchasing power.  Imported goods will cost Chinese consumers three times as much in real terms.  All of the "bad assets" and off-the-books accounting shortfalls will need to be written off and/or re-financed and the cost of this debacle will be placed squarely on the shoulders of the hard working, intelligent and soon to be really pissed off Chinese people once they understand that their global purchasing power will be a third of what it used to be.

I first discussed the aforementioned carnage in my March of 2016 Monopoly Money post.  Let's revisit some of the relatively obvious casualties from this blow back:

The "Biggest Losers" in the RMB depreciation:

1.) The hard working Chinese people. Their work and effort, assets and bank accounts will be worth a third (or less) of what it once was, had China's financial architects not taken the path they did.  I'm sure that Xi does not believe that there is any chance at all of hyperinflation, but on the other hand, I'm sure, neither did Kaiser Wilhelm.

2.) US Universities will lose foreign student enrollment and tuition.  The cost of a Western education will be 3x what it once was in relative terms.

3.) US Investors. Chinese financial assets listed on Western markets will be revalued. ADRs will be repriced. Bond issues will be repriced and/or default. The direct effect (loss) will be roughly $2.5 Trillion.  The multiplier impact is incalculable, but enormous.

4.) Western Holders of RMB denominated collateral, specifically HK & EU banks (HSBC, Deutsche, Credit Suisse, Standard Chartered) who have significant interests in Mainland Real Estate collateral will be hurt badly.  When 90% of a project is financed and the underlying collateral takes a 66% haircut, the math no longer works.

5.) Chinese Retail Investors and equity markets.  We had a prelude to this in August of 2015.  There will be a flight to safety.  Capital inflow will dry up. Mainland equity markets will collapse. Loans will default, real estate values will be reset and life savings will be lost. Tienanmen Square II?

6.) CMFC financial systems will revert to "pre-China" circa 2010 levels. There are (probably) huge leveraged Bets out there going the wrong way. We just don't know who's swimming naked. We'll find out only after it's too late to do anything about it.

7.) US retail Investors. Those of us who continue to blindly plow a percentage of our paychecks into Index funds and Mutuals in the mistaken belief that US Stocks, like real estate, will always go up "for the long run" and that a CAPE of 35 should be the "new normal".

8.) The FED and by extension, the US Taxpayer. Once everything is revalued we'll need a TARP II (maybe even a three and four) to hold all of the troubled assets generated by yet another mess brought to us by the US Banking System. Moreover, if all of this carnage takes place in a zero-interest rate environment, all bets are off as to what the FED might be able to do to support capital formation and keep the economy out of a recession/depression. Quadruple M2, to keep up with the EU and China? Negative 10% Interest Rates?  Again, we'd be in uncharted waters.

9.) US Investment Banks. There will be a populist uprising to "break 'em up"...."close the borders"...."build a wall"...."get 'em outta here". This time, someone might actually be going to jail. (Just kidding...there's no way...)  Money will flow out of Wall Street and back to Main Street. Capital formation, despite Jay Clayton's best effort, will be crippled for years, perhaps decades to come.  We'll be back to the days of "intelligent" i.e.) local capital formation.

10.) International Trade - There will be a political "Anti-Global-Anti-China-Anti-Trade" backlash the likes of which we've never seen. Like the the aftermath of the housing bubble, when interest rates declined and the cost of getting a mortgage on a home was dramatically reduced, the cost of trade may actually decrease....but try to get a mortgage (or a trade deal) done.  Similarly, the cost of Chinese goods will be next to nothing (plus freight), but the probable administrative, political, compliance, tariff, regulatory costs and red-tape would likely increase geometrically.  More than half the resellers on Amazon will be gone.  Walmart's prices will double and product selection will become relatively limited.

11.) New York City, Bay Area and Silicon Valley Real Estate prices will correct/collapse. Foreign money would dry up with an RMB revaluation.  No more vacations and second homes in America for rich Chinese Elite's.  $5 Million condos with a view of the Bay or the River will become a thing of the past and banks will be writing off/down mortgages in these markets at a pace that will make 2010 look like a walk in the park.

12.) Alibaba, Yahoo and Softbank, along with their market caps, will all be gone, as will many of the Unicorns in the pipeline.

13.) Bankers will have to find jobs and move to the country's new financial centers, Chicago, Omaha, Denver, Atlanta and Cleveland (OK....I admit Cleveland is a bit of a reach...but you get the drift).

