A Substantial Chance Of A Major Financial Collapse & The End Of Offshored Industrialization

  This article reminds me of a funny Canadian joke of a decade ago where for the weather forecast they predict -10C for the next 9 days and +1C for the 10th day to keep hope alive! 

  Here, it's the exact opposite, they predict "A Substantial Chance Of A Major Financial Collapse" (in the future) whereas the numbers show that it's already happening in slow motion. Declining energy consumption cannot be interpreted any other way: The West is past its peak and energy is now too expensive to be used effectively. (Declining return on investment) Cheap imports from China mostly, have been hiding this fact for almost a decade but no longer now that the decline is accelerating in absolute terms.       

  I can still remember British historians highlighting in the 1980s the incontrovertible fact that the West was already in decline then, something which was still far from obvious at the time. Later understanding that social and economic decline are tightly intertwined and seeing in Japan the ever so slow slide downward post bubble, the process became clearer. 

  A financial collapse WILL happen. It is the unavoidable consequence of excess money printing and more generally, fiat currency, meaning based on no assets whatsoever. The money is creating liabilities but not enough assets to cancel the debt which will therefore have to be forfeited. Monetary authorities understand this perfectly and will therefore push toward a conflict to avoid taking responsibility for the crash. With this in mind, the tensions with Russia, Iran and China are easier to understand. No compromise will be accepted. Surrender and be quartered the Iraq way or accept a conflict which the West needs to justify restructuring of their financial system. There is simply no viable alternative to this dark scenario.

Authored by Gail Tverberg via Our Finite World,

Moving industrialization offshore can look like a good idea at first. But as fossil fuel energy supplies deplete, this strategy works less well. Countries doing the mining and manufacturing may be less interested in trading. Also, the broken supply lines of 2020 and 2021 showed that transferring major industries offshore could lead to empty shelves in stores, plus unhappy customers.

The United States started moving industry offshore in 1974 (Figure 1) in response to spiking oil prices in 1973-1974 (Figure 2).

Figure 1. US industrial energy consumption per capita, divided among fossil fuels, biomass, and electricity, based on data from the US Energy Information Administration (EIA). All energy types, including electricity, are measured their capacity to generate heat. This is the approach used by the EIA, the IEA, and most researchers.

Industry is based on the use of fossil fuels. Electricity also plays a role, but it is more like the icing on the cake than the basis of industrial production. Industry is polluting in many ways, so it was an “easy sell” to move industry offshore. But now the United States is realizing that it needs to re-industrialize. At the same time, we are being told about the need to transition the entire economy to electricity to prevent climate change.

In this post, I will try to explain the situation–how fossil fuel prices have spiked many times, including 1973-1974 (oil) and more recently (coal in 2022). I will also discuss the key role fossil fuels play. Because of the key role of fossil fuels, a reduction in per-capita fossil fuel consumption likely leads to a transition to fewer goods and services, on average, per person. A transition to all electricity does not seem to be feasible. Instead, we seem to be headed for increased geopolitical conflict and the possibility of a financial crash seems greater.

[1] When fossil fuel supplies become constrained, prices tend to spike to high levels, and then fall back again.

Economists and energy analysts have tended to assume that fossil fuel prices would rise to very high levels, allowing extraction of huge amounts of difficult-to-extract fossil fuels. For example, the International Energy Agency (IEA) in the past has shown forecasts of future oil production assuming that inflation-adjusted oil prices will rise to $300 per barrel.

Instead of rising to a very high level, fossil fuel prices tend to spike because there is a two-way contest between the price the consumers can afford and the price the sellers need to keep reinvesting in new fields to keep fossil fuel supplies increasing. Prices oscillate back and forth, with neither buyers nor sellers finding themselves very happy with the situation. The current price of the benchmark, Brent oil, is $81.

[2] Historical data shows spiking oil and coal prices.

Figure 2. World oil prices, adjusted to the US 2022 price level, based on data of the 2023 Statistical Review of World Energy, prepared by the Energy Institute.

When world oil prices started to spike in the 1973-1974 period, the US started to move its industrial production offshore (Figure 1). The very low inflation-adjusted prices that prevailed up until 1972 no longer held. Manufacturing costs climbed higher. Consumers wanted smaller, more fuel-efficient vehicles, and such cars were already being manufactured both in Europe and in Japan. Importing these cars made sense.

