Ghost Cities & White Elephants

Just because I’m enjoying a little vacation time, doesn’t mean Money & Crisis headquarters is closed for business.

I’ve asked some of my colleagues, as well as some industry experts, to fill in for me while I’m gone. These folks know more about crisis, money and personal liberty than anyone I’ve ever met.

Today’s issue comes to you courtesy of Jim Rickards, economist and author of New York Times bestseller Currency Wars.

All the best,

Owen Sullivan
Editor, Money & Crisis

P.S. Jim Rickards was one of the few big name economists who actually predicted the 2008 financial crisis. For a limited time, you can grab a free copy of his new book The Road to Ruin: The Global Elites’ Secret Plan for the Next Financial Crisis as a reader of Money & Crisis. In it, Jim reveals the powerful strategies you can take to protect your money and your family from the next crisis. Claim your FREE copy now.

I’ve written for years that Chinese economic development is partly real and partly smoke and mirrors, and that it’s critical for investors to separate one from the other to make any sense out of China and its impact on the world.

There’s no denying China’s remarkable economic progress over the past thirty years. Hundreds of millions have escaped poverty and found useful employment in manufacturing or services in major cities.

Infrastructure gains have been historic, including some of the best trains in the world, state-of-the-art transportation hubs, cutting edge telecommunications systems and a rapidly improving military.

Yet, that’s only half the story.

The other half is pure waste, fraud and theft. About 45% of Chinese GDP is in the category of “investment.” A developed economy GDP such as the U.S. is about 70% consumption and 20% investment.

There’s nothing wrong with 45% investment in a fast-growing developing economy – assuming the investment is highly productive and intelligently allocated.

That’s not the case in China. At least half of the investment there is pure waste. It takes the form of “ghost cities” that are fully-built with skyscrapers, apartments, hotels, clubs and transportation networks – and are completely empty.

This is not just Western propaganda; I’ve seen the ghost cities first hand and walked around the empty offices and hotels.

Chinese officials try to defend the ghost cities by claiming they are built for the future. That’s nonsense. Modern construction is impressive, but it’s also high maintenance. Those shiny new buildings require occupants, rents and continual maintenance to remain shiny and functional. The ghost cities will be obsolete long before they are ever occupied.

Other examples of investment waste include over-the-top white elephant public structures such as train stations with marble facades, 128 escalators (mostly empty), 100-foot ceilings, digital advertising and few passengers. The list can be extended to include airports, canals, highways and ports, some of which are needed and many of which are pure waste.

Communist party leaders endorse these wasteful projects because they have positive effects in terms of job creation, steel fabrication, glass installation and construction. However, those effects are purely temporary until the project is completed. The costs are paid with borrowed money that can never be repaid.

China might report 6.8% growth in GDP, but when the waste is stripped out the actual growth is closer to 4.5%. Meanwhile, China’s debts grow faster than the economy and its debt-to-GDP ratio is even worse than the U.S.

All of this would be sustainable if China had an unlimited ability to rollover and expand its debt and ample reserves to deal with a banking or liquidity crisis. It doesn’t. China’s financial fragility was revealed during the 2014-2016 partial collapse of its capital account.

China had about $4 trillion in its capital account in early 2014. That amount had fallen to about $3 trillion by late 2016. Much of that collapse was due to capital flight for fear of Chinese devaluation (which did occur in August 2015 and again in December 2015).

China’s $3 trillion of remaining reserves is not as impressive as it sounds. $1 trillion of that amount is invested in illiquid assets (hedge funds, private equity funds, direct investments, etc.) This is real wealth, but it’s not available on short notice to defend the currency or prop up banks.

Another $1 trillion of Chinese reserves are needed as a precautionary fund to bail-out the Chinese banking system. Many observers are relaxed about the insolvency of Chinese banks because they are confident about China’s ability to rescue them. They may be right about that, but it’s not free. China needs to keep $1 trillion of dry powder to save the banks, so that money’s off the table.

That leaves about $1 trillion of liquid reserves to defend the Chinese currency, if so desired. At the height of the Chinese capital outflows in 2016, China was losing $80 billion per month of hard currency to defend the yuan.

At that tempo, China would have burned through $1 trillion in one year and become insolvent. China did the only feasible thing, which was to close the capital account (interest rate hikes and further devaluation would have caused other more serious problems).

This distress might have been temporary if China had managed to maintain good trading relations with the U.S. But that proved another chimera. The trade war, which has broken out between the U.S. and China, has damaged Chinese exports and raised costs on Chinese imports at exactly the time China was counting on a larger trade surplus to help finance its mountain of debt.

Now trade is drying up and China is stuck with debt it can’t repay or rollover easily. This marks the end of China’s Cinderella growth story, and the beginning of a period of economic slowdown and potential social unrest.

This slowdown comes just months after Chinese dictator Xi Jinping was offered a dictator-for-life role by the removal of term limits and was placed on the same pedestal as Mao Zedong by the creation of “Xi Jinping Thought” as a formal branch of Chinese Communist ideology.

The Book of Proverbs says, “Pride goeth before destruction, and a haughty spirit before a fall.” Xi Jinping now finds himself in precisely this position. His political ascension inflated his pride just as he now faces the reality of a falling economy and possible destruction of any consensus around his power and the lack of accountability.

Trump continues to tighten the screws with more tariffs, more penalties and a near complete shutdown of China’s ability to invest in U.S. markets.

Turkey, Argentina and Venezuela are large developing economies that are in different stages of collapse and threaten the global economy with panic through contagion.

Yet, those three economies combined are not as large or important as China. Only Trump and Xi can salvage the situation with negotiation and reasonable compromise on trade and intellectual property. But, Trump won’t blink first; that’s up to Xi.

So far, a spirit of compromise is not in the air. A spirit of Chinese collapse and contagion is.

Regards,

Jim Rickards

Editor’s note: For more of Jim’s insights into developing financial crises, check out his new book The Road to Ruin: The Global Elites’ Secret Plan for the Next Financial Crisis. Right now, it’s free to readers of Money & Crisis. Click here to get a hardback copy delivered straight to your home.

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