Does China have a Golden Parachute

Does China have a Golden Parachute?A New Zealand perspective

4 March 2016

Remember when inflation was enemy number one in world economics?

Funny how now it is the one thing that every central bank on the planet craves for (and at any cost).

The difference today is debt. The world economies are so laden with debt that inflation is the friend they need in their sinking ship to stay afloat. Inflation means that every dollar borrowed today gets to be repaid with 90 cents in the future for an asset that is growing in value.  

Deflation on the other hand means that a dollar borrowed today results in a $1.10 repayable in the future for an asset that is declining rapidly in value.

Debt (both public debt and private debt) is a real worry when deflationary pressures are in play.

NZ Public Debt Exposure

The estimated NZ national debt currently (Mar 2016) stands at $119b with interest on this around 5% pa equates to $5.95b of interest pa. This published national debt is only part of the jigsaw unfortunately. 

The hidden part of our debt is our exposure to derivatives. 

Derivatives are a type of insurance policy taken to protect against fluctuations in exchange rates and interest rates. Again, in a normal world such insurances are just part and parcel of prudent financial management.  Derivatives are purchased and sold to provide certainty within an acceptable range for wild variations that might occur in currency and interest rates. The key to understanding the danger of derivatives is being aware of counter-party default risk on these products. It’s all very well paying an insurance company premiums in case your house burns down, but what happens if your insurance company burns to the ground in the same fire? 

This is risk that New Zealand Inc. faces in the event of an economic melt-down. We would be forced to honour payment of the derivatives we had issued and yet not be in a position to collect on the debts owed to us by those we purchased derivatives from. i.e. we take a hit on both sides (still have liabilities to pay but no corresponding asset to collect on).

Unfortunately we only get to know the extent of the NZ Government’s exposure to derivatives once a year when they publish the NZ financial statements. Even then they are very scant on detail as to what these derivatives are, strike prices and who the counter party is. As at 30 June last year the derivatives classed as assets on our balance sheet were valued at $3.015b and those classified as liabilities were $6.261b. In a hypothetical melt down (on 30 June 2015) our exposure to derivatives would be the combined effect of having to write off our assets $3b plus pay out our liabilities $6b giving a combined hit to NZ Inc. of $9b!

These derivatives also make/lose us money each year depending on the movements in exchange rates and/or interest rates. In 2015 the Government collected $66b in taxation revenues (this includes GST, income tax, corporate tax, excise tax, duties…everything). In the same year the Government made gains on financial instruments totalling $6.2b. It is these gains and smaller than budgeted losses from non-financial instruments that gave the NZ books its surplus of $5.771b last year. It was not from collecting more revenue or spending less than budgeted… it was from winning bets on interest rate and exchange rate fluctuations which the Government showed a paper profit on.

If any particular derivative goes into freefall the cost to exit the derivative increases exponentially. So in reality NZ’s exposure under these instruments of financial destruction is far greater than the $9b shown above. $9b is only our exposure in sound, stable times.

Global Deflation

The world is suffering from deflationary pressures (blamed on a slowdown in China’s growth). When any particular country suffers from deflation the quick-fire response is to steal growth from your trading partners by devaluing your own currency which has the effect of exporting your deflation and importing inflation.

In 2015 China responded to slowing domestic growth by de-pegging the Yuan from the US dollar and devaluing the Yuan in gradual steps. This was really the first step towards a global currency war.

The Euro is facing tremendous pressure  from weakness in a number of its member economies namely Greece, Portgual, Italy, Spain etc.  In reality the only way forward for these countries is to eventually default on their debts, exit the Euro, devalue their currencies and hope to import some inflation into their economies.  The problem is that Germany would be the last man standing and be left with an ever growing deflationary pressure on their economy. So, Germany has no option but to apply massive pressure for all member countries to remain in the Euro. If one goes then potentially they all go.

Teunis Brosens, senior economist at ING suggests the time has come for the ECB to resort to direct injection Quantitative Easing (the infamous helicopter money) to put cash directly in the hands of individual consumers to get them to spend money in the economy. As I write this the ECB have a QE programme equating to 60 billion Euro per month being created. This QE money is used to purchase assets, driving down bond yields and lifting share market prices. 