14.) The PBOC. After loosing control of the currency and the Chinese economy, Chinese bankers will no longer be allowed unrestricted playtime in the global financial sandbox.

15.) Apple.  With a depreciated RMB, production/import costs will, of course, decrease dramatically.....expanding the huge margins and competitive moat Apple already enjoys.  On the other hand, with virtually all of its production and supply chain run through FOXCONN on the Chinese mainland any significant disruption (e.g.) political turmoil or an ill conceived, black swan accelerated trade war) would be devastating to the company.

Finally, nothing like this, in the history of economics and finance, has happened before.  The conditions are developing into a perfect storm.  We are talking about tens of Trillions of dollars of Assets that will have to be repriced or vaporized.  This slick-used-car-dealer manipulation of the RMB is indeed the greatest financial misrepresentation in history.  Incredibly, the world's governments and regulators allowed it to happen.  It makes Bernie Madoff's printing fake account statements in his back office and Jeff Skilling's "ass hole" testimony pale by comparison, not only in audacity, but by the sheer scope and magnitude of this con.  Madoff and Enron generated a few Billion in losses.  That amount was a pittance compared to this mess.

It's not like we shouldn't have seen this coming.  Wouldn't you think that the ROTW's bankers and regulators might have at least thought it a bit peculiar when jumbo jets full of citizens from a country whose GDP per capita was only a few thousand US dollars, started showing up on tarmacs in New York, L.A., San Francisco, Luxembourg and London, escorted by US lawyers and armed with seven figure wire transfers?  Might they have at least wondered "Hey....where did you guys get all of this money?" If you or I showed up in a bank lobby with steamer trunks full of currency don't you think it would raise some eyebrows?  Wouldn't the bankers and regulators want to know exactly where we got all of that money?  Rather than try to figure out what's really going on, in the case of Chinese investors, the bankers happily set up accounts and provided the wire instructions hoping there was indeed "more where that came from" while the regulators looked the other way.

As I mentioned, I'm hoping and praying that the world's Central Bankers and regulators, who are famous for occasionally driving the financial bus over the cliff while looking in the rear view mirror, are paying less attention to largely irrelevant and arguably misleading traditional economic metrics and have retrained their laser-like focus on the list of "the things we should be looking for" as described above, feverishly working on a contingency plan to minimize the carnage.

More likely, when this eventually hits the fan, just like every financial crisis, it will be marketed to the masses as yet another once in a lifetime, black swan event that no Central Banker, world leader, economist or financial professional could have possibly seen coming.  Those responsible for regulating and managing the world's financial systems will once again publicly feign shock and outrage that there's actually been gambling going on in this casino!  The wealth transfer will continue and the suffering will be ratcheted up a notch from the pain of the last crisis.  We will grapple for political solutions and common ground on Facebook and Twitter to make sure that, under no circumstances, once again, nothing like this ever happens again, every decade, in our lifetime again, or even every ten years, like it always does ....again.

The Investment Bankers, who've made gobs of money on these debacles, will hire an army Madison Avenue media wizards to again convince the dumb-ass American people (us) that the bankers are indeed looking out for our best interests, doing "God's work" and facilitating essential "capital formation".  Sufficient time will pass and then we'll do it all over again.......You know, just like we've handled school shootings, gun suicides, tobacco deaths, on-line identity theft and drug overdoses.  A good advertising campaign will make us understand that this is again, unavoidable and we'll all feel much better about what's happened....again. 

Finally, when the dust settles and the smoke clears, and sufficient time passes, we will all wait with bated breath as the world's next generation of high-energy, creative, newly energized and empowered investment bankers come up with the next wave of ballyhooed, self-inflicted, shell-game "capital formation"....and like lemmings, we'll all just jump right in.  The beat goes on....

The world will most likely also find it peculiar, that when all of this finally implodes, that an insurance agent in Cleveland had been writing about this impending crisis, in detail for years.  They might further ask, if a Cleveland insurance agent can figure this out....why can't the smartest guys (Investment Bankers) in the room?  The simple answer is:  They already have.

If only Kaiser Wilhelm had been here to guide us through it all.....