More recently, coal prices have begun to spike. Coal prices vary by location, but the general patterns are similar for the types of coal shown.

Figure 3. Coal prices per ton, at a few sample locations, based on data shown in the 2023 Statistical Review of World Energy prepared by the Energy Institute. Prices have not been adjusted for inflation.

Before China joined the World Trade Organization (WTO) in 2001, coal prices tended to be below $50 per ton (figure 3). At that price, coal was a very inexpensive fuel for making steel and concrete, and for many other industrial uses.

Figure 4. World coal consumption per capita, based on data of the 2023 Statistical Review of World Energy prepared by the Energy Institute, except for 2023, which is based on an estimate by the IEA.

After China joined the WTO, China’s coal consumption soared (Figure 4), allowing it to industrialize. Figure 3 shows that the extra demand initially pushed coal prices up a little. By 2022, coal prices had soared. At present, coal prices are part-way back down, perhaps partly because higher interest rates are dampening world demand for coal.

Natural gas prices also soared in 2022, at the same time as coal prices. Both coal and natural gas are fuels that are burned to produce electricity. When the coal supply is constrained, utilities will try to purchase more electricity produced by burning natural gas. However, it is difficult to store much natural gas for future use. Thus, a shortage of internationally traded coal can simultaneously lead to a shortage of internationally traded natural gas.

Having oil, coal, and natural gas prices spiking at the same time leads to inflation and to many unhappy citizens.

[3] The 1997 Kyoto Protocol encouraged the trend toward moving industry to lower-cost countries.

In Figure 1, I show a dotted line at 1997. At that time, an international treaty stating that the participating countries would limit their own CO2 emissions attracted a lot of attention. An easy way to limit CO2 emissions was by moving industry overseas. Even though the US did not sign the treaty until later, the treaty gave the US a reason to move industry overseas. We can see from Figure 1 that US industrialization, as measured by the energy per capita required to industrialize, began to fall even more rapidly after 1997.

[4] There were many reasons besides the Kyoto Protocol why Advanced Economies would want to move industry overseas.

There were many reasons to move industry overseas besides spiking oil prices and concern over CO2 levels. With such a change, customers in the US (and European countries making a similar change) gained access to lower-cost goods and services. With the money the customers could save, they were able to buy more discretionary goods and services, which helped to ramp up local economies.

Also, industry tends to be polluting. Smog tends to be problem if coal is burned, or if diesel with high sulfur content is burned. Mining tends to produce a lot of toxic waste. Moving this pollution offshore to poorer countries would solve the pollution problem without the high cost of attempting to capture this pollution and properly store it.

Furthermore, business-owners in the United States could sense the opportunity to grow to be truly international in size if they moved much of their industry overseas.

[5] All the globalization and moving of industry overseas had a downside: more wage and wealth disparity.

In a matter of a few years, the economy changed to provide fewer high-paying factory jobs in the United States. Increasingly, those without advanced education found it difficult to provide an adequate living for their families. The high incomes were disproportionately going to highly educated workers and the owners of capital goods (Figure 5).

Figure 5. U. S. Income Shares of Top 1% and Top 0.1%, Wikipedia exhibit by Piketty and Saez.

[6] Part of what caused the growing wage and wealth disparities in Figure 5 was the growing industrialization of China (Figure 6).

China, with its growing industrialization, could outcompete whole industries, such as furniture-making and garment-making, leaving US workers to find lower-paid jobs in the service sector. Similar outcomes unfolded in the EU and Japan, as industrialization started moving to different parts of the world.

Figure 6. Industrial production in 2015 US$, for the United States, the EU, Japan, and China, based on World Bank Industrial Production (including construction) data. These amounts are not per capita.

[7] The indirect impact of the Kyoto Protocol was to move CO2 emissions slightly away from the Advanced Nations. Overall, CO2 emissions rose.

Figure 7. Carbon dioxide emissions from energy utilization, based on data of the 2023 Statistical Review of World Energy, prepared by the Energy Institute. These amounts are not per capita.

Anyone who expected that the 1997 Kyoto Protocol would reduce world CO2 emissions would have been disappointed.

[8] The direct use of fossil fuels plays a far more important role in the economy than we have ever been taught.

