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Paper Tiger
James Rickards

The story of China’s explosive growth from 1978 to 2008 is well-known.

China’s GDP surged from less than $150 billion in 1978 to over $3 trillion by 2008. China’s average annual growth rate exceeded 10% from 1978 to 2005. During this period, over 600 million people escaped poverty to obtain at least a stable if low-income standard of living.

Between 2000 and 2008, China became the factory to the world providing everything from simple assembly to textiles to world-class automobiles and laptop computers.

In the 1960s and 1970s, development economists believed that moving an economy from low-income to middle income was a huge challenge, but once middle-income status was reached the path to high-income was just a matter of time.

This was called the “takeoff ” theory based on the view that it was hard to get a plane off the ground, but once airborne it could soar to almost any feasible altitude in time.

It turns out that theory was completely wrong.

In fact, it’s relatively easy to move an economy from low-income to middle-income. All that is required is cheap and plentiful labor, urban infrastructure, basic education, and foreign capital. With those ingredients, an economy can turn itself into a manufacturing powerhouse.

The catch is that this manufacturing is mostly assembly-based. Investors may know that China is the source for about 90% of all iPhones. They may not know that Chinese value-added to the iPhone is only 6% of the sale price.

The other 94% of value added comes from the U.S. (invention and patents), Japan (gorilla glass), South Korea (semiconductors), and 26 other countries that supply critical parts.

China assembles the phones, but they did not invent them, and they did not create the high-tech inputs.

A low-income country is considered to have about $5,000 annual income per capita. The middle-income countries begin at about $10,000. The high-income countries begin around $20,000 annual per capita income but have no ceiling.

China is often touted as the “second largest economy in the world,” which it is on an aggregate basis. But when calculated on a per capita basis, it drops from number 2 to number 77 in global rankings, between Equatorial Guinea and Botswana. On a per capita basis, U.S. income is six times greater than China.

So much for China taking over the world.

Therefore, the challenge for China is how to break out of the middle-income trap and reach high-income status. This is extremely difficult to do. The only countries that have made the leap are Japan, South Korea, Hong Kong, Taiwan and Singapore.

The list of countries stuck in the middle-income trap along with China is a long one — Malaysia, India, Turkey, Thailand, Brazil, Mexico, Argentina, Russia, Chile and others.

China Is Trapped

The way out of the middle-income trap is to develop your own high-technology intellectual property that you can then apply yourself and license to others. The middle-income countries basically pay others licensing fees for the technology they need to grow.

It’s only when you develop your own technology that you can move to higher value-added in your manufacturing and earn fees from others. The key to forecasting Chinese growth in the years ahead is therefore technology.

Can China develop its own technology ahead of advanced economy competitors and create the high-value-added industries that come with it? The outlook here is not good for China. They have shown little or no capacity to invent or produce in areas such as advanced semiconductors, high-capacity aircraft, medical diagnostics, nuclear reactors, 3D printing, AI, water purification, and virtual reality.

The projects that China does have on display that are advanced (such as their bullet trains that run quietly at 310 kph) are done with technology licensed from Germany or France or with stolen technology. China has produced major technological advances, but it has done so in non-sustainable ways including excessive debt and theft of intellectual property.

China has done little innovation on its own. The stolen technology channel is being shut down by bans on advanced semiconductor exports to China, and sanctions on the use of 5G systems from Huawei. Even China’s ability to import high-tech semiconductor manufacturing equipment as a path to developing their own semiconductors has been cut off through export bans from the U.S. and Netherlands.

The second hurdle to growth in China is its overreliance on investment to drive GDP. A country’s GDP account consists of consumption + investment + government spending + (exports–imports).

Investment can be a good way to drive an economy forward assuming the investment is carefully chosen and the returns on investment exceed any financing costs. That has not been the case in China.

Most developed economies (Germany is an exception) have consumption at about 50% to 70% of total growth with investment around 25%. In China, consumption is only 25% of GDP while investment is 45%. (Net exports are a large percentage).

China’s problem is that much of its investment is wasted. It consists of large white elephant infrastructure projects (such as the Nanjing South train station which I have visited; it has high marble walls and 128 escalators mostly empty). I’ve also visited the construction sites of the “ghost cities” one after the other almost to the horizon, also mostly empty.

This infrastructure binge is financed with debt that is now both unpayable and acts as a drag on real growth in other sectors of the economy. China has consistently failed to pivot its economy from investment to consumption with the result that the waste continues and the debt pile grows larger. China is trapped in an infrastructure and debt dead-end with no way out.

There are many other headwinds to Chinese growth in addition to the middle-income trap and the debt trap. These include declining demographics, geopolitics, corruption, extreme income inequality, and the rise of Xi Jinping as the new Mao Zedong.

But I want to widen the aperture and look at new challenges to China beyond those I’ve covered in the past. These new challenges include the risk of financial panic and new corporate failures that make the notorious Evergrande collapse look like small beer.

China is not only slowing but it may be on the brink of a financial and economic collapse that will reverberate around the world. That’s because what happens in China doesn’t stay in China. It’s critical to understand that what’s happening in China today is more than a slowdown and more than a credit crunch. It’s much closer to a full scale financial collapse.

It is possible that the Chinese government can intervene with massive fiscal stimulus. Of course, that simply increases the already colossal debt burden and kicks the problem into the tall grass for the time being.

That said, it’s not clear that the Chinese government wants to intervene in this manner. Chairman Xi may just let the chips fall where they will, knowing that most of the losses will actually fall on U.S. investors and Japanese banks.

If Xi takes that approach, the damage will not be confined to China. In fact, the financial contagion could resemble the virus contagion that began in China. It starts in China, but spreads quickly to Europe, Japan, and the United States. The damage here may be greater than the damage there; a strange kind of net benefit to China.

This comes at a time when the U.S., Europe, and Japan are facing their own headwinds (in terms of reduced commercial lending, declining manufacturing, and contracting world trade despite consumers remaining somewhat strong for the moment).

So, a Chinese collapse would be a force multiplier that might throw the world into a global financial panic.

In fact, China is facing a new financial crisis that may leave the rest in the shade. This involves the collapse of a shadow bank called Zhongrong International Trust. Zhongrong is not a pure play property developer like Evergrande nor is it a bank. Instead, it is a shadow bank (offering notes and investing the proceeds) with some property development activities, but many other investment schemes as well.

For years, Zhongrong relied on its reputation as one of the top financial groups in China. Yet, it’s now been revealed that assets taken in as wealth management products were transferred to corporate headquarters and used for various speculations not connected to any specific wealth management goal.

In this respect, Zhongrong resembles the notorious FTX crypto fraud in which billions of dollars of customer funds were diverted to proprietary speculation and spending sprees by the principals. Above all, Zhongrong is non-transparent and lightly regulated, which has resulted in a complete lack of accountability. As the firm fails it has become impossible for regulators to respond appropriately since they really have no idea what is going on inside the company.

Chinese authorities have established a task force to study possible contagion. Of course, the contagion has already started, which shows how behind the curve regulators are. I can’t say with certainty how large the losses from the Zhongrong will be although a total loss of $500 billion taking into account shareholder equity, wealth management products, and direct accounts seems likely.

Of course, that will just be the tip of the iceberg as contagion takes hold and the panic spreads.

My expectation is that Chairman Xi and the CCP will not resort to fiscal stimulus this time, but will let the rotten edifice of bad debt and fraud collapse of its own weight. Chinese stock markets will fall 50% or more as a result. This will give China a chance to clean out the deadwood (with lots of fraud trials and jail terms) and reset the system.

Of course, a collapse of that size will not be confined to China. In fact, the CCP may be betting that much of the economic fallout will land in the United States. Investors in the U.S. should expect a U.S. stock market collapse along with bank failures and a wave of bad debts beginning late this year.

It’s not too late to prepare accordingly. Yet, this may be the last warning.



James G. Rickards is the editor of Strategic Intelligence. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He was the principal negotiator of the rescue of Long-Term Capital Management L.P. (LTCM) by the U.S Federal Reserve in 1998. His clients include institutional investors and government directorates. His work is regularly featured in the Financial Times, Evening Standard, New York Times, The Telegraph, and Washington Post, and he is frequently a guest on BBC, RTE Irish National Radio, CNN, NPR, CSPAN, CNBC, Bloomberg, Fox, and The Wall Street Journal. He has contributed as an advisor on capital markets to the U.S. intelligence community, and at the Office of the Secretary of Defense in the Pentagon. Rickards is the author of The New Case for Gold (April 2016), and three New York Times best sellers, The Death of Money (2014), Currency Wars (2011), The Road to Ruin (2016) from Penguin Random House.

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