Meanwhile, Treasury Secretary Jack Lew's demand at the opening of this year's US-China Strategic and Economic Dialogue that the latter crack down on excess capacity in steel, aluminum, and other commodity industries underscores what Washington perceives to be the crux of the global economic funk.
"Excess capacity has a distorting and damaging effect on global markets," Lew said in a statement at the start of the two-day meeting. "And implementing policies to substantially reduce production in a range of sectors suffering from overcapacity, including steel and aluminum, is critical to the function and stability of international markets."But later in the day, Mr. Lew's counterpart, finance minister Lou Jiwei, decried such "hype" on overcapacity, firing back that it was fueled largely by Beijing's massive post-crisis stimulus that was initially hailed everywhere as a boon for global recovery.
“At that time, the whole world applauded and thanked China,” Mr. Lou told a news briefing near the end of a day of annual meetings in Beijing between senior Chinese and American officials. “Now they’re saying that China has a production glut that is a drag upon the world. But what did they say at the time?”The world's pivotal bilateral relationship has reached a new, awkward juncture. 2016 has exposed the two biggest economies as being just as intertwined on the downside as on the upside, as the Lew-Lou exchange is essentially the following spat:
US: Since you've invested like crazy in your industrial capacity, you're killing prices and threatening asset values all over the world.
China: We wouldn't even be talking about this if you hadn't urged us to chase growth and profits quarter by quarter instead of pursuing a more thoughtful long-term strategy.
The plain reality is that the US and China share the blame for the sorry state of the global economy in mid-2016. Nearly eight years after the onset of the global financial crisis, both countries remain fundamentally unbalanced - and badly in need of political leadership to rebalance faster.
The US "financialist" growth model was exposed as being broken in 2008, but it hasn't been replaced or even meaningfully reformed. Rather than end our reliance on debt-fueled asset inflation in the stock and housing markets to drive real economic growth, we simply let the federal government (with its trillion-dollar deficits) and Federal Reserve (zero interest rates and multi-trillion dollar QE over several iterations) pick up the slack that cash-strapped consumers left. It fueled a great recovery and bull run in housing, stocks, and bonds, but at the expense of even further financialization and decoupling of asset valuations from real economic growth and activity (i.e. employment and wages). The result: Donald Trump and Bernie Sanders.
For a while, in 2009-12, China offered some tangible pep to this even deeper retrenchment by Wall Street: its crisis-busting infrastructure and construction stimulus drove a global commodities boom that buoyed resource exporters on every continent and helped fuel the shale-fracking revolution in North America, even as it filled the coffers of established petro-states. The resultant financial and trade flows in turn lifted resource-poor emerging markets, as well; it also made a rising Chinese middle class the darling of Western multinationals.
But there was a fatal flaw to the Chinese rescue: it remained heavily dependent on exporting massive volumes of manufactured goods to the rich world. Before long, Chinese firms had captured such a large share of these lucrative markets that they had to engage in cutthroat price warfare both domestically and abroad, and their margins collapsed.
2012 thus marked a turning point for the "Chimerican" engine of the global economy: the slowdown in the first half of that year was effectively the end of the post-crisis recovery, which the eurozone periphery debt conundrum since late 2010 had exposed as running on thin ice.
Unhappily, however, 2012 was also a year of power transition in both Beijing and Washington, and both capitals chose one more bout of stimulus to promote stability - QE3 by the US followed by another infrastructure and real estate stimulus by China. This forestalled another global growth crash, but at the price of an irrevocable downward trajectory of global growth rates, as both east and west Chimerica were essentially papering over their structural distortions with more superficial expansion instead of actually attempting to fix them.
In the spring of 2013, as Xi Jinping took power and Obama began his second term, it was clear that the Fed's QE3 had introduced the unwelcome prospect of overheating and overspeculation in financial markets; thus did US monetary authorities announce a shift to a new tightening and "normalizing" policy stance - triggering the infamous "taper tantrum" of May and June - even though employment and inflation were still well below target.
But it was too late for China. The country had literally doubled down on its artificial stimulant recipe to goose GDP growth: in 2013, per one unofficial estimate, nearly half the country's entire fixed capital formation was wasted. Largely funded by "shadow" banks and financial institutions, a huge number of secondary market players had crowded into an already oversupplied and cash-tight economic environment with steadily building deflationary pressures (PPI had slipped into negative territory the previous March). In late June 2013, in reaction to the Fed's taper threat, an interbank bond default signaled a dramatic escalation of real (deflation-adjusted) borrowing costs which has been an unmistakable indicator of chronic industrial overcapacity and overproduction that only continued to worsen until the first quarter of this year.