Thanks to the direct use of fossil fuels, the world can have paved roads, bridges made of steel, and electricity transmission lines. It can have concrete. It can have pharmaceutical products, herbicides, and insecticides. Many of these benefits come from the chemical properties of fossil fuels. Electricity, by itself, could never provide these products since it has been stripped of the chemical benefits of fossil fuels. Electricity is also difficult to store.

With the benefit of fossil fuels, the world can also have high-quality steel, with precisely the composition desired by those making it. With only electricity, it is possible to use electric arc furnaces to recycle used steel, but such steel is limited both in quantity and quality. US production of steel amounts to 5% of world supply (primarily using electric arc furnaces), while China’s production (mostly using coal) amounts to 50% of world supply.

I highly recommend reading the article, Trapped in the Iron Age, by Kris De Decker. He explains that the world uses an enormous amount of steel, but most of it is hidden in places we can’t see. Today, with the US’s limited steel-making capability, the US needs to import most of its steel, including steel pipes from China to drill its oil wells. We cannot see how dependent we have become on other countries for our basic steel needs.

China and India have both based their recent growth primarily on rising coal consumption. This is what has kept world CO2 emissions high. The US is now exporting coal to these countries.

[9] Citizens of Advanced Economies are easily confused about the importance of fossil fuel use because they have never been taught about the subject and because their worldview is distorted by the narrow view they see from within their homes and offices.

Figure 8. Electricity consumption as a percentage of total energy consumption by US sector, based on the data of the US EIA. Amounts are through 2023.

Figure 8 shows that the sector with the highest share of electricity use is the commercial sector. This includes uses such as stores, offices, and hospitals. The most visible energy use is lighting and operating computers, which gives the perception that electricity is the greatest energy use. But these businesses also need to be heated, and heat is often produced by burning natural gas directly. Businesses also need back-up for their electrical systems. Such back-up is typically provided by diesel-powered generators.

Residential usage is similar. It is easy to see the use of electricity, but heat is generally needed during winter. This is often provided by natural gas or propane. Natural gas is also often used in hot water heaters, stoves, and clothes dryers. Occasionally, wood is used to heat homes; this would go into the non-electricity portion, as well.

The thing that most people do not realize is that industrial use and transportation use are extremely large sectors of the economy (Figure 9), and these sectors are very low consumers of electricity (Figure 8). Also, if the US and Europe were to re-industrialize to produce more of our manufactured goods, our industrial sectors would need to be much larger than they are today.

Figure 9. US Energy Consumption per capita by sector based on data of the US EIA. Amounts are through 2023.

In recent years, electrical consumption as a percentage of total energy consumption for the industrial sector has averaged about 13% of the total (Figure 9). Industries typically need high heat levels; such heat can usually be achieved at lowest cost by burning fossil fuels directly. Wikipedia claims, “Electric arc steelmaking is only economical where there is plentiful, reliable electricity, with a well-developed electrical grid.” An electric grid, powered only by intermittent electricity from wind turbines and solar panels, would not qualify.

In Figure 8, electricity consumption as a percentage of total energy consumption for the US transportation sector rounds to 0%, for every year. Even the amount of biomass (ethanol and biodiesel) used by the transportation sector doesn’t have much of an impact, as shown in Figure 10.

Figure 10. US transportation energy by type through 2023, based on data of the US EIA. Biomass includes ethanol and any biofuels made to substitute for diesel.

A major issue is that transportation is a broad sector, including trucks, trains, planes, and boats, in addition to private passenger autos. Also, I expect that the only electricity that would be considered in the transportation energy calculation would be electricity purchased from an away-from-home charging facility. Electricity used when charging at home would likely be part of residential electricity consumption.

[10] The narrative saying that we can transition to an electricity-only economy, powered by intermittent wind and solar electricity, has major holes in it.

One major issue is that the pricing of wind and solar tends to drive out other electricity providers, particularly nuclear. Intermittent wind and solar are given “priority” when they are available. This leads to very low or negative prices for other electricity providers. Nuclear is particularly affected because it cannot ramp up and down, in response to prices that are far below its cost of production.

Nuclear is a far more stable source of electricity than either wind or solar, and it is also a low-carbon source. As a result, economies end up worse off, in terms of electricity supply per capita, and in stability of available supply, when wind and solar are added.