Similarly the EU needs solidarity from its members to remain viable. A British exit would potentially lead to a run on countries wishing to exit the EU to protect their own export trade while imposing import tariffs to protect their own national industries.

NZ Dairy Sector Exposure

Commodity markets globally are extremely unstable. Oil in particular has been in free-fall mode but also the mining commodities like iron ore and copper.  Dairy prices have fallen dramatically such that if these low prices continue for too much longer as many as 10% of today’s dairy farmers in NZ will probably not be farming in 12 months’ time.

A prolonged downturn in the dairy industry will lead to a reduction in demand for new plant and machinery, reduction in demand for new cars, boats, holiday homes etc. Remember that dairy farmers are huge spenders within the NZ economy and as such the trickle down impact will be far greater than any other sector of the economy – Stockfeed, supplements, farm merchandising, irrigation, cropping contractors, stock agents, fuel companies, engineering companies, milk factories…etc.

One Potential Scenario for NZ

A prolonged downturn in the dairy dairy sector slowdown would eventually see a trickle-down effect to the Auckland economy within a 12-24 month period, which will lead to people trying to quit their expensive homes in favour of relocating to cheaper accommodation. This in turn triggers an immediate downturn in house prices and a rush to get out while there is still value in the house. More sellers than buyers drives values lower much quicker than a rising market. At that point we will see large numbers of people with negative equity in their homes. Banks will start demanding increased security to prop up existing loans, guarantees will be called upon…

The NZ banks having already taken a bath on the dairy sector will start taking hits on the residential sector and from that point things start to unravel rather quickly.

Here is a potential scenario of how this unravelling might occur:

The Reserve Bank responds to the crisis by cutting rates to zero, but there is still no demand for people to borrow money. The banks eager to recoup losses and to meet the increasing demands for higher interest from their offshore lenders will be forced to increase lending margins significantly. The Reserve Bank will again respond by talking negative interest rates as a possibility. People start to hoard cash, the Reserve Bank responds by imposing restrictions on cash withdrawals. The Reserve Bank then follows through on its threat to impose negative interest rates to force people to spend their savings. The opposite occurs. People start hoarding things to trade with as an alternative to cash. No-one has confidence to borrow even at negative rates because assets are falling in value faster than the rate of return that you receive on your negative interest rate.

The Reserve Bank admits defeat as it no longer has any tools left to combat deflation.

Enter the Government to put capital controls in place to stop capital exiting the country. Fiscal policy tools then come in to play as the Government seeks the Robin Hood approach of taxing the rich to keep the economy afloat.

Think this is all a little farfetched?

Such a scenario all but occurred in Japan twenty years ago. Japan did not go to the extreme of bringing in negative interest rates as their economists did not believe rates could go lower than zero percent. The difference with Japan was that the rest of the world was in boom times and was prepared to buy everything that Japan could produce. And yet despite this, Japan could not inspire confidence of its people to invest and grow their businesses even with zero rate loans.

If you think negative interest rates are a fiction ask anyone with money in Switzerland, Sweden or Denmark. In the past 6 months each of these countries have done just that. Japan last month (Feb 2016) announced its plan to go negative rates as well. 

Other Warning Signs

There are plenty of warning signs out there that things are much worse than we might be led to believe.

The oil industry for example. The oil industry has been battling these past months in the face of free-falling demand for oil and corresponding price falls. What is not widely known is that the majority of the high cost oil producers (namely the fracking boys from Canada and USA) are funded by bonds that come to maturity within the next 12 months. These bonds are sitting as assets at face value today on the lenders balance sheet but will end up as worthless junk bonds by year end as the fracking companies go broke and will be unable to refinance their debts. Not all the fracking industry borrowing was by way of bond issues – some of it was through normal commercial bank loans. None of these banks are volunteering to let us know how exposed they are to this oil industry.

The shipping industry is going through its worst time in modern history as evidenced by the all-time lows in the Baltic Dry Index. On Thursday 3 March 2016 dry bulk shipper Golden Ocean Group CEO, Herman Billung, addressed an industry conference:

"In the coming months there will be a lot of bankruptcies, counterparty risk will be on everybody's lips."

"The market has never been this bad before in modern history. We haven't seen a market this bad since the Viking age. This is not sustainable for anybody and will lead to dramatic changes."

Bank Exposures

The exposure that banks have to lending within failing commodity markets is as yet unknown, but all will be revealed when the bankruptcies start. These exposures will undoubtedly reveal some of the stronger banks are in fact insolvent. This then leads to risk premiums being loaded onto inter-bank lending which will see lending rates start to rise and a potential for difficulty for some borrowers to even refinance their existing debts.

Some of these banks will be found to hold large portfolios of derivatives which will suddenly see counterparty defaults spread a contagion of defaults throughout the financial and sovereign debt markets.

NIRP and The War on Cash

A number of countries world-wide are declaring a war on cash in preparation for NIRP (Negative Interest Rate Policy). They are doing this under the guise of reducing organised crime, drugs, tax evasion, terrorism etc. but the real thrust is to prepare people for fully digital currency that the Government can have absolute control over.  

The Eurozone countries are clearly preparing for this. In France it will be illegal to use cash for any transaction exceeding 1,000 euros from 1 September 2016. Any cash deposit or withdrawal of more than 10,000 euros will be reported to the French anti-fraud and money laundering agency. Italy already has a ban on cash transactions exceeding 1,000 euros and Spain has one at 2,500 euros.  Even economic commentators from the USA are suggesting the removal of the high denomination US dollar notes from circulation. The Federal Reserve is also not ruling out the possibly of using negative interest rates if required.

There is a lot of talk about removing the €500 note from circulation, even in the US, Larry Summers, a former Treasury Secretary and Harvard president, is pushing the U.S. to ban $50 and $100 bills.

The Reserve Bank of Australia (RBA) has recently appointed the immediate past president of Google Australia to its team to increase the Reserve Bank’s capabilities in digital currencies. The bank has also announced its plans to investigate a move to a digital currency http://www.smh.com.au/business/banking-and-finance/reserve-bank-says-australian-dollars-could-come-in-digital-form-in-future-20160223-gn0zxx.html

Japan has proven that at some point close to zero there is no incentive to borrow money when you know the asset you are borrowing for will be worth less in the future. Zero interest rates placed Japan into a coma economically for more than twenty years. Negative interest rates will be like pulling the plug on a patient reliant on life support.

Meltdown

The world is directly headed for an economic meltdown fuelled by decades of excessive and ever growing debt and asset bubbles that were not allowed to pop when they were relatively small. Low interest rates have provided the fuel for high risk lending on assets such as housing and the share market. The increased demand for these assets has inflated the asset bubble leading to more debt accumulation and an increasing appetite for yield with little or no thought to risk.

Company profits have been falling and yet their share prices continue to rise both from an increase in demand (more people buying shares) and a reduction in supply (as companies invest their own surplus cash in buying back their own shares).

Housing yields continue to fall and yet more and more demand for city housing continues to drive prices higher as employment moves with population to where the economies of scale are (in big cities). This urbanisation is a global phenomenon from Auckland to London, from New York to Shanghai.

The hunt for yield, combined with low interest rates over an extended period of time, combined with a too big to fail bail-out mentality that started in 2008 has seen the measurement of risk skewed immensely. Markets are cyclical in nature like any system. Boom will always be followed by bust, which enables markets to re-evaluate, revalue, and grow again in a sustainable fashion.  To believe otherwise and “protect” markets from failure results in a ponzie scheme on a global scale. Such is the monster we have all allowed to occur since 2008.

Demographics

In the western world we also have demographics working against us. An aging population is going to see demand side economics fail. In Germany the production of adult nappies will soon out-number baby nappies. This is already the case in Japan. This type of population shift out of the workforce means reductions in productivity will occur. It means less demand for goods and services. It means less demand for housing. It means less investment in capital, less of everything on the demand side leads to excess supply and shrinking prices. Even if we cure deflation at an economic level in the next 10 years we are still faced with the reality of deflationary pressures from an aging population. 

Germany (seen as the strongest economy in Europe) will be the first victim of the demographic demise.  Perhaps this is the problem Angela Merkel was looking to solve when deciding to open the doors to refugees from Syria.  Just as attempting to import inflation by devaluing your currency is essentially a zero-sum-gain or a race to the bottom, attempting to attract immigrants to your country by offering incentives or taxing those who try to depart will also be a zero-sum-gain.

USA has already prepared for an exodus of its wealthy citizens by imposing FATCA rules on every banking institution in the world. The Eurozone and other big players globally are looking at introducing similar measures as FATCA to control capital and labour exiting their country.

Surely if this melt-down were coming everyone would be talking about it, economists would be warning of its coming etc?

The reality is that it is not in an economists’  best interest to point out that the emperor has no clothes. Economists are not going to bite the hand that feeds them as they are invariably employed by the banks, by the Government or at least by Government funded entities. There are not enough lifeboats for the flood coming so there is no point creating widespread panic by warning the public what is coming. The Government clearly believe they have a better chance of controlling matters through their own planned initiatives (like negative interest rates and controls on cash). These initiatives rely on the element of surprise to be effective.

In the end savers will be essentially taxed to destruction as the Government seeks to repay its debts and cover its derivatives exposures. 

In a global melt-down there is no-one left to borrow from. Central banks can’t print their way out of trouble this time around without causing a crash in faith in the currency as a whole. Payment for our exports would be in default, demand for our commodities would all but dry up and the NZ economy would come to a grinding halt.

Government balance sheets globally would see massive write-downs in the value of their assets, defaults on their borrowings, and they would be looking for a way to get out of the mess relevant to their neighbour.

Enter the IMF.

The IMF are the only player with very little debt on their balance sheet. They alone have the power to issue a new currency that all countries would have faith in. They already have this currency in the form of SDR (Special Drawing Rights) which comprise a basket of currencies at relative values. China’s Yuan currency will join this basket with the current participants USD, Euro, GBP and the Yen later this year.

The IMF has the ability to issue a currency which already has the faith of the participating countries. This would have the potential to be not only the new reserve currency for world trade but also act as a backstop for the currencies within the SDR.

Will China follow suit?

China have followed suit in terms of inflating asset prices (both stock market and real estate bubbles)  and increasing debt to extreme levels. The difference with China is that they borrowed to build new infrastructure. They created excess capacity that one day will be filled. They are playing the game slightly ahead of their demographic situation.  When the bubble bursts they will still have their physical assets along with a growing population to demand them. Elsewhere in the world we will have assets and infrastructure that will be aging, falling into disrepair, and falling demand for their use.

China play the long game. They plan generations ahead not 4 years ahead. So what is their game?

Let’s look at what they are buying and selling for clues.

China are selling their foreign reserves i.e. US Treasury bonds. Q. Who is buying them? A. Difficult to tell as it appears mystery buyers of these are buying though institutions in Brussels. You can bet it’s not the Belgian's  buying these. Rumour has it that the Federal Reserve is buying these to keep the demand for the US dollar going. Regardless who is buying the Chinese are selling these in large quantities every month. (China were buyers until 2010.)

China is buying gold. Lots of gold.  Physical gold (not paper gold, not gold options or futures).  Not only is China the largest producer of mined gold in the world, they have also been buying vast quantities of gold each month for the past 5 or more years. The gold is being acquired from USA, Canada, European countries as well as emerging markets. Gold has been historically held by central banks as a strong asset backing for their balance sheet. It is held as a store of value, irrespective of movements in interest rates and currency movements. In essence countries used gold instead of, or together with derivatives for this purpose. Three countries are known to be buying gold in recent times. China, India and Russia.

India are in fact even willing to rent gold from their citizens by paying interest on any gold the public of India allow the Government to hold on their behalf.

Why is China buying gold?

1.  It is a natural hedge against the US dollar. Any collapse of the USD would see a run to gold for safety. China still holds vast amounts of US Treasury Bonds so it makes sense that they would want to create an insurance policy to protect themselves if the dollar collapsed and made their Treasury bonds worthless.

2.  Bill Holter from JSMineset.com believes China plan to devalue the Yuan against gold. Instead of devaluing against the US dollar, if China devalue their currency against gold they are essentially going to collapse the entire global financial system as it forces the devaluation of all global currencies along with it. This then makes gold extremely valuable for countries that still have it. Gold reserves held by a central bank then become the backing for revaluing the country’s balance sheet and essentially allows the country to move forward with debt (denominated in their old currency) wiped clean.

So what would China end up with under scenario 2?

An initial collapse, followed by default on the treasury bonds it holds, followed by devaluation of all currencies, followed by write-off of its treasury bonds after offsetting the write of its own debts owed, a revalued Treasury full of gold, brand new infrastructure that cost pittance in terms of the replacement cost to build if using gold as the currency.

China would emerge as the super-power economy that could pick off any key economic or strategic asset it desires globally to acquire at cents on the dollar.

What about Bitcoin and other Cryptocurrencies as a hedge?
This relatively new asset class appears to have tremendous potential as a store of value that is uncorrelated to other assets. Bitcoin in particular with its distributed ledger "Blockchain" technology, immense security from attack (the reward for successfully attacking the network is all the Bitcoin in existence - and this has been open to every hacker in the world to attack from the day it launched in January 2009) and its ability to move currency any where, any time, instantaneously, essentially free of cost and is censorship resistant.  The pseudonymous nature of being able to disguise the owner's identity made it the favoured currency for the infamous Silk Road website where people were buying drugs, weapons etc.  These attributes coupled with scarcity of supply (there can only ever be $21m Bitcoins created, and creation or "mining" of new Bitcoins halves every 4 years or so). 

The concept of a Cyrptocurrency is relatively new. The idea was brought to reality by an anonymous person or group of persons known as Satoshi Nakamoto who solved the problem of double-spending digital currency in the production of a whitepaper in 2008. This was followed soon after with the release of code and the creation of the first block of 1 million Bitcoins on January 2009 together with the following message (quoted from https://en.bitcoin.it/wiki/Genesis_block) 

The Times 03/Jan/2009 Chancellor on brink of second bailout for banks^[1]

This was probably intended as proof that the block was created on or after January 3, 2009, as well as a comment on the instability caused by fractional-reserve banking. Additionally, it suggests that Satoshi Nakamoto may have lived in the United Kingdom.^[3]

This detail, "second bailout for banks" could also suggest that the fact a supposedly liberal and capitalist system, rescuing banks like that, was a problem for Satoshi . . . the chosen topic could have a meaning about bitcoin s purpose . . .

The current price of Bitcoin is USD$385.00 and fluctuates wildly. This volatility makes it difficult to see Bitcoin as a store of value at the present time but if a financial collapse occurred then this asset class could well be an alternative to gold based on the attributes described above. All things being equal, the scarcity and deflationary nature of the supply alone should see its value increase over time.

The use cases for Bitcoin are limited at present, however this technology may well be the future of our financial system in both currency, accountability, stewardship, governance and proof of ownership.

Bitcoin is mined or created by a network of computers racing to solve a new mathematical problem every 10 minutes. The first computer to solve it, broadcasts the solution to the other machines on the network and is rewarded with newly minted Bitcoin. The current reward is 12.5 Bitcoins and is due to halve to 6.25 Bitcoins in mid 2016. In 2020 this miner reward will again halve to 3.125 Bitcoins. The miner is free to sell these newly created coins, save them as a store of value or spend them to defray mining costs. 

The big cost of mining is the cost of hardware and electricity. The computers required to win this race need to be extremely fast in performing the calculations - fast processors = big dollars, and working these processors to perform millions of trial and error calculations per minute uses vast amounts of electricity. Processors working hard generate a lot of heat which also requires electricity to drive massive fans and heat exchangers to keep the machinery from overheating.

China inadvertently (or perhaps purposely) created an environment where the world's largest miners are found. This is due to their cold climate which helps keep the mining machinery cool and their heavily subsidised electricity for Bitcoin miners. In some cases the miners are getting their power for free (with an appropriate fee paid to the right people). 

Control of Bitcoin mines is almost the equivalent of control of gold mines. Control production and supply of scarce mined assets can create additional scarcity and demand which in turn sees prices skyrocket in times of economic turmoil.

With the knowledge of an imminent collapse in credit coupled with some insurance by way of increasing gold reserves, brand new infrastructure, and the majority of Bitcoin mines residing inside their borders it is not hard to see why China was so happy to join the world debt accumulation game in recent years. They clearly had their exit strategy worked through before climbing the debt ladder in what they must know will be a free-fall to the bottom… the difference between China and the western world is they have a golden parachute and a Bitcoin reserve chute.

© 2016