The End of the Communist Dynasty

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By Craig Tin­dale

There is a cri­sis of con­fi­dence unfold­ing in Chi­na that is like­ly to end in a full scale cap­i­tal flight and a dis­or­der­ly col­lapse in both eco­nom­ic and polit­i­cal cohe­sive­ness. The low­er­ing of the reserve require­ments for Chi­nese banks, while report­ed in the media as a loos­en­ing of cred­it, is more like­ly an ear­ly sign of cap­i­tal flight. Sim­i­lar­ly reflec­tive of this, are the large increas­es of gold pur­chas­es by Chi­nese cit­i­zens who have few diver­si­fi­ca­tion options away from the RMB.

China’s wealth is con­cen­trat­ed abnor­mal­ly with­in an elite 1% of high net worth indi­vid­u­als. This 1% com­mand up to $5 USD tril­lion dol­lars in wealth. If these elite should rush the doors to move their wealth out of the coun­try using the mul­ti­tude of avenues that exist to evade Chi­nese cap­i­tal con­trols, then the Chi­nese banks may face the biggest bank run in his­to­ry.

The prob­lem is that while the pro­pa­gan­da machine might con­trol the minds of the mass­es, the wealthy elite are vir­tu­al­ly immune to thought con­trol and are like­ly to be the best informed and have the means to be the first to leave. Reserves are most­ly tied up in USD and trea­suries can­not be liq­ui­dat­ed for fear of rais­ing the val­ue of the RMB. Along with fur­ther erod­ing trade sur­plus­es, this means a cap­i­tal flight by the elite occur­ring with mas­sive insol­ven­cy in the cred­it mar­ket could vapor­ize the Chi­nese liq­uid­i­ty in what will seem like an eco­nom­ic Cat 5 hur­ri­cane.

The Chi­nese econ­o­my is in the final stages of largest Ponzi scheme ever devised. Min­sky out­lined three dis­tinct phas­es in the cred­it cycle: In the first phase known as the hedge phase; eco­nom­ic actors bor­row mon­ey to invest in order to cre­ate goods to sell for prof­it. In the sec­ond stage, the spec­u­la­tive phase, more eco­nom­ic actors join the econ­o­my, bor­row­ing mon­ey to invest in assets in the expec­ta­tion that these assets will rise in val­ue. In the last stage, known as the Ponzi stage, eco­nom­ic actors bor­row in the hope that con­di­tions will improve. This bor­row­ing is designed to avoid insol­ven­cy dur­ing what is per­ceived or hoped to be a short to medi­um term set­back in eco­nom­ic con­di­tions.

Some may argue that the Min­sky mar­ket dri­ven insta­bil­i­ty hypoth­e­sis is not suit­ed to Chi­na and that they are chiefly a cen­tral­ly planned state con­trolled econ­o­my. This reflects a fun­da­men­tal mis­un­der­stand­ing of Minsky’s work. The West­ern economies’ attempt to cen­tral­ly plan eco­nom­ic activ­i­ties from the con­sump­tion end, the state based cap­i­tal­ism that Chi­na has become known for attempts to cen­tral­ly con­trol the econ­o­my from the pro­duc­tion side.

The Chi­nese pro­duc­tion econ­o­my can­not be seen in iso­la­tion from the con­sump­tion economies of the West; debt based con­sump­tion pro­vid­ed the umbrel­la under which the Chi­nese mir­a­cle grew. When the GFC col­lapsed West­ern debt based con­sump­tion react­ed by pro­vid­ing the last line of Min­sky Ponzi financ­ing via gov­ern­ment bail-outs. Gov­ern­ments faced with bank­ing col­lapse chose keep the sys­tem going by trans­fer­ring debt from pri­vate hands to those of the tax­pay­ers.

The Chi­nese, faced with a mas­sive col­lapse in export income, chose to keep the econ­o­my func­tion­ing by stim­u­lat­ing the econ­o­my with mas­sive cap­i­tal works and lend­ing. In both cas­es the gov­ern­ment was the provider of the last line Ponzi financ­ing to keep the econ­o­my rolling.  Now that this Ponzi financ­ing has been near exhaust­ed in both the West and the East, pro­found col­lapse is the only log­i­cal out­come.

Where­as the Min­sky moment in West­ern economies comes by way of over-enthu­si­as­tic pri­vate bor­row­ers, the insta­bil­i­ty in Chi­na is poten­tial­ly more vir­u­lent in that its source is an over-enthu­si­as­tic gov­ern­ment: the for­mer rely­ing on the sol­ven­cy of bor­row­ers and the lat­er rely­ing on the sol­ven­cy of the state.  Some argue that while the Chi­nese state remains sol­vent, no mat­ter how many emp­ty build­ings exist they can con­tin­ue the game.  The ques­tion then is — Are they sol­vent and how long can they remain that way? The expo­nen­tial growth in Chi­nese debt and mal-invest­ment and the very unlike­ly return of West­ern demand means the sys­tem will become insol­vent in the short to medi­um term.

The num­ber of investors who have suf­fered loss­es due to wide­spread fraud is grow­ing expo­nen­tial­ly and the list of those that have racked up sub­stan­tial loss­es includes some of the lead­ing investors in the world.  This list of investors includes invest­ment leg­ends like Antho­ny Bolton one of Europe’s most well-known fund man­agers, leg­endary invest­ment icon John Paul­son have been the vic­tims of fraud, the scale of which has nev­er been seen in eco­nom­ic his­to­ry.

Bolton came out of retire­ment in 2009 specif­i­cal­ly to invest in Chi­na and his invest­ments have turned into a com­plete dis­as­ter. In fact, Bolton was forced to offer an apol­o­gy for his com­pa­nies poor per­for­mance after los­ing 28.9% of its near­ly 430M pound cap­i­tal­iza­tion in the last six months of 2011 Antho­ny Bolton apol­o­gis­es for Chi­na fund’s poor per­for­mance. Ram­pant fraud was evi­dent right at the core of his invest­ment dif­fi­cul­ties. This appears to have reached epi­dem­ic pro­por­tions right across the Chi­nese cor­po­rate land­scape, so much so that Bolton has been forced to turn to pri­vate inves­ti­ga­tors after investors in Fideli­ty’s Chi­na fund suf­fer loss­es of 21%.

Bolton wasn’t the only one. The leg­endary investor John Paul­son is being sued by his investors after los­ing $462M of his 23B fund invest­ing in Sino For­est Paul­son Fund Sued Over Sino-For­est Loss­es. The Sino For­est deba­cle was kicked off with a 19 page report issued by Car­son Block of Mud­dy Water Sino For­est Report. This report didn’t mince words and came out form the start com­par­ing the com­pa­ny to Bernie Madoff’s Ponzi scheme.

Like Mad­off, TRE is one of the rare frauds that is com­mit­ted by an estab­lished insti­tu­tion.  In TRE’s case, its ear­ly start as an RTO fraud, luck, and deft nav­i­ga­tion enabled it to grow into an insti­tu­tion whose “qual­i­ty man­age­ment” con­sis­tent­ly deliv­ered on earn­ings growth.” 

The prob­lem with Sino For­est was that most of the forests the com­pa­ny claimed as assets sim­ply didn’t exist.  Rather than being a few iso­lat­ed cas­es, these exam­ples sig­nal an epi­dem­ic of sys­temic fraud and cor­rup­tion that per­vades entire Chi­nese econ­o­my.  This sys­temic fraud direct­ly cor­re­lates to Minsky’s final Ponzi phase: cheap cred­it, floods the econ­o­my, even­tu­al­ly exhaust­ing use­ful ways it can be uti­lized. This, togeth­er with the lack of sys­temic con­trols that accom­pa­ny cheap cred­it, ini­tial­ly caus­es mal-invest­ment into projects that will nev­er return enough to ser­vice their debt. Then, hav­ing exhaust­ed all rea­son­able avenues of mal-invest­ment, large amounts get siphoned into the hands of crim­i­nal oppor­tunis­tic eco­nom­ic agents who game the sys­tem.

In Decem­ber anoth­er Chi­nese stock research firm Cit­ron came out with this report Qihoo : Fraud­u­lent Financials,Terminal Busi­ness, Or Both….You Decide. Cit­ron main­tains price tar­get of $5. In late Feb­ru­ary 2012 they sub­mit­ted this report to the SEC Cit­ron Reports to Secu­ri­ties and Exchange Com­mis­sion. Aus­tralian, John Hemp­ton of Bronte Cap­i­tal, famous local­ly for uncov­er­ing the Astara Trio Cap­i­tal Ponzi scheme, has been instru­men­tal in uncov­er­ing a long list of Chi­nese frauds includ­ing: Long­top Finan­cial Tech­nolo­gies, Uni­ver­sal Trav­el Group, Chi­na Media Express, and Chi­na Agritech

A few weeks ago, Boshi­wa Hold­ings the  licensee and man­u­fac­tur­er of Har­ry Pot­ter relat­ed toys plunged 42% on news that its audi­tor had quit. In late Feb­ru­ary Puda Coal raised a $100M from US investors based coal assets that were nev­er there: A Fraud Went Unde­tect­ed, Although Easy to Spot.

What is China’s response to this plague of fraud in Chi­nese US list­ed stocks? They intend to make it very dif­fi­cult for the Big 4 to con­tin­ue to work in Chi­na ‘Big Four’ audi­tors brace for big changes in Chi­na. In the case of Long­top Finan­cial, Deloites, the firms’ audi­tors have been unable to pro­vide the SEC with any doc­u­men­ta­tion about the col­lapse for fear of break­ing China’s state secre­cy laws.

These frauds are extreme­ly sophis­ti­cat­ed and have gone unde­tect­ed by the large audit firms. They are not just the result of a series of inde­pen­dent events under­tak­en by sim­i­lar­ly dis­hon­est busi­ness peo­ple act­ing alone. Rather, a recent report sug­gests they are part of a sys­temic net­work of agents act­ing inside and out­side of Chi­na whose main pur­pose is to per­pet­u­ate invest­ment fraud on a scale nev­er seen before in eco­nom­ic his­to­ry.

One of the cen­tral play­ers in uncov­er­ing Chi­nese invest­ment fraud research is the firm Mud­dy Waters who recent­ly pub­lished a white paper enti­tled Fraud­u­ca­tion Part I: in this paper the author out­lines how Chi­nese busi­ness­men are taught and spon­sored by experts, who spon­sor and coach fraud­sters in sub­jects like fal­si­fy­ing records, account­ing, assets and  the var­i­ous meth­ods need­ed to pull off  grand frauds. When a char­ac­ter like John Paul­son gets tak­en for near­ly half a bil­lion there is a lot of moti­va­tion on the crim­i­nal side to get things right

The fraud school’s assis­tance went well beyond pro­vid­ing doc­u­ment and account­ing tem­plates. The fraud school pro­vid­ed a net­work of “friend­ly” audi­tors that would help the com­pa­nies get through the ini­tial due dili­gence process­es. The fraud school also helped com­pa­nies game the due dili­gence process by pro­vid­ing the com­pa­nies with con­tact infor­ma­tion of sup­pli­ers and cus­tomers to give to poten­tial investors. The

sup­pli­ers and cus­tomers were frauds – the school hired them mere­ly to play a role and answer ques­tions accord­ing to the script. (Source: Mud­dy Waters)

Fraud is cen­tral to the Chi­nese sys­tem, it has emerged via vir­u­lent muta­tion of the ancient trib­ute sys­tem.  In the past, these trib­ute sys­tems reflect­ed an ancient form of pri­vate reg­u­la­to­ry order. In the past there was often a lim­it­ed basis for the rule of law to gov­ern trans­ac­tions. Through­out Chi­nese his­to­ry, trade relied on sys­tems of trib­ute to ensure secure busi­ness and polit­i­cal out­comes.

These old sys­tems were still essen­tial through­out Asia up until only a few decades ago because, trans­act­ing par­ties could not rely on the rule of law to ensure the secu­ri­ty of terms gov­ern­ing a trans­ac­tion. In Chi­na this has evolved into gov­ern­ment spon­sored sys­temic cor­rup­tion with West­ern moti­va­tions of greed and crim­i­nal­i­ty. It infects every lev­el of the pri­vate and pub­lic sec­tor.

A small piece of it was exposed recent­ly in the “Bo” scan­dal, where there are reports of it infect­ing the fam­i­lies: Not only the Bo Lai fam­i­ly but even to the high­est lev­el of gov­ern­ment- up to and includ­ing the fam­i­ly of Pro­pa­gan­da Min­is­ter, Liu Yun­shan .Who 16 elder retired  elder states­men peti­tioned to have sacked

Rather than being seen as iso­lat­ed inci­dents, these exam­ples reflect a cul­tur­al meme, a way of doing busi­ness that rep­re­sents the stan­dard oper­at­ing pro­ce­dure for a large seg­ment (if not all) of the Chi­nese econ­o­my.