Additional Reading/References

The Bank of International Settlements thinks China is one of the countries most likely to suffer a banking crisis, due to its debt and the high level of its debt servicing ratio. In its quarterly review, the bank also said that Canada and Hong Kong were at risk of banking crises, partly due to an increase in property prices. However, it was keen to stress than it wasn't saying any of these three countries were definitely heading for a crisis. CNBC

FSB - Global Shadow Banking Monitoring Report - 2017
Pg 10 Composition - $340T up 7.5% from 2015
Caymans GDP US$3.2 Billion in 2016  - US$7.9T Total AUM.
http://www.fsb.org/wp-content/uploads/P050318-1.pdf

Pg 50 - As in previous years, the US had the largest narrow measure, at $14.1 trillion in 2016, representing 31% of the total narrow measure assets reported by the 29 jurisdictions (Exhibit 4-5). The eight participating EU jurisdictions comprised the next largest share (with a combined $10.1 trillion, 22%), followed by China ($7.0 trillion, 16%), the Cayman Islands ($4.7 trillion, 10%), and Japan ($2.8 trillion, 6%).

FSB - Global Shadow Banking Monitoring Report - 2016
Pg 10 Composition - Inclusion of Luxembourg
Caymans GDP US$3.2 Billion in 2016  - US$7.9T Total AUM.
http://www.fsb.org/wp-content/uploads/global-shadow-banking-monitoring-report-2016.pdf

FSB - Global Shadow Bank Monitoring Report - 2014 (Inclusion of China & Cayman #'s)
Pg 44 - Assets Caymans US$3.3T 1,600x GDP;
http://www.fsb.org/wp-content/uploads/r_141030.pdf

FSB - Global Shadow Banking Report - 2012
http://www.fsb.org/wp-content/uploads/r_121118c.pdf

Hong Kong Monetary Authority - Hong Kong - Global Business Hub
http://www.hkma.gov.hk/media/eng/doc/key-functions/monetary-stability/rmb-business-in-hong-kong/hkma-rmb-booklet.pdf

IMF - Global GDP bumping along at 3% since the financial Crisis.  Financial Assets have been growing at 2x that rate.
http://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD

Dr. Michael Pettis
GDP as an Input
http://carnegieendowment.org/chinafinancialmarkets/75355

CNBC - BIS
https://www.cnbc.com/2018/03/12/bank-of-international-settlements-countries-at-risk-of-banking-crisis.html

BIS - Quarterly Review
https://www.bis.org/publ/qtrpdf/r_qt1803.pdf

Softbank Cashing out
https://www.bloomberg.com/gadfly/articles/2018-03-11/masa-son-is-finally-cashing-out-but-he-s-forgetting-something

Yukon Hunang
China's Economy is different
https://www.nytimes.com/2018/03/13/opinion/china-economy-corruption.html

Brad Setser - China's Unnecessary Fiscal Consolidation
https://www.cfr.org/blog/chinas-own-goal-unnecessary-and-counterproductive-budget-fiscal-consolidation?sp_mid=56183499&sp_rid=ZGVlcC50aHJvYXQuaXBvQGdtYWlsLmNvbQS2

WSJ - Relisting in China
https://www.wsj.com/articles/china-tech-titan-alibaba-plans-stock-market-homecoming-1521116131

Brad Setser - Bad Trade Practices
https://www.cfr.org/blog/forming-alliance-us-allies-against-bad-chinese-trade-practices-wont-be-enough-bring-trade?sp_mid=56199508&sp_rid=ZGVlcC50aHJvYXQuaXBvQGdtYWlsLmNvbQS2

Brad Setser - PBOC Balance of Payments
https://www.cfr.org/blog/balance-payments-world-changed-2014?sp_mid=56211509&sp_rid=ZGVlcC50aHJvYXQuaXBvQGdtYWlsLmNvbQS2

Mizuho - CNY vs CNH dated "cheat sheet for dummies"
https://www.mizuhobank.com/fin_info/cndb/rmb/pdf/double.pdf

RMB Deposits by Country
https://www.globalcapital.com/rmb/data/offshore-deposit-tracker

PWC - Offshore RMB Primer - 2015
https://www.pwc.lu/en/china/docs/pwc-where-do-you-renminbi.pdf

RMB - Offshore Deposits
https://www.globalcapital.com/rmb/data/offshore-deposit-tracker

FRED - China - M3/Exchange Rate/CPI Chart
"The only accurate information on the front page of a Chinese newspaper is the date"
https://fred.stlouisfed.org/series/MABMM301CNQ189S#0

