Playing the Chinese Trump Card

By John Mauldin

“I know the Chinese. I’ve made a lot of money with the Chinese. I understand the Chinese mind.” – Donald Trump, 2011

Back in the olden days (pre-2000 or so), information junkies like me relied on printed newspapers, paper magazines, TV newscasts, and snail mail newsletters. All these channels still exist, but they can’t begin to compete with the constant stream of data rushing into our tablets and smartphones. And on some days the stream rushes faster.

Last week, for instance, it seemed I couldn’t go five minutes without another story on either (a) China or (b) Donald Trump. For a day or so, I really wondered if someone had planted malware in my browser to make me think all other topics were inconsequential. It was all Trump and China, all day and all night. China has pushed the Fed into second place (for a few days at least) – perhaps we should be grateful that at least something has. Of course, there is the little problem that a bear market might be in the offing. Commodity prices seem to be in the toilet. Global currency markets are throwing up. Isn’t the world supposed to be on vacation in August?

Let’s see if we can find a connecting thought or three among all these topics. Plus, I want to show you how the current market meltdown is being brought to you courtesy of your friendly US Federal Reserve Bank. As our starting point, though, let’s cast an eye at The Donald and Chinese currency manipulation.

“Nobody Does Anything”

As we all know by now, on Aug. 11 the People’s Bank of China changed the way it manages the renminbi daily trading band against the US dollar. The result was a two day drop for the RMB and a lot of consternation on trading floors around the world.

Taking questions at an event in Michigan that day, Donald Trump had this to say:

I think you have to do something to rein in China. They devalued their currency today. They’re making it absolutely impossible for the United States to compete, and nobody does anything. China has no respect for President Obama whatsoever, whatsoever.

Well, you have to take strong action. How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.

                       

They think we’re run by a bunch of idiots. And what’s going on with China is unbelievable, the largest devaluation in two decades. It’s honestly – great question – it’s a disgrace.” Before you dismiss this as nonsense, remember that it comes from a Wharton School graduate.

Still not impressed? You’re right; it is indeed nonsense. Trump and all those who prattle on about Chinese currency manipulation have the economic comprehension of a parakeet. Is Trump really so clueless?

In one sense, it doesn’t matter. Trump isn’t talking to most of us. He draws an audience of frustrated, mostly middle-class Americans who are still hurting from the Great Recession. They want to blame someone. China is an easy target. So are illegal immigrants and Mexico and other faceless culprits. Furthermore, his audience has legitimate concerns. They are fully aware that both political parties ignore them.

A recent Gallup poll shows that 75% of our country believes there is significant corruption in government. They’re tired of it. They want to try something different. It is telling that a recent Michigan poll of Republican party activists found that 55% would go with either untested non politicians or Ted Cruz, who is about as much of an outsider as you can find inside the Washington DC Beltway.

I find almost nothing attractive about Donald Trump, but significant numbers in both parties have clearly demonstrated that they are looking for real change. Shades of Greece and Syriza’s coming to power, or France and the startling surge by Marine Le Pen’s Front National. The US is beginning to experience what our European friends have been living through the past few years.

Back to Trump and currency manipulation. I could do a sentence-by-sentence analysis of his populist harangue on China, but let’s take the really egregious statement: How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.

No, they haven’t. This whole myth that China has purposely kept their currency undervalued needs to be completely excised from the economic discussion. First off, the two largest currency manipulating central banks currently at work in the world are (in order) the Bank of Japan and the European Central Bank. And two to four years ago the hands down leading manipulator would have been the Federal Reserve of the United States. The leaders/aggressors in the currency wars come and go.

Today, the euro is off over 30% from its highs, as is the Japanese yen. Numerous other currencies are likewise well into double digit slides. China has moved maybe 3 to 4%. Oh, wow.

Secondly, Donald (and to be fair I should address this to Senators Schumer and Graham, et al., too) the Chinese have not been continuously cutting their currency for years. In fact, if they have manipulated their currency, it was first to make it even stronger when the dollar was falling and then to hold those gains in the face of the steadily rising dollar. Meanwhile the rest of the world (Japan, Europe, Great Britain, Brazil, India, among others) was letting their currencies drift down.

The simple fact is that the Chinese currency rose by 20% over the last five years up until a week ago, for reasons we will examine a little later. It is utterly wrong headed to call a 20% rise over almost 10 years “continuous devaluation.” Yes, prior to that time they did allow their currency to devalue rather precipitously, but if you look back and think about it, they were faced with something of a crisis at the time. Most currencies do fall during periods of economic stress.

Don’t get me wrong. The United States and China have a several page list of issues that need to be worked out between them. If you read my recent book on China, you learned about more than a few of those problems. But given that the Federal Reserve has been the most egregious currency manipulator in the world over the last five years, hearing the pot calling the kettle black probably sticks in the craw of most non US citizens. I understand it makes for a great populist harangue. It’s always easiest to blame our problems on someone else. But it doesn’t get us anywhere we want to go.

Back to the main story. Let’s look at this fascinating chart from my friend Chris Whalen over at the Kroll Bond Rating Agency:

Chris writes:

With the end of QE in sight in 2014, the dollar began to climb against most major currencies with the exception of the yuan, which remained effectively pegged against the dollar because of intervention by the PBOC. The yuan has, in fact, appreciated steadily against the dollar since 2006 and continued to move higher within the managed foreign exchange regime maintained by the Chinese government. 

