It's Time to Get Real About Your Investments

Thoughts from the Frontline

ThePeoplesRepublicofDebt
BYJOHNMAULDIN

JUNE14,2015

ABrandNewBookAvailableOnline
ThePeoplesRepublicofDebt
NewYork,Maine,andBoston
ItwasntthatmanycenturiesagothatChinawastheabsoluteeconomiccenteroftheworld.ThatcentergravitatedtoEuropeandthentowardsNorth
AmericaandhasnowbegunmovingbacktoChina.MycolleagueJawadMianprovidedthischartshowingtheevolutionofEarthseconomiccenterof
gravityfrom2000yearsagotoafewyearsandintothefuture:

MostinvestorsarewellawareoftheenormousimpactChinahashadonthemodernworld.ThirtyfiveyearsagoChinaswasprimarilyanagrarian
society,withmuchofthenationtrappedinmedievaltechnologiesandlivingstandards.Today500millionpeoplehavemovedfromthecountrytothe
citiesandChinasurbaninfrastructureis,ifnotthebestintheworld,closetothatstandard.
TheeconomicmiraclethatisChinaisunprecedentedinhumanhistory.Therehassimplybeennothinglikeit.DengXiaopingtookcontrolofthe
nationinthelate70sandpropelleditintothe21stcentury.Butnowthestoryischanging.Thosewhothinkthatallprogressionislinearareinfora
rudeawakeningiftheyarebettingonChinatounfoldinthefutureasithasinthepast.
Amongthemostimportantquestionsforallinvestorsandbusinessmenis,howwillChinamanageitsfutureandtheproblemsitfaces?Therearemany
problems,someofthemmonumentalandatthesametimethereisanamazingamountofopportunityandpotential.Understandingthechallenges
anddecipheringthelikelyoutcomesisitselfanimmensechallenge.
ABrandNewBookAvailableOnline
MycolleagueWorthWrayandIhavebeeninvestigatingandwritingaboutChinaforsometimenow.TodayImannouncingabookthatwehave
writtenandeditedincollaborationwith17wellknownexpertsonChina.ThebookiscalledAGreatLeapForward?MakingSenseofChinas
CoolingCreditBoom,TechnologicalTransformation,HighStakesRebalancing,GeopoliticalRise,&ReserveCurrencyDream,
andwethinkitwillhelpyoutoasolidunderstandingofbothChinasproblemsanditsopportunities.Iknow,thesubtitleisatadlong,butthebook
doesreallycoverallthoseaspectsoftodaysChina.

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Noticethatthereisa?afterthetitleAGreatLeapForward.ThefirstGreatLeapForward,initiatedbyMaoTsetungintheearly60s,wasanutter
disaster.Itdevastatedthenation,bankruptedtheeconomy,andcausedthedeathsoftensofmillionsofpeople.Letsreviewalittlehistoryfromthe
introductiontothebook:
WhenChairmanMaodecidedin1958totransformChinaslargelyagrarianeconomyintoasocialistparadisethroughrapidindustrialization,
collectivization,andacompletesubjugationofthemarkettoChineseCommunistParty(CCP)centralplanners,thewidespreadmisallocationof
resourcesledtotheworstfamineinrecordedhistoryandtheoutrightcollapseofChinaseconomy.
WithverylittlecapitalatChinasdisposalafteritslongcivilwarandevenlongersubjugationtoforeigncolonialistsinthenineteenthandearly
twentiethcenturies,Maodecidedthebestwaytofundthecountrysrapidindustrializationwasforhisgovernmenttomonopolizeagricultural
production,usethenationsbountytosupportindustrializingurbanpopulations,andfinancefixedassetinvestmentswithcropexports.

1959Prosperitybroughtbythedragon&thephoenix
SeeinggrainandsteelproductionastheessentialelementsofChinasrapiddevelopment,Maoboastedin1958thatChinawouldproducemore
steelthantheUnitedKingdomwithinfifteenyears.

1959Smeltalotofgoodsteelandacceleratesocialistconstruction.
Maohadverylimitedknowledgeofagricultureorindustrialproduction,yetheruledChinawithanironfistandsilencedevenwellintentioned
opposition.Chinasruralpeasantswereforcedintocollectiveshouseholdsweretornapartandprivatepropertyrightswerecompletely
abolished.Maoorderedagriculturalcollectivestoproducemoregrainwhileforcingfarmerstoemploylessproductivemethodshemobilized
farmerstokilloffpestslikemosquitos,rats,flies,andsparrows(acampaignthatupsettheecologicalbalanceinChinasfarmlands)and
insistedonadoublingofsteelproductiontobeachievedbydivertingfarmerswithnoindustrialskillintooperatingpoorlysuppliedbackyard
furnaces(whichcouldnotburnhotenoughtoproducehighqualitysteel).