The epi­dem­ic of fraud sits like a struc­tur­al ele­ment across both the pri­vate and gov­ern­ment sec­tor fur­ther mag­ni­fy­ing the mal-invest­ment caused by the mas­sive cred­it expan­sion. For exam­ple: The high speed rail project  audits reveal mil­lions have been siphoned toward cor­rupt con­trac­tors and gov­ern­ment offi­cials. This amount mere­ly rep­re­sents the siphon­ing on the core bud­get and doesn’t reflect the extra costs loaded by each of the con­trac­tors.

Take for exam­ple Hollysys, the provider of sig­nalling and con­trol sys­tems for many the Chi­nese high speed train projects. This com­pa­ny man­aged to earn ‘154M (2009)-175M(2010) with a tri­fling $3.1 M in cap­i­tal equip­ment. Their expla­na­tion for this is they out­source all man­u­fac­tur­ing, which is a lit­tle odd since they have such mas­sive build­ings, cov­er­ing hun­dreds of acres and $24M in inven­to­ries.

On its web­site, the com­pa­ny boasts of over 40 major projects cov­er­ing every­thing from Nuclear Pow­er sta­tion instru­men­ta­tion to cut­ting edge high-speed rail. All of these projects com­bined require no more than $3.1 mil­lion in cap­i­tal equip­ment? In a coun­try where cor­rup­tion is evi­dent at every lev­el, the cor­rup­tion appar­ent in the high-speed rail project was even too much for the Chi­nese sys­tem to car­ry. Chi­na’s Com­mu­nist Par­ty has expelled a once-pow­er­ful for­mer rail­ways min­is­ter accused of seri­ous cor­rup­tion, state-run media report.

Chi­na is a coun­try that is essen­tial­ly a direct­ly fund­ed fiat sys­tem, where­as in a tra­di­tion­al fiat fund­ed sys­tem the state prints mon­ey to direct­ly pur­chase goods and ser­vices. Here, the Chi­nese sys­tem achieves the same out­come by lend­ing with lit­tle prospect of repay­ment.  A sys­tem that per­pet­u­al­ly rolls over debts does not con­sti­tute a cred­it based mon­ey sys­tem. Whether they are cor­po­ra­tions or indi­vid­u­als, many of state affil­i­at­ed eco­nom­ic agents sim­ply can­not default because the lender is unwill­ing to fore­close on an influ­en­tial polit­i­cal play­er. If you can­not pay you can sim­ply ring the par­ty to arrange a rollover the bal­ance.

The funds are effec­tive­ly fis­cal stim­u­lus car­ried out gov­ern­ment-con­trolled inter­me­di­aries, state and local gov­ern­ments, who then spend these funds on projects dreamt up by cor­rupt local politi­cians. These projects are built with bor­rowed mon­ey by var­i­ous state aligned eco­nom­ic agents. These agents have lit­tle hope of repay­ing the debts incurred. This in turn means that the debts are roll over when they fall due. In real­i­ty the State is sim­ply print­ing mon­ey, spend­ing it and then at some point writ­ing it off. This is being done at a speed and scale nev­er before seen in human his­to­ry.

Jim Chanos the famous hedge fund investor who fore­saw the sub­prime cri­sis described the entire Chi­nese econ­o­my as “1000 times worse than Dubai”. In 2008, when the world expe­ri­enced the GFC, Chi­na dou­bled down and sim­ply spent their way through via mas­sive cred­it stim­u­lus. When China’s mas­sive export mar­kets shrank due to the West­ern debt cri­sis the Chi­nese elect­ed to con­vert their econ­o­my from an export based one to a con­struc­tion based econ­o­my.  Mean­while, the West­ern media per­pet­u­ates the myths of China’s sup­posed ascent to dis­place the US as being the world largest econ­o­my.

The prob­lem is that the West­ern economies nev­er recov­ered and the Chi­nese have had to con­tin­ue their mas­sive growth pure­ly based on con­struct­ing roads, bridges, air­ports, dams and var­i­ous oth­er con­struc­tion based infra­struc­ture

If one starts with the offi­cial eco­nom­ic sta­tis­tics and works down through the account­ing, tax­a­tion, bank­ing sys­tems and then across Chi­nese indus­try, there is ram­pant fraud, poor report­ing and out­right pro­pa­gan­da at every lev­el. The Chi­nese econ­o­my is large­ly a cen­tral gov­ern­ment bud­getary sys­tem of fis­cal spend­ing; each local gov­ern­ment sub­mits spend­ing plans to cen­tral par­ty author­i­ties, who in turn rec­om­mend expen­di­ture up the line.