World Bank - China Net FDI Outflow
https://data.worldbank.org/indicator/BM.KLT.DINV.CD.WD?end=2016&locations=CN&start=2010&view=chart


World Bank - 2016 GDP by Country
https://databank.worldbank.org/data/download/GDP.pdf

World Bank - Intractive GDP By Year
https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?end=2016&name_desc=false&start=2015 

ECB - Report on Financial Structures
https://www.ecb.europa.eu/pub/pdf/other/reportonfinancialstructures201610.en.pdf

OEC State - China Import/Export Graphics
https://atlas.media.mit.edu/en/profile/country/chn/

Steve Martin - The Jerk
https://youtu.be/-7aIf1YnbbU

OECD - FDI & OFDI
http://www.oecd.org/daf/inv/investment-policy/investmentnews.htm

OECD Trade In Goods & Services
https://data.oecd.org/trade/trade-in-goods-and-services.htm#indicator-chart

World Bank - Exports
https://data.worldbank.org/indicator/NE.EXP.GNFS.CD?end=2016&locations=CN&name_desc=false&start=2013

Listing of 158 Licensed Banks in the Cayman Islands
https://thebanks.eu/banks-by-country/Cayman-Islands 158 Banks in the Caymans

Nice PWC Summary of RMB sponsored by the Grand Duchy of Luxembourg
https://www.pwc.lu/en/china/docs/pwc-where-do-you-renminbi.pdf

China's Capital Capital Controls
https://www.forbes.com/sites/ywang/2017/03/16/chinas-crackdown-on-capital-flight-is-claiming-some-of-its-first-and-biggest-victims/#5912c2933da6

China's US$3.8 Trillion in Capital Flight in the last Decade
https://www.forbes.com/sites/insideasia/2017/02/22/china-capital-flight-migration/#21a51f444a37

SCMP - Non Convertibility of the RMB
http://www.scmp.com/business/investor-relations/article/2024014/chinas-yuan-set-become-only-imf-reserve-currency-isnt

SCMP - 3/18 - 1.56% of global transactions are settled in RMB.
http://www.scmp.com/business/banking-finance/article/2139462/renminbi-slips-7th-domestic-and-international-payments

OPEC - How OPEC lost its power - 2014 The Conversation
https://theconversation.com/opec-v-oil-prices-how-the-worlds-biggest-oil-cartel-lost-its-power-34923

Richmond Fed - German Monetary History
https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_quarterly/2002/winter/pdf/hetzel.pdf

All FRED Citations:
https://fred.stlouisfed.org/series/MABMM301CNQ189S#0

Suggested Citation:

Organization for Economic Co-operation and Development, Current Price Gross Domestic Product in China [CHNGDPNQDSMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CHNGDPNQDSMEI, April 2, 2018.
SCMP - Wealthy Chinese - Methods of Capital Flight
http://www.scmp.com/business/banking-finance/article/1551510/how-elude-chinese-foreign-exchange-laws-take-your-pick-ways

SCMP - Sneaky Cross Border Transactions - Moving money out of China
http://www.scmp.com/news/china/economy/article/2096032/chinas-watchdog-tracks-underground-cash-trail 

Financial Instability in China: Possible Pathways And Their LiklihoodMERICS Mercator Institute for China Studies)
https://www.merics.org/sites/default/files/2017-10/191017_merics_ChinaMonitor_42.pdf

36 comments:

  1. That was a great read. What are some of your best ways of trading this? Alibaba long dated puts? Gold ?

    thanks

    ReplyDelete
    Replies
    1. There are really no good ways to trade this until we see real signs of capitulation on the part of the PBOC. This has gone on far longer than I would have expected and it could go on much longer.....it's the Keynes "The market can stay irrational much longer than you can stay solvent..." conundrum....

      Delete
  2. If all of this is true, then you could be breaking the biggest financial story.... maybe ever.

    Given, I know a lot of this has been coming together over recent years and piecing various parts together. But this is the best "summation" of things as I see it right now. I really think you need to push your research on to regulators, watchdogs, and other sources.

    ReplyDelete
    Replies
    1. Thank you so much for the kind words.....I agree...this is without a doubt the greatest financial story in history. Lots of really smart, talented people are reading my work now, and I'm grateful for that. I also have no doubt that the ROTW will eventually figure this out.....one way or another.