Until last week, the PBOC had been using its foreign exchange reserves to cope with the increased demand for dollars from domestic investors. The decision to end the defense of the currency has economic as well as financial ramifications. For example, investors are starting to wonder just how much foreign currency debt China has accumulated to fund infrastructure investment as well as foreign ventures, and whether this total is reflected in official debt statistics.

Oil and copper are priced in dollars. From the point of view of China, and much of the rest of the world, oil is up several times in the last 15 years, and copper is up 2 to 3 times, even after the recent selloffs. From an inflation-adjusted standpoint, the rest of the world just sees things as getting back to normal. A strong dollar can do that.

Chinese Déjà Vu

Trump’s China complaints are nothing new. I wrote an entire issue on this topic five years ago (and Jonathan Tepper and I dealt with it at length in both Endgame and Code Red.) At that time, economist Paul Krugman and a group of senators led by New York Democrat Chuck Schumer wanted to impose a 25% tariff on Chinese imports. This is from my March 20, 2010, issue: I probably shouldn't take on a Nobel Laureate who got his prize for his work on trade, but this truly scares me. People pay attention to this nonsense, including the five senators, led by Schumer of New York, who want to start the process of targeting China.

First, the Chinese have got to be wondering what they have to do to make these guys happy. In 2005 they were demanding a 30% revaluation of the Chinese yuan. And over the next three years the yuan actually rose by 22% at a gradual and sustained pace. Then the credit crisis hit, and China again pegged their currency [even as the dollar got weaker!]. From their standpoint, what else were they to do? Force their country into a recession to appease our politicians?

They responded by a massive forcing of loans to their businesses and governments and huge infrastructure projects. Kind of like our stimulus, except they got a lot more infrastructure to show for their money. It remains to be seen how wise that policy was, and how large the bad (non performing) loans will be that came from that push – just as there are those (your humble analyst included) who do not think the way we went about the stimulus plan in the US was the wisest allocation of capital.

But the reality is that the Chinese will do what is in their best interest. I wrote in 2005 that the yuan would rise slowly over time. The political posturing of Schumer, et al., was counterproductive then, and it still is now.

My prediction? The Chinese will begin to allow the yuan to rise again sometime this year, just as they did three years ago, because it will be to their advantage. A stronger yuan will act as a buffer to inflation, which they may face due to the massive stimulus they created. They are going to need some help in that area. But it will be 5–7% a year, so as not to create a shock to their export economy. Not 25% at one time. And at some point they will allow the yuan to float against the dollar. They know they will have to in order to get the currency status they want.

Back then, it was Schumer and Krugman who wanted to “rein in” China. Now we have Trump saying more or less the same things. Look at what happened in the intervening five years, in this chart from Krugman’s home-base New York Times.

And sure enough, right on schedule and as I predicted in 2010, the RMB began to slowly rise and rose through early 2014. This was about the same time that “China stopped acting Chinese,” as I wrote earlier this month. At about that time, China Beige Book detected a noticeable shift in Chinese business behavior, when companies stopped using the government’s stimulus to add new capacity.

Our hypothesis, you may recall, is that the Chinese monetary stimulus began going into stocks instead of capital improvement projects. That inflow led to the stock bubble that has popped over the last few weeks. Which resulted in an apparent panic in the halls of Chinese government.

Code Red at the PBOC

Sorting through the approximately 47,000 China reports people sent me in the last 10 days, I see two broad categories of analysis. To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: Playing the Chinese Trump Card was originally published at mauldineconomics.com.

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When China Stopped Acting Chinese

By John Mauldin

“The one thing I know for sure about China is, I will never know China. It's too big, too old, too diverse, too deep. There's simply not enough time.”

– Anthony Bourdain, Parts Unknown

Much of the world is focused on what is happening in Greece and Europe. A lot of people are paying attention to the Middle East and geopolitics. These are significant concerns, for sure; but what has been happening in China the past few months has more far reaching global investment implications than Europe or the Middle East do. Most people are aware of the amazing run up in the Shanghai stock index and the recent “crash.” The government intervened and for a time has halted the rapid drop in the markets.

There have been a number of concerns about what this means for the Chinese economy. Is China getting ready to implode? Certainly there are those who have been predicting that outcome for some time. In this week’s letter I am going to try to explain both what caused the Chinese stock market to rise so precipitously and then fall just as fast and why we have to view China’s stock market differently from its economy.

As I have been saying for several years, in order for the Chinese economy to continue to grow, the Chinese must shift their emphasis from industrial production and infrastructure investment to a services oriented economy. That is indeed what they are trying to do, and we are beginning to see signs of the services sector taking on a role as important to the Chinese economy as services are to the US economy. They have a long way to go, but they have begun the trip.

A Transformation Like No Other

When the US stock market crashed in October 1987, commentators on that era’s primitive financial media (I recall seeing them on the large wooden box in my living room) rushed to distinguish between the country’s economy and its stock market.

The American economy, they said, is just fine. Life will go on, and businesses will make money. As it turned out, that was good analysis – and it still is today – and not just for the United States. Stock markets do reflect the economy over time, but they can lead it or lag it for years.

Anyone who owns China stocks has probably sought solace in such thinking the last few weeks. The Chinese stock bubble is deflating in spectacular fashion. The sharp decline and Beijing’s flailing efforts to stabilize the market have many economists seeing deeper trouble.

We’ll compare and contrast the Chinese stock market and economy by looking at an unusual but very reliable data source. With apologies to Anthony Bourdain, whom I quoted at the beginning of the letter, we can know China. We just have to ask the right people the right questions.

Back in 1987, as American investors were licking their wounds, the Shanghai skyline looked like this:

Here is a 2013 view from the same spot:

Photo credit: Carlos Barria, Reuters

A lot can change in 26 years. Transformations like this are commonplace in China. Gleaming cities now tower over what was undeveloped land a decade or two ago. Most of those cities even have people living in them, although the ghost cities are legendary.

You can crunch any numbers you like in any way you like, and it will be clear that China’s rapid growth is unprecedented. It is changing the course of human history. China has moved more than 250 million people from living a medieval lifestyle in the country to living and working in these fabulous new cities. And they have built the infrastructure to connect and supply them.

Worth Wray and I explored China from many different perspectives in our e-book, A Great Leap Forward? Our all-star cast of China experts variously see both opportunity and risk. The book is getting rave reviews. If you’re interested in an in-depth analysis of China, it’s the place to start (Click here for more information and to order the book.)

In thinking about China last week, I skimmed through the book and noticed something that, with the benefit of hindsight, is simply stunning. The paragraphs I read brought all the pieces together to explain the Chinese stock market’s epic drawdown.

China GDP Versus China Beige Book

The part that made me sit up straight was in the contribution by Leland Miller of China Beige Book. His chapter “How Private Data Can Demystify the Chinese Economy” comes at the Chinese economy from a unique angle.

We all know government economic data isn’t always reliable. That is especially true in China. It is the only country in the world that can report its GDP quarter after quarter and never have to revise its calculations. That is just the most obvious of its economic data manipulations.

Even knowing that, most China analysts still rely on that GDP number, because it is all they have. That is beginning to change because of the work of Leland Miller. Leland, along with his colleague Craig Charney, decided to build an alternative analysis to government GDP numbers. Using the same methodology that the Federal Reserve uses in its quarterly Beige Book, they gather data from a network of observers all over China. Their clients – who include the world’s largest central banks – provide granular data that gives a much deeper view of the Chinese economy.

In A Great Leap Forward? [get it here on Amazon] Leland describes how China Beige Book picked up on a major change in Chinese businesses. He says the country’s 2014 slowdown was different.

The slowdown of 2013 was the result of subtle credit tightening, few signs of which were evident in official data right up until the June interbank credit crunch caused a market panic. Small and medium-sized companies during that period still wanted to access credit but found – TSF data notwithstanding – that it was difficult if not impossible to do so. 2014, intriguingly, has proven to be a very different story.

One of the most interesting dynamics we’ve tracked across corporate China has been the historical disconnect between company performance and the willingness of those companies to continue to borrow and spend. In many sectors, particularly troubled ones such as mining and property, firms typically reacted to poor results in a peculiarly Chinese way: they doubled down.

Too often, the thinking appeared to be: good results were good, but bad results were not necessarily bad, because the government was expected to step in and bail them out. Perhaps with subsidies, perhaps by ordering loans to be rolled over to another day. Firms often chose to act in demonstrably non-commercial ways.

Since early 2014, however, our data suggest a startling transformation. During the second quarter, CBB data showed a particularly broad deceleration in revenue growth nationwide: for the first time in our survey, not one sector showed on quarter improvement. Yet firms reacted to this slowdown in a surprisingly rational way: capital expenditure growth fell broadly, as did capex expectations, as did loan demand – all to the lowest levels in the history of our survey. The third quarter then showed yet another quarter of weak loan demand, with even lower levels of current and expected capex.

Firms watching the economic slowdown didn’t want to spend – and they didn’t want to borrow either. For the time being, they preferred to watch events unfold from the sidelines.

Leland says, and I agree, that this was a positive development. Both businesses and investors need the discipline of free markets. Experiencing failure forces everyone to learn what works and what doesn’t work.

In a phone call this week, Leland told me their data actually pinpointed this change in the second quarter of 2014. He thinks it was the most important single quarter in Chinese economic history. I’m sure that Leland, as an Oxford educated China historian, doesn’t say that lightly. It was in that quarter, Leland thinks, that Chinese business leaders “stopped acting Chinese.” Faced with falling demand, they did the rational thing and stopped adding new capacity. As he says in the excerpt above, they didn’t want to spend or borrow.

They just sat on the sidelines. That was a good business decision. Unfortunately, it wasn’t consistent with Beijing’s master plan.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: When China Stopped Acting Chinese was originally published at mauldineconomics.com.

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Is Gold as Dead as Florida Hurricanes?

By Dennis Miller

It’s been over 3,280 days since a hurricane hit Florida. As hurricane season comes to a close next month, only Mother Nature knows how long the streak will last.

Like many Floridians, my wife and I stayed home and rode out a hurricane—once! We’d built a home on Perdido Key, a barrier island west of Pensacola. It was engineered to withstand 150 plus mph winds, and it was a beautiful home with a master bedroom spanning the entire third floor, looking out across the Gulf of Mexico.

Hurricane Danny hit the Gulf shortly after we moved in. It was a fast moving Category I with winds gusting in the 75 - 80 mph range. Full of confidence and a bit curious, we decided to hunker down and ride it out. At the speed it was traveling, it should have been over in a matter of hours. Then, Danny caught everyone by surprise and stalled in Mobile Bay, pounding us for three days.

The waves on the Gulf were terrifying. We watched the rising tide bang boats against the rocks and sink others. Our front door had a double deadbolt with a keyhole on each side. Water shot through three feet into the room for 24 hours straight. Newly planted palm trees strained against support wires and toppled onto their sides.

We tried to get some sleep in our bedroom, but we could feel the house move with each gust of wind. We watched bits and pieces of our neighbor’s tile roof fly off and smash a few feet from our house. We were trapped and terrified for three days.

The no-hurricane record has been all over the Florida news, highlighting concern that people are becoming complacent. They don’t understand what adequate preparation entails. The storm itself can be horrific, but the aftermath can be equally disastrous, leaving people without food, water, power, and access to basic services for several days. Homes that survive a storm often have to be gutted because of mold and mildew. Without power, sewage immediately becomes a problem.

Plus, if your flood, wind, and homeowners insurance is not up to date, say hello to serious financial hardship. Many Floridians discovered too late that their policy limits had not increased with inflation and wouldn’t cover the cost of rebuilding.

Are You Crazy?—Part 1

Just for fun, I told a friend that I was thinking about selling my generator and dumping our emergency supplies. He looked at me in disbelief and finally uttered, “Are you crazy? When the next one hits, don’t try to mooch off of us. It’s every man for himself.”

Exasperated, he explained that hurricane-causing conditions had not gone away. Until the sun no longer heats the water, we no longer have large and fast temperature changes, and there are no trade winds, a hurricane is a constant threat. He was red in the face when he finished. I told him I was kidding and wanted to discuss something else: economic hurricanes.

Food, Water, a Generator, and Gold

Many financial pundits are shining the all clear signal, saying that our economy is fine. People are bailing on gold and mining stocks because they’ve dropped so low. To paraphrase my colleague, Casey Research Chief Economist Bud Conrad, gold sentiment has dropped to zero.
Take a look at the price of gold over the last decade:

Precious Metals Fall into Two Camps

High inflation (Hurricane Danny) and hyperinflation (Hurricane Katrina) are two potential threats to all of our lives. While we hope neither hits, we should still prepare.

At Miller’s Money, we put metals into two categories. The first is core holdings. This is pure insurance against a catastrophe—much the same as our hurricane survival package. Not all storms are category V. Even if we don’t have hyperinflation, during the Jimmy Carter era we experienced double-digit inflation that devastated a lot of retirement nest eggs. Investors holding long-term 6% certificates of deposit would have lost 25% of their buying power during a five-year period, even after they collected the 6% interest.

What if the storm intensifies into hyperinflation and its inevitable aftermath? Many of the items we keep for hurricane emergencies may come in handy if the food supply is interrupted, electricity is cut off, or the currency collapses. Metals will protect us from the rising tide of inflation and protect our purchasing power.
The second category for metals and metal stocks is investment. These holdings are bought with the express intent of selling down the road for a nice profit. There is quite a debate going on in this arena. Some experts are touting the terrific buying opportunity. Others say gold is an ancient relic and there are a lot of better investment opportunities available. Should you take advantage of the buying opportunity or unload?

We set strict position limits in the Money Forever portfolio. When you’re investing money earmarked for retirement, which is our focus, the speculation portion is limited because preserving capital is the overriding consideration.

Gold stocks fall into two general categories. The first is established mining companies and the second is exploration and development companies. Stock in the first group is more directly related to the current price of gold. Every dollar fluctuation in the price of gold adds or subtracts from their net profit as their costs are primarily fixed.

For exploration and development companies, it’s a combination of the price of gold, their ability to raise capital, and a heavy emphasis on the economic viability of their discovery. In a large number of cases a major mining company buys them out and takes them into the production phase.

In both cases, there are certain events that can produce spectacular results; however, the risk is also high. The real question is do you have room to invest any more capital in the speculative portion of your portfolio? That’s up to the individual investor to answer. If you do have room, there are some incredible bargains in the market today. Our metals team travels the globe and has identified many candidates selling at true bargain-basement prices.

What about your core holdings? Should you buy or lighten your portion of metals? The first question to answer is: do you have ample core holdings at the moment? We recommend holding 10% - 20% of your net worth in core holdings, depending on your comfort level. (Mining stocks are generally not core holdings; they are speculative.) A lot of investors are slowly building to that target. If you think you should add more, then the current prices present a terrific opportunity.

Once you add to these core holdings, then the daily price fluctuations are no more relevant than the price of the case of beef stew we have stored in our closet. It’s insurance for a catastrophe we hope never happens. When the big one hits, we could probably sell our stew for an astronomical sum, but we won’t because it will help us survive. We would use some of our metal holdings, priced at current value, to buy things we need.

Are You Crazy?—Part 2

The same friend who was flabbergasted by my pretend plan to dump our hurricane supplies asked if I planned to sell any of our gold. I looked at him and asked, “Are you crazy?” Then I explained that the conditions that spawn inflation have not gone away either.

The reasons to own gold have compounded over the last decade. The U.S. government has printed trillions of dollars, our country’s debts are out of sight, and the Chinese and Russians are doing everything they can to oust the U.S. dollar as the world’s reserve currency. When the world no longer needs or wants to hold dollars, they will fly out the door faster than any hurricane wind mankind has ever seen. The value of the dollar will drop like a two-ton anchor and the price of gold will soar.

Precious metals are insurance against the ultimate financial hurricane. Fiat currencies eventually collapsed; the U.S. dollar will not get a free pass. Just as sure as the sun heats the water, we have large and fast temperature changes, and there are trade winds, an overly indebted government will experience a currency collapse.

We have all had ample warning and should be prepared. Don’t be fooled by the short term thinking.

For more up to date economic analysis and time-tested tips for protecting your nest egg, sign up for our free weekly e-letter, Miller’s Money Weekly

The article Is Gold as Dead as Florida Hurricanes? was originally published at millers money

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Can Central Planners Revive China’s Economic Miracle?

By John Mauldin

For years, when asked whether I thought China would experience a hard landing, I would simply answer, “I don't understand China. Making a prediction would be pretending that I did, so I can’t.” The problem is that today China is the most significant macroeconomic wildcard in the global economy. To understand both the risks and the potentials for the future you have to reach some understanding of what is happening in China today. Last week we started a two part series on what my young associate Worth Wray and I feel is the significant systemic risk that China poses to global growth.

The first thing in my inbox this morning here in Tuscany was a note from a friend about the growing scandal in Quingdao. For a long time many of us have known that there has been “double counting” in the commodities trade sector in China, where local “entrepreneurs” create multiple warehouse receipts on which to borrow money cheaply, and then invest in what are essentially subprime securities that pay higher rates. Everyone “knows” that the government is not going to let anyone lose money on investments, so what could possibly go wrong? It turns out that Chinese warehouse officials are now emigrating in significant numbers to parts unknown around the world, armed with only their passports and whatever money they made through producing such bogus receipts.

My sources suggest that the size of the problem is approaching $1.3 billion (far greater than the number being bandied about in public reports). Since one of the guiding principles operative in any scandal is that there is never just one cockroach, I expect the ultimate losses to be far larger. And it appears that the People’s Bank of China is finally going to let people lose money on these fraudulent schemes. Good for them. But to suggest there is no risk in cleaning up corruption and fraud misses the point of our own subprime crisis. In a world where global economic trade and international banks are so intricately linked, trying to determine the actual risk to the system is difficult. And as I will note in my “final thoughts” section, corruption is a very real issue.

We are going to try gamely to finish with China today, having left at least three or four letters worth of copy on the editing floor. There is just so much information and misinformation to cover. I’m going to turn it over to Worth and then follow up with a few final thoughts of my own. (Please note that this letter will print exceptionally long as there are a number of charts and other graphics.) Now let’s do a deep dive into part two.

Can Central Planners Revive China’s Economic Miracle?

By Worth Wray
In my Thoughts from the Frontline debut this past March (“China’s Minsky Moment?”), I highlighted the massive bubble in Chinese private-sector debt and explored the near-term prospects for either (1) a reform-induced slowdown or (2) a crisis-induced recession. Unfortunately, it was not an easy or straightforward analysis, considering the glaring inconsistencies between “official” state compiled data and more concrete measures of all real economic activity, which is why I suggested that China is simultaneously the most important and most misunderstood economic force in the world today.

With the stakes now higher than ever, I returned to Asia’s “miracle” last week (“Looking at the Middle Kingdom with Fresh Eyes”) and probed deeper into the shadows (including China’s shadow banks) with the help of my new friend Leland Miller and a few illuminating excerpts from his Q1 2014 China Beige Book (the largest and most comprehensive survey series ever conducted on a closed or semi-closed economy).
Pulling back the Bamboo Curtain, Leland’s data revealed aspects of the Chinese economy that John and I could have only guessed at before, giving us a rare opportunity to explore regional contrasts in Chinese economic activity, to survey the modest (but still insufficient) rebalancing among sectors, and to identify a series of pressure points within the credit markets that suggest last summer’s interbank volatility may return in 2014.

Unfortunately, Leland’s key insights confirmed our fears that China’s consumption-repressing, debt-fueled, investment-led growth model is slowing down and starting to sputter… but not collapsing (at least not yet). 

What happens next – with huge implications for global markets – depends largely on the economic wisdom and political resolve of China’s central planners, who must find a way to gradually deleverage overextended regional governments and investment-intensive sectors while also rebalancing the national economy toward a consumption driven growth model.

Finessing the challenges will require not just one but a series of miracles.

Like Every Other Investment-Driven Growth “Miracle” 

After 34 years of booming economic growth averaging over 9% per year (the longest sustained period of rapid economic growth in human history), China’s credit-fueled, investment-driven growth model is exhausted and increasingly unstable. As you can see in the chart below, the Middle Kingdom’s credit boom is well past the point of diminishing marginal returns; and no one can deny that the misallocation is widespread, with capacity utilization now below 60%. (I should also note that Societe Generale’s Wei Yao has consistently published some of the best research on China in recent quarters; personally, I won’t be surprised to see her vault to rock-star status as the People’s Republic decelerates.)


Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.

Moreover, state perpetuated distortions in the cost and availability of financing are (1) funneling huge amounts of capital toward increasingly unproductive, state directed investments, and (2) pushing household and private business borrowers into the shadows, where the burden of substantially higher interest rates drags on household consumption.


Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.

It doesn’t require much imagination to connect the dots. Structural distortions in Chinese financial markets are a major cause of debt fueled overinvestment; and without sweeping structural reforms (along with a major crackdown on corruption at all levels of government), captive capital will continue to flow toward unproductive investments, capacity utilization will continue to fall, and China’s investment boom will continue its march toward a mega Minsky moment.

This kind of structural distortion is a classic symptom of an overextended investment boom and a warning sign that rebalancing – whether it’s induced by voluntary reforms or an involuntary debt crisis – will not be easy. The critical adjustments – gradual deleveraging and structural rebalancing – will require a greater slowdown in economic growth and a sharper fall in still-bubbly asset prices than China’s policymakers are letting on.

