On Mises Weekends this week, James Rickards joins Jeff to discuss The Road to Ruin, his latest book outlining what financial elites have planned for the next financial crisis. Rickards highlights a number of policy tools governments and central bankers have created for themselves, and points to their handling of recent crises in Cypress and Greece bail-in approach as patterns for the rest of the world. - Source
Is a massive collapse brewing in the Chinese economy? Perhaps, and what would this entail? Can it be staved off, or are we looking at a massive economic collapse on the horizon, that will have drastic effects on the world? James Rickards explores. - Source
Gold's got a little bit of a headwind right here in the short run, because I expect the Fed to raise interest rates in March.
If they don't, they'll almost certainly raise them in June, I think March, but whether it's March or June, you're looking at a rate hike, you're looking at the market discounting further rate hikes. This is what Janet Yellen said in her recent testimony before the Congress, and so that's going to make the dollar stronger which is a little bit of a headwind for gold. But just looking passed that a little bit, we have an extraordinary situation where there are three vacancies on the Federal Reserve Board right now. Two completely empty seats, and one, Dan Tarullo, who just announced his resignation.
He announced it, but I think it'll be effective sometime in April, so count that as a third seat and then we have two others, one Janet Yellen, her term expires next January, so the President's going to have announce that replacement by December, and then beyond that, Stan Fisher in the middle of next year. You're looking at three seats immediately for appointees by the end of the year, including a new chairman, and then one just six months behind that. There are only seven seats on the Board of Governors at the Fed, so Trump is going to fill five of them at a minimum, so five of them in the next 16 months, and there's one Republican already on the board, Jay Powell, you don't hear much about Jay Powell, that's because he's outnumbered by the Democrats. Well, that's about to change.
He's going to find a lot of his buddies sitting next to him, so Yellen, to say her days are numbered as Chairman is an understatement. She's going to be outvoted, outgunned, out manned almost immediately once the President makes these announcements. So, Trump basically owns the Federal Reserve Board because of this appointment position situation, so Trump's going to get whatever he wants. The question is what does he want? Well, he kind of told us. He and Steve Mnuchin, the new Secretary of the Treasury said they want a weaker dollar. Well, okay, if you want a weaker dollar, then don't be raising rates, don't be pursuing a tight money policy.
If Trump follows through on the logic of the cheaper dollar, he's going to appoint doves to the board, the market's going to get the signal immediately, and the price of gold is going to soar because easy money, weak dollar means higher dollar price for gold. So, we've got some very short run headwinds, maybe between now and April, but for the certainly the second half, even the last three quarters of the year, I'm extremely bullish on gold.
If your investors, your citizens perceive that the exchange rate is going to break and you're trying to maintain the exchange rate, the way you do it, you use your reserves to buy your own currency. So, if money's going out the door and my currency's trying to get weaker, and I'm trying to hold it up to a certain level, I'm trying to peg it to a certain level, how do I actually do that?
Well, the way I do it if I'm China, and I'm trying to prop up the yuan, I take dollars and I buy the yuan. Some businessman says, "I want to get my yuan out of the country," and I'm the central bank, I say, "Okay, give me your yuan. Here are the dollars," and you send the dollars out of the country. But I buy it at a fixed rate and that's how I maintain the pace. In other words, you have to use up your reserves to maintain the peg if you have an open capital account and the peg's always going to be under stress because of these interest rate and currency differentials. That's what China's doing. It cannot work, they will go broke, you always fail.
Now, having said that, China is not actually going to go broke. They understand what I just described to the listeners, they see this coming, so they're saying to themselves, "What can I do? What can China do to keep it from happening?" Well, they can close the capital account and they're starting to do that in a small way. The problem is it's kind of all or none. You can completely close the capital account and use firing squads for anyone who tries to get the money out of the country, but now you've taken yourself out of the international monetary system. They can't do that. They just got into the international monetary system, the Chinese yuan was just included in the IMF's special drawing rights, that's this world money that the IMF prints.