A Stratfor assessment of the Chinese steel sector demonstrates the severity of the problem: in 2012, China's top five steelmakers accounted for 45 percent of nationwide output; in 2015, this was down to 34 percent. This points to a glut of steel firms and not merely steel plants: the 2012 stimulus clearly kickstarted capacity expansions at numerous smaller and less efficient concerns run by local governments or private individuals hoping to compete on land, subsidy, or labor cost advantages. Being as they were mostly in hinterland or otherwise domestically oriented economic zones, they still had plenty of short-term infrastructure and real estate construction business to feed, but in the process they brought online additional capacity that could only have been justified by the spillover of a resounding global recovery.
The only problem is that said global recovery didn't materialize. The Fed's flirtation with ending QE in 2013 turned out to be 18 months premature: it was expected at the time that US growth, which had averaged around a measly 2 percent since Q2 2009 to produce the weakest recovery on record, would somehow finally hit its potential of sustained 3 or even 4 percent expansion. Instead, the Fed discovered conclusively that 3+ percent annualized quarterly growth was unsustainable, but that it apparently wasn't necessary anyway, because even the prospect of ending QE and normalizing interest rates was enough to send hundreds of billions of offshore dollars - which had chased yields in emerging markets ever since US rates hit rock bottom in end-2008 - pouring back into US asset markets and taking stocks to new highs.
So in the latter half of 2013 and through 2014, American policymakers effectively convinced themselves that all that really mattered was their flagship market indices such as the S&P 500: it was still going up, so what could that possibly mean other than that the long-awaited true recovery was just around the corner? Unfortunately, their confidence rubbed off through virtual osmosis on their peers worldwide, leading financial institutions and firms everywhere to buy into not just the imminent recovery narrative, but more generally the supposed omnipotence of central bankers. Despite all the talk about eventually unwinding QE, the Fed gave the unmistakable impression that its extraordinary accommodative stance wouldn't in effect end until frothy asset valuations had demonstrated they could do without it: it was a seemingly unbeatable formula of sustaining the hope of global recovery as if that alone would eventually actualize it, and it was such a no-brainer that the whole rich world was now following the Fed's lead and actually diving deeper into the kool-aid of this hyper-financialism even as the Fed itself was seeking to sober up again, however long this would take.
In fact, the whole grand experiment of ultra-easy monetarism was now producing increasingly pronounced imbalances and distortions. In the US, as the rush of returning offshore dollars hit the wall of prolonged zero rates and low revenue growth, the sure way for firms to keep their stocks elevated was to issue historically cheap bonds and recycle the proceeds to buy back their own shares. Tellingly, US yields were now so low that the junk-rated debt of small to mid-size shale frackers now cost them as little as 4 to 5 percent to issue; with oil prices still in the low-$100s, the renewed black gold rush was on - with devastating implications for crude prices in due course. Even so, things were getting even more out of whack in Europe and Japan: in the former, collapsing growth and returns coupled with the ECB's reluctance to emulate the Fed's QE meant that negative interest rates had to be introduced in mid-2014 (QE had to be launched anyway the following March); in the latter, the much-vaunted "Abenomics" inaugurated at the end of 2012, reliant on the BOJ's wholesale buying of government bonds, had persistently failed to restoke the flame of inflation. And of course, even these OECD travails were nothing compared to the virtual price Armageddon that was about to hit commodities and oil exporters in late 2014.
In this environment, China with its slowdown to 7.7 percent official growth in 2013 and 7.3 percent in 2014 - where close to 10 percent had been projected before the 2012 downturn - still appeared to be a great investment. But this only fed further into the fixed-asset bubble driven by the white-hot real estate market: even as that market leveled off and began to decline, through 2014 Chinese firms were able to gorge on even more cheap dollar-denominated debt from yield-starved international investors.
By the time the Fed finally wound down its QE purchases in November 2014, it was clear that interest rate normalization would have to wait: pressures which had been building in emerging markets over the past 18 months were now truly coming to a head, and before long, even China couldn't escape the nasty effects of the drastic constriction of global dollar-denominated finance and trade flows.
The catalyst was oil, which in H2 2014 plunged from nearly $120 a barrel to little above $40; initially hailed as a boon for Western consumers and Asian manufacturers, by early 2015 signs were unmistakable that this crash, along with a much broader general bust in commodities, was quite the contrary sending a major deflationary wave across the global economy. It was at this juncture that China suddenly came to the forefront as the vortex of a disinflationary, growth-draining whirlpool from which the entire world would struggle to escape.