“This is not an easy task,” The Daily Telegraph’s Ambrose Evans Pritchard says, in a truly brilliant article published this week, “not least because land sales and taxes make up 39% of state revenue in China, and the property sector employs 20% of workers one way or another. It is clearly a bubble of epic proportions and already losing air. Mao Daqing from Vanke – China’s top developer – says total land value in Beijing has been bid up to such extremes that is on paper worth 61.6pc of America’s GDP. The figure was 63.3pc for Tokyo at the peak of the bubble in 1990.” Yikes.

As Peking University professor Michael Pettis explains in his 2013 book, Avoiding the Fall: China’s Economic Restructuring, “Every country that has followed a consumption-repressing, investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led to either a debt crisis or a lost decade of very low growth.”
China’s “miracle” is no different from any other investment-driven growth binge where high levels of leverage (directly or indirectly paid for by the household sector), combined with high levels of fixed investment, eventually result in excessive and unsustainable debt loads. Pettis elaborates:

While these policies can generate tremendous growth early on, they also lead inexorably to deep imbalances. As demonstrated by the history of every investment-driven growth miracle, including that of Brazil, high levels of state-directed subsidized investment run an increasing risk of being misallocated, and the longer this goes on the more wealth is likely to be destroyed even as the economy posts high GDP growth rates. Eventually the imbalances this misallocation created have to be resolved and the wealth destruction has to be recognized. What’s more, with such heavy distortions imposed and maintained by the central government, there is no easy way for the economy to adjust on its own…. [Furthermore], Beijing [will] not be able to raise the consumption share of GDP without abandoning the investment-driven growth model altogether.

In other words, the world’s second largest economy is approaching its debt limit and the end of the line for investment led growth… but China’s financial system is structurally designed to prevent capital from flowing freely toward more productive uses. One way or another, the world’s largest contributor to global economic growth must slow down – either because Beijing has the foresight, resolve, and political capital to pursue aggressive economic and financial market reforms or because party elites fail to address the country’s structural imbalances and policy-induced distortions before the credit bubble pops. “Debt,” Pettis explains, “as we will learn over the next few years in China, has always been the Achilles’ heel of the investment-driven growth model…”

Which Way to Sustainable Growth?

Among the various reforms set forth in last November’s Communist Party Third Plenum, ranging from financial liberalization to a crackdown on corruption and pollution, the most challenging is the gradual deleveraging of the Chinese economy while simultaneously rebalancing the national economy toward a more sustainable, consumption-driven growth model.

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The article Thoughts from the Frontline: Can Central Planners Revive China’s Economic Miracle? was originally published at Mauldin Economics

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Mining and the Environment — Facts vs. Fear

By Laurynas Vegys, Research Analyst

“I would NEVER invest in a mining company—they destroy land, pollute our water and air, and wreck the habitat of plants and animals.”


These were the points made to me by a woman at a social gathering after I told her what I do for living. She prided herself on her moral high ground and looked upon me with obvious disdain. It was clear that as a mining researcher, I was partly responsible for destroying the environment.

I knew a reasonable discussion with her wouldn’t be possible, so I opted out of trying. (As Winston Churchill said, “A fanatic is one who can’t change his mind and won’t change the subject.”) She left the party convinced her position was indisputably correct. But was she?

Not at all.

In fact, with few exceptions, today’s mining operations are designed, developed, operated, and ultimately closed in an environmentally sound manner. On top of that, considerable effort goes into the continued improvement of environmental standards.

My environmentalist acquaintance, of course, would loudly disagree with those statements. Many people may feel uncomfortable investing in an industry that’s so closely scrutinized and vehemently criticized by the public and mainstream media—whether there’s good reason for that criticism or not. This actually is to the benefit of those who dare to think for themselves.

So let’s examine what mining REALLY does to the environment. As Doug Casey always says, we should start by defining our terms…

How Do You Define “Environment”?

In modern mining, the term “environment” is broader than just air, water, land, and plant and animal life. It also encompasses the social, economic, and cultural environment and, ultimately, the health and safety conditions of anyone involved with or affected by a given mining activity.

Armed with this more comprehensive view of the industry’s impact on the environment, we can evaluate the effects of mining and its benefits in a more holistic fashion.

Impact on the Economy

According to a study commissioned by the World Gold Council, to take an example from mining of our favorite metal, the gold mines in the world’s top 15 producing countries generated about US$78.4 billion of direct Gross Value Added (GVA) in 2012. (GVA measures the contribution to the economy of each individual producer, industry, or sector in a country.) That sum is roughly the annual GDP of Ecuador or Azerbaijan, or 30% of the estimated GDP of Shanghai, China. Here’s a look at the GVA for each of these countries.

Keep in mind that this doesn’t include the indirect effects of gold mining that come from spending in the supply chain and by employees on goods and services. If this impact were reflected in the numbers, the overall economic contribution of gold mining would be significantly larger. Also, it’s evident that gold mining’s imprint on national economies varies considerably. For countries like Papua New Guinea, Ghana, Tanzania, and Uzbekistan, gold mining is one of the principal sources of prosperity.

Another measure of economic contribution is the jobs created and supported by businesses. The chart below shows the share of jobs created of each major gold-producing country.

The four countries with the highest numbers of gold mining employees are South Africa (145,000), Russia (138,000), China (98,200), and Australia (32,300). The industry also employs 18,600 in Indonesia, 17,100 in Tanzania, and 16,100 in Papua New Guinea. (As an aside, it’s quite telling that South Africa employs more gold miners than China, but China produces more gold than South Africa.)

Note that these employment figures don’t include jobs in the artisanal and small-scale production mining fields, or any type of indirect employment attributable to gold mining—so they understate the actual figures
For many countries, gold mining accounts for a significant share of exports. As an example, gold merchandise comprised 36% of Tanzanian and 26% of Ghana’s and Papua New Guinea’s exports in 2012.

Below, you see a more comprehensive picture of gold exports by 15 major gold-producing countries.

Other, often overlooked ways in which the mining industry supports the economy include:

• Foreign Direct Investment (FDI). The three mining giants—Canada, the United States, and Australia—have been dominating this category for a number of years, both as the primary destinations for investment and as the main investor countries.

• Government revenue. All mining businesses, regardless of jurisdiction, have to pay certain levies on their revenue and earnings, including license fees, resource rents, withholding and sales taxes, export duties, corporate income taxes, and various royalties. Taken all together, these payments make up a large portion of overall mining costs. For example, estimates suggest that the total of mining royalty payments in 2012 across the top gold-producing countries worked out to the tune of US$4.1 billion. This, of course, doesn’t account for other types of tax normally applied to the mining industry.

• Gold products. Gold as a symbol of prosperity and the ultimate “wealth insurance” is very important to many nations around the globe—especially in Asia and Africa. Gold jewelry is given as a dowry to brides and as gifts at major holidays. In India, the government’s ban on gold purchases by the public led to so much smuggling that the incoming prime minister is considering removing it. Chinese, Vietnamese, and peoples of India and Africa may all be divided across linguistic lines, but they all share the view of gold being a symbol of prosperity and ultimate insurance against life’s uncertainties.

It’s also important to note that jobs with modern mining companies are usually the most desirable options for poverty stricken people in the remote areas where many mines are built. These jobs not only pay more than anything else in such regions, they provide training and health benefits simply not available anywhere else.
Mining provides work with dignity and a chance at a better future for hundreds of thousands of struggling families all around the world.

Let’s now have a look at the most debated and contentious side to mining.

Impact on the (Physical) Environment

In previous millennia, humans labored with little concern for the environment. Resources seemed infinite, and the land vast and adaptable to our needs. An older acquaintance of ours who grew up in 1930s Pittsburgh remembers the constant coal soot hanging in the air: “Every day, it got dark around noon time.” Victorian London was famous for its noxious, smoky, sulfurous fog, year round.

Initially, the mining industry followed the same trend. Early mine operations had little, if any, regard for the environment, and were usually abandoned with no thought given to cleaning up the mess once an ore body was depleted.

In the second half of the 20^th century, however, the situation turned around, as the mining industry realized the need to better understand and mitigate its impact on the environment.

The force of law, it must be admitted, had a lot to do with this change, but today, what is sometimes called “social permitting” frequently has an even more powerful regulatory effect than government mandates. Today’s executives understand that good environmental stewardship is good business—and many have strong personal environmental ethics.

That said, mining is an extractive industry, and it’s always going to have an impact. Here’s a quick look at some of the biggest environmental scares associated with gold mining and how they are confronted today.

Mercury

Symbol: Hg

Occurrence in the earth’s crust: Rare

Toxicity: High

Mercury, also known as quicksilver, has been used to process gold and silver since the Roman era. Mercury doesn’t break down in the environment and is highly toxic for both humans and animals. Today, the use of mercury is largely limited to artisanal and illegal mining. Industrial mining companies have switched to more efficient and less environmentally damaging techniques (e.g., cyanide leaching).

Developing countries with a heavy illegal mining presence, on the other hand, have seen mercury pollution increase. The United Nations Industrial Development Organization (UNIDO) estimates that 1,000 tons of mercury are annually released into the air, soil, and water as a result of illegal mining activity.

To help combat the problem, the mining industry, through the members of the International Council on Mining & Metals (ICMM), has partnered with governments of those nations to transfer low- or no-mercury processing technologies to the artisanal mining sector.

Sodium Cyanide

Mining compound employed: NaCN

Occurrence in nature: Common

Toxicity: High

This is one of the widely used chemicals in the industry that can make people’s emotions run high. Historically considered a deadly poison, cyanide has been implicated in events such as the Holocaust, Middle Eastern wars, and the Jonestown suicides. Given such associations, it’s no wonder that the public perceives it with alarm, without even adding mining to the equation.

It is important, however, to understand that cyanide:

• is a naturally occurring chemical;
• is not toxic in all forms or all concentrations;
• has a wide range of industrial uses and is safely manufactured, stored, and transported every day;
• is biodegradable and doesn’t build up in fish populations;
• is not cumulative in humans and is metabolized at low exposure levels;
• should not be confused with Acid Rock Drainage (ARD; see below); and
• is not a heavy metal.

Cyanide is one of only a few chemical reagents that dissolves gold in water and has been used to leach gold from various ores for over a hundred years. This technique—known as cyanidation—is considered a much safer alternative to extraction with liquid mercury, which was previously the main method used. Cyanidation has been the dominant gold extraction technology since the 1970s; in Canada, more than 90% of gold mined is processed with cyanide.

Despite its many advantages for industrial uses, cyanide remains acutely toxic to humans and obviously is a concern on the environmental front. There are two primary environmental risks from gold cyanidation:

• Cyanide might leach into the soil and ground water at toxic concentrations.
• A catastrophic spill could contaminate the ecosystem with toxic levels of cyanide.