In 2008 in order to counter the shock of the GFC the Chi­nese Com­mu­nist Par­ty (CCP) engaged in mas­sive stim­u­lus pro­grams just as the West did. The dif­fer­ence though was in the way the stim­u­lus was deliv­ered. In Aus­tralia, stim­u­lus was deliv­ered as gov­ern­ment spend­ing. This is tra­di­tion­al­ly known as fis­cal stim­u­lus where the gov­ern­ment bor­rows mon­ey to spend on projects like the new fibre optic NBN Net­work. In Chi­na, though the stim­u­lus was deliv­ered much less tra­di­tion­al­ly; the increase in expen­di­ture was deliv­ered through banks who were encour­aged to offer mas­sive amounts of debt to provin­cial gov­ern­ments, state owned and spon­sored owned enter­prise.

The impe­tus for the stim­u­lus might have been cen­tral­ly planned, but the spend­ing was decen­tralised. Provin­cial gov­ern­ments in Chi­na are not able to issue bonds, so state owned invest­ment vehi­cles bor­row the mon­ey, often using state gift­ed real estate col­lat­er­al as secu­ri­ty. The real­i­ty is that the major­i­ty of these invest­ments, do not or will not pay a return any­where near that required to make debt repay­ments. These projects born of cor­rup­tion, nursed by self-serv­ing bureau­cra­cy fail to thrive due to the defec­tive finan­cial DNA.

Provin­cial cred­it expand­ed at a rate of +35% of GDP per annum and many of the loans need­ing to be rolled over, with no prospect of ser­vice­abil­i­ty. For this luna­cy to con­tin­ue, what is pri­mar­i­ly a con­struc­tion econ­o­my must build more infra­struc­ture this year than last and more again next year and the year after into per­pe­tu­ity. If these projects had no chance of becom­ing sol­vent going con­cerns in the past, then new projects are even less like­ly to repay their lenders in the future. In this envi­ron­ment of man­ic over­pro­duc­tion, elite cap­i­tal at some point will pan­ic and run for the exits.

To a large extent the Chi­nese pro­pa­gan­da machine has cap­tured an unques­tion­ing West­ern media;, the meme that Chi­na is the next ris­ing super pow­er and will short­ly over­take the US is a part of this pro­pa­gan­da sto­ry. West­ern­ers imbue their view of Chi­na’s future with cul­tur­al qual­i­ties that have sim­ply nev­er been reflect­ed in his­tor­i­cal fact. In fact, pro­grams like the one child pol­i­cy reflect the oppo­site

If the projects in 2009 and 2010 can­not pay ade­quate returns to ser­vice debt then what hope do the new projects have? Fur­ther­more, due to the epi­dem­ic of cor­rup­tion through­out China’s pub­lic and pri­vate sec­tor, the projects rarely reflect good val­ue for mon­ey. This places the entire Chi­nese econ­o­my in Minsky’s last phase of expan­sion: The Ponzi phase, where lend­ing is per­pe­trat­ed in the hope that con­di­tions will improve and with lit­tle hope of repay­ment.

In the West debt is to be freely giv­en but even at its worst it is done on some basis of return. When an eco­nom­ic sys­tem los­es its way, to the extent Chi­na has done, the ten­sion it cre­ates on a soci­ety becomes unbear­able. When the even­tu­al day of reck­on­ing comes and the abil­i­ty to expand debt is exhaust­ed, then the physics of com­plete col­lapse come into play.

A bleak harsh real­i­ty will descend on a polit­i­cal sys­tem that’s run out of options. One unique fea­ture will come the fore: That Chi­na unique­ly spends more on inter­nal secu­ri­ty than exter­nal defence.  Chi­na will at once face a great leap back­ward forc­ing a mil­i­tary coup and the effec­tive end of CCP rule. Whether the mil­i­tary can hold the coun­try togeth­er through a Sovi­et style col­lapse is anyone’s guess. One out­come could see the wealth­i­er provinces seek­ing inde­pen­dence, how­ev­er it ends it will be the end of a dynasty that start­ed with Mao.

Chi­na will not be be the world’s biggest econ­o­my this cen­tu­ry.  It will fal­ter, due to its demo­graph­ic arthri­tis and debt explo­sion. The denoue­ment of its cor­rup­tion will pull it down like no oth­er col­lapse in his­to­ry. Chi­na will short­ly have “inter­est­ing times.”

Craig Tin­dale is the Vice Pres­i­dent of the Cen­tre for Eco­nom­ic Sta­bil­i­ty, Pro­fes­sor Steve Keen’s non-prof­it research ini­tia­tive.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.