China is Going Broke, Regardless of Trump's Policies

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