Figure 11. US per capita electricity generation based on data of the US Energy Information Administration. (Amounts are through 2023.)

Figure 12. Electricity generation per capita for the European Union based on data of the 2023 Statistical Review of World Energy, prepared by the Energy Institute. Amounts are through 2022.

Another issue is that wind turbines and solar panels are made with fossil fuels and repaired using fossil fuels. Without fossil fuels, we cannot maintain electricity transmission lines and roads. Thus, wind turbines and solar panels are as much a part of the fossil fuel system as hydroelectric electricity and electricity made from coal or natural gas.

Also, as discussed above, only a small share of the economy is today operated using electricity. The IEA says that 20% of 2023 world energy supply comes from electricity. The amounts I calculated as “Overall” in Figure 8 indicate an electricity share of 18%, which is a bit less than the IEA is indicating for the world. Figure 8 shows an early upward trend in this ratio, but no upward trend since 2012. Fossil fuels are being used today because they have chemical characteristics that are needed or because they provide the energy services required in a less expensive manner than electricity.

Even in the early days of the Industrial Revolution, wind and waterpower provided only a small portion of the total energy supply. Coal provided the heat energy that both industry and residences needed, inexpensively. Wind and waterpower were not well adapted to providing heat energy when needed.

Figure 13. Annual energy consumption per head (megajoules) in England and Wales 1561-70 to 1850-9 and in Italy 1861-70. Figure by Wrigley, in Energy and the English Industrial Revolution.

If we are short of inexpensive-to-extract fossil fuels, relative to today’s large population, we certainly could use some new inexpensive source of stable electricity supply. But this would not solve all our energy problems–we would still need a substantial amount of fossil fuel supplies to grow our food and keep our roads repaired. But if a new type of electricity production could reduce the demand for fossil fuels, it would make a larger quantity of fossil fuels available for other purposes.

[11] Practically everyone would like a happily-ever-after ending, so it is easy for politicians, educators, and the news media to put together overly optimistic versions of the future.

The narrative that CO2 is the world’s biggest enemy, so we need to move quickly away from fossil fuels, has received a great deal of publicity recently, but it is problematic from two different points of view:

(a) The feasibility of moving away from fossil fuels without killing off a very major portion of the world’s population seems to be virtually zero. The world economy is a dissipative structure in physics terms. It needs energy of the right kinds to “dissipate,” just as humans are dissipative structures and need food to dissipate (digest). Humans cannot live on lettuce alone, or practically any other foodstuff by itself. We need a “portfolio” of foods, adapted to our bodies’ needs. The economy is similar. It cannot operate only on electricity, any more than humans can live only on high-priced icing for cakes.

(b) The narrative about the importance of CO2 emissions with respect to climate change is quite possibly exaggerated. There are many other things that would seem to be at least as likely to cause short-term shifts in temperatures:

• Lack of global dimming caused by less coal dust and reduced sulfur compounds in the atmosphere; in other words, reducing smog tends to raise temperatures.
• Small changes in the Earth’s orbit
• Changes in solar activity
• Changes related to volcanic eruptions
• Changes related to shifts in the magnetic north and south poles

Politicians, educators, and the news media would all like a narrative that can explain the need for moving away from fossil fuels, rather than admit that “our easy to extract fossil fuel supply is running out.” The climate change narrative has been an easy approach to highlight, since clearly the climate is changing. It also provides the view that somehow we will be able to fix the problem if we take it seriously enough.

[12] Today, we are in a period of conflict among nations, indirectly related to not having access to enough fossil fuels for a world population of 8 billion. There is also a significant chance of financial collapse.

In my opinion, today’s world is a little like the “Roaring 20s” that came shortly before a major stock market crash in 1929 and the Great Depression of the 1930s. After the Great Depression, the world entered World War II. There is huge wage and wealth disparity; energy supplies per capita are stretched.

Today, NATO and Russia are fighting a proxy war in Ukraine. Russia is a major fossil fuel producer; it would like to be paid more for the energy products it sells. Russia could perhaps get better prices by selling oil and other energy products to Asian customers instead of its current customer mix. At the same time, the US claims primary leadership (hegemony) in the world but, in fact, it needs to import many goods from overseas. It even needs supply lines from around the world for weapons being sent to Ukraine. The Ukraine conflict is not going well for the US.

