"[China has] built more factories, shopping malls, condos, roads and bridges than could ever be put to good use, even assuming a dramatic upswing in global growth... Growth in actual wealth has dramatically lagged growth in credit, growth in money supply and growth in GDP. This is not sustainable."
– Mark Hart III, Corriente Advisors LLC
Why did Bernie Madoff finally get caught? After years (decades) of pulling off a multibillion-dollar Ponzi scheme, why did it all come crashing down overnight?
One might chalk up Bernie’s undoing to a sudden absence of liquidity. During flush times, client withdrawals were always covered by new incoming funds. But then came the credit crunch, too many clients made withdrawal requests at once, and poof... that was that.
Keep that in mind – you’ll see how it ties in momentarily.
“Too Big to Fail,” China Style
Source: PBS Video "The World's Largest Shopping Mall"
“The largest mall in the world,” PBS reports, “turns out not to be the famous Mall of America in Bloomington, Minn. It’s the South China Mall outside of Guangzhou, China.”
Outdoing the techniques of American consumerism, South China Mall is Disneyland, Las Vegas and Mall of America rolled into one. There are carnival rides, mini-parks, canals and lakes amid classic Western-style buildings with space for hundreds of shops.
But along with the glitz and glory of middle-class shopping, the mall’s Chinese developers seem to have imported something else — a cautionary tale of capitalist hubris. Alex Hu, a local Guangzhou boy who made it big in international business, wanted South China Mall to be a hometown monument to his success — even though Guangzhou has no major airports or highways nearby. And four years after its construction, the mall sits virtually empty of both shops and shoppers. But the Chinese have imported yet another concept familiar to Americans — South China Mall is considered too big to fail. So, employees line up for flag-raising ceremonies and pep talks about “brand building” before going off to maintain the deserted concourses meticulously.
The above picture and commentary come from a fascinating (and rather eerie) 13-minute PBS video segment on the world’s largest shopping mall. You can watch the video here of "The World's Largest Shopping Mall".
“The area that the mall occupies now was farmers’ fields five years ago,” mall consultant Ted deSwart reports. “And now, in the middle of a town that nobody in the West has ever heard of, is the largest shopping center in the world. So this really is sort of a very colorful illustration of how fast China is not only catching up with the West, but surpassing the West too.”
As Sarah Palin might say, you betcha!
Trouble is, the Chinese dragon has not only glommed on to the “best practices” of Western capitalism, but the very worst practices too. As a glittering monument to folly, the South China Mall is as foolish and expensive as anything America could have dreamed up. (Actually, scratch that. The South China Mall is far bigger than any monstrosity America could have dreamed up. The Mall of America in Minnesota, the previous record holder, is less than half the size of this new beast. And the MOA at least has visitors...)
Landslide Coming?
Other “boots on the ground” type reports from China deliver similar verdicts. The construction is out of control. Buildings sprout like weeds, only to stand empty or even be torn down again.
Mark Hart, a money manager with Corriente Advisors out of Forth Worth, Texas, sees China as a “communist propaganda machine” according to The Dallas Morning News. Unlike those who see China as invincible, Hart believes the dragon’s success is a false front, born of even more aggressive Keynesian policies – i.e. government spending gone wild – than the U.S. has implemented.
The hundreds of billions that China has rammed down the throat of its economy have shown up in some very odd places. By some estimates, at least a quarter of it has made its way directly into speculative plays – aggressive bets on commodities and the stock market. Billions more have no doubt been funneled into “Too Big to Fail” projects like the South China Mall.
Hart thinks the complacency surrounding China will only make the break that much worse when reality hits. “It’s like the mudslide after a heavy rain,” he said at an investor conference. “The more it rains, the more unstable the hillside becomes. Eventually, a landslide ensues.”
The Perils of Complacency
China’s big advantage in all this is an overflowing war chest. Unlike, say, the U.S. or Great Britain, China is not forced into a pattern of “borrow and spend.” Instead, the dragon can draw down its huge cash surplus.
But could this major advantage also be China’s Achilles’ heel?
There is nothing quite like a few trillion in reserves (or so your editor speculates) to make a country feel invincible. So invincible, in fact, that boondoggles like the South China Mall can be propped up all over the country for a seemingly indefinite length of time.
Why, China is so rich they can afford to do anything! Heck, they can even afford to replicate the exact same mistakes foisted upon the world by Alan “Easy Money” Greenspan and the ensuing subprime crisis. Chinese banks can be forced to lend in stunning amounts to any business that can fog a mirror, with the government backing their every move. Bad loans can be rolled over in perpetuity, postponing the day of reckoning for as long as Beijing likes.
And everything will be just fine because, just as U.S. housing prices can never fall – the central conceit that drove the entire housing bubble – the Chinese government can never run out of cash. Right?
To be clear, the major risk here is not that China squanders its pocket money on sixteen-million-square-foot vanity projects (though such projects are by no means cheap).
No, the major risk is that China itself has become a retail ghost town... a manufacturer to the world plagued by deadly overcapacity.
Hugh Hendry, the head of Eclectica Asset Management, put it well in a Financial Times interview earlier this year:
My fear is that China and its contemporaries have built productive capacity not only to service a $14 trillion dollar U.S. economy, but to service an economy and an America that they believed would be $20 trillion dollars in seven years time. My fear is that it could be closer to $15 trillion dollars...
Think of all China as a single giant factory: Billions of square footage, covered with workers and industrial machines.
Now imagine that, like the South China Mall, the problem on the whole was overbuilding... a failure of the “build it and they will come” ethos... and that much of the great factory that is China has actually gone silent (due to a mass shortfall in projected customer demand).
As long as the factory owners (i.e. Beijing) can keep up appearances via rampant stimulus spending and reckless bank loan creation, how would we even know anything was wrong? If it is true that China has overestimated long-run customer capacity on a grand scale (as Hugh Hendry and others fear), not even Beijing’s pockets will be deep enough...
“A Rolling Loan Gathers No Loss”
Circling back to this exquisitely bizarre market rally, here is your editor’s take:
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Beijing has directly emulated the stimulus plans of the U.S. Fed and Treasury. The hundreds of billions of dollars’ worth of rainy day funds pumped into China’s economy, combined with forced loans doled out by China’s banks, have created a huge, yet temporary, multiplier effect.
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As far as bad loans go, Chinese banks and U.S. banks are running the same stall-and-delay playbook. In the United States, banks are hiding a veritable tsunami of losses on residential and commercial real estate loans. This not hard to do, especially given current lax accounting practices. Even the Federal Reserve has recognized the problem. A Federal Reserve presentation obtained by the Wall Street Journal observes that “Banks will be slow to recognize the severity of the [CRE] loss – just as they were in residential.”
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China is also emulating the U.S. Fed and Treasury in terms of directly propping up shaky institutions. “China’s $300 billion sovereign wealth fund said it will continue increasing its stakes in the nation’s three biggest lenders,” Bloomberg reports, “seeking to bolster investor confidence after Chinese shares fell last quarter.”
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“A Rolling Loan Gathers No Loss.” In its October communication to shareholders, money management firm Hayman Advisors coined the pithy phrase just noted. As Hayman further observes, “In an environment where credit is unlimited and underwriting standards are all but non-existent, it is pretty hard to default or be delinquent on a loan when it can be constantly refinanced or termed out to an even larger one... the current situation is only sustainable as long as credit continues to expand at a dizzying pace. [The Chinese lending situation] feels eerily similar to credit markets in the United States in 2006-2007.”
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The perpetual hiding of loan losses and state-sponsored bidding up of assets have lent false weight to the bulls. Evidence of true economic recovery is still very thin on the ground, while evidence of pain and trouble continues to mount. For regional banks, small businesses, and the average U.S. consumer, the state of affairs has passed beyond “dire” and headed into the realm of “catastrophic.” Yet this has all been successfully ignored – deliberately swept under the rug – by way of the supposed healing taking place on Wall Street, a process in which the megabanks use government funds to profit from asset inflation at taxpayers’ expense.
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As various wise men have observed, that which cannot go on indefinitely must stop. To the degree that this global market rally is perpetuated by stall-and-delay tactics, mass stimulus schemes, and uncritical bad loan extensions in both China and the United States, the true state of the global economy gets worse, not better. The longer that euphoric falsehoods are celebrated as true, the more disconnected markets become from underlying reality – yet again.
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I’m a Madoff, You’re a Madoff
In sum, China holds the key to understanding this rally because Beijing has joined hands with Washington. Both power centers have rewarded mass speculation and a mass squandering of wealth by pouring good taxpayer money after bad, pretending that the best medicine is more of the same.
Meanwhile the bears have been tortured by logic, watching feats of impossible levitation unfold before their very eyes, because the key underlying driver for this extended run of global euphoria has been more deceptive, and more Madoff-like, than just about anyone could have imagined.
To wit, it has not been the impact of stimulus alone (nor positive investor sentiment alone) that has kept the raucous party going, but a frank willingness to “extend and pretend” to an astonishing degree... a concerted, sustained effort on the part of Beijing and Washington to keep the illusion intact as long as possible, violating every conceivable free market tenet under the sun while doing so.
And thus, at some point the extend-and-pretend merry-go-round will come to a jarring halt... just as it did for Bernie Madoff.
On balance, it’s more fun to be an optimist. It feels better when one has reason to be bullish on America, on China, on the global economy at large. (And in the longer term, your editor does count himself an optimistic bull in many respects.) But episodes like this just do not end well. They end, in fact, in crashes and chaos.
When the powers that be force us all to become complicit in a giant Madoff scheme, the bullish logic becomes toxic... like a feel-good drug that takes you high as the heavens now, only to crash you down into the gutter later. To stall, delay and deceive is to invite future ruin – just as Bernie Madoff delighted his clients for years before wiping out their hopes in one stunning reveal.
Warm Regards,
JL
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