It's Time to Get Real About Your Investments

ABrandNewBookAvailableOnlineThePeoplesRepublicofDebtNewYork,Maine,andBoston

ItwasntthatmanycenturiesagothatChinawastheabsoluteeconomiccenteroftheworld.ThatcentergravitatedtoEuropeandthentowardsNorthAmericaandhasnowbegunmovingbacktoChina.MycolleagueJawadMianprovidedthischartshowingtheevolutionofEarthseconomiccenterofgravityfrom2000yearsagotoafewyearsandintothefuture:

MostinvestorsarewellawareoftheenormousimpactChinahashadonthemodernworld.ThirtyfiveyearsagoChinaswasprimarilyanagrariansociety,withmuchofthenationtrappedinmedievaltechnologiesandlivingstandards.Today500millionpeoplehavemovedfromthecountrytothecitiesandChinasurbaninfrastructureis,ifnotthebestintheworld,closetothatstandard.

TheeconomicmiraclethatisChinaisunprecedentedinhumanhistory.Therehassimplybeennothinglikeit.DengXiaopingtookcontrolofthenationinthelate70sandpropelleditintothe21stcentury.Butnowthestoryischanging.ThosewhothinkthatallprogressionislinearareinforarudeawakeningiftheyarebettingonChinatounfoldinthefutureasithasinthepast.

Amongthemostimportantquestionsforallinvestorsandbusinessmenis,howwillChinamanageitsfutureandtheproblemsitfaces?Therearemanyproblems,someofthemmonumentalandatthesametimethereisanamazingamountofopportunityandpotential.Understandingthechallengesanddecipheringthelikelyoutcomesisitselfanimmensechallenge.

ABrandNewBookAvailableOnline

MycolleagueWorthWrayandIhavebeeninvestigatingandwritingaboutChinaforsometimenow.TodayImannouncingabookthatwehavewrittenandeditedincollaborationwith17wellknownexpertsonChina.ThebookiscalledAGreatLeapForward?MakingSenseofChinasCoolingCreditBoom,TechnologicalTransformation,HighStakesRebalancing,GeopoliticalRise,&ReserveCurrencyDream,andwethinkitwillhelpyoutoasolidunderstandingofbothChinasproblemsanditsopportunities.Iknow,thesubtitleisatadlong,butthebookdoesreallycoverallthoseaspectsoftodaysChina.

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Noticethatthereisa?afterthetitleAGreatLeapForward.ThefirstGreatLeapForward,initiatedbyMaoTsetungintheearly60s,wasanutterdisaster.Itdevastatedthenation,bankruptedtheeconomy,andcausedthedeathsoftensofmillionsofpeople.Letsreviewalittlehistoryfromtheintroductiontothebook:

WhenChairmanMaodecidedin1958totransformChinaslargelyagrarianeconomyintoasocialistparadisethroughrapidindustrialization,collectivization,andacompletesubjugationofthemarkettoChineseCommunistParty(CCP)centralplanners,thewidespreadmisallocationofresourcesledtotheworstfamineinrecordedhistoryandtheoutrightcollapseofChinaseconomy.

WithverylittlecapitalatChinasdisposalafteritslongcivilwarandevenlongersubjugationtoforeigncolonialistsinthenineteenthandearlytwentiethcenturies,Maodecidedthebestwaytofundthecountrysrapidindustrializationwasforhisgovernmenttomonopolizeagriculturalproduction,usethenationsbountytosupportindustrializingurbanpopulations,andfinancefixedassetinvestmentswithcropexports.

Thoughts from the Frontline

ThePeoplesRepublicofDebtBYJOHNMAULDIN JUNE14,2015

1959Prosperitybroughtbythedragon&thephoenix

SeeinggrainandsteelproductionastheessentialelementsofChinasrapiddevelopment,Maoboastedin1958thatChinawouldproducemoresteelthantheUnitedKingdomwithinfifteenyears.

1959Smeltalotofgoodsteelandacceleratesocialistconstruction.

Maohadverylimitedknowledgeofagricultureorindustrialproduction,yetheruledChinawithanironfistandsilencedevenwellintentionedopposition.Chinasruralpeasantswereforcedintocollectiveshouseholdsweretornapartandprivatepropertyrightswerecompletelyabolished.Maoorderedagriculturalcollectivestoproducemoregrainwhileforcingfarmerstoemploylessproductivemethodshemobilizedfarmerstokilloffpestslikemosquitos,rats,flies,andsparrows(acampaignthatupsettheecologicalbalanceinChinasfarmlands)andinsistedonadoublingofsteelproductiontobeachievedbydivertingfarmerswithnoindustrialskillintooperatingpoorlysuppliedbackyardfurnaces(whichcouldnotburnhotenoughtoproducehighqualitysteel).

1959UnskilledworkerssmeltsteelinChinasbackyardfurnaces.

Steelproductionsurged,andtheeconomyappearedtoboombutatleasthalfofthatnewproductionwasunusable.Aproliferationofcropeatinglocusts(afterthesparrowshadbeenkilledoff)andthediversionoffarmworkerstoindustrialandpublicworksprojectsledtoacollapseincropyields.Still,localofficialsalloverChinafalsifiedtheirproductionfiguresinanefforttowinfavorwithBeijing(andtosparethemselvesMaoswrath),whichledtolargerandlargergrainshipmentstoChinascitiesandsmallerandsmallerrationsforthoselivinginitsagriculturalcollectives.

InsteadoftakingaGreatLeapForwardtoaharmoniousindustrialsociety

1959Thecommuneislikeagiganticdragon,productionisnoticeablyaweinspiring.

MaoscommandandcontrolsystemdismantledtheChineseeconomy,ruinedmillionsoflives,andleftanenormousshareofChinaspopulationdisillusioned.

Industrializationfailed.From1958to1961,millionsdiedofstarvationandexhaustionacrossChinascountryside(independentestimatesrangefrom30millionto70million,whiletheCCPstillinsiststhedeathtollwasonly17million),andthePeoplesRepublicremainedanetexporterofgrain.AsHarvardeconomistDwightPerkinsremembersit,Enormousamountsofinvestmentproducedonlymodestincreasesinproductionornoneatall....Inshort,theGreatLeapwasaveryexpensivedisaster.

AsproductionandproductivitycollapsedalongwiththeCCPssocialcontract,MaostruggledtoretainpowerasanumberofinfluentialofficialssoughttoimplementmoremarketorientedpoliciesinresponsetotheGreatFamine.FearingthatgrowingoppositioncouldleadthePartytorejectitsMarxistspirit(astheSovietUnionhaddoneunderNikitaKhrushchevadecadeearlier),in1966MaoandhisRedGuardslaunchedtheCulturalRevolutionadecadelongseriesofpurgesintendedtorootoutenemiesofCommunistthoughtlurkingwithintheParty,cleanseChinesesocietyofmanyofitstraditionalvalues,eliminateelitisturbansocialstructures,andrenewthespiritofChinasCommunistrevolution.

1967Scattertheoldworld,buildanewworld.

UnderMaosleadership,thePartydestroyedculturalartifacts,bannedthevastmajorityofbooks,dismantledtheeducationalsystem,andsilencedmillionsforthoughtcrimesagainsttheParty.InadevastatingblowtoChinashumancapital,MaoorderedchildrenofprivilegedurbanfamiliesincludingcurrentPresidentXiJinping,whenhisfather,XiZhongxun,waspurgedtorelocatefarawayfromtheirfamiliestobereeducatedthroughmanuallaborinChinascountryside.WhatmayhavebeenthemostpromisingyouthofthatLostGenerationweredeprivedoftheireducationsandforcedintohardship.

1972PresidentXiJinpingduringtheCulturalRevolution

ConsideringthelegacyoftheGreatLeapForward,theGreatChineseFamine,andtheCulturalRevolution,itisanunderstatementtosaythatMaoshardlinepoliciesdevastatedtheeconomyandleftdeepscarsatalllevelsofChinesesociety.AfterMaosdeathin1976,itdidnttakelongforthepragmaticDengXiaopingtowincontrolofthePartyandtakeChinainaneweconomicdirectionthoughwithessentiallythesamerepressivepoliticalsystem.

AndnowyoungXIJinpinghascomefromexperiencingtheCulturalRevolution,gettingreadytoembarkuponwhatwebelieveissomethingasequallyasrevolutionaryasthefirstGreatLeapForward.Thequestionmarkiswhetheritwillbeanotherdisasteroradecisiveleapintoanewfuture,perhapsevenanewworldorder.

MyfriendWoodyBrockremindsusinhislatestPROFILEthatthetheoryofgrowthinemergingmarketsdatesfrom1960,withthepublicationofWaltWhitmanRostowsbookTheStagesofEconomicGrowth.Rostowgaveusadescriptionoffivedifferentstagesthatmarkthetransformationoftraditional,agriculturalsocietiesandmodern,massconsumptionsocieties.

Thefirstthreestagescanbeaccomplishedjustasreadilyinatopdowneconomyasinabottomupeconomy,andtherearehistoricalreasonstobelieveacommandeconomymighthavesomeadvantages.Thetrickypartisintheevolutionfromasocietythatisindustrializingandbuildinginfrastructureintoaneconomythatisconsumerdrivenandthusbydefinitionmustbebottomupandentrepreneurial.

Commandeconomies,withtheircronycapitalismandunequalruleoflaw,simplywillnotdevelopintofullfledged,economicallysuccessfulnations.Further,therehastobebothexplicitandimplicitpermissionforentrepreneurialachievements.Cronycapitalism,whichisafalsecapitalism,seekstokeeptheprofitsfromaneconomyinthehandsofasmallgroup.Andthatdynamiclimitsthegrowthoftheoveralleconomy.Toachieveafullconsumersocietytheremustbeopenadmissionforeveryoneintothehallsofbusinessandprivatepropertyownership.

WhatXiJinpingisattemptinginChinaisnolessrevolutionarythanwhatDengXiaopingdidin1980.Inmanywaysitwillbeharder,becauseDengwasembarkingonaphaseinwhichatopdowneconomymightthrive.Xihastochangetheverynatureofthecurrentsysteminspiteofentrenchedforcesthatdonotwanttogiveuptheirprivileges.

ThereisreasontobelievethatXiunderstandsexactlywhatneedstobedone.Thequestionis,canhepullitoff?Ifhedoes,Chinawillforatimegrowatamuchslowerrate,andthenatureofitseconomicprogresswillshift.Heunderstandsthathecannotcontinuetogrowtheeconomyondebtforever.Oratleastitappearsthathedoes.OnewaytolookatthecurrentanticorruptioneffortistoseeitasawaytodemonstratetodeeprootedcronycapitaliststhattheirtimeisatanendandthatitstimetofigureouthowtoworkinthenewChinathatXiistryingforcefullytopullthenationtowards.

AnumberofourcontributorstothebookareoptimisticaboutthepotentialforChinatosucceed.Otherstheclearmajorityseelittlehope.Whatwehavetriedtodointhebookisgiveyouasenseofallsidesoftheargument.Fortheoptimiststoberightwewillneedtoseecertaineventsunfoldinareasonablytimelyfashion.Iftheydont,itwillbetimetotakeamorepessimisticview.Wehavetriedtobeevenhandedandopenmindedinourselectionofauthorsandtopics.Andwhilewehaveourownviews,wehaveletourcontributorspresenttheirsasforcefullyaspossible.

ImimmenselyproudofthisbookandbelieveitwillbecomeoneofthedefinitiveexpositionsonmodernChina.Anditshouldbe,consideringthebreadthanddepthofthecontributingauthors,manyofwhomyouwillrecognizeandotherswhomyouwillbegladtohavemet.Takeaglanceatthelistofcontributingauthors(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.Ifyouwanttoknowmoreaboutthebookandtheauthors,youcangotothispageonmywebsite.

Amazingly,andthankfully,therehavebeenanumberofverypositivereviewsbeforeweveevenannouncedthebook.(Ithasbeenliveforafewdaysjusttomakesurethatallthetechnologywasworkingright.)

Andonelastdetail.Wehavesetthepriceofthebookat$8.99.Thatisnotatypo.Ifwetriedtodothebookinaprintformat,wewouldhavetosetthepricecloserto$50.Thereareatleast100fullcolorgraphsandchartsintheentirebook,anditwouldjustnotbethesametopublishtheminablackandwhiteformat.Attheendoftheletter,inmypersonalsection,IwillcommentontheprocessofselfpublishinganebookandhowonegoesaboutmarketinginthisbravenewInternetworld.Someofyoumightfindthosethoughtsinteresting,butfornowletslookatakeysectionfromtheintroductiontothebook:

ThePeoplesRepublicofDebt

ItsnosecretthatChinahasamassivedebtproblem.RaoulPal(Chapter1:TheresSomethingWronginParadise)warnedbackin2003thattherewassomethingamissinChinassuccessstory.Sincethattime,foreigncapitalchasingabullishgrowthstoryandnervouscentralplannersinBeijingactingtomaintainrapidGDPgrowthpost2008haveconjoinedtoenableoneofthelargestcreditboomsinhistory.

AccordingarecentreportfromtheMcKinseyGlobalInstitute,Chinastotaldebtstockmorethantripledbetween2000and2007andnearlyquadrupledfrom2007to2014asprivatesectorandlocalgovernmentborrowersaddedmorethan$26trillioninnewdebt.ThatexplosionindomesticcreditliftedthecountrystotaldebttoGDPratiofrom121%in2000to158%in2007andto282%bytheendof2014andChinas$21trillioninnetnewdebtincurredbetween2007and2014accountedformorethan36%ofthe$57trillionincumulativeglobaldebtgrowthfollowingtheglobalfinancialcrisis.

Byanothermeasure,theexplosivegrowthinChinasfinancialsystemisliterallyunprecedented,withtotalassets(outstandingloans)standingaround$27trillionorroughlyonethirdofglobalGDP.AccordingtoMedleyGlobalAdvisorsLoganWright,Chinasbankingassetshavegrownbyroughly$17trillionsince2008,whilenominalGDPhasgrownto$4trillion.AsWrightexplainsinChapter3(Deliquification&ChinasDeflationaryAdjustment),Therearenoavailablecomparisonsforacountryaddingaround20%ofglobalGDPinnewbankassetsoversuchashortperiodtheJapanesebankingsystempeakedataround20%ofglobalGDPintotalassets.AndweknowwhathappenedinJapan.

Notonlyisthiskindofcreditboomunsustainable,itsalsoinherentlydestabilizing.Theharderandfasterthatcreditgrowthruns,thehigherthechanceofbroadbasedmisallocation,whicheventuallyexertsadragoneconomicactivityjustaspowerfulastheboostitprovidedinpreviousyears,andsometimesmoreso.AsGMTResearchsGillemTullochexplainsinChapter2(TheTyrannyofNumbers),Bubblesstartonthebackofvastquantitiesofcheapcredit,arefedbythecreationofevergreaterquantitiesofit,andcollapsewhenthetapsareturnedoff.

ThismaximmayproveespeciallytrueforafinancialsystemlikeChinas,wherestateperpetuateddistortionsinthecostandavailabilityoffinancinghave(1)funneledhugeamountsofcapitaltowardincreasinglyunproductive,statefavoredfirms

and(2)pushedhouseholdandprivatebusinessborrowersliterallyintotheshadows(withtheveryrecentdevelopmentofthenowmassiveshadowbankingsystem),wheretheburdenofsubstantiallyhigherinterestratesdragsonhouseholdconsumptionandraisestheoddsofborrowerdefaults.

NowthatChinasbankingsystemhasbecomedeliquified,thethreatofdeflationisloominginaveryrealway.

AsChinascreditboomslows,theriskofborrowerdefaultsandtheburdenofbaddebtswillweighheavilyonthecountryslenders.Itsimportanttonotethatnoonereallyknowshowlargethatburdenistoday.Whiletheofficialnonperformingloan[NPL]ratioreportedbyChinesebankshasrisenby50%sinceearly2014,thecountrysregulatedlendinginstitutionscontinuetoclaimtheNPLsareonly1.54%ofallloans.

Wehaveaveryhardtimebelievingthatnonperformingloansareonly1.5%(orevenlimitedtothehighsingledigits),consideringhowquicklythePeoplesBankofChinaloosenedcreditconditionsandmandateditsbankstolendwhentheglobalfinancialcrisishit.Underwritingstandardstendtogooutthewindowduringperiodsofstatemandatedrapidcreditgrowth,particularlyintimesofcrisis.

Forexample,justlookatthechangeintotalsocialfinancinggrowthsince2005(redlinebelow)versusChinasbanklendingboomfrom1991to2004(blueline).Whilesomeanalystswouldarguetheeconomywasevenmorebeholdentothestatesectorinthe1990sandthatlendingpracticesthenwerefarlessefficient,wedoubtthatChinaslendershaveimprovedtheirunderwritingpracticestothepointthatnonperformingloanswoulddramaticallydifferbetweenthetwoepisodes.

AsyoucanseeinthechartbelowfromTheEconomist,itiswidelybelievedthatChinasnonperformingloanratiopeakedsomewherebetween30%and40%bythelate1990salthoughsomeanalysts(likeSocieteGeneralesWeiYao)arguethatthetruenumberwasmorelike50%higherthanRussiasin1995,Chilesin1981,orMalaysiasin1997,andtwicethatofMexicosin1994.ThebottomlineisthatChinaslastcomparablelendingboomproducedanonperformingloanburdenatleast20xlarger(asapercentageoftotalloans)thanthefigureChineselendersarereportingtoday(andperhaps30x!).

IfyoutalkwiththemanagementatmajorChinesebanks,asChinaBeigeBookInternationalsLelandMiller(Chapters8and19)doesonaregularbasis,theyallconfessthatnonperformingloansareaMAJORprobleminChinabutaskifnonperformingloansareaproblemattheirparticularbanks,andthemanagersconsistentlyreportthattheirbanksareinperfecthealth.ThatdynamicisuncomfortablyreminiscentofJapaninthelate1980s,whichservesasachillingreminderthatmanageablerotwithinalargelystatecontrolledbankingsystemcanexplodeintohigherthanexpectedNPLsintheeventofarealcrisis.

HereswhatLelandMillerhastosayaboutChinasNPLproblem:

TheNPLsituationiscompletelyopaqueit'sthedeepestanddarkestofBeijing'sstatesecrets.Butwecanbeveryconfidentofafewthings:

a.ThelevelofreportedNPLsiscompletelyunrealistic(take,e.g.,ChinaDevelopmentBank'ssub1%NPLlevelformanyyears...despiteaportfolioofborrowersthatincludesCentralAsiankleptocrats,unprofitableChineseSOEs[stateownedenterprises],Africansmallbusinesses,andLatinAmericanenergyplays)

b.NPLlevelshavealwaysbeenkeptartificiallylowsimplybyrollingoverthedebt,sothatthedebtnevertechnicallybecomesnonperformingand

c.NPLsarerecordedaspartofa5levelclassificationsystem,butthelevelsaresubjectquiteeasilytomassmanipulationsimplybytweakingtheparticularclassificationoftheloan.Ifyouhavetoomanylevel3loans,e.g.,thenjustmoveabunchofthemtolevel2asanadministrativematter.

Withallthatinmind,theofficialNPLnumbersaresimplynotbelievableandthetrueburdenofbaddebtsmaynotbemanageable.

WhileBeijinghadthewherewithaltocleanupitsbanksintheearly2000sbyrecapitalizingmajorlendersandshiftingthebadassetstoassetmanagementcompanies(AMCs),ithasntactuallyresolvedthebaddebts,evenaftermorethanadecade.AccordingtoTheEconomist,

NPLs[theworstoftheworstbadloans]werehivedoffintofournewAMCs:Huarong,ChinaOrient,ChinaGreatWallandCinda.From1999to2004loansworthover2trillionyuan($242billion)weretransferred.Thoughmostlybad,theloanswereusuallysoldatfullfacevalue.Theywerepaidforwithtenyearbonds,backedbythefinanceministry,thattheAMCsissuedtothebigstateownedbanks.ButsincemostNPLsfailedtorecoverinthattime,thesebondswereextendedanotherdecade.Inshort,thebailoutisstillgoingon.WhattheAMCshavedonewiththeirassetsisunclear,astheyhavenotreleasedproperaccounts.SomeNPLshavebeensoldbutreportedlyatonly20%offacevalue.

AcomparableNPLproblem(orevenatrueNPLrateonethirdofthesize)wouldbefarmoredifficulttomanagefifteenyearslaterbecause,whileChinasGDPhasgrownnearlyeightfoldsincetheyear2000,growthinbankingsystemassetshasdramaticallyoutstrippedthecountryseconomicgrowth.If,aswesuspect,NPLsarecloserto11%(ataminimum)thantotheofficial1.54%,Chinamayhaveamountainofbadloansequaltomorethan20%ofitsGDPandmaybemorethan40%ofGDP.Wearenowtalkingtrillionsofdollars.EvenforChina,thatisagreatdealofmoney.

RecapitalizingChinaslenderswouldlikelyrequireamassivetransferoftoxicprivatesectorassetsdirectlyontothestatesbalancesheetandasweveseeninJapansincethelate1980sandacrossthedevelopedworldsince2008,majorpublicsectorbailoutstendtodragheavilyoneconomicgrowth(asdothelongertermheadwindsofChinasdemographicdecline,whichSaeculumResearchsNeilHoweoutlinesinChapter4:ACrisisLoomsinChina.)

ButasLoganWrightexplainedtousrecently,Beijingdoesnthaveasmuchincentivetocleanupitsbankstodayasitdidintheearly2000s,withtheintenttoissuebankequitytotherestoftheworld.TheCCPleadershipismoreinterestedinmakingsuretheNPLsecretstayshidden.Fornow,theproblemremainsunconfronted,tothedetrimentofChinasfinancialsystem.AsLoganexplainsinChapter3(Deliquification&ChinasDeflationaryAdjustment),thebanksareforcedtopretendthatthismountainofbadassetsisperformingbutthatpretensedoesntchangethefactthatimpairedcashflowsfromthebanksloanportfolioswhatLogancallsdeliquificationareforcingmanyofthebankstoscrambletoborrowcashfromoneanotherorfromthePBoCjusttostayliquid.

Itsarecipeforinevitabledeleveraginganddeflation,ifnotdisaster.

ButtheproblemisnotfullycontainedwithinChinasregulatedbankingsystem.Wevealsoseensubstantialgrowthoverthepastfewyearsinshadowlending.Thesumsinvolvedcould,accordingtoNomuraSecurities,standatmorethan$3.5trillion.Alotoftheseloansmade

throughwealthmanagementproductsandtrustsareactuallyoffbalancesheetassetsofChinasbanks,butverylittleisknownabouttheirassetquality.Defaultsintheshadowscouldcastacloudofnegativeconfidenceontheentirefinancialsystem,whichinturnincreasestheriskthatBeijingcouldlosecontrol.

Fornow,creditgrowthisslowingasChinasinherentlydeliqufiedbankingsystemscramblestostayliquid,anditishavingamaterialimpactoneconomicactivity.Asyoucanseeinthechartbelow,ChinasyearoveryearcreditgrowthisstilloutpacingthecountrysGDPgrowthratebutbothareslowingmaterially.AndsinceitdoesnotseempossibleforrapidcreditgrowthtocontinueformuchlongerwithouttriggeringsomenastyconsequencesinChinasfinancialmarkets,growthshouldslowsubstantiallymore.

OurconcernatthisjunctureisthatamaterialslowdowninbothcreditgrowthandeconomicactivitydoesnotseemconsistentwithBeijingsimmediateplans.PremierLiKeqianghasadamantlymaintainedthatBeijingwillhitits7.1%growthtargetin2015andinsiststhattheStateCounciliscommittedtobothmanagingcreditgrowthandmaintainingmediumtohighspeedgrowthwhilemakingsurethattheChineseeconomyachievesamediumtohighlevelofdevelopment(intermsofrealGDPpercapita).AsformerUBSChiefEconomistGeorgeMagnusoutlinesinChapter10(TheContradictionattheHeartofChinasGrowthStrategy),thesegoalsareindirectcontentionwithoneanother.

UntilPresidentXiJinpingandhisreformersmoveforwardwithmeaningfulreformstorebalanceChinaseconomytoahealthiergrowthmodel(whichwewilldiscussshortly,butsufficeittosayitwillrequireatleastasubstantialslowdowntoactuallywork),thereisnochanceofmaintaining5%+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]andbasedonthe2013creditmultiplierof0.3x.ThisistheequivalentofreplicatingthebalancesheetofCitigroupninetimesover.Moretothepoint,itmeansalmostreplicatingtheentirelistedUSfinancialsectorinjustfiveyears,afeatthattooktheworldsrichest,largestandmostsophisticatedeconomy200yearstoachieve[IfChinacontinuesatthisrate,]by2018itwillhavebuiltenoughnewapartmentsovertheprevious15yearstopotentiallyrehouse55%ofitspopulation[and]willcommand65%oftheworldscementproductionand59%ofitssteel.

IfthecreditboomthatledtoanoutrightexplosioninChinasdebtfrom$2.1trillionto$28.2trillionin14yearswasunsustainable,thekindofcreditgrowthrequiredtomeettheChineseCommunistPartysgrowthtargetoverthenextfiveyearsisliterallyimpossible.ThisdynamiccouldsetupacrisisofconfidenceinthecomingyearsifBeijingdoesnotmateriallyloweritsgrowthtargetandtakeurgentstepstowardreformmovesthatrepresentamajorbutnecessaryriskforadangerouslyoverleveragedeconomy.

Thatriskbegsthemostimportantquestionofall:isChinasdebtburdenmanageablewithoutdisastrousconsequences?Analystsbroadlydisagree,asyouwillseeinthisbook,butitsaconversationweneedhave.Theanswertothisquestionwillhaveaprofoundimpactonglobalgrowthandyourinvestmentportfolio.Therearefewmoreimportantquestionsinthemacroeconomicworld.

Whatsmore,thereareNOexamplesofANYcountrysaddingbankingassetsasquicklyhasChinahasoverthepastseveralyearsandcertainlynotonthisscale.Therearesimplynogoodhistoricalprecedentsbutifwemakeasimplecomparisontothelargestfiveyeardebtboomsinmodernhistory,ChinasexplosivegrowthinTotalSocialFinancingfrom2009to2013(whencreditgrowthwasthemostintense)ranksinthetopfive.

Lookingatasampleof43majoreconomiesoverthelast50years,IMFeconomistsGiovanniDellAriccia,DenizIgan,andLucLaevenfoundonlyfourothercasesofcomparablelendinggrowthandeachofthosecountriesexperiencedabankingcrisisand/orasharprecessionwithinthreeyearsoftheirrespectivebooms.

Inotherwords,therearenocasesinmodernhistorywhereaneconomyhasmanagedtoavoidanoutrightbustafterexperiencingrapidlendinggrowthanywhereintheneighborhoodofChinasongoingcreditboom.None.Andevenifwelooktothe48instancesoverthelast50yearswherelendingmeasuresexpandedbyaslittleas30%overfiveyears(lessthanhalfthemagnitudeofChinascreditexplosion),thereisstilla50%chanceofabankingcrisisoranabruptfallingrowthduringthepostboomperiod.

Moreover,themodelforatypicalcreditboom(outlinedinDellAriccia,Igan,Laeven,&Tongs2012paperPoliciesforMacrofinancialStability:HowtoDealwithCreditBooms)suggeststhatpainfulpostboomadjustmentstendtooccurwhenthepaceofcreditgrowthsimplycoolsbacktowarditslongtermmedian.ThatcoolingprocessisalreadywelladvancedinthePeoplesRepublic,whichmeanswehavetoconsiderwhatthelackofcheapandindiscriminatefundingwillrevealaboutthequalityofloans(andthevalueoftheunderlyingcollateralmostlyrealestatebutalsocommoditystockpiles)madeinpreviousyears.Itsnotaprettypicture.

AsidefromtheclearandpresentdangerthateachofthesevulnerabilitiesposestoChinasfuturegrowth,thesituationinthePeoplesRepublicdoesstandoutfrompastcreditboomsinoneway.ThePeoplesRepublichassubstantialbuffersoratleasttheoutwardappearanceofbuffers,basedonofficialdatatosupposedlydefendagainstcapitalflight,absorbsuddenlossesinabankingcrisis,andcommuteahardlandingintoalongerperiodofsubduedgrowth(whichBeijingmightormightnotallowtobeshowninitsheadlineGDPfigures).AccordingtoofficialdatasanctionedbytheChinesegovernmentandoutlinedbytheIMFinitslatestannualChinastaffreport,Totalpublicdebtisrelativelylowpublicsectorassetsarelarge(includingforeignexchangereserves)domesticsavingsarehigh,andforeigndebtexposureslowcapitalcontrolslimittheriskofcapitalflightandthegovernmentretainssubstantialleverstocontroleconomicandfinancialactivity.

Thelegitimacyandadequacyofthesebuffersinarealcrisisiscertainlyupfordebate,butitishardtoarguethattheChinesegovernmentdoesnothaveatleastsomeresourcestocontainanimminentcrisisandbuymoretime.

JudgingfromanIMFpodcastreleasedinAugust2014,thesebuffersareoneoftheonlyreasonsforoptimism,evenifBeijingdoesmaketheharddecisiontoexpediteitshighstakesreformagenda.ThoughtheIMFsChinamissionchief,MarkusRodlauer,isagenerallyoptimisticquasigovernmentstaffeconomist,hesclearlysoundingthealarm:

Ourassessmentaftercarefulanalysisisthattheneartermriskofahardlandingreallyislow.Andwecometothisjudgmentbecauseweseeaneconomythatstillhassubstantialbuffersbothintermsoftherealeconomyandthewaythegovernmentcanmanagetheeconomyinthenearterm,andthereforepreventahardlanding....

Bythesametoken,weneedtosaythatgiventhewaytheeconomyisgrowing,giventhewaytheriskshavebeenaccumulatingandarecontinuingtoaccumulateintheeconomy,unlessreformsareimplementedtoredirecttheeconomytoasomewhatsafergrowthpath,theriskofahardlandingwillcontinuetoincrease....Generallythesesortsofrapidcreditgrowthdoleadtoeitherabankingcrisisorasharpslowdownofgrowth[emphasisours].

Ifpastperformanceispredictiveoffutureoutcomes,growthmiraclesbuiltoncreditboomsalwaysendthesameway.Anepicbustmaynotcomeasquicklyasitmighthaveotherwise,butabustwillultimatelybedifficulttoavoidifBeijingrefusestoacceptalastingslowdown.Broadbased,debtfueledoverinvestmentmayappeartokickeconomicgrowthintooverdriveforawhilebuteventuallydisappointingreturnsandconsequentsellingleadtoinvestmentlosses,defaults,andbankingpanics.Chinacandefyhistoryabitlonger,butnotforever.

NewYork,Denver,Maine,andBoston

TomorrowIleaveforNewYork,whereIwillspendthenextfourweeksworkingandtryingtoplaytouristwhenIcan.BusinessrequiresthatIspendamonthinManhattan,butIhavetoadmitthatIvealwayswantedtospendamonthinTheCityThatNeverSleeps,livinginoneoftheneighborhoodsandabsorbingthecultureandspendingsomewhatmorecasualtimewithfriends.Dutycalls,butIdontthinkitsgoingtobehardduty,evenforthisTexasboy.

LaterinthemonthIwillgotoDenvertobewithmypartnersAltegrisInvestmentsataFinancialAdvisormagazineconferenceonalternativeinvesting,whereIseeIwillbewithmyfriendLarryKudlow.ThenIandmyyoungestson,Trey,willonceagaingotoGrandLakeStream,Maine,fortheannualCampKotok(a.k.a.TheShadowFed)migration.ThiswillbetheninthsummerthatTreyandIhavebeentothefishingandeconomicsfest.Heisnow21yearsold,anditwilltechnicallybelegalforhimtoparticipateinthewinedrinking,althoughafewofmyfellowfishereconomistshaveindulgedhimhereandthereovertheyears.LaterinAugustIintendtospendsometimewithWoodyBrockandotherfriendsinMassachusettsbeforeresumingmyperipateticwaysthisfall.

ImentionedthatIwouldsayawordortwoaboutthequandariesofpublishingAGreatLeapForward?asanebook.Choosingatraditionalpublisherwouldofcoursegetmeareasonableadvance,andthereiscertainlynoassurancethatthisbookwillbringinthesamesortofincomewithoutaprintversion.Itmightsurprisereaderstoknowthatauthorsreallydontgetallthatmuchfromabooksoldbyatraditionalpublisherinanebookformat.Maybe10to15%.Technically,wewillbegetting70%.Isaytechnicallybecause

(1)Wehavetoassumeallthecostofeditingandformatting,whichisnotinconsequentialifyouretryingtodoitright,whichistheonlywayIwilldoit.And,

(2)Thisbookisactuallyfairlygraphicallydense.Andthevariousformats(Kindle,iTunes,andNook)actuallychargefortheextrabandwidththatittakestodownloadabookaboveafewmegabytes.Andbelieveme,weareaboveafewmegabytes.Dependingontheformatandthequantities,ourauthorssharecaneasilydropto50%.

Alotofpeopleassumethattodaythemajorityofbooksaresoldasebooks.Nottrue.Whiletheebookformatisstillgrowing,therateofgrowthnowisnowherenearitstrajectoryinearlieryears.Therearealotofpeople(andIexpecttohearfromyou)whostillwanttheirbooksinphysicalform.Asonereviewersaid,hewishedhecouldunderlineanddogearthepages.

Likewhatyourereading?SubscribenowandreceivethefullversionofJohnMauldin'sThoughtsfromtheFrontlinedeliveredtoyourinboxeachweek.

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ButasaformerLudditewhothoughthewouldnevergiveuphisphysicalbooks,letmeofferthisthought.InowalmostalwaysrefusetoreadabookifIcantfinditonKindle.IcanstillhighlighteverythinginKindlewithmyfinger,makenotesinthemargins,anddocrossreferencesthatIcouldneverdoinprintedform.Further,andamazingly,AmazonoffersmeatabsolutelynocosttheabilitytocheckandcrossreferenceallofthosehighlightsonmypersonalAmazonKindlepage.Ithinkbackovermylast50yearsofbookreadingandrealizethatalltheparagraphsIunderlinedandnotesIwroteareessentiallylost.IfIdonthavethebookandcantrememberwhatpagesomethingwason,Icantfindit.Now,withKindle,IcanandIfindthatabilityremarkablyliberatingandempowering.WhileIdespairoverwhattimeandanimperfectmemoryhavecostme,IcannowspendapleasantafternoonreviewingmyhighlightsandnotesandremindingmyselfofwhatIthoughtwasimportantatthetime.

AndsinceIcanreadonanyelectronicdevice(youdontneedaKindleoriPadorNook)andIcannowreadthesamebookonmultipledevices,Ienjoythefreedomofnothavingtocarry10poundsofbookswithmethroughanairportinordertohavesomethingtoread.

Andsoletmeclose(itstimetohitthesendbutton)withablatantmarketingmoment:ifyouhaventalreadyembracedwhattechnologycandoforreaders,youshouldseeournewbookasyourimpetustolaunchyourforayintotheworldofelectronicbooks.Again,youcangetthebookatKindle,iTunesorNook,orcheckusoutatMauldinEconomics.

Youaregoingtothankmenotlongafteryoubeginreading.AnddareIpointoutthat$8.99isnotahugepricetopayforexploringanewtechnology.Youcandownloadallthosebookappsonwhatevercomputerorotherdeviceyoumayhave.Forwhatitsworth,IhavemyKindleonmyiPhone,myiPad,andmybrandnewMSIcomputer.(Afewofyoumightbesurprisedatmychoiceofboxes,asMSIisahardcoregamingcomputerbutitjusthassomuchpowerpackedintosuchasmallformatthatIthoughttheextrafewhundreddollarswasworthit.Butthen,askmeagaininafewmonths.IthoughtmyMicrosoftSurfaceProtabletcomputerwasgoingtobeagoodinvestmentandithaditsadvantagesbutattheendofthedayIjustfoundittobetoounderpoweredformetoworkon.)

Haveagreatweek.Iseealotofpoliticsandfundinnersandwritinginmynearfuture.IdontwanttoeventhinkaboutthenextbookIllwrite,butIhavetoadmit,therearethreeorfourprojectsbrewinginthebackofmyhead.AtsomepointthissummerIwillhavetoletoneofthemintomyforebrain.Untilthen,IwillconcentrateonmyweeklyletterandgivingyouthebestofwhatIcomeupwith.

YourehopingChinacanleapthechasmanalyst,

JohnMauldinsubscribers@mauldineconomics.com

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ThoughtsfromtheFrontlineisafreeweeklyeconomiceletterbybestsellingauthorandrenownedfinancialexpert,JohnMauldin.Youcanlearnmoreandgetyourfreesubscriptionbyvisitingwww.MauldinEconomics.com.

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ThoughtsFromtheFrontlineandMauldinEconomics.comisnotanofferingforanyinvestment.ItrepresentsonlytheopinionsofJohnMauldinandthosethatheinterviews.Anyviewsexpressedareprovidedforinformationpurposesonlyandshouldnotbeconstruedinanywayasanoffer,anendorsement,orinducementtoinvestandisnotinanywayatestimonyof,orassociatedwith,Mauldin'sotherfirms.JohnMauldinistheChairmanofMauldinEconomics,LLC.HealsoisthePresidentandregisteredrepresentativeofMillenniumWaveAdvisors,LLC(MWA)whichisaninvestmentadvisoryfirmregisteredwithmultiplestates,PresidentandregisteredrepresentativeofMillenniumWaveSecurities,LLC,(MWS)memberFINRAandSIPC,throughwhichsecuritiesmaybeoffered.MWSisalsoaCommodityTradingAdvisor(CTA)registeredwiththeCFTC,aswellasanIntroducingBroker(IB)andNFAMember.MillenniumWaveInvestmentsisadbaofMWALLCandMWSLLC.Thismessagemaycontaininformationthatisconfidentialorprivilegedandisintendedonlyfortheindividualorentitynamedaboveanddoesnotconstituteanofferfororadviceaboutanyalternativeinvestmentproduct.Suchadvicecanonlybemadewhenaccompaniedbyaprospectusorsimilarofferingdocument.Pastperformanceisnotindicativeoffutureperformance.Pleasemakesuretoreviewimportantdisclosuresattheendofeacharticle.Mauldincompaniesmayhaveamarketingrelationshipwithproductsandservicesmentionedinthisletterforafee.

Note:JoiningTheMauldinCircleisnotanofferingforanyinvestment.ItrepresentsonlytheopinionsofJohnMauldinandMillenniumWaveInvestments.ItisintendedsolelyforinvestorswhohaveregisteredwithMillenniumWaveInvestmentsanditspartnersatwww.MauldinCircle.com(formerlyAccreditedInvestor.ws)ordirectlyrelatedwebsites.TheMauldinCirclemaysendoutmaterialthatisprovidedonaconfidentialbasis,andsubscriberstotheMauldinCirclearenottosendthislettertoanyoneotherthantheirprofessionalinvestmentcounselors.Investorsshoulddiscussanyinvestmentwiththeirpersonalinvestmentcounsel.JohnMauldinisthePresidentofMillenniumWaveAdvisors,LLC(MWA),whichisaninvestmentadvisoryfirmregisteredwithmultiplestates.JohnMauldinisaregisteredrepresentativeofMillenniumWaveSecurities,LLC,(MWS),anFINRAregisteredbrokerdealer.MWSisalsoaCommodityTradingAdvisor(CTA)registeredwiththeCFTC,aswellasanIntroducingBroker(IB).MillenniumWaveInvestmentsisadbaofMWALLCandMWSLLC.MillenniumWaveInvestmentscooperatesintheconsultingonandmarketingofprivateandnonprivateinvestmentofferingswithotherindependentfirmssuchasAltegrisInvestmentsCapitalManagementGroupAbsoluteReturnPartners,LLPFynnCapitalNicolaWealthManagementandPlexusAssetManagement.InvestmentofferingsrecommendedbyMauldinmaypayaportionoftheirfeestotheseindependentfirms,whowillshare1/3ofthosefeeswithMWSandthuswithMauldin.Anyviewsexpressedhereinareprovidedforinformationpurposesonlyandshouldnotbeconstruedinanywayasanoffer,anendorsement,orinducementtoinvestwithanyCTA,fund,orprogrammentionedhereorelsewhere.Beforeseekinganyadvisor'sservicesormakinganinvestmentinafund,investorsmustreadandexaminethoroughlytherespectivedisclosuredocumentorofferingmemorandum.SincethesefirmsandMauldinreceivefeesfromthefundstheyrecommend/market,theyonlyrecommend/marketproductswithwhichtheyhavebeenabletonegotiatefeearrangements.

PASTRESULTSARENOTINDICATIVEOFFUTURERESULTS.THEREISRISKOFLOSSASWELLASTHEOPPORTUNITYFORGAINWHENINVESTINGINMANAGEDFUNDS.WHENCONSIDERINGALTERNATIVEINVESTMENTS,INCLUDINGHEDGEFUNDS,YOUSHOULDCONSIDERVARIOUSRISKSINCLUDINGTHEFACTTHATSOMEPRODUCTS:OFTENENGAGEINLEVERAGINGANDOTHERSPECULATIVEINVESTMENTPRACTICESTHATMAYINCREASETHERISKOFINVESTMENTLOSS,CANBEILLIQUID,ARENOTREQUIREDTOPROVIDEPERIODICPRICINGORVALUATIONINFORMATIONTOINVESTORS,MAYINVOLVECOMPLEXTAXSTRUCTURESANDDELAYSINDISTRIBUTINGIMPORTANTTAXINFORMATION,ARENOTSUBJECTTOTHESAMEREGULATORYREQUIREMENTSASMUTUALFUNDS,OFTENCHARGEHIGHFEES,ANDINMANYCASESTHEUNDERLYINGINVESTMENTSARENOTTRANSPARENTANDAREKNOWNONLYTOTHEINVESTMENTMANAGER.Alternativeinvestmentperformancecanbevolatile.Aninvestorcouldloseallorasubstantialamountofhisorherinvestment.Often,alternativeinvestmentfundandaccountmanagershavetotaltradingauthorityovertheirfundsoraccountstheuseofasingleadvisorapplyinggenerallysimilartradingprogramscouldmeanlackofdiversificationand,consequently,higherrisk.Thereisoftennosecondarymarketforaninvestor'sinterestinalternativeinvestments,andnoneisexpectedtodevelop.Youareadvisedtodiscusswithyourfinancialadvisersyourinvestmentoptionsandwhetheranyinvestmentissuitableforyourspecificneedspriortomakinganyinvestments.

Allmaterialpresentedhereinisbelievedