More Evidence of the China Ponzi

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Today arrives with some good news for commodities…sort of.

Credit ratings agency S&P downgraded BHP Billiton [ASX:BHP] from A+ to A. Why is this good news?

Well, ratings agencies are ALWAYS behind the curve. This announcement is not news at all. The market knew this information a long time ago.

It’s good because it reflects a progression in the mining and commodities bear market. When the rating agencies begin to acknowledge what the market already knows, it’s a sign that the cycle is turning.

It doesn’t mean the cycle is at the bottom, but it does mean we’re getting closer.

It won’t feel like that if you’re exposed to the oil market though. The rollercoaster continued overnight, with prices plunging around 6%. Save yourself the angst and avoid this market for now. It will probably only be safe to look later this year.

That’s because there is still a lot to play out in China, the source of all things painful in the commodities world. A massive credit boom comes with all sorts of unpleasant side effects. The Financial Times reports on one such episode…

Chinese police have arrested more than 20 people associated with “a complete Ponzi scheme” that allegedly took more than Rmb50bn ($7.6bn) from investors, according to the official Xinhua news agency.

It is the biggest scam yet to emerge from China’s unruly and largely unregulated peer-to-peer lending sector, part of the country’s shadow banking sector. Police had to use two excavators to uncover some 1,200 account books that had been buried deep below ground, according to Xinhua.

More accurately, the ‘complete Ponzi scheme’ is the whole Chinese economy. It now requires more and more credit growth to produce less and less economic growth. That shows you the Ponzi is getting long in the tooth.

There are two main forces at play in the Chinese economy right now. Total system credit growth, which includes new loans and local government debt issuance, reached a 12 month high of 14.4% in December. That’s inflationary.

But much of this new credit creation isn’t hanging around. It’s escaping the economy, which is why you’re hearing so much about the risk of capital flight from China. That’s deflationary.

The fact that credit growth of nearly 15% produces economic growth of less than 7% should be a major concern.

Big US hedge funds are beginning to wake up to this. They are all lining up to bet against the Chinese currency, the yuan, and other Asian currencies. Names like Kyle Bass, Stanley Druckenmiller, David Einhorn and David Tepper have reportedly taken bets against the yuan.

If you’re not aware, these guys manage serious money. The People’s Bank of China has a fight on its hands if they want to ‘control’ the market. They will certainly win battles, but they cannot possibly win the war. No entity is more powerful than the market. Eventually, everything succumbs to the power of nature.

I’ll leave China’s woes there for today. But don’t worry, there will be plenty more opportunities to chronicle the fallout from the credit bubble. I mean, if things are this tense with credit expanding at 15% annually, what’s it going to looking like when it falls below 10%, which is entirely likely?

I shudder to think…

I’ll finish up today with a reader question. It’s in response to Friday’s Daily Reckoning, where I discussed Australia’s public and private debt levels.

Your article today about public/private debt canvasses a couple of areas that I would appreciate some clarification. Firstly, the percentage of debt held by foreign creditors would be 100% private debt, since all government debt is issued in Australian currency and does not involve any foreign currency buying.

Secondly, a monopoly currency issuer such as Australia can always meet its debt obligations. It’s borrowing via the issue of treasury bonds is primarily to control overnight interbank lending, not to finance deficit spending. All government spending is new money, so, why do we bother issuing bonds when there are simpler ways of controlling interest rates?

Why do we elect to pay interest on bonds when we can satisfy our debt obligations by issuing new money? Provided deficit spending is dedicated to employment projects there can be no threat of inflation.

Thanks for the question. There are a couple is misconceptions though that I need to clear up.

The percentage of debt held by foreign creditors is NOT 100% private debt. When the government issues bonds, both foreigners and Australian residents buy the debt. As at 1 December 2015, foreigners held 63.6% of Aussie government debt. Go here if you want more info.

When foreigners buy Aussie debt, they simply sell their currency and buy Aussie dollars. They can hedge against currency movements (and therefore just earn the interest rate) for a cost. Banks facilitate these hedges.

Yes, a monopoly currency issuer like Australia can always meet its obligations. But you’re incorrect in saying governments issue bonds to control overnight interbank lending. That’s the RBA’s role.

Governments borrow purely to finance the deficit! Why else would they do it?

How they choose to spend the borrowed funds is the critical issue. If they invest in long term, productivity enhancing projects, spending will be non-inflationary over the longer term.

But Australia is mostly borrowing to maintain inefficient entitlements, and to offset the revenue falls resulting from collapsing iron ore and other commodity prices. In short, we spent the dividend from the commodity boom, but can’t claw it back now the boom is over.

If we decided to just print money (i.e. getting the RBA to buy government bonds…our very own quantitative easing) what do you think would happen to the Aussie dollar?

Do you think foreigners would continue to finance private sector deficits? They would run for the hills, and our dollar would collapse.

That would send inflation higher. And if the RBA keep printing to buy all the debt the foreigners dumped, well…have you been to Argentina?

Australia needs to maintain conservative financial settings. Or I should say, relatively conservative settings. That’s why QE or negative interest rates here is a pipedream. Creditor nations can get away with it. Debtor nations, like Australia, cannot.

Greg Canavan,
For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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