      Delete
    2. I'm curious to hear your opinions on if a few other items fit into the scenario here.

      - How does the CNY oil contract fit in here? What role does that play? It looks like it could be another ploy in the book of using USD to buy hard assets?

      - How does the HKD fit into all of this? USDHKD is sitting as close to the peg as it has ever been right now, and I don't doubt that is on purpose. I know Jeffrey Snyder has from AIP has blogged about this a good bit, but I feel like it's just one piece of a much bigger picture that is being missed.

      - Slight side note, but I think it's worth noting that real estate has already started to slip in some of the cities you mentioned. New York has seen some significant drops in RE, and other non-usa cities like Vancouver, Toronto, and Australian cities have started to show some signs of stress as well.

      Delete
    3. I haven't really thought about the CNY/Oil exchange...I don't know much about it. I'd guess since most contracts are closed out without delivery and my understanding is that the ROTW is prevented from trading the contracts, that it won't have much impact. I could be very wrong but I'd think it's just another way for on-shore money to speculate.

      Your HKD question is another topic that I've not thought much about. The Peg has always been consistent/managed. I'd guess that peg has been consistent with money growth (i.e. HK & US M3 have probably been growing at about the same rate) so I'd expect the peg to track. But I really hadn't thought about the Current Account & Capital Account relationship. Also as I recall, like the mainland, the HKD in circulation is HUGE in relation to the HK economy. Thoughts?

      Funny you mentioned the RE weakness.....I was emailing with a friend of mine in Toronto and he voiced localized bubble concerns as well.

      You ask great questions....

      Delete
    4. I only what I know from reading other great posts and authors like yourself. Most of the stuff relating to the HKD peg I got from Jeff Snyder as I mentioned. I do understand that once the HKD reaches the peg, that means Hong Kong will have to withdraw liquidity, which will shoot Hibor rates higher.

      Here are two links. He writes a lot about the HKD as well as eurodollar system and how it affects things. I feel like this is likely an important piece in all of your writing. Note - you'll probably have to pore over a lot of the writing here, even I don't have a great grasp on things after reading quite a bit.

      http://www.alhambrapartners.com/2018/01/16/confirming-the-big-change-in-2017/

      http://www.alhambrapartners.com/2018/03/08/nearly-time-for-some-speculator-blame/

      Delete
    5. As a long time Hong Kong resident that just signed another brand new lease- god I hope HIBOR rates go higher! This place is absurd and it is ground zero for financial tyranny.

      Delete
  3. Why then do world leaders and some economist seem mostly worried about the opposite, i.e. China purposefully devaluing the RMB to help the competitiveness of its exports? As recently as a few months ago, Trump was calling China a chronic currency manipulator for trying to devalue the RMB.

    ReplyDelete
    Replies
    1. I've always found it difficult to try to figure out why people think the way they think. Very intelligent people can look at the same data and come to completely opposite conclusions. As a consequence they follow different decision paths.

      My work has no agenda. I read, think and write. In that order.

      I'd invite anyone, Donald Trump included, to read my work and comment/Tweet on it. I enjoy hearing different points of view and If I'm indeed wrong I'd like to know why.

      If we believe a story simply because someone with a string of credentials tells it, without truly understanding the essence of the story, that's how we get into trouble.

      All the best.....

      DT

      Delete
  4. Hmm are you sure RMB is pegged and China is a two-currency system? What I found on Investopedia and Quora suggest it floats and it's one-currency (RMB=yuan). If this is accurate it could change some of your conclusions?

    ReplyDelete
    Replies
    1. Yup....I'm sure. The mechanics of the RMB Onshore(CNY)/Offshore(CNH) currency market mechanisms are well chronicled. I've cited a number of academic resources in the "Additional Reading/References" section of the post.

      Delete
  5. "11.) New York City, Bay Area and Silicon Valley Real Estate prices will correct/collapse. Foreign money would dry up with an RMB revaluation"

    Should that be RMB devaluation?

    ReplyDelete
  6. it's not "Wiemar" but "Weimar"

    ReplyDelete
    Replies
    1. Ooopppss.....sorry, you are correct....my bad. Thanks for reading my work so closely!

      Delete
  7. What do you think of Adair Turners work on Direct Monetary Finance? In relation to the events you see rolling out of this.
    "Between Debt and the Devil"

    ReplyDelete
    Replies
    1. The short answer is.....it's brilliant.

