China’s shock currency devaluation last week begs the following questions: Is China a rising giant of the twenty-first century poised to overtake the United States in wealth and military prowess? Or is it a house of cards preparing to implode?
Conventional wisdom espouses the former. Yet, hard evidence suggests the latter.
Your correspondent in the world famous Long Bar on the Bund in Shanghai, China. The Long Bar (about 50-yards long) was originally built in 1911 during the heyday of foreign imperialism in China just before the formation of the Republic of China (1912-1949). Bar regulars were divided into “tai-pans” (bosses who sat near the window), “Shanghailanders” (who sat in the middle), and “griffins” (newcomers who sat at the far end).
I made my first visits to Hong Kong and Taiwan in 1981 and my first visit to Communist China in 1991. I have made many visits to the mainland over the past twenty years and have been careful to move beyond Beijing (the political capital) and Shanghai (the financial capital) on these trips. My visits have included Chongqing, Wuhan, Xian, Nanjing, new construction sites to visit “ghost cities,” and trips to the agrarian countryside.
I spent five days cruising on the Yangtze River before the Three Gorges Dam was finished so I could appreciate the majesty and history of the gorges before the water level was lifted by the dam. I have visited numerous museums and tombs both excavated and unexcavated.
My trips included meetings with government and Communist Party officials and numerous conversations with everyday Chinese people, some of who just wanted to practice their English language skills on a foreign visitor.
In short, my experience with China goes well beyond media outlets and talking heads. In my extensive trips around the world, I have consistently found that first-hand visits and conversations provide insights that no amount of expert analysis can supply.
These trips have been supplemented by reading an extensive number of books on the history, culture and politics of China from 3,000 BC to the present. This background gives me a much broader perspective on current developments in China and a more acute analytical frame for interpretation.
An objective analysis of China must begin with its enormous strengths. China has the largest population in the world, about 1.4 billion people (although soon to be overtaken by India). China has the third largest territory in the world, 3.7 million square miles, that’s just slightly larger than the United States (3.6 million square miles), and only slightly behind Canada (3.8 million square miles).
China also has the fifth largest nuclear arsenal in the world with 280 nuclear warheads, about the same as the UK and France, but well behind Russia (6,490) and the U.S. (6,450). China is the largest gold producer in the world at about 500 metric tonnes per year.
China has the second largest economy in the world at $15.5 trillion in GDP, behind the U.S. with $21.4 trillion, and well ahead of number three Japan with $5.4 trillion. China’s foreign exchange reserves (including gold) are the largest in the world at $3.2 trillion (Hong Kong separately has $425 billion in additional reserves).
By way of contrast, the number two reserve holder, Japan, has only $1.3 trillion in reserves. By these diverse measures of population, territory, military strength and economic output, China is clearly a global super-power and the dominant presence in East Asia.
Yet, these blockbuster statistics hide as much as they reveal. China’s per capita income is only $11,000 per person compared to per capita income of $65,000 in the United States. Put differently, the U.S. is only 38% richer than China on a gross basis, but it is 500% richer than China on a per capita basis.
China’s military is growing stronger and more sophisticated, but it still bears no comparison to the U.S. military when it comes to aircraft carriers, nuclear warheads, submarines, fighter aircraft and strategic bombers.
Most importantly, at $11,000 per capita GDP, China is stuck squarely in the “middle income trap” as defined by development economists. The path from low income (about $5,000 per capita) to middle-income (about $10,000 per capita) is fairly straightforward and mostly involves reduced corruption, direct foreign investment and migration from the countryside to cities to purse assembly-style jobs.
The path from middle-income to high-income (about $20,000 per capita) is much more difficult and involves creation and deployment of high-technology and manufacture of high-value-added goods.
Among developing economies (excluding oil producers), only Taiwan, Hong Kong, Singapore and South Korea have successfully made this transition since World War II. All other developing economies in Latin America, Africa, South Asia and the Middle East including giants such as Brazil and Turkey remain stuck in the middle-income ranks.
China remains reliant on assembly-style jobs and has shown no promise of breaking into the high-income ranks.
In short, and despite enormous annual growth in the past twenty years, China remains fundamentally a poor country with limited ability to improve the well-being of its citizens much beyond what has already been achieved.
With this background and a flood of daily reporting on new developments, what do we see for China in the months and years ahead?
Right now, China is confronting social, economic and geopolitical pressures that are testing the legitimacy of the Communist Party leadership and may lead to an economic crisis of the first order in the not distant future.
In contrast to the positives on China listed above, consider the following negative factors:
Trade wars with the U.S. are escalating, not diminishing as I warned from the start in early 2018.
Trump’s recent imposition of 10% tariffs on the remaining $300 billion of Chinese imports not currently tariffed (in addition to existing tariffs on $200 billion of Chinese imports) will slow the Chinese economy even further.
China retaliated with a shock devaluation of the yuan below 7.00 to one dollar, a level that had previously been defended by the People’s Bank of China. Resorting to a currency war weapon to fight a trade war shows just how badly China is losing the trade war.
But, this currency war counterattack will not be successful because it will incite more capital outflows from China. The Chinese lost $1 trillion of hard currency reserves during the last round of capital flight (2014-2016) and will lose more now, despite tighter capital controls. The spike of bitcoin to $11,000 following the China devaluation is a symptom of Chinese people using bitcoin to avoid capital controls and get their money out of China.
The unrest in Hong Kong is another symptom of the weakening grip of the Chinese Communist Party on civil society. The unrest has spread from street demonstrations to a general strike and shutdown of the transportation system, including the cancellations of hundreds of flights.
This social unrest will grow until China is forced to invade Hong Kong with 30,000 Peoples’ Liberation Army troops now massed on the border. This will be the last nail in the coffin of the academic view of China as a good global citizen. That view was always false, but now even the academics are starting to understand what’s really going on.
International business is moving quickly to move supply chains from China to Vietnam and elsewhere in South Asia. Once those supply chains move, they will not come back to China for at least ten years if ever. These are permanent losses for the Chinese economy.
Of course, lurking behind all of this is the coming debt crisis in China. About 25% of China’s reported growth the past ten years has come from wasted infrastructure investment (think “ghost cities”) funded with unpayable debt. China’s economy is a Ponzi scheme like the Madoff Plan and that debt pyramid is set to collapse.
This cascade of negative news is taking its toll on Chinese stocks. This weakness began in late June 2019 when the summit meeting between U.S. President Trump and President Xi of China at the G20 Leaders meeting in Osaka, Japan failed to produce substantive progress on trade disputes.
Since then, the trade wars have gone from bad to worse and China’s economy has suffered accordingly. My expectation is that a trade war resolution in nowhere in sight and the trade war issues have been subsumed into a larger list of issues involving military and national security policy.
The new “Cold War” is here. Get used to it.
for The Daily Reckoning
Markets are still digesting last week’s Chinese devaluation that sent the Dow crashing over 700 points last Monday.
And as everyone knows by now, the Trump administration labelled China a currency manipulator.
The ironic part of it is that China has been manipulating its currency to strengthen it against the dollar.
Here’s the dynamic you need to understand…
The Chinese yuan is softly pegged to the dollar. To maintain the soft peg, the People’s Bank of China (PBoC) sells dollars and buys yuan.
That props up the yuan. It’s basic supply and demand economics.
One of the primary reasons China tries to strengthen the yuan is to prevent capital flight out of the country. If the yuan depreciates too rapidly, massive amounts of Chinese money would look to flee abroad where it can get much higher returns.
After all, would you want to hold a rapidly deteriorating asset that constantly loses value? Or if you were a Chinese investor, would you try to convert your money into a currency that holds its value?
That’s the question Chinese investors have been facing.
A capital drain could devastate the Chinese economy, which badly needs the capital to remain in China to support its massive Ponzi schemes, ghost cities and overinvestment.
That’s why the PBoC has been trying to support the yuan, even though a cheaper yuan helps Chinese exports.
That’s the conundrum China faces. It wants a cheap yuan — but not too cheap.
I wouldn’t call last Monday’s devaluation the sort of “max devaluation” I’ve warned my readers about before. That would have been a devaluation of 5% or more in a single day, and that’s not what happened last week. I would classify it as a “red line” devaluation.
The yuan temporarily broke through the 7.00:1 “red line” dollar peg. It has since returned to normalized levels.
It’s actually ironic that China is being labelled a currency manipulator, if manipulating your currency means cheapening it.
That’s because China was manipulating its currency to strengthen it against the dollar. And when the yuan/dollar exchange rate crossed the 7.00:1 “red line,” that meant China temporarily stopped manipulating its currency higher.
If China didn’t manipulate the yuan higher, it would depreciate even more against the dollar. And the exchange rate stabilized last week when China resumed the manipulation. In other words, when China strengthened the yuan.
Welcome to the currency wars! They take on a logic all their own. In many ways it’s a race to the bottom.
I explained it all years ago in my 2011 book Currency Wars.
As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. China’s case is complicated by its desires for both a strengthened and weakened yuan.
But the ultimate reality is that currency wars produce no winners, just continual devaluation until they are followed by trade wars. That’s exactly what has happened in the global economy over the past 10 years.
Currency wars and trade wars go hand in hand. Often they lead to actual shooting wars, as I have repeatedly pointed out.
Let’s hope the currency wars and trade wars don’t turn into shooting wars as they have in the past.
But below, I show you why China is more of a paper tiger than an actual one. Why do I say that? Read on.
for The Daily Reckoning
My Dad had to put himself through college.
To pay his own way, he worked a number of jobs while taking classes and studying. And to save money and time, he ate the vast majority of his meals at “greasy spoon” diners.
So by the time I was born he had gained a college diploma… a solid job… and also more than a hundred pounds of extra weight.
One day, when I was in elementary school, Dad decided it was time to do something about his health.
He wanted to be around as I grew up so he designed a simple weight loss system that relied on the same discipline he used during his school years.
The first step was watching what he ate a bit more carefully. For example, I remember him removing half of the bun whenever he had a hamburger.
But the keystone of the whole plan was that, instead of eating lunch, he started taking a brisk two-mile walk every day during his break.
Sounds almost too simple, right? And yes, it flies in the convention of “smaller meals throughout the day” and all the other current thinking on weight loss.
Still, it worked! And Dad went from more than 280 pounds to back under 180.
More importantly, he has kept the majority of that weight off all the way through today – 35 years later!
Weight Loss and Wealth Building
As a lot of people like to point, weight loss simply boils down to fewer calories coming in than you’re burning off.
That’s exactly what Dad accomplished by cutting out lunch and replacing it with exercise.
Really, all he had to do was stick with the system and some degree of success was practically inevitable!
It’s the same basic thing with wealth building.
If you spend less than you earn, you gain money over time. The longer you do it, the more you gain. The bigger the difference, the more you save. If there are investment earnings in there, things compound even faster.
Again, it’s pretty simple.
Want to take it a step further and become a trader?
Then you want to increase your number of winning trades to pack on the wealth by compounding the gains on top of each other.
And you want to cut your losers before they do much damage to your overall results.
That way your portfolio grows fatter, faster!
But how do you do this in a systematic way?
Just like dad’s diet, there are two basic steps to take:
Step 1: Institute Stop Losses on Every Trade You Make
These orders tell your brokerage to automatically sell a given investment if it drops to a predetermined level.
That way, you are out before the investment has a chance to drop any further.
You can also continually raising these stop losses along with any success you begin seeing – so that your overall downside keeps getting reduced in the process.
Please note: I am not talking about so-called “mental stop losses,” which so many people love to use.
Having predetermined prices at which you MIGHT cut losses is far different from actually entering those orders with your brokerage the minute you institute any particular position.
In fact, I would say this crucial difference is what separates successful traders from the legions of wannabes.
It’s too easy to change your mind once a trade goes against you!
Of course, you also need…
Step 2: Determine Your Price Targets and Enter Them as Additional Sell Orders
In a more active approach, having predetermined profit targets is just as important as having defined stop losses.
Because the whole point is moving from one winner to the next as quickly as possible… unemotionally… and without looking back or second-guessing your decisions.
No matter how good of an investor you are, you’ll never get your timing right all of the time.
Nor do you need to. You simply need to have the profits from your good trades total more than the losses from your bad trades.
This is precisely what a combination of stop losses and profit targets can help you accomplish.
That way the overall results get better and better, just as my Dad’s weight dropped consistently over time.
To be clear, I don’t believe you need such a system with long-term approaches like buying and holding quality income stocks.
However, I think this type of discipline is absolutely necessary if you’re looking for bigger, faster returns in a shorter period of time by actively trading your portfolio.
To a richer life,
— Nilus Mattive
Editor, The Rich Life Roadmap