How China Broke the World’s “Bubble Machine”

Submitted by William Bonner, Chairman – Bonner & Partners 

Magical Money System

POITOU, France – U.S. stocks still going up. What does Mr. Market know that we don’t know? Plenty. He knows everything. Millions of facts. Millions of opinions. Millions of guesses. A damned know-it-all. Mr. Market is always right; there is no higher authority except God Himself So, if Mr. Market says stocks should go up, who are we to argue?


“Don’t fight the tape,” is another old-timer expression on Wall Street. When stocks are going up, you don’t want to be short. When they are going down, you don’t want to be long. As simple as that sounds, it doesn’t help you much. Because you never know which side the tape is on.

INDUDJIA, daily. At some point, the “tape” is going to mislead those “millions of well-informed investors” – click to enlarge.

Mr. Market is a cunning, wily, and tricky fellow. He’s perfectly capable of leading investors up and up… only to knock them down from a higher place. Also, he’s known to give out the word that it’s “all clear” in the stock market… while brewing up the storm of a century.

Or you may hear him singing the blues about how awful everything is… and then discover that he’s been buying the entire time. So, even though the Dow has been trending upward… we’d be careful about drawing any conclusions. Mr. Market could be up to his old tricks; the tape could reverse at any time. And we kinda think it will.

Friend and economist Richard Duncan points out that the booms and bubbles of the last 35 years had a particular cause. They weren’t the product of Mr. Market’s caprice or of investors’ shrewd judgments. Instead, an almost magical money system drove consumption, production, and asset prices to new highs all over the world. What a hoot! Wages rose 10 times in China. Stocks rose 16 times in the U.S. But now the party is over…

Wheels A’Turning

Here’s how it worked: Once the world’s money lost its golden anchor in 1971, things got a little funny. Americans spent money they never earned and never saved – dollars created “out of nothing” with nothing more than keystrokes on a computer.

Much of this new money went overseas, where foreign nations – notably China – had to print their own currency to keep up with it. But you’ve heard this story before. China makes. The U.S. takes. In the process, a glut of dollars ends up in the hands of the Chinese feds as foreign exchange reserves.

China money supply-aChina – M2 (black line) and M1 (red line). The cows are coming home…and there are suspicions that they are highly unpleasant cattle from hell – click to enlarge.

The buildup of these reserves is both the cause and the measure of the globalized boom the world has enjoyed since the early 1980s. As Americans bought more goods from China than they sold to China, they sent more dollars to the Middle Kingdom. These dollars boosted the world’s money supply… and set heads a’spinning, wheels a’turning, and chimneys a’smokin’.

China (and other countries) filled the orders and banked the dollar sales. Of course, you can’t easily spend dollars in China. So the Chinese central bank, the People’s Bank of China (PBoC) exchanged merchants’ and manufacturers’ dollars for renminbi at a fixed rate (otherwise, the demand for renminbi would push up its exchange value – something the Chinese have been keen to avoid).

This left the PBoC with lots of dollars. What could it do with its stash? Buy U.S. Treasury bonds! As China recycled its export dollars into U.S. government debt, it lowered U.S. interest rates and increased the amount of money bidding for U.S. financial assets.

That – roughly – is how we got to where we are today. China’s supply of foreign currency reserves rose from zero in 1979 to $4 trillion in 2014. Worldwide, reserves grew by $12 trillion.

Broken Bubble Machine

Here, you can easily see the difference between this new credit-based system and the gold-backed system it replaced. You could never add $12 trillion to the world’s money supply in the same way if it was linked to gold. All the gold ever mined has a present value of only about $6 trillion.

This big increase in the global money supply was what set off the booms and bubbles of the last 35 years. But now, what’s this? The bubble machine is broken? The PBoC is no longer adding to its dollar reserves. Instead, it is offloading them. About $400 billion has been clipped from China’s foreign exchange reserves since 2014.

ftblog939China’s foreign exchange reserves accumulation is going into reverse – and that affects the global liquidity situation.

This drop is a big change for China… and for the world’s financial system. Imports into China – mostly raw materials – are dropping at a double-digit rate. Exports are rolling over, too.

There is nothing like easy money to cause people to make mistakes. Americans overspent. China overproduced. Now, Americans can’t step up their buying (they owe too much already)… and China has too much capacity.

China’s growth, by the way, has been heavily concentrated on building factories and infrastructure – capital investment. China spent $4.3 trillion on fixed capital investment in 2013 – 10 times more than in 2000. But when you produce too much already, building more factories only makes the situation worse. Prices fall; on a year-over-year basis, producer prices in China haven fallen every month for the last three and half years.

macro_china_graph1_bigInvestment to GDP ratios compared. A lot of the debt-financed investment in China is malinvestment (with its infamous ghost cities an especially glaring example; this is like Keynesian pyramid building) – click to enlarge.

Adding output capacity – often done with the connivance of local governments – was largely financed on credit. Bank loans have risen threefold since 2007. These loans must now be going bad. Nonperforming loans should be shooting up. Recession should be coming. Instead of driving the world economy forward, China should become a drag on the whole world economy.

What does this mean? China can’t allow its industrial economy to sink without a fight. It will have to devalue the renminbi to try to get more market share for its exports. It still has 80% of its workers earning less than $10 a day. A lower renminbi will reduce real wages further and make China’s exports cheaper than ever.

And then, what about the rest of the world? As the renminbi goes down, the dollar, yen, and euro will have to go up. Commodities – priced in dollars – will stay down. U.S. corporate profits will fall. The stock market “tape” will go down. Consumer prices, too, will remain low… or go negative. Deflation. Deflation. Deflation.

Charts by: StockCharts, FT/Haver Analytics, St. Louis Federal Reserve Research, Bloomberg