      I discuss similar concepts in an albeit less academic/professional, but yet (hopefully) entertaining format in my post:

      https://deep-throat-ipo.blogspot.com/2016/08/the-theory-of-financial-relativity.html

      The flaw in the slaw, that we both describe, albeit getting there using differnet paths, is the inherent limitation and bias preventing the world's Central Banks from rowing the boat in the same direction.

      In Turner's model, as I recall, he advocates that the world doesn't necesssarily need loose money to grow (I agree) and there are various Central Bank tools available to limit credit/money supply growth. The debate lies in which tools to use. We are in agreement.

      What I see is that, in the world today, there will always be a Central Banker (or two) out there that, in the interest of their own nation(s) will exercise their soverign right to march to a different drummer.

      Weimar Republic? Post WWII Hungary? PBOC? Who knows....

      Thanks for reading my work....

      Delete
    2. Keep up the good work. We appreciate it, wider audiences do require the talking points, abbreviated summaries, and I appreciate them as well. Is difficult to flow stream of conscious, try to integrate humor and humility and express the gravity of the issues you discuss, all in the same breath. Frankly, I think you do a good job at all of these. But in the same notion, i belief that this is very important work, and understand if others have hit you for organization of narrative issues. But really, astounding....

      I suspect that Adair's discussion of Direct Monetary Finance, and how it is needed, will be felt eventually, and directly. Frankly, without the continued bad news that we see on the global front (China particularly), and before Trumps, talk up the market to stupid levels, as if the bulls needed a reason to charge the average schlub even more for their quarterly contribution, I suspect by latest 2021-23, if not before we would have started to deal with declining equities, of mandatory drawdowns, against a critical mass of Baby Boom 401kers. So as relates to Adair's perspectives I suspect we might need go route of direct monetary finance to consumers. To this, I hope it is geared, in US to service industries, to support, wages, revenues, tax takes, consumption to gdp dynamics, and to avoid leakage through trade channels, at least for a few cycles before it leaks out in new flat screen purchases (increasing velocity). Such, might even draw some flows out of ridiculous asset valuations more productively.

      Delete
  8. Excellent article, and I'll probably have to read it a few more times to fully digest it, so apologies if what follows misses the mark.

    It occurs to me that CNH is only significant in the whole picture inasmuch as regulation on cross-border RMB flows are more permissive than they are in USD or other currencies, and I'm not sure that they are in reality. BOCI has a quasi monopoly on them in HK, but even they cannot do as they please - any kind of outbound flow (whether writing a loan or settling a trade invoice) is heavily scrutinised these days, and RMB is no exception. PBOC controls the supply of CNH very tightly, as you note, but this is in my opinion more to do with window-dressing, to prevent CNH wandering off to a more market-based level.

    The whole devaluation of 2015 was most probably nothing of the sort: it was an extremely cack-handed debacle of an attempt to rid themselves of the pesky basis that had set up between the daily fix, USDCNY and USDCNH (pesky only to those overly-obsessed with optics over reality). Without warning, they moved the daily fix up, in USD terms, to where USDCNY had been trading at the weaker end of the permitted daily band, and towards USDCNH. The result was, predictably, that the markets saw a near 2% devaluation and USDCNY fled for the weakest end of the new daily band, and USDCNH went absolutely ham. PBOC came in hard, and started sucking the liquidity out of the CNH market in order to make life harder for "malicious shorters" of the currency. Overnight rates quickly hit double digits, and I think the highest implied overnight rate I saw in the market that day was north of 90% before liquidity vanished altogether. It was painful; ask me how I know.

    But I digress - the point is, the pool of CNH sharply reversed course and has steadily declined ever since that day, as you note. The PBOC hasn't stopped intervening, and in the general panic of the capital flight that inevitably ensued, it and SAFE cracked down hard, as we know, on all cross-border (out)flows - and continue to do so. I don't know that those flows being RMB as they jump the border as in your Apple/Foxconn example makes much of a difference to the overall picture.

    If CNH has been significant, it's only that it was from day one a construct (like so many other schemes, like Stock Connect or that CNY Oil Futures nonsense) to try and pretend that the capital account was being opened and that China was committed to a market-based determination of its exchange rate. The single most important thing in getting away with the Grand Scam has been, as you note, to get central bankers looking the other way as the capital account remained as closed as ever. CNH has only been a part of that whole charade - it helped fool the IMF and others, but then they were willing to be fooled anyway.