In response to these concerns, gold mining companies around the world have developed precautionary systems to prevent the escape of cyanide into the environment—for example, special leach pads lined with a plastic membrane to prevent the cyanide from invading the soil. The cyanide is subsequently captured and recycled.

Further, to minimize the environmental impact of any cyanide that is not recycled, mine facilities treat cyanide waste through several processes that allow it to degrade naturally through sunlight, hydrolysis, and oxidation.

Acid Rock Drainage (ARD)

Target chemical: Sulfuric acid

ARD occurrence in nature: Common

Toxicity: Varies

Contrary to popular belief, ARD is the natural oxidation of sulfide minerals such as pyrite when these are exposed to air and water. The result of this oxidation is an increase in the acidity of the water, sometimes to dangerous levels. The problem intensifies when the acid comes into contact with high levels of metals and thereby dissolves them, which adds to the water contamination.

Once again, ARD is a natural process that can happen whenever such rocks are exposed on the surface of the earth, even when no mining was involved at all. Possible sources of ARD at a mine site can include waste-rock piles, tailings storage facilities, and mine openings. However, since many mineral deposits contain little or no pyrite, ARD is a potential issue only at mines with specific rock types.

Part of a mining company’s environmental assessment is to conduct technical studies to evaluate the ARD potential of the rocks that may be disturbed. Once ARD has developed, the company may employ measures to prevent its spread or reduce the migration of ARD waters and perhaps even treat the water to reduce acidity and remove dissolved metals.

In some places where exposed sulfide minerals are already causing ARD, a clean, modern mine that treats all outflowing water can actually improve water quality.

Arsenic

Symbol: As

Occurrence in the earth’s crust: Moderate

Toxicity: High

Similar to mercury, arsenic is a naturally occurring element that is commonly found as an impurity in metal ores. In fact, arsenic is the 33rd most abundant element in the earth’s crust and is present in rocks and soil, in natural waters, and in small amounts in all living things. For comparison, silver (Ag) is 47th and gold (Au) 79th (see the periodic table of elements). Arsenic is toxic in large doses.

The largest contribution of arsenic from the mining industry comes from atmospheric emissions from copper smelting. It can also, however, leach out of some metal ores through ARD and, when present, needs to be removed as an impurity to produce a saleable product.

Several pollution-control technologies have been successful at capturing and removing arsenic from smelting stacks and mine tailings. As a result, between 1993 and 2009, the release of arsenic from mining activities in Canada fell by 79%. Similar figures have been reported in other countries.

Mythbusters

Now, here’s our quick stab at dispelling the three most widespread myths environmentalists commonly bring up in their rants against the mining industry.

Myth 1: Mining Uses Excessive Amounts of Land

Reality: Less than 1% of the total land area in any given jurisdiction is allotted for mining operations (normally far less than that). Even a modest forestry project affects far more trees than the largest open-pit mine. Mining activities must also meet stringent environmental standards before a company can even get a permit to operate.

The assessment process applied to mining operations is very detailed and based on a long string of policies and regulations (e.g., the National Environmental Policy Act in the US). Environmentalists may claim that the mining industry is rife with greedy land barons, but there’s more than enough evidence to the contrary.

Myth 2: Mining Is Always Detrimental to the Water Supply

Reality: Quite the opposite, actually. Before mine operations start, a mining company must submit a project proposal that includes detailed water utility studies (which are then evaluated by scientists and government agencies). Many companies even install water supply systems in local communities that lack easy access to this basic resource. It’s also common for the rocks to be mined to be naturally acid-generating—a problem the mine cleans up, by its very nature.

Some die hard zealots blame the mining industry for consuming huge amounts of water, but in fact it normally only uses +1% of the total water supplied to a given community, and 80% of that water is recycled continuously.

Myth 3: Mining Is Invasive to the Natural Environment

Reality: Yes, mining activity in certain countries has led to negative outcomes for certain plants and animals—not to mention the rocks themselves, which are blasted and hauled away. However, the industry has progressed a long way in the last few decades and, apart from rare accidents, the worst is behind us now.

The key determinant here is compliance. All mining activity must comply with strict environmental guidelines, leading up to and during operations and also following mine closure. After mining activity ends, the company is required to rehabilitate the land. In some cases, the land is remediated into forests, parks, or farmland—and left in better condition than before.

It’s worth reiterating that in some cases—where there’s naturally occurring ARD or where hundreds of years of irresponsible mining have led to environmental disasters—a modern mine is a solution to the problem that pays for itself.

Can You Be Pro-Mining and an Environmentalist? Absolutely.

Gold mining (and mining in general) is extractive and will always leave some mark on our planet. Over time, however, the risks have been mitigated by modern mining technologies. This is an ongoing process; even mining asteroids instead of planet Earth is now the subject of serious consideration among today’s most visionary entrepreneurs.

Meanwhile, the (vastly diminished) risks associated with mining are far outweighed by the economic contribution and positive effects on local communities and the greater society. This net positive contribution is here to stay—unless our civilization opts for collective suicide by sending us all back to the Stone Age.

Right now, gold and gold stocks are so undervalued that you can build a sizable portfolio at a fraction of what you would have had to spend just a few years ago. To discover the best ways to invest in gold, read Casey Research’s 2014 Gold Investor’s Guide—Get it for Free Here.

The article Mining & Environment—Facts vs. Fear was originally published at Casey Research

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