With US QE's end and the tightening of dollar trade triggered by plunging commodities, the Chinese central bank (PBOC) had to embark on a series of interest rate and reserve requirement ratio (RRR) cuts for the banking system simply to keep growth from falling off a cliff; but as the dollar strengthened dramatically against other currencies, the dollar-pegged yuan shot up with it. As China's oil and commodity suppliers slid into outright recession in early 2015, they were creamed by this double whammy of an ultra-strong dollar-yuan pair, but China was itself now hardly immune to the greenback's shrinkage: the yuan's appreciation against the euro and yen crimped the dollar value of exports to Europe and Japan so badly that new record exports to the US couldn't compensate. Through all of this, Chinese firms kept churning out ever cheaper goods in ever greater quantities, hammering industrial commodity prices worldwide and putting even more pressure on manufacturers across the spectrum in both developed and emerging markets; but by April and May of 2015 they were downright struggling with dollar funding and cash flow shortages to keep up with the dollar liabilities they had racked up, and PBOC now had to start draining its once nearly $4 trillion-strong chest of foreign exchange reserves to plug the gaps lest a run on the yuan force a devaluation.
That devaluation turned out to be unavoidable. In the wake of the Chinese stock market crash in late June and early July (and Beijing's botched rescue effort) against the backdrop of continued growth and trade deterioration, Chinese corporates ramped up their redemptions of yuan for precious scarce dollars so much that PBOC had no choice but to break the currency peg on August 11 with a nearly 2 percent cut of the yuan's daily fixing against the dollar. That's when hell broke loose. Capital outflows grew from a leak to a flood, forcing Beijing to run down its reserves to stop a tanking yuan sliding even faster and further, especially in the open offshore market (Hong Kong). This sudden, unanticipated nearly 4 percent decline in the tender of the world's factory floor proved too much for the global financial system to handle: beginning with an eye-popping 1,000-point intraday selloff in the Dow on August 24, US stocks suffered a massive correction over the following 3-4 weeks, which ended up liquidating over $5 trillion in market capitalization worldwide; in August and September alone, Chinese forex reserves fell by about $200 billion as PBOC scrambled to prop up the yuan.
The final nail in the coffin of the US-China global growth engine was the Fed's long-awaited first rate hike in nearly a decade in mid-December. China's woes over the summer were a rude wake-up call that the middle kingdom had indeed caught the deflationary contagion that had already devastated its commodity suppliers, and this was enough to delay a hike in September. By then, financial markets had begun in earnest to reprice risk, rate, and growth expectations: yield premiums ballooned and yield curves flattened. Despite these red flags, the Fed wouldn't waver in its commitment to get the rate normalization ball rolling at long last: its very credibility was on the line, and the most widely followed headline metrics - Chinese GDP growth along with US jobs and stock indices - seemed resilient and buoyant enough for liftoff even if they weren't exactly stellar.
The rest is history. In January and early February, global markets vociferously disagreed with the Fed's hawkishness of planning four more hikes during 2016 on top of the 25-basis point bump on December 16. The new year started with Chinese stocks crashing again, and Beijing had to introduce draconian capital controls to stem a run on the RMB trumpeted by George Soros, starting off with an all-out sweep of the offshore market on January 12 which catapulted the overnight interbank rate in Hong Kong to over 66 percent. As China struggled to keep its financial system from getting away from it, turmoil now engulfed oil and commodities afresh, and this is where Uncle Sam finally got the message: with crude plunging to barely $26 a barrel in early February (towards what some were forecasting to be as little as $10), even flagship Western investment banks were coming under threat from the prospect of massive defaults of their big plays in the oil patch. In collusion with the BOE and ECB, the Fed bailed Deutsche Bank out of a complete meltdown on February 11. That was the day Washington effectively slammed the breaks on its rate normalization schedule. It also marked the start of a provisional global collusion to stabilize the yuan against the dollar by weakening the latter against the euro and yen, which some suspect was fleshed out secretly at the G-20 meeting in Shanghai on February 26-27.
And so, here we are: China and the US have been forced into an uneasy cooperation to keep the global economy they jointly lead from falling apart. The discomfort and inconvenience of the arrangement for both sides is palpable - akin to a husband and wife who literally can't bear one another but must still share a roof for the sake of the kids.
While American pleas over Chinese overcapacity don't quite amount to the absurdity of asking China to make the world poorer by raising the cost of basic materials and components which are the building blocks of the real economy, that's because an even more sardonic twist is approaching completion. America's "free market", having succeeded so thoroughly over the past generation in enlisting the very archetype of socialist command-and-control (China) to enrich its ruling caste, now finds itself begging those communists to forestall that very "free market" from playing out globally - lest it naturally correct its gross imbalances and distortions too efficiently for said caste's psychological tolerance for losses.
Indeed, Chimerica's turning out to be even more chimerical on the downside than on the upside. The real world may not be such a horrible place for it - that is, its masses of ordinary inhabitants. But it's become downright FUBAR for the ideological fundamentalists who long ago cheerfully reduced capitalism to just one thing: a black bottom line.
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