    I think in terms of the USD Boomerang you describe, very often it's that the Foxconns of your example will these days want to settle as little of the contract in RMB as they possibly can (and let's not forget that Foxconn itself is ultimately a foreign-controlled company). They do need to pay wages, rents and the like, but they will for preference take payment of the contract in USD (or HKD, or whatever), outside of China, where it will remain. (And the kickbacks will almost certainly be more welcome in an offshore account). This has always been a feature of exports from China, but I would be willing to bet it is more significant now, as getting money out is harder than ever. I'd also be willing to bet that companies that can do so will for preference borrow RMB onshore to pay their workers rather than convert the proceeds of an export contract into RMB at any point.

    None of my rambles really run counter to any of your points, other than that I would play down the significance of the existence of CNH as anything other than yet another exercise in obsessive CCP window-dressing, which is something that only really works when they audience has already drunk the Kool-Aid anyway.

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    1. Outstanding!....what do you do for a living & where do you do it? I suspect, from the nature of your commentary, that you have more "boots on the ground" experience than a Cleveland Insurance Agent.....LOL

      No need to respond if you choose not to. It's none of my business. Just curious as to the genesis of your perspective.

      Thank you for reading my work!

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    2. Yeah my perspective is from being fairly close, geographically and functionally, to the "action". Just a small cog in the machine.

      Thanks for sharing your work! I know I'm not the only one in this town and this industry that waits with baited breath for every update of your blog. :)

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    3. Thanks Rob...."small cogs" are an incredibly important in any complex machinery.....they either make it hum...or they can shut it down.....

      Thanks for the kind words!

      DT

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  9. Hi, great post, I am still trying to wrap my head around it.

    Isn’t this trick of expanding RMB credit rather than allowing the exchange rate to fluctuate known as sterilization? I have heard that term used in the pre-financial crisis days to describe how China kept its currency from appreciating. What you are pointing out here is that it does not just keep it from appreciating, it keeps it from depreciating as well, and in fact shields it from any kind of price discovery.

    Question: If the RMB is indeed 3x overvalued, does that mean that, when the dust settles, that the already-cheap goods imported from China on sale at Walmart and on Amazon will be three times cheaper than they are today? That would be astounding and sounds very deflationary.

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    1. Exactly.....by my reckoning, correct on all counts.

      If the RMB were truly floating the result would be inflationary in China, think Weimar-esque wheelbarrows of RMB to buy a dish of noodles.....and deflationary here. When the exchange rate resets, the hard work of the Chinese people would be worth even less in Dollar/Euro terms. On the other hand.....there would presumably be room for Chinese producers to raise prices and consequently, real income. e.g. Think post WWII Japan.

      As an aside, one of my readers sent me this link re: The "Vancouver Model".

      https://globalnews.ca/news/4149818/vancouver-cautionary-tale-money-laundering-drugs/

      I'm trying to get a copy of Professor Langdale's Report. The report apparently describes similar mechanisms to what I discuss, but adds a more salacious criminal element to the activities... ...as described by David Eby, the B.C. Attorney General.

      I'm most interested in the scope and estimates to the level of funding involved. It's yet another illustration of the "Boomerang" phenomenon I described above.

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    2. OK, there you lost me a bit. The point of using credit to increase the money supply rather than just printing money was to avoid inflation. If a Weimar-style inflation were to happen, the effects would be felt as soon as the printing started.

      What you are describing sounds more like 1989 Japan rather than post-war Japan. Lots of zombie companies with loans that may never be repaid, slowly deflating asset bubbles in real-estate and common stocks, and a never-ending recession.

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    3. But there is still the fact that the currency is non-convertible. That puts us into uncharted waters when that fact changes.

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    4. Do you know how the M3 of Japan looked like prior to 1989? That might give a clue.

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    5. "there would presumably be room for Chinese producers to raise prices and consequently, real income. e.g. Think post WWII Japan." As a Chinese supplier to the western world, I wouldn't count on that. Post WWII Japan could also be known as "pre Wal Mart days". There is very little chance Chinese suppliers could recoup profit nowadays as western retailers/wholesalers know their profit structures down to a tee. In addition such an environment would bring about a fresh round of cut throat competition which Chinese suppliers are drawn to like a bug to light!

