Sean Corrigan Explains Why "This Cannot End Well"

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From Sean Corrigan Of Diapason Securities

This Cannot End Well

Markets were briefly cheered earlier in the week by news that the Chinese government was planning to relieve its banks of up to $450 bln in poorer quality local authority loans, hence removing a looming threat to the nation's credit-fuelled expansion.

As is usual with China, though, this was both something and nothing. Nothing because the announcement was only one of vague intent rather than a concrete proposal, much less one with a verifiable timetable. As is so often the case, the authorities may well be employing the typical ruse of benefiting from an initial headline effect and the subsequent goldfish memory capability of the vast majority of investors who only want to believe the best about the place, in any case.

Nothing, too, because the 'bail-out' will probably take the time-honoured form of simply re-labelling one form of irredeemable debt as a more prestigious marque—this time, perhaps, one with an MOF imprimatur on it—without altering the fact that it will remain as a low-interest drag on bank balance sheets in perpetuity.

Never mind, the banks can always shore up their balance sheets by selling another slice of overpriced equity to the biddable gweilo suckers who are so anxious to get a piece of the China-to-the-Moon action, even if they then cough up most of the proceeds by making over a series of dividends to their governmental majority shareholders with which these latter will meet the re-packaged junk interest payments.

If this seems a classic shell game of the kind so well described in Walter & Howie's 'Red Capitalism', there were also rather more disconcerting echoes of Frank Dikotter's 'Mao's Great Famine' in an official news story which attributed the calamity, that the recent drought in China has given way to a series of deadly floods, to the failure of the local cadres to arrange for the peasants to 'volunteer' to complete water management projects in the agricultural low season as they used to do in the 60s and 70s.

Given that the during the first of these alone— the risibly named Great Leap Forward— a near-unimaginable 45 million of those same peasants are reckoned to have been starved or beaten to death, the wistfulness with which this was recalled sheds a worrying light on the unsoftened callous which still passes for the heart of the central planner.

At root, of course, the bank lending splurge was a fiscal programme, not a commercial one: one which was inherently monetized and hence one which has lead straight to the inflationary problems of today.

Worse even than that, this New Deal was just as morally corrupting and societally enervating as have been all its less-than illustrious predecessors. In a one-party state, there may have been no need to 'Tax, tax, tax. Spend, spend, spend. Elect, elect, elect,' as Harry Hopkins categorized FDR's cynical exploitation of executive patronage in 1930s America, but the money will nonetheless have gone preferentially to the well-connected - the party loyalists, the SOE apparatchiks, and the princeling- run oligopolies—each eager to extend their fiefdoms as much as possible along the way.

Now that credit is being partly rationed, these, too, are the ones who will suffer last and least, meaning that genuine entrepreneurs are the ones who will have to bear the brunt of an adjustment process which has not only tightened funding and raised interest rates—especially the usurious curb rates which are often their only source of working capital and which some sources say are running at 5% a month—but which has crushed their export margins under the weight of the Yuan's ascent and the sharply raised the cost of both the labour and material inputs they require to stay in business.

Even the state mouthpiece, the Shanghai Times, admitted as much in running the results of a survey conducted by the All-China Federation of Industry and Commerce which said that SMEs across the 16 provinces canvassed were suffering a 'cash crunch' as tight as that experienced at the height of the LEH-AIG Crisis in 2008.

With the Western press full of stories of Chinese 'fraud caps' and with the signal, first ever failure of a domestic IPO this week to top a run of disappointing after-markets for a whole host of flotations, undeniable evidence of the deterioration in the economic environment may coincide with widespread investor distrust to provide a rather salutary end to this latest stage of the Sinomania.

Certainly, equities are beginning to look vulnerable, while the latest trade data shows that exports have been essentially static in Yuan terms for the past six months, with the YOY rate trending down even more sharply than in the run-up to the bust.

Apart from another round of anaemic import-export numbers (e.g., for copper, where we are already back to the stationary, 2001-08 mean), one portentous indicator is the volume of coal exports from Australia — and the corresponding length of the queue off the principal port of Newcastle— given that almost four-fifths of these are bound for either India or the China-Taiwan-Japan-Korea global production hub.

Another country getting little bang for its monetized buck is dear old Blighty— the UK— where well over 90% of gilt issuance has been taken up by the banks, stepping in for the rather more embarrassing direct money printing of the Old Lady herself conducted in 2009.

The author is old enough to remember how controversial was the proposal, mooted and then adopted during the previous housing crash, to insist no longer that, as an act of anti-inflationary prophylaxis, only government debt sold to non-monetary institutions and individuals would count as being 'funded' (admittedly, this was fast becoming a dead-letter with the rapid development of repo markets). We are along way from such days of virtue.

Here, again, we have a direct impediment to the necessary cleansing and re-ordering of society in that the feckless and unfortunate are preferentially receiving finance at the expense of the would-be phoenixes.

Is it any wonder that the country still runs a trade deficit of roughly £100 billion a year (a per capita equivalent of over $800 bln were the US to be as badly placed), despite the 20% decline in its currency (a real effective exchange rate decline which was the biggest undergone of the 57 nations the BIS tracks with the sole exception of benighted Iceland!)?

Is it any wonder that prices are rising so fast (despite the supposedly prohibitive Keynesian presence of an 'output gap') when so much of the money being created is not giving rise to goods and services, but is being used to furnish the means for the unproductive to maintain their soft budget lifestyle in all its £650 billion total, £120 billion deficit majesty?

But if Britain looks no further forward in clearing up the toxic legacy of RobespiBlaire and Culpability Brown (or Crash Gordon, if you prefer), who else will take up the challenge? The Europeans? What, with whatever political will which remains after failing to break the Greek impasse being squandered on the mindless rush to 'decarbonise' and to denuclearise the most successful economies on the Continent simultaneously?

It's not even that there is much of a Plan B, other than that of despoiling the environment, ruining the vistas, decimating the wildlife, and crippling both industrial and household budgets with vast, rent- sucking arrays of unwieldy, uneconomical and largely impractical windmills and solar panels.

As the Swiss environment minister, Doris Leuthard, so marvellously put it, when hailing the Bundesrat's decision to abandon the clean, quiet, low 'footprint' source of 38% of the country's electricity without having any obvious replacement to hand in a small, land-locked country where even shale gas exploration has met with overwhelming regulatory difficulties: 'I believe in a Switzerland of innovation.' Talk about the politics of the Tooth Fairy!

Even as it stands, there are just a few hints that some of the shine may be coming off the Mittelstand's gold stars. Export revenues— while still running at double digit rates— are seeing a progressively faster deceleration, with domestic sales picking up smartly in what may be a sign of the inflationary pressures bubbling up in this notoriously lacklustre sector.

Be aware, too, of the greatly elevated German business reliance on north Asia, whence it sends twice as many exports as in 2005, with their relative scale increasing by half from 22% of EZ exports then, to 35% today. If China sneezes... Gesundheit!

A glance at the chart of Dutch industrial production on the previous page may be telling us that this faltering of pace is proceeding there in a similar fashion and so presumably for similar reasons.

Looking further afield, Japan is not yet in any position to help and—besides—it, too, is now too intimately tied up with what happens on the Asian mainland to provide a separate driver, its tragedy being that it has replaced a dependence on one intemperate giant with a fate closely intertwined with the caprices of two.

As for the US, there is not too much new to say on the monthly data flow, with what there is of note being more long-term in nature, as the quarterly financial numbers show the maintenance of the split between the vitality of Corporate America and that of the rest of the private sector, as well as the contrast between the unretarded profligacy of the state and the ongoing resizing of the 'shadow' banking sector.

What we can also see is the scale of the distortions being introduced into the market where, despite the superficial health of both profits and cash flow (these a touch less impressive if we adjust for either of the US dollar's internal or external loss of value, one should constantly remind oneself), it is apparent that the balance sheet is still being strip-mined to salt the income statement and, more particularly, the per share ratios via debt-financed equity buybacks.

Even as this increases the overall fragility of the corporate structure, however, the Fed's egregious obliteration of capital market pricing signals has kept equities looking 'cheap' - with dividend yields anomalously above an artificially-depressed LIBOR and equity earnings yields at par with QE-shrunken corporate bond yields for the first time in almost three decades.

This cannot end well.