I do not know how this will work out. I am hoping that there will not be a World War III, in the same way that there was a World War II. All countries are terribly dependent on each other, even though there are not enough fossil fuels to go around. Perhaps countries will try to sabotage one another, using modern techniques, such as cyber warfare.

I think that there is a substantial chance of a major financial collapse in the next few years. The level of debt is very high now. A major recession, with lots of collapsing debt, seems to be a strong possibility.

[13] A presentation I recently gave to a group of actuaries that touches on several of these issues, plus others.

My presentation can be found at this link: Beware: The Economy Is Beginning to Shrink

Has China Run Out of Dollars?

  Here's an interesting contrarian view of China. My understanding is that the Chinese economy is following on the tracks of Japan's post bubble in the 1990s but I may be wrong. The bad investments may be far worse than stated and not just limited to real estate. In which case the crash could come much faster than in Japan and be more global. The current deflationary trend out of China as well as the weakening of the Yuan could be indications that this analysis in indeed correct. 

  In such a case, the coming recession in the West instead of being softened by mild Chinese economic growth will be further amplified into a depression as real money becomes scarce and investment evaporates. We may have inadvertently created a perfect storm. Predicting exactly when it's going to break is impossible but the gathering clouds are clearly indicating that we may not have very long to wait. 

  Two consequences may occur more or less simultaneously: A breakdown of the global supply chain and the start of military operation almost simultaneously around the globe. Who will strike first? Israel in Lebanon in the coming weeks? But does it really matter at this stage? Putting straw next to flammable material was the mistake. Watching the barn burn is just a consequence. 

Has China Run Out of Dollars? by Geovest

What is wanted is not the will to believe, but the will to find out, which is the exact opposite – Bertrand Russell

I would like to know how many dollars are in China’s Reserve Account but the number is a state secret.  For a nation that has been as successful as China in employing mercantilist strategies, you’d expect them to advertise this success.  Yet we do know some things which makes it possible for us to infer with some degree of confidence that China is running out of dollars.  I consider this variable to be the single biggest risk to the global financial system and it’s hardly on anyone’s radar.

It helps to first understand the economics of banking and money supply.  When all debt instruments – loans and bonds – pay interest and principal as they are supposed to, money supply grows.  When some of those debt instruments go bad, the amount that gets written off reduces money supply.  It’s the definition of deflation; disinflation is when the general price level declines.  The distinction is critical to understand.

My thesis is that China has made so many bad dollar-denominated loans that their true net holdings of dollars is either negative or close to going negative.  And based on watching how China operates for 30 years, I believe they may be supplementing their currency reserve account with yuan, which has technically been a reserve currency since 2016. 

For starters, we know that the yuan became a supplementary reserve currency in October 2016, at a time when China’s holdings of dollars, euros, and yen was rapidly declining.  I believe the timing of this change is critical for accepting my thesis.  Technically, this change made it possible for China to hold yuan in their measurement of foreign exchange reserves.      

   

Appearances are more important than the truth in China and the Chinese Communist Party has proven that duplicity is acceptable as long as you can sell it to the broader community. 

We know that the US dollar represented 79% of the reserve account in 2005 and that dollar holdings fell to 58% of the reserve account by 2014.  2014 was the high-water mark for China’s foreign currency reserves which declined by $1 trillion from late 2014 until the start of 2017.  Over the past seven years, reserves have stabilized around $3.2 trillion.

We also know that trade with the US has NOT grown since 2014 indicating that China has had limited opportunities to re-build their dollar positions.  Here’s a chart of China’s trade surplus with the US.  Keep in mind that China needs to generate significant dollar levels in trade to pay for imports of food (20%+), energy (80%), and high-end technology that they can’t produce domestically.  Apart from Russia and Iran, these markets don’t accept yuan.    

Over the past two years, trade with the US and Europe has weakened while trade with Russia has doubled.  The Russians don’t pay in US dollars, nor does Iran. 

Don’t Forget the Debt!

Debt is one person’s liability, but another person’s asset – Paul Krugman

Fifteen years ago, when the Fed’s quantitative easing program was in full swing, the only smart bet seemed to be shorting the dollar in the form of dollar-denominated debt.  Today that bet doesn’t look smart at all.   

