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Well, That Didn’t Last Long. China Blinks When It Comes to Financial Reform

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China is on the horns of a dilemma with no good way out. On the one hand, China has driven growth for the past eight years with excessive credit, wasted infrastructure investment and Ponzi schemes like wealth management products (WMPs).

The Chinese leadership knows this, but they had to keep the growth machine in high gear to create jobs for millions of migrants coming from the countryside to the city and to maintain jobs for the millions more already in the cities. The Communist Chinese leadership knew that a day of reckoning would come.

The two ways to get rid of debt are deflation (which results in write-offs, bankruptcies and unemployment) or inflation (which results in theft of purchasing power, similar to a tax increase). Both alternatives are unacceptable to the Communists because they lack the political legitimacy to endure either unemployment or inflation. Either policy would cause social unrest and unleash revolutionary potential.

The Tiananmen Square protests and massacre of 1989 did not start out as a liberty movement, although that’s how they are remembered in the West. It started out as an anti-inflation protest, and that’s how the Communists remember it. Instead of these unpalatable extremes, the Chinese leadership is trying to steer a middle course with gradual financial reform and gradual limits on shadow banking.

In prior columns, I predicted that this gradual policy would not work because the credit situation is so extreme that even modest reform would slow the economy too fast for comfort. That’s exactly what has happened, according to this article.

China has already flip-flopped and is easing up on financial reform. That works in the short run but just makes the credit bubble worse in the long run.

China may soon resort to a combination of a debt cleanup and a maxi-devaluation of their currency to export the resulting deflation to the rest of the world. When that happens, possibly later this year in response to Trump’s trade war with China, the effects will not be confined to China.

A shock yuan maxi-devaluation will be the shot heard round the world as it was in August and December 2015 (both times, U.S. stocks fell over 10% in a matter of weeks). The trade and currency wars are far from over. Get ready for more volatility and drawdowns in U.S. stocks.

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