Having gone to great lengths to join the club, they can't now quit the club and close the capital account. So, they're working around the edges, but it will not be successful and always fails. They could raise interest rates, give up the independent monetary policy and say, "We're going to raise interest rates to 10%." Well, that could work because hey, you put the interest rates that high people will say, "Well, I'll leave my money here. I'm not worried about the devaluation anymore because I'm getting so much interest that I'll keep my money here." The problem with that is going back to what I said earlier about the bad loans, there are companies who are already going bankrupt. What's going to happen if you raise interest rates?
They'll go bankrupt faster and then that's going to cause unemployment, that's going to destabilize the people in the Communist Parry of China, so they can't do that, so what's the third thing? If you can't close the capital account, at least not completely, and if you can't raise interest rates without sinking the economy, what can you do? You can devalue the yuan. That's what they're going to do. That makes that a very easy forecast. Now, I'm not going to say it's going to happen tomorrow morning, but you look at how George Soros broke the Bank of England in 1992, this is how he did it. He just said, "I can sell Sterling longer than you can buy dollars," and he did, and eventually the Bank of England devalued the currency.
That's what China's going to have to do, but now, come over to our friend, Donald Trump, President of the United States. What is his biggest complaint? He says that China's a currency manipulator, they keep their currency too weak. Well, from 2000 to 2014, approximately, that was a valid complaint. They were keeping their currency too weak, but it's not true anymore, as I described. China's using their hard currency reserves to prop the yuan up, actually make it stronger, so it's not true that they're weakening the yuan today. They're actually propping it up, as I said, they're going broke in the process, but what's going to happen if they devalue to save the capital account, to save the reserves? What's that going to do? That's going to inflame Trump and he's going to come down with them with hammer and tongs and tariffs, and we're going to have a trade war with China.
By the way, this has happened time and time again where something starts out as a currency war and it turns into a trade war. It's what happened in the 1930's, and I can kind of see that happening again. So, we're looking at a train wreck, but in terms of what to expect, on August 10th, 2015, China devalued 3% in two days. Not 10%, not 20%, 3%. The U.S. stock market crashed immediately from August 10th to August 31st, 2015. The U.S. stock market went down over 10%. Think about where you were at the end of the summer in 2015, on vacation or taking the kids back to school or whatever, but people thought they were staring into the abyss.
Now, the Fed came out, they didn't hike rates in September '15, as expected. That was the famous liftoff which got postponed and there was a lot of happy talk, and yeah, the market turned around and I know it's at an all-time high, but for those three weeks you saw the market completely crash. Well, what do you think's going to happen if China devalues 5% or 10%? It's going to be even worse. So, there's just some big, big stressors in the system and I'm watching them all very closely. Interesting times.
The thesis on China is really independent of the election of Donald Trump and Trump's policy. Now, I think that's a big deal obviously. Trump has very firm views on China and he's got a staff of advisors who are going to pursue those, so I think there are a lot of very important things in play in the area of currency manipulation, tariffs, trade, subsidies to Chinese state owned enterprises, et cetera. We'll talk a little bit about that but there are bigger things going on in China that are true, regardless of Trump's policies, even regardless of his president. Just to cut to the chase, China is going broke and when you say that, people roll their eyes. They go, "What do you mean China's going broke? It's the second largest economy in the world and it's got the largest reserve position in the history of the world and it's got a big trade surplus. I mean, what are you talking about?"
Well, all those things are true. When I say they're going broke I don't mean that China's going to disappear or the civilization's going to collapse. What I mean is that they are running out of hard currency. They're going to get to the point where they don't have any money, or at least money that the world wants. Let me explain, Mike, exactly what I mean by that. Going back to the end of 2014, China had a reserve position of about four trillion dollars. That was the largest reserve position in the history of the world. Now, just for the listeners' benefit, what is a reserve position? It's actually very easy to understand.
Imagine you make $50,000 a year and your taxes and your expenses and your rent and all of the things you've got to pay come to $40,000 a year, and you have $10,000 left over, you put that in your savings account or you can put it in the stock market, whatever you want with it, but that simple example where you make $50,000, you spend and pay taxes up to $40,000, you've got $10,000 left over, that's your surplus. That goes in your savings account, that's your reserve. It's no different for a country. A country exports things and gets paid in hard currency and then they import things and they have to pay hard currency to get it, and they invest overseas and people invest in them, so you've got all these capital flows and trade flows going back and forth.
