China's Dirty Little Secret: Broke By The End Of 2017

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China is facing a little known dilemma: the communist nation is literally going broke.

Think about where you were at the end of the summer in 2015. Maybe you were wrapping up summer vacation, or gearing up to take the kids back to school. Or perhaps you recall watching your investment portfolio get promptly obliterated.

On August 10, 2015, China devalued the Yuan by a mere 3% over the course of two days. Over the next few weeks, the US stock market crashed 10% before it began to recover, and many investors believed they were staring into the abyss.

But the fact is, this slight currency maneuver in 2015 was nothing compared to what may be awaiting the world economy in the near future. And it all boils down to one simple truth: China is going broke.

Some readers may find themselves skeptical of this statement: China is going broke? How is this possible as the planet’s second largest economy? Plus, don’t they have the largest reserve position in the history of the world?

Yes, China is the second largest economy, and it does boast the world’s largest reserve position. But what many readers may not understand is just how rapidly that position is being eroded. In fact, over the course of two years, it has dwindled from $4 trillion to $2.9 trillion. That’s a reduction of 25% from 2014 to the end of 2016.

Sure, but $2.9 trillion is still a lot of money, isn’t it?

Not really, at least when you examine the rest of the data.

First, let’s review the meaning of a country’s ’reserve position,’ which is really no different than an individual’s savings account. Let’s say someone makes $50,000 per year, and spends $40,000 on rent, food, clothes, taxes, etc. The remaining $10,000 is available for savings or investment. Essentially, those same principles apply to a country.

China gets paid in hard currency when it exports products, and pays in hard currency when it imports products. The surplus, or savings, is referred to as a ‘reserve position.’ But over the course of two years, China’s ‘savings account’ has been depleted by $1.1 trillion.

So where did all that money go?

We’ll return to that in just a moment.

First let’s breakdown China’s remaining $2.9 trillion:

• $1 trillion is illiquid (invested in various assets to yield a higher return)
• $1 trillion must be held as a precautionary reserve to bail out the Chinese banking system when it fails (more on this in a moment)
• $900 billion is available for expenditure, but is actually being used to defend the Chinese Yuan by artificially propping it up

Basically, China only has $900 billion left in reserves, but has to use it to buy its own currency – which is exactly how the other $1.1 trillion disappeared. The goal is to keep the Yuan pegged to a certain level, but that peg is under increasing distress due to currency and interest rate differentials. Therefore, the solution so far has been to fund the difference at a rate of anywhere between $30-50 billion per month, which is a pace that will result in China going broke by the end of 2017.

But wait…there’s more!

The corruption, fraud and under-performance of Chinese banks only adds fuel to the monetary fire. Private estimates report that bad debts are approximately 25% of total assets. This is an astronomically high level, and is more than enough to collapse the entire system. By comparison, US banks generally run at a level of 5-8%. Understanding this inherent dysfunction will shed light on why $1 trillion of China’s reserve position must be allocated for a future bailout, which is most certainly coming.

Ok, so China is going broke if they don’t stop spending their reserves. What can they do to stop the leak?

Quite simply, the economic dilemma leaves China with only 3 options:

1. Close the capital accounts, which is another way of saying to stop money from leaving the country. China has been somewhat successful in doing this, but can only achieve it at a small level without basically leaving the international monetary system.
2. Raise interest rates and create an incentive for savers to keep their money at home. However, this would lead to an obvious crisis with already-delinquent borrowers. Raising rates means that bad loans get worse faster.
3. Succumb to the inevitable and devalue the Yuan.

Given that China is clearly exhausting its reserves to prop up its own currency, the only remaining option is to ultimately face the music and devalue the Yuan. No one knows when this will happen, or by how much.

However, if you consider that a small 3% devaluation in 2015 was enough to temporarily sink the US stock market…what happens when the Yuan invariably gets marked down by a considerably greater figure?

An international economic disaster?

Probably a good guess.