1959UnskilledworkerssmeltsteelinChinasbackyardfurnaces.
Steelproductionsurged,andtheeconomyappearedtoboombutatleasthalfofthatnewproductionwasunusable.Aproliferationofcrop
eatinglocusts(afterthesparrowshadbeenkilledoff)andthediversionoffarmworkerstoindustrialandpublicworksprojectsledtoacollapse
incropyields.Still,localofficialsalloverChinafalsifiedtheirproductionfiguresinanefforttowinfavorwithBeijing(andtosparethemselves
Maoswrath),whichledtolargerandlargergrainshipmentstoChinascitiesandsmallerandsmallerrationsforthoselivinginits
agriculturalcollectives.
InsteadoftakingaGreatLeapForwardtoaharmoniousindustrialsociety

1959Thecommuneislikeagiganticdragon,productionisnoticeablyaweinspiring.
MaoscommandandcontrolsystemdismantledtheChineseeconomy,ruinedmillionsoflives,andleftanenormousshareofChinas
populationdisillusioned.
Industrializationfailed.From1958to1961,millionsdiedofstarvationandexhaustionacrossChinascountryside(independentestimatesrange
from30millionto70million,whiletheCCPstillinsiststhedeathtollwasonly17million),andthePeoplesRepublicremainedanetexporterof
grain.AsHarvardeconomistDwightPerkinsremembersit,Enormousamountsofinvestmentproducedonlymodestincreasesinproductionor
noneatall....Inshort,theGreatLeapwasaveryexpensivedisaster.
AsproductionandproductivitycollapsedalongwiththeCCPssocialcontract,Maostruggledtoretainpowerasanumberofinfluential
officialssoughttoimplementmoremarketorientedpoliciesinresponsetotheGreatFamine.Fearingthatgrowingoppositioncouldleadthe
PartytorejectitsMarxistspirit(astheSovietUnionhaddoneunderNikitaKhrushchevadecadeearlier),in1966MaoandhisRedGuards
launchedtheCulturalRevolutionadecadelongseriesofpurgesintendedtorootoutenemiesofCommunistthoughtlurkingwithinthe
Party,cleanseChinesesocietyofmanyofitstraditionalvalues,eliminateelitisturbansocialstructures,andrenewthespiritofChinas
Communistrevolution.

1967Scattertheoldworld,buildanewworld.
UnderMaosleadership,thePartydestroyedculturalartifacts,bannedthevastmajorityofbooks,dismantledtheeducationalsystem,and
silencedmillionsforthoughtcrimesagainsttheParty.InadevastatingblowtoChinashumancapital,Maoorderedchildrenofprivileged
urbanfamiliesincludingcurrentPresidentXiJinping,whenhisfather,XiZhongxun,waspurgedtorelocatefarawayfromtheirfamiliesto
bereeducatedthroughmanuallaborinChinascountryside.WhatmayhavebeenthemostpromisingyouthofthatLostGenerationwere
deprivedoftheireducationsandforcedintohardship.

1972PresidentXiJinpingduringtheCulturalRevolution
ConsideringthelegacyoftheGreatLeapForward,theGreatChineseFamine,andtheCulturalRevolution,itisanunderstatementtosaythat
MaoshardlinepoliciesdevastatedtheeconomyandleftdeepscarsatalllevelsofChinesesociety.AfterMaosdeathin1976,itdidnttakelong
forthepragmaticDengXiaopingtowincontrolofthePartyandtakeChinainaneweconomicdirectionthoughwithessentiallythesame
repressivepoliticalsystem.
AndnowyoungXIJinpinghascomefromexperiencingtheCulturalRevolution,gettingreadytoembarkuponwhatwebelieveissomethingas
equallyasrevolutionaryasthefirstGreatLeapForward.Thequestionmarkiswhetheritwillbeanotherdisasteroradecisiveleapintoanew
future,perhapsevenanewworldorder.
MyfriendWoodyBrockremindsusinhislatestPROFILEthatthetheoryofgrowthinemergingmarketsdatesfrom1960,withthepublicationofWalt
WhitmanRostowsbookTheStagesofEconomicGrowth.Rostowgaveusadescriptionoffivedifferentstagesthatmarkthetransformationof
traditional,agriculturalsocietiesandmodern,massconsumptionsocieties.
Thefirstthreestagescanbeaccomplishedjustasreadilyinatopdowneconomyasinabottomupeconomy,andtherearehistoricalreasonsto
believeacommandeconomymighthavesomeadvantages.Thetrickypartisintheevolutionfromasocietythatisindustrializingandbuilding
infrastructureintoaneconomythatisconsumerdrivenandthusbydefinitionmustbebottomupandentrepreneurial.
Commandeconomies,withtheircronycapitalismandunequalruleoflaw,simplywillnotdevelopintofullfledged,economicallysuccessfulnations.
Further,therehastobebothexplicitandimplicitpermissionforentrepreneurialachievements.Cronycapitalism,whichisafalsecapitalism,seeksto
keeptheprofitsfromaneconomyinthehandsofasmallgroup.Andthatdynamiclimitsthegrowthoftheoveralleconomy.Toachieveafull
consumersocietytheremustbeopenadmissionforeveryoneintothehallsofbusinessandprivatepropertyownership.
WhatXiJinpingisattemptinginChinaisnolessrevolutionarythanwhatDengXiaopingdidin1980.Inmanywaysitwillbeharder,becauseDeng
wasembarkingonaphaseinwhichatopdowneconomymightthrive.Xihastochangetheverynatureofthecurrentsysteminspiteofentrenched
forcesthatdonotwanttogiveuptheirprivileges.
ThereisreasontobelievethatXiunderstandsexactlywhatneedstobedone.Thequestionis,canhepullitoff?Ifhedoes,Chinawillforatimegrow
atamuchslowerrate,andthenatureofitseconomicprogresswillshift.Heunderstandsthathecannotcontinuetogrowtheeconomyondebtforever.
Oratleastitappearsthathedoes.Onewaytolookatthecurrentanticorruptioneffortistoseeitasawaytodemonstratetodeeprootedcrony
capitaliststhattheirtimeisatanendandthatitstimetofigureouthowtoworkinthenewChinathatXiistryingforcefullytopullthenation
towards.
AnumberofourcontributorstothebookareoptimisticaboutthepotentialforChinatosucceed.Otherstheclearmajorityseelittlehope.Whatwe
havetriedtodointhebookisgiveyouasenseofallsidesoftheargument.Fortheoptimiststoberightwewillneedtoseecertaineventsunfoldina
reasonablytimelyfashion.Iftheydont,itwillbetimetotakeamorepessimisticview.Wehavetriedtobeevenhandedandopenmindedinour
selectionofauthorsandtopics.Andwhilewehaveourownviews,wehaveletourcontributorspresenttheirsasforcefullyaspossible.
ImimmenselyproudofthisbookandbelieveitwillbecomeoneofthedefinitiveexpositionsonmodernChina.Anditshouldbe,consideringthe
breadthanddepthofthecontributingauthors,manyofwhomyouwillrecognizeandotherswhomyouwillbegladtohavemet.Takeaglanceatthe
listofcontributingauthors(inalphabeticalorder),allfirstrateexpertsintheirfields:
AndrewBatson,IanBremmer,ErnanCui,JasonDaw,AmbroseEvansPritchard,LouisVincentGave,DavidGoldman,MarkHart,NeilHowe,
SimonHunt,GeorgeMagnus,JawadMian,LelandMiller,RaoulPal,MichaelPettis,SamRines,JackRivkin,NourielRoubini,GillemTulloch,
LoganWright,andWeiYao.PlusanintroductionandeditingbyWorthWrayandyourhumbleanalyst.

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Thebookisavailable(fornow)onlyinanebookformat.YoucangetitonAmazonKindle,iTunesBooks,andBarnes&NobleNook.Ifyouwantto
knowmoreaboutthebookandtheauthors,youcangotothispageonmywebsite.
Amazingly,andthankfully,therehavebeenanumberofverypositivereviewsbeforeweveevenannouncedthebook.(Ithasbeenliveforafewdays
justtomakesurethatallthetechnologywasworkingright.)

Andonelastdetail.Wehavesetthepriceofthebookat$8.99.Thatisnotatypo.Ifwetriedtodothebookinaprintformat,wewould
havetosetthepricecloserto$50.Thereareatleast100fullcolorgraphsandchartsintheentirebook,anditwouldjustnotbethesametopublish
theminablackandwhiteformat.Attheendoftheletter,inmypersonalsection,Iwillcommentontheprocessofselfpublishinganebookandhow
onegoesaboutmarketinginthisbravenewInternetworld.Someofyoumightfindthosethoughtsinteresting,butfornowletslookatakeysection
fromtheintroductiontothebook:
ThePeoplesRepublicofDebt
ItsnosecretthatChinahasamassivedebtproblem.RaoulPal(Chapter1:TheresSomethingWronginParadise)warnedbackin2003that
therewassomethingamissinChinassuccessstory.Sincethattime,foreigncapitalchasingabullishgrowthstoryandnervouscentralplanners
inBeijingactingtomaintainrapidGDPgrowthpost2008haveconjoinedtoenableoneofthelargestcreditboomsinhistory.
AccordingarecentreportfromtheMcKinseyGlobalInstitute,Chinastotaldebtstockmorethantripledbetween2000and2007andnearly
quadrupledfrom2007to2014asprivatesectorandlocalgovernmentborrowersaddedmorethan$26trillioninnewdebt.Thatexplosionin
domesticcreditliftedthecountrystotaldebttoGDPratiofrom121%in2000to158%in2007andto282%bytheendof2014andChinas
$21trillioninnetnewdebtincurredbetween2007and2014accountedformorethan36%ofthe$57trillionincumulativeglobaldebtgrowth
followingtheglobalfinancialcrisis.

Byanothermeasure,theexplosivegrowthinChinasfinancialsystemisliterallyunprecedented,withtotalassets(outstandingloans)standing
around$27trillionorroughlyonethirdofglobalGDP.AccordingtoMedleyGlobalAdvisorsLoganWright,Chinasbankingassetshave
grownbyroughly$17trillionsince2008,whilenominalGDPhasgrownto$4trillion.AsWrightexplainsinChapter3(Deliquification&
ChinasDeflationaryAdjustment),Therearenoavailablecomparisonsforacountryaddingaround20%ofglobalGDPinnewbankassets
oversuchashortperiodtheJapanesebankingsystempeakedataround20%ofglobalGDPintotalassets.Andweknowwhathappenedin
Japan.

Notonlyisthiskindofcreditboomunsustainable,itsalsoinherentlydestabilizing.Theharderandfasterthatcreditgrowthruns,thehigher
thechanceofbroadbasedmisallocation,whicheventuallyexertsadragoneconomicactivityjustaspowerfulastheboostitprovidedin
previousyears,andsometimesmoreso.AsGMTResearchsGillemTullochexplainsinChapter2(TheTyrannyofNumbers),Bubblesstarton
thebackofvastquantitiesofcheapcredit,arefedbythecreationofevergreaterquantitiesofit,andcollapsewhenthetapsareturnedoff.
ThismaximmayproveespeciallytrueforafinancialsystemlikeChinas,wherestateperpetuateddistortionsinthecostandavailabilityof
financinghave(1)funneledhugeamountsofcapitaltowardincreasinglyunproductive,statefavoredfirms

and(2)pushedhouseholdandprivatebusinessborrowersliterallyintotheshadows(withtheveryrecentdevelopmentofthenowmassive
shadowbankingsystem),wheretheburdenofsubstantiallyhigherinterestratesdragsonhouseholdconsumptionandraisestheoddsof
borrowerdefaults.
NowthatChinasbankingsystemhasbecomedeliquified,thethreatofdeflationisloominginaveryrealway.

AsChinascreditboomslows,theriskofborrowerdefaultsandtheburdenofbaddebtswillweighheavilyonthecountryslenders.Its
importanttonotethatnoonereallyknowshowlargethatburdenistoday.Whiletheofficialnonperformingloan[NPL]ratioreportedby
Chinesebankshasrisenby50%sinceearly2014,thecountrysregulatedlendinginstitutionscontinuetoclaimtheNPLsareonly1.54%ofall
loans.
Wehaveaveryhardtimebelievingthatnonperformingloansareonly1.5%(orevenlimitedtothehighsingledigits),consideringhowquickly
thePeoplesBankofChinaloosenedcreditconditionsandmandateditsbankstolendwhentheglobalfinancialcrisishit.Underwriting
standardstendtogooutthewindowduringperiodsofstatemandatedrapidcreditgrowth,particularlyintimesofcrisis.
Forexample,justlookatthechangeintotalsocialfinancinggrowthsince2005(redlinebelow)versusChinasbanklendingboomfrom1991to
2004(blueline).Whilesomeanalystswouldarguetheeconomywasevenmorebeholdentothestatesectorinthe1990sandthatlending
practicesthenwerefarlessefficient,wedoubtthatChinaslendershaveimprovedtheirunderwritingpracticestothepointthatnonperforming
loanswoulddramaticallydifferbetweenthetwoepisodes.

AsyoucanseeinthechartbelowfromTheEconomist,itiswidelybelievedthatChinasnonperformingloanratiopeakedsomewherebetween
30%and40%bythelate1990salthoughsomeanalysts(likeSocieteGeneralesWeiYao)arguethatthetruenumberwasmorelike50%
higherthanRussiasin1995,Chilesin1981,orMalaysiasin1997,andtwicethatofMexicosin1994.ThebottomlineisthatChinaslast
comparablelendingboomproducedanonperformingloanburdenatleast20xlarger(asapercentageoftotalloans)thanthefigureChinese
lendersarereportingtoday(andperhaps30x!).

IfyoutalkwiththemanagementatmajorChinesebanks,asChinaBeigeBookInternationalsLelandMiller(Chapters8and19)doesona
regularbasis,theyallconfessthatnonperformingloansareaMAJORprobleminChinabutaskifnonperformingloansareaproblemattheir
particularbanks,andthemanagersconsistentlyreportthattheirbanksareinperfecthealth.Thatdynamicisuncomfortablyreminiscentof
Japaninthelate1980s,whichservesasachillingreminderthatmanageablerotwithinalargelystatecontrolledbankingsystemcanexplode
intohigherthanexpectedNPLsintheeventofarealcrisis.
HereswhatLelandMillerhastosayaboutChinasNPLproblem:
TheNPLsituationiscompletelyopaqueit'sthedeepestanddarkestofBeijing'sstatesecrets.Butwecanbeveryconfidentofafew
things:
a.ThelevelofreportedNPLsiscompletelyunrealistic(take,e.g.,ChinaDevelopmentBank'ssub1%NPLlevelformanyyears...despite
aportfolioofborrowersthatincludesCentralAsiankleptocrats,unprofitableChineseSOEs[stateownedenterprises],Africansmall
businesses,andLatinAmericanenergyplays)
b.NPLlevelshavealwaysbeenkeptartificiallylowsimplybyrollingoverthedebt,sothatthedebtnevertechnicallybecomes
nonperformingand
c.NPLsarerecordedaspartofa5levelclassificationsystem,butthelevelsaresubjectquiteeasilytomassmanipulationsimplyby
tweakingtheparticularclassificationoftheloan.Ifyouhavetoomanylevel3loans,e.g.,thenjustmoveabunchofthemtolevel2asan
administrativematter.
Withallthatinmind,theofficialNPLnumbersaresimplynotbelievableandthetrueburdenofbaddebtsmaynotbemanageable.
WhileBeijinghadthewherewithaltocleanupitsbanksintheearly2000sbyrecapitalizingmajorlendersandshiftingthebadassetstoasset
managementcompanies(AMCs),ithasntactuallyresolvedthebaddebts,evenaftermorethanadecade.AccordingtoTheEconomist,
NPLs[theworstoftheworstbadloans]werehivedoffintofournewAMCs:Huarong,ChinaOrient,ChinaGreatWallandCinda.From
1999to2004loansworthover2trillionyuan($242billion)weretransferred.Thoughmostlybad,theloanswereusuallysoldatfullface
value.Theywerepaidforwithtenyearbonds,backedbythefinanceministry,thattheAMCsissuedtothebigstateownedbanks.But
sincemostNPLsfailedtorecoverinthattime,thesebondswereextendedanotherdecade.Inshort,thebailoutisstillgoingon.What
theAMCshavedonewiththeirassetsisunclear,astheyhavenotreleasedproperaccounts.SomeNPLshavebeensoldbutreportedlyat
only20%offacevalue.
AcomparableNPLproblem(orevenatrueNPLrateonethirdofthesize)wouldbefarmoredifficulttomanagefifteenyearslaterbecause,
whileChinasGDPhasgrownnearlyeightfoldsincetheyear2000,growthinbankingsystemassetshasdramaticallyoutstrippedthecountrys
economicgrowth.If,aswesuspect,NPLsarecloserto11%(ataminimum)thantotheofficial1.54%,Chinamayhaveamountainofbadloans
equaltomorethan20%ofitsGDPandmaybemorethan40%ofGDP.Wearenowtalkingtrillionsofdollars.EvenforChina,thatisagreat
dealofmoney.
RecapitalizingChinaslenderswouldlikelyrequireamassivetransferoftoxicprivatesectorassetsdirectlyontothestatesbalancesheetandas
weveseeninJapansincethelate1980sandacrossthedevelopedworldsince2008,majorpublicsectorbailoutstendtodragheavilyon
economicgrowth(asdothelongertermheadwindsofChinasdemographicdecline,whichSaeculumResearchsNeilHoweoutlinesinChapter
4:ACrisisLoomsinChina.)
ButasLoganWrightexplainedtousrecently,Beijingdoesnthaveasmuchincentivetocleanupitsbankstodayasitdidintheearly2000s,
withtheintenttoissuebankequitytotherestoftheworld.TheCCPleadershipismoreinterestedinmakingsuretheNPLsecretstayshidden.
Fornow,theproblemremainsunconfronted,tothedetrimentofChinasfinancialsystem.AsLoganexplainsinChapter3(Deliquification&
ChinasDeflationaryAdjustment),thebanksareforcedtopretendthatthismountainofbadassetsisperformingbutthatpretensedoesnt
changethefactthatimpairedcashflowsfromthebanksloanportfolioswhatLogancallsdeliquificationareforcingmanyofthebanksto
scrambletoborrowcashfromoneanotherorfromthePBoCjusttostayliquid.
Itsarecipeforinevitabledeleveraginganddeflation,ifnotdisaster.
ButtheproblemisnotfullycontainedwithinChinasregulatedbankingsystem.Wevealsoseensubstantialgrowthoverthepastfewyearsin
shadowlending.Thesumsinvolvedcould,accordingtoNomuraSecurities,standatmorethan$3.5trillion.Alotoftheseloansmade

throughwealthmanagementproductsandtrustsareactuallyoffbalancesheetassetsofChinasbanks,butverylittleisknownabouttheir
assetquality.Defaultsintheshadowscouldcastacloudofnegativeconfidenceontheentirefinancialsystem,whichinturnincreasestherisk
thatBeijingcouldlosecontrol.

Fornow,creditgrowthisslowingasChinasinherentlydeliqufiedbankingsystemscramblestostayliquid,anditishavingamaterialimpact
oneconomicactivity.Asyoucanseeinthechartbelow,ChinasyearoveryearcreditgrowthisstilloutpacingthecountrysGDPgrowthrate
butbothareslowingmaterially.Andsinceitdoesnotseempossibleforrapidcreditgrowthtocontinueformuchlongerwithouttriggeringsome
nastyconsequencesinChinasfinancialmarkets,growthshouldslowsubstantiallymore.

OurconcernatthisjunctureisthatamaterialslowdowninbothcreditgrowthandeconomicactivitydoesnotseemconsistentwithBeijings
immediateplans.PremierLiKeqianghasadamantlymaintainedthatBeijingwillhitits7.1%growthtargetin2015andinsiststhattheState
CounciliscommittedtobothmanagingcreditgrowthandmaintainingmediumtohighspeedgrowthwhilemakingsurethattheChinese
economyachievesamediumtohighlevelofdevelopment(intermsofrealGDPpercapita).AsformerUBSChiefEconomistGeorgeMagnus
outlinesinChapter10(TheContradictionattheHeartofChinasGrowthStrategy),thesegoalsareindirectcontentionwithoneanother.
UntilPresidentXiJinpingandhisreformersmoveforwardwithmeaningfulreformstorebalanceChinaseconomytoahealthiergrowthmodel
(whichwewilldiscussshortly,butsufficeittosayitwillrequireatleastasubstantialslowdowntoactuallywork),thereisnochanceof
maintaining5%+growth,muchlesstheStateCouncils7.1%GDPtarget,withoutrelyingoncreditexpansion.
Thereinliestheproblem,asyoucanseeinthegraphbelowfromGMTResearchsGillemTulloch(Chapter2:TheTyrannyofNumbers).
Chinasprivatesectoristakingonmoreandmoredebtwithlessgrowthtoshowforiteveryyear.Andasthatcreditmultipliercontinuestofall,
moreandmorecreditgrowthwillbeneededjusttomeetBeijingstarget...oreventosupportagradualslowdownoverthenextseveralyears.

Gillemelaborates:
Inordertoachievethe7%[annual]realGDPgrowthtargetoverthenextfiveyears(20142018),thebankingsystemwillneedtocreate

RMB106trillion(US$17trillion)ofnewcredit.ThisassumesnominalGDPgrowthof9%[peryear]andbasedonthe2013credit
multiplierof0.3x.ThisistheequivalentofreplicatingthebalancesheetofCitigroupninetimesover.Moretothepoint,itmeansalmost
replicatingtheentirelistedUSfinancialsectorinjustfiveyears,afeatthattooktheworldsrichest,largestandmostsophisticated
economy200yearstoachieve[IfChinacontinuesatthisrate,]by2018itwillhavebuiltenoughnewapartmentsovertheprevious15
yearstopotentiallyrehouse55%ofitspopulation[and]willcommand65%oftheworldscementproductionand59%ofitssteel.
IfthecreditboomthatledtoanoutrightexplosioninChinasdebtfrom$2.1trillionto$28.2trillionin14yearswasunsustainable,thekindof
creditgrowthrequiredtomeettheChineseCommunistPartysgrowthtargetoverthenextfiveyearsisliterallyimpossible.Thisdynamiccould
setupacrisisofconfidenceinthecomingyearsifBeijingdoesnotmateriallyloweritsgrowthtargetandtakeurgentstepstowardreform
movesthatrepresentamajorbutnecessaryriskforadangerouslyoverleveragedeconomy.
Thatriskbegsthemostimportantquestionofall:isChinasdebtburdenmanageablewithoutdisastrousconsequences?Analystsbroadly
disagree,asyouwillseeinthisbook,butitsaconversationweneedhave.Theanswertothisquestionwillhaveaprofoundimpactonglobal
growthandyourinvestmentportfolio.Therearefewmoreimportantquestionsinthemacroeconomicworld.
Whatsmore,thereareNOexamplesofANYcountrysaddingbankingassetsasquicklyhasChinahasoverthepastseveralyearsandcertainly
notonthisscale.Therearesimplynogoodhistoricalprecedentsbutifwemakeasimplecomparisontothelargestfiveyeardebtboomsin
modernhistory,ChinasexplosivegrowthinTotalSocialFinancingfrom2009to2013(whencreditgrowthwasthemostintense)ranksinthe
topfive.

Lookingatasampleof43majoreconomiesoverthelast50years,IMFeconomistsGiovanniDellAriccia,DenizIgan,andLucLaevenfound
onlyfourothercasesofcomparablelendinggrowthandeachofthosecountriesexperiencedabankingcrisisand/orasharprecessionwithin
threeyearsoftheirrespectivebooms.
Inotherwords,therearenocasesinmodernhistorywhereaneconomyhasmanagedtoavoidanoutrightbustafterexperiencingrapid
lendinggrowthanywhereintheneighborhoodofChinasongoingcreditboom.None.Andevenifwelooktothe48instancesoverthelast50
yearswherelendingmeasuresexpandedbyaslittleas30%overfiveyears(lessthanhalfthemagnitudeofChinascreditexplosion),thereis
stilla50%chanceofabankingcrisisoranabruptfallingrowthduringthepostboomperiod.
Moreover,themodelforatypicalcreditboom(outlinedinDellAriccia,Igan,Laeven,&Tongs2012paperPoliciesforMacrofinancial
Stability:HowtoDealwithCreditBooms)suggeststhatpainfulpostboomadjustmentstendtooccurwhenthepaceofcreditgrowthsimply
coolsbacktowarditslongtermmedian.ThatcoolingprocessisalreadywelladvancedinthePeoplesRepublic,whichmeanswehaveto
considerwhatthelackofcheapandindiscriminatefundingwillrevealaboutthequalityofloans(andthevalueoftheunderlyingcollateral
mostlyrealestatebutalsocommoditystockpiles)madeinpreviousyears.Itsnotaprettypicture.

AsidefromtheclearandpresentdangerthateachofthesevulnerabilitiesposestoChinasfuturegrowth,thesituationinthePeoplesRepublic
doesstandoutfrompastcreditboomsinoneway.ThePeoplesRepublichassubstantialbuffersoratleasttheoutwardappearanceof
buffers,basedonofficialdatatosupposedlydefendagainstcapitalflight,absorbsuddenlossesinabankingcrisis,andcommuteahard
landingintoalongerperiodofsubduedgrowth(whichBeijingmightormightnotallowtobeshowninitsheadlineGDPfigures).Accordingto
officialdatasanctionedbytheChinesegovernmentandoutlinedbytheIMFinitslatestannualChinastaffreport,Totalpublicdebtis
relativelylowpublicsectorassetsarelarge(includingforeignexchangereserves)domesticsavingsarehigh,andforeigndebtexposureslow
capitalcontrolslimittheriskofcapitalflightandthegovernmentretainssubstantialleverstocontroleconomicandfinancialactivity.
Thelegitimacyandadequacyofthesebuffersinarealcrisisiscertainlyupfordebate,butitishardtoarguethattheChinesegovernmentdoes
nothaveatleastsomeresourcestocontainanimminentcrisisandbuymoretime.

JudgingfromanIMFpodcastreleasedinAugust2014,thesebuffersareoneoftheonlyreasonsforoptimism,evenifBeijingdoesmakethe
harddecisiontoexpediteitshighstakesreformagenda.ThoughtheIMFsChinamissionchief,MarkusRodlauer,isagenerallyoptimistic
quasigovernmentstaffeconomist,hesclearlysoundingthealarm:
Ourassessmentaftercarefulanalysisisthattheneartermriskofahardlandingreallyislow.Andwecometothisjudgmentbecausewe
seeaneconomythatstillhassubstantialbuffersbothintermsoftherealeconomyandthewaythegovernmentcanmanagethe
economyinthenearterm,andthereforepreventahardlanding....
Bythesametoken,weneedtosaythatgiventhewaytheeconomyisgrowing,giventhewaytheriskshavebeen
accumulatingandarecontinuingtoaccumulateintheeconomy,unlessreformsareimplementedtoredirectthe
economytoasomewhatsafergrowthpath,theriskofahardlandingwillcontinuetoincrease....Generallythesesortsof
rapidcreditgrowthdoleadtoeitherabankingcrisisorasharpslowdownofgrowth[emphasisours].
Ifpastperformanceispredictiveoffutureoutcomes,growthmiraclesbuiltoncreditboomsalwaysendthesameway.Anepicbustmaynot
comeasquicklyasitmighthaveotherwise,butabustwillultimatelybedifficulttoavoidifBeijingrefusestoacceptalastingslowdown.Broad
based,debtfueledoverinvestmentmayappeartokickeconomicgrowthintooverdriveforawhilebuteventuallydisappointingreturnsand
consequentsellingleadtoinvestmentlosses,defaults,andbankingpanics.Chinacandefyhistoryabitlonger,butnotforever.
NewYork,Denver,Maine,andBoston
TomorrowIleaveforNewYork,whereIwillspendthenextfourweeksworkingandtryingtoplaytouristwhenIcan.BusinessrequiresthatIspenda
monthinManhattan,butIhavetoadmitthatIvealwayswantedtospendamonthinTheCityThatNeverSleeps,livinginoneoftheneighborhoods
andabsorbingthecultureandspendingsomewhatmorecasualtimewithfriends.Dutycalls,butIdontthinkitsgoingtobehardduty,evenforthis
Texasboy.
LaterinthemonthIwillgotoDenvertobewithmypartnersAltegrisInvestmentsataFinancialAdvisormagazineconferenceonalternativeinvesting,
whereIseeIwillbewithmyfriendLarryKudlow.ThenIandmyyoungestson,Trey,willonceagaingotoGrandLakeStream,Maine,fortheannual
CampKotok(a.k.a.TheShadowFed)migration.ThiswillbetheninthsummerthatTreyandIhavebeentothefishingandeconomicsfest.Heisnow
21yearsold,anditwilltechnicallybelegalforhimtoparticipateinthewinedrinking,althoughafewofmyfellowfishereconomistshaveindulged
himhereandthereovertheyears.LaterinAugustIintendtospendsometimewithWoodyBrockandotherfriendsinMassachusettsbeforeresuming
myperipateticwaysthisfall.
ImentionedthatIwouldsayawordortwoaboutthequandariesofpublishingAGreatLeapForward?asanebook.Choosingatraditional
publisherwouldofcoursegetmeareasonableadvance,andthereiscertainlynoassurancethatthisbookwillbringinthesamesortofincomewithout
aprintversion.Itmightsurprisereaderstoknowthatauthorsreallydontgetallthatmuchfromabooksoldbyatraditionalpublisherinanebook
format.Maybe10to15%.Technically,wewillbegetting70%.Isaytechnicallybecause
(1)Wehavetoassumeallthecostofeditingandformatting,whichisnotinconsequentialifyouretryingtodoitright,whichistheonlywayI
willdoit.And,
(2)Thisbookisactuallyfairlygraphicallydense.Andthevariousformats(Kindle,iTunes,andNook)actuallychargefortheextrabandwidth
thatittakestodownloadabookaboveafewmegabytes.Andbelieveme,weareaboveafewmegabytes.Dependingontheformatandthe
quantities,ourauthorssharecaneasilydropto50%.
Alotofpeopleassumethattodaythemajorityofbooksaresoldasebooks.Nottrue.Whiletheebookformatisstillgrowing,therateofgrowthnowis
nowherenearitstrajectoryinearlieryears.Therearealotofpeople(andIexpecttohearfromyou)whostillwanttheirbooksinphysicalform.Asone
reviewersaid,hewishedhecouldunderlineanddogearthepages.

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ButasaformerLudditewhothoughthewouldnevergiveuphisphysicalbooks,letmeofferthisthought.Inowalmostalwaysrefusetoreadabookif
IcantfinditonKindle.IcanstillhighlighteverythinginKindlewithmyfinger,makenotesinthemargins,anddocrossreferencesthatIcouldnever
doinprintedform.Further,andamazingly,Amazonoffersmeatabsolutelynocosttheabilitytocheckandcrossreferenceallofthosehighlightson
mypersonalAmazonKindlepage.Ithinkbackovermylast50yearsofbookreadingandrealizethatalltheparagraphsIunderlinedandnotesI
wroteareessentiallylost.IfIdonthavethebookandcantrememberwhatpagesomethingwason,Icantfindit.Now,withKindle,IcanandIfind
thatabilityremarkablyliberatingandempowering.WhileIdespairoverwhattimeandanimperfectmemoryhavecostme,Icannowspendapleasant
afternoonreviewingmyhighlightsandnotesandremindingmyselfofwhatIthoughtwasimportantatthetime.
AndsinceIcanreadonanyelectronicdevice(youdontneedaKindleoriPadorNook)andIcannowreadthesamebookonmultipledevices,Ienjoy
thefreedomofnothavingtocarry10poundsofbookswithmethroughanairportinordertohavesomethingtoread.
Andsoletmeclose(itstimetohitthesendbutton)withablatantmarketingmoment:ifyouhaventalreadyembracedwhattechnologycandofor
readers,youshouldseeournewbookasyourimpetustolaunchyourforayintotheworldofelectronicbooks.Again,youcangetthebookatKindle,
iTunesorNook,orcheckusoutatMauldinEconomics.
Youaregoingtothankmenotlongafteryoubeginreading.AnddareIpointoutthat$8.99isnotahugepricetopayforexploringanewtechnology.
Youcandownloadallthosebookappsonwhatevercomputerorotherdeviceyoumayhave.Forwhatitsworth,IhavemyKindleonmyiPhone,my
iPad,andmybrandnewMSIcomputer.(Afewofyoumightbesurprisedatmychoiceofboxes,asMSIisahardcoregamingcomputerbutitjust
hassomuchpowerpackedintosuchasmallformatthatIthoughttheextrafewhundreddollarswasworthit.Butthen,askmeagaininafew
months.IthoughtmyMicrosoftSurfaceProtabletcomputerwasgoingtobeagoodinvestmentandithaditsadvantagesbutattheendoftheday
Ijustfoundittobetoounderpoweredformetoworkon.)

Haveagreatweek.Iseealotofpoliticsandfundinnersandwritinginmynearfuture.IdontwanttoeventhinkaboutthenextbookIllwrite,butI
havetoadmit,therearethreeorfourprojectsbrewinginthebackofmyhead.AtsomepointthissummerIwillhavetoletoneofthemintomy
forebrain.Untilthen,IwillconcentrateonmyweeklyletterandgivingyouthebestofwhatIcomeupwith.
YourehopingChinacanleapthechasmanalyst,

JohnMauldin
subscribers@mauldineconomics.com

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