But if at the end of the day you have more hard currency coming in than going out, that's your savings, and your national savings account if you want to think of it that way, is your reserves. That's what we mean by reserves and China had basically a four trillion-dollar reserve at the end of 2014. Today, that number is about 2.9 trillion. In other words, they have lost 1.1 trillion dollars in their reserve position in a little over two years, not quite two years. The reserves are going out the door. Now, people say, "Well, you've got 2.9 trillion left, isn't that a lot of money?"
Well, it is a lot of money except of the 2.9 trillion, about one trillion of that is not liquid, meaning it's wealth of some kind, it represents investment, but China wanted to improve their returns actually on their investments, so they invested in hedge funds, they invested in private equity funds, they made direct investments in gold mines in Zambia and so forth, so about a trillion of that is, it's wealth, but it's not liquid. It's not money that you can use to pay your bills. So now, we're down to 1.9 trillion liquid. Well, about another trillion is going to have to be held in what's called a "precautionary reserve" to bail out the Chinese banking system.
When you look at the Chinese banking system, private estimates are that the bad debts are 25% of total assets. Banks usually run with 5, maybe 7-8% capital. Even if you said 10% capital, well, if 25% of your assets are bad, that completely wipes out your capital, so the Chinese banking system is technically insolvent, even though they don't admit that. I mean, they cook the books, they take these bad loans. Let's say I'm a bank and I have a loan to a state-owned enterprise, a steel mill or something and the guy can't pay me, can't even come close to paying me and the loan's due, I say, "Well, look, you owe me 300 million dollars. I'll tell you what. I'll give you a new loan for 400 million dollars, but I'll take the money and pay myself back the old loan plus the interest, and then I'll give the new loan to your maturity and I'll see you in two years."
So, if you did that in the U.S. banking system you'd go to jail. You're not allowed to do that. You're throwing good money after bad and you're supposed to right off a loan that is clearly not performing or where the borrower is unable to pay. But in this case, it's just extend to pretend, and so it's still on the books, in my example, 400 million dollar good loan with a two year maturity, but in fact it's a rotten loan that the guy couldn't pay in the first place, and now he just can't pay a bigger amount. He's probably going to go bankrupt and I'll have to write it off at the end of the day. So, with that as background for the Chinese banking system, people kind of shrug and say, "Well, can't China just bail it out? They've got all this money."
Well, the answer is they could, and they've done so before, and they can bail it out, but it's going to trust a trillion dollars, so you've got to put a trillion dollars to one side, for when the time comes, to bail out the banking system. Well, now you're down to 900 billion, right? Remember, we started with four trillion, 1.1 trillion's out door, 1 trillion's their liquid, 1 trillion you've got to hold to one side to bail out the banking system, well now you only have 900 billion of liquid assets to defend your currency, to prop up the Chinese yuan. But the problem is the reserves are going out the door at a rate of, it varies month to month, 30, 40, 50 billion dollars a month. Some months more, some months over 100 billion dollars.
So, if you just say, "Well, I've got 900 billion in the kitty, it's going out the door at 50 to 100 billion a month," I'm going to be broke by the end of 2017. That's what I mean by going broke. You say, "Well, wait a second. Where did the 1.1 trillion, the first part we talked about that the reserve position went down, where did the money go? It didn't disappear." Well, no, it didn't disappear. What's happening is that everybody in China is getting their money out. They're scared to death that the yuan's going to devalue, so what are the Chinese doing? By hook or by crook, some of it's legitimate, some of it's corrupt, some of it involves bribery, some of it involves false invoicing.
As I said, by hook or by crook. I travel around the world quite a bit and you go to Sydney, Australia, Melbourne, Vancouver, Canada, London, Istanbul, Paris, New York, the story's the same everywhere. The Chinese are buying up all the high end real estate, the Chinese are buying up condos. Well, they sure are, and that's part of this capital flight, that's part of this money getting out of China. We've seen it before in Argentina in 2000, Mexico in 1994. It's happened over and over again, and it always ends in complete disaster. This is what's confronting China. - Source, James Rickards via Minyanville