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China? I Thought They Fixed That!


I remember back in 2010 when the European sovereign debt crisis began to blossom. The scene that best embodied the crisis was the burning streets in Athens, Greece. Back then, we looked on in horror while we sold anything remotely related to Greece and the European Union. The easiest thing to sell was the Euro, and we sold it. The currency dropped approximately 21% over the next six months, and it looked as if the European Union was going to be torn apart. Subsequently, a series of bailout measures were enacted and the problem of Greece was “solved.” Then, lo and behold, a couple of months into 2011, the streets of Athens burned again. The financial markets reacted a little less violently and the problem was “solved” once more. Going forward, whenever Greece would flair up, every six months or so, my trading desk buddies and I would look at each other and someone would ask, “Greece? I thought they fixed that?” And then everyone would laugh and carry on.

Now, it seems this same question is being asked about China, except nobody is laughing. Last winter, the financial markets reacted violently to China’s crises. The Chinese Yuan was rapidly weakening against the U.S. Dollar, capital was fleeing the country at a clip of approximately $70 billion/month, bad loans made by Chinese banks to Chinese companies were soaring, and the one country that the world relied on to consume mass quantities of commodities seemed to stop in its tracks.

The result of China seizing up was a sharp sell-off in commodities such as crude oil, which in turn hurt emerging market bonds and currencies, U.S. High Yield bonds, and a large swath of high flying energy-producing equities. Then in the spring, as suddenly as the Chinese crisis appeared, it disappeared. The market consensus was that the Chinese economy had stabilized, GDP was growing at a respectable 6.5–7%, and all was well. The question no one seemed to be asking was, how? What rabbit did the magicians in Beijing pull out of their hat to solve the crisis and save the day?

It turns out, the solution was the time-tested, short-term gain, long-term disaster strategy of, “when in doubt, pump up a real estate bubble.” Actually, in the case of China, the strategy was really to pump up a gigantic real estate bubble further. As noted in The Telegraph article, by Ambrose Evans-Pritchard:

“In June of this year, the State Council stated that households could ‘leverage up’ on property, supposedly to ‘help the corporate sector lower their leverage.’ Whatever they were thinking, the net effect was to draw yet more people into the quagmire.

This State Council endorsement was the green light for a final blow-off in a country where people are highly attuned to signals from the Communist Party. Down payments for mortgages were cut to 20pc, and to 30pc for second homes. Both buyers and developers seized on the latest Beijing 'Put' with alacrity.”

And just like that, real estate roared, commodities were consumed, and the world was saved. Whenever I see situations like this, I always think of the lab rat in a maze. The lab rat finds the magic lever that if pulled, delivers a tasty treat. The lab rat, if not restrained, just keeps pulling the lever and eating until he explodes. As a survivor and witness to numerous boom-bust cycles that have occurred all over the world, I have come to see the lab rat eating until he explodes analogy as one of the bedrocks of economic and financial theory.

Further, Ambrose-Pritchard contends:

“The bubble went mad in September. Home prices in Shanghai rose 5pc in one month. Over the last year they have risen 28pc in Beijing, 33pc in Shanghai, 37pc in Xiamen, and 47pc in Hefei.”

Now, it appears Beijing is removing ‘the put’ as quickly as they issued it. Beijing has now decreed that the minimum down payment on a first home will be 50% as opposed to 20%, and 70% on a second home from 30%. And with that, the credit spigot has been turned off. Game over.

This month, the Chinese Yuan has depreciated 1.6% against the U.S. Dollar and is weaker now than when it sent shock waves through the global financial system and economy in early 2016. Estimates of capital leaving the country range between $45–$55 billion/month and the People’s Bank of China (PBOC) is trying to defend the currency by selling as much as $50 billion in foreign reserves last month. If you’ve been wondering why the long end of our Treasury yield curve is under pressure, the PBOC is a big seller. Unfortunately for China, this selling of foreign reserves (and buying Yuan) acts as a tightening of monetary policy right when the economy needs an easing. United States Dollar funding rates have been steadily rising since the beginning of summer, putting further pressure on the PBOC and Yuan.

With regard to capital flight, the Ambrose-Pritchard article revealed: “Institutions must now justify why they need foreign exchange. The worry is a ‘negative feedback loop between a weakening Yuan and capital flight.’”

It appears the China problem isn’t fixed at all. In fact, they seem to have made a bad problem worse. When you’ve already used the “real estate bubble” option and it has popped, there isn’t much left to do but take your medicine. Unfortunately, when China takes its medicine, so too does the rest of the world.

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