      

Since 2009, China has amassed between $2.5 trillion and $3 trillion worth of US dollar-denominated loans, effectively hedging their $3.2 trillion of forex reserves.  What originally looked like an intelligent move to insure against Federal Reserve profligacy, now represents a significant hurdle to overcome in attracting foreign capital. 

A sharp drop in the yuan versus the dollar and a further decline in US imports of Chinese-made goods and that dollar-denominated debt becomes untenable.  That’s when it becomes a huge problem for the unregulated Eurodollar markets that supplied the funding.  In other words, the global banking system is on the cusp of having a massive hole blown in it when the yuan eventually reaches intrinsic value and the Chinese are unable to service Eurodollar debt.

 

Deflation in its simplest form means loss.  If you’re Tom Brady, you remove air from a football and the world calls it “Deflategate”.  If you have an unsustainable high opinion of your worth, you are subject to having your ego deflated.  In economics, they tell you that the general price level has declined, blah, blah, blah. 

Deflation means losses.  If a nation’s banking system makes bad loans in the collective, that nation will experience deflation because money in circulation declines when the banking system incurs losses.  This is what happened in the US in 2008 which is why the Fed started quantitative easing, or QE.  In effect, they injected dollars into the banking system to replace the dollars destroyed with bad investments.  According to HSBC, the People’s Bank of China has “printed” 15% of currency in circulation over the past year as a means towards offsetting part of the deflation in their domestic economy.  It’s not nearly enough.

The Fed also created swap vehicles with global central banks to effectively inject US dollars into the Eurodollar markets.  The Fed will swap dollars for yuan, yen, euros, etc., to get past temporary imbalances in the Eurodollar markets.     

China, collectively, has been making massive investments for the past fifteen years and suffering massive losses.  These losses span from excess industrial capacity to consumer loans to massive “glamour” infrastructure projects across the nation.  These projects required trillions of dollars to pay for the imported components of the investments.  Everything has been capitalized with debt.  Perhaps the most egregious of these losses has been Xi’s once vaunted Belt and Road Initiative. 

A Brick and Road Upside the Head

The only thing my old man ever gave me was a beating – Sonny Liston

Just about every investment initiative backed by Xi Jinping has taken a beating.  Whereas King Midas turned everything he touched into gold, Xi turns everything he touches into deflation.  This acolyte of Mao seems to have the same flair for economic and social destruction as his mentor.

His acumen is on full display in his Belt & Road Initiative, supposedly a modern attempt at recreating the Silk Road between the East and West by building rail lines through much of the most inhospitable topography in the world.  This includes the Tibetan Plateau and the Himalayas, tunneling through mountains and building massive bridges between mountains, to access regions with very little economic potential. 

But it’s not just rail, he’s invested massively in places where nobody else would invest such as a massive port facility for Sri Lanka and a massive airport in the jungles of Cambodia.  In total, Xi has spent at least $1trillion on the BRI, most of which is valued in dollars.  The result is that at least 75% of the BRI investments are already bad which implies that nearly $800 billion has vanished from the Eurodollar markets – gone.

The BRI was started when China was flush with excess dollar reserves acquired through exports to the US and foreign direct investment (FDI) from investors who believed China was the future.  Those exports haven’t grown since 2014 and FDI has dropped by over 90%.  The dollar-denominated debt represented a synthetic short on the US dollar and US economy and a long position on the emerging economies of the world.  It’s been a disaster which is why debtor nations have needed aid from the IMF and World Bank to help with their excessive dollar-denominated obligations. 

Despite all of these red flags, the prevailing narrative holds that China is flush with dollars in their currency reserve account.  My thesis is that China is holding renminbi in that account and bluffing on their financial strength.  If I’m right, the global economy is facing the biggest “beating” since WWII and possibly bigger than anything faced in the 20^th Century.

Export Focus

As Austrian business cycle theory has pointed out, any bank credit inflation sets up conditions for “boom-and-bust”; there is no need for prices to actually rise – Murray Rothbard

We may not have the numbers to conclude that China has run out of dollars but we can deduce China’s reserve predicament by observing what China is doing in international markets.  They are flooding the world with their excess production instead of developing their own domestic markets.  They are also paying higher prices for their imports even as their consumer and producer prices fall.