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  10. An interesting, though tangential to your current blog, aspect of the invasion of U.S. markets by Chinese commerce is that Chinese merchants (and various other countries) can send products directly to U.S. household addresses at substantially lower cost than domestic merchants can. This is subsidized by none other than the USPS. If Trump, for example, really wanted to slam Jeff Bezos (who frequently complains about the USPS, incidentally) he would move to abolish this subsidy (assuming the dysfunctional could be that well informed). See the Forbes article: https://www.forbes.com/sites/wadeshepard/2017/11/05/how-the-usps-epacket-gives-postal-subsidies-to-chinese-e-commerce-merchants-to-ship-to-the-usa-cheap/#1fa7888e40ca

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    1. Excellent comment!..this is far from "tangential". Although neither Amazon nor Walmart discuss 3rd party GMV in their filings, they discuss "percent increases" and other ambiguous metrics. (I wonder how they get away with that?? Wouldn't Investors want to know how much merchandise actually flows through these "ecosystems"??)

      Analyst guesses range from US$200B to US$400B for the TPGMV of both companies combined. And yes, the USPS gives a de facto competitive/cost advantage to Amazon.com and Walmart.com 3rd Party Sellers. Moreover, when you add in the "no sales tax" impact on top of the exchange rate subsidy....it's a wonder any brick & mortar retailer can compete at all.

      As an aside...based solely on your comment....did someone slip you a draft of my next post?....LOL

      All the best!

      DT

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    2. Yes, prior to the Alibaba USPS signing deal this was a concern, but afterwards, just ridiculous.

      If you use Ebay, they often state that they are resident in California or New York, then it takes a significant amount of time for it to arrive; and/or often arrives in cheap white/grey plastic bags.

      I have taken to buying as much used goods these last 10 years since the GFC as possible.

      Or buying at Goodwill.
      Funnily, even have taken to dying my old t-shirts rather than buying new. Speak with your pocketbook.

      I am so glad people like Deepthroat are starting to publish what is necessary. Anyone see Setser's new post...

      Asia's Central Banks and Sovereign Funds Are Back

      https://www.cfr.org/blog/asias-central-banks-and-sovereign-funds-are-back

      It makes me wonder how so many, can be so clueless...that either the system is built on Neo-Colonial premises, or that the US requires foreign financing of its economy.

      British India, a market for British manufactures.
      French West Africa, so on, and so forth.

      Seems the US is being used at present for such.
      And all around the dialogue, nothing but ignorance and the opposite of what is imagined.

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  11. Top-shelf post, DT, excellent work.

    The West made a deal with the devil in 2008 when we advanced the idea that China would provide the new demand to carry the world economy, willfully looking the other way so that we could spin the plates just a little longer. We bought some time, and some of us got paid. And, yes, it will come apart, with blazing speed once we are finally there.

    IMO the wicked-steep slope on these recent declines hints at what is lurking. Now imagine a sell-off like what we have seen lasting for a month, or for three months. I have.

    I have Weimar framed in my living room. Unfortunately, the largest bill I could manage is the 500MM DM. No Millarden in the Haus.

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    1. 2008, try a decade before, with Financial deregulation, in US, and negotiation, capitulation on the part of admitting non-market economies to WTO. Something that occurred, during the era highly influenced by the Newt Gingrich, Neo-Libertarian, Hayekian 1990's.

      That is why 2007-2008 occurred.
      Twin towers, of deficits (budget and current account) going vertical; essentially the use of the American financial system by global business community and HNW.

      All occurring... thereafter, the mere impact, of the elements of the system and the new interactions evolving of new influences in the dynamic self-organizing complex adaptive system.

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  12. "A reset, moving toward a depreciated RMB value in the 18:1 range would be more in line with what a floating RMB might look like in relation to China's money supply and burgeoning debt levels."
    Where do you derive this? Could you explain this estimate a bit more?
    Thanks.

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  13. FYI

    https://www.bloomberg.com/news/articles/2018-05-27/china-energy-misses-dollar-bond-payment-triggering-cross-default

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  14. It seems Chinese bankers are getting depressed because their banks have too much debt.
    https://abcnews.go.com/International/wireStory/head-major-chinese-bank-found-dead-apparent-suicide-55483099

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