China is built on debt; there is practically no equity to soften their decline.  They may be the world’s leading manufacturing nation but manufacturing brings both operational and financial leverage and China has extraordinary excesses of both.  Slowing demand makes both forms of leverage unbearable thanks to cost absorption over fewer units.

Let’s use the steel industry to illustrate this point.  In 2023, China represented 50% of global steel output by tonnage but only 30% of steel output by value.  For all of 2023, Chinese steel exports rose by 36% based on tonnage but declined by 8.3% by value.  That, my friends, is dumping.  We can observe similar behavior in electric vehicles, solar panels, and lithium batteries.

Making matters worse, Xi Jinping has directed state-owned enterprises (SOE’s) to “bet the ranch” on EV’s and green energy right when the Western world is coming to its senses on the viability of this form of transportation and energy.  Europeans are cutting back on EV purchases even as BYD’s cheap EV cars are piling up on the dock in Rotterdam and Bristol. 

The biggest problem for China, by far, is the fact that contract manufacturing is migrating out of China and with it, China’s biggest source of dollars in trade.  The once bustling cities of Shenzhen, Dongguan, Guangzhou, and Hangzhou are starting to resemble Detroit with empty factories and apartment buildings.  The private owners of these factories are closing their doors because there are insufficient orders from foreign buyers.  The ones that do keep the lights on are forced to price at the margin and often finance the orders themselves.  We normally see this kind of activity in companies that are close to bankruptcy where they are simply generating cash flow to make it to next month.     

Phantom Reserve of Dollars

The first lesson of economics is scarcity: there is never enough of anything to fully satisfy all those who want it.  The first lesson of politics is to disregard the first lesson of economics – Thomas Sowell

You know there is a serious problem when a story hits the media in June of 2023 about China having excess stores of US dollars in its banking system.  The source was credited to Brad Setser, a former Treasury official.  Setser claimed that Chinese banks held $3 trillion in “shadow” reserve accounts.

The problem is that you can’t hide $3 trillion.  Is Setser referring to deposits at Chinese commercial banks from trade?  Are they the aggregate notional amount of a swap arrangement?  Are they assets on the books of Chinese banks that are a function of a carry-trade – perhaps they borrowed in yen and bought US dollar assets?  The only usable reserves would come from dollar deposits or from a swap arrangement with the Federal Reserve.  All we know for certain is that China supposedly had $3.2 trillion in official currency reserves against aggregate short-term borrowing in the Eurodollar markets of $2.9 trillion.  Everything else is noise.

You could say that nobody would fall for that nonsense but the truth is that we’ve been falling for China’s nonsense for 30 years.  China has been the perfect example of the old credit card model from the 1990’s where bad underwriting standards were obscured by growth of card balances.  Once the growth stopped, losses overwhelmed their capital positions. 

Conclusion

For at least another hundred years we must pretend to ourselves and to every one that fair is foul and foul is fair; for foul is useful and fair is not.  Avarice and usury and precaution must be our gods for a little longer still – John Maynard Keynes

As it pertains to China, the market is disregarding the growing suppuration of deflation coming from China.  In the first half of the Great China Cycle, cheap imports from China allowed central bankers to concentrate on creating an asset bubble to allow an aging western society to continue consuming.  It was great while it lasted but now the second part of the cycle has arrived – some call it the Great Reckoning. 

The political class wants you to ignore what I believe is obvious and potentially contagious.  I believe China is close to running out of dollars and when it happens, we’re going to see scarcity in the Eurodollar markets along with financial insolvency far worse than 2008.

The authorities know about the problem otherwise there would never have been a need for Setser to comment on hidden reserves.  That was the tell and we’ve seen the authorities play this hand many times before. 

I’ve got two indicators.  The first is the yuan.  When it decisively breaks above 7.36 to the dollar, it will be game-on.

The second is copper which I believe is elevated from a false belief that we’ll aggressively add to the electric grid to accommodate artificial intelligence.  When copper breaks below 3.20 on the CME along with a weak yuan, deflation will follow.  

I don’t know when it’s going to break because China has been holding onto the ghost since 2016.  It’s also an election year in the US.  But ultimately, cash flow forces markets to clear at intrinsic value for at least a little while and that’s why my best advice is to expect this to be the second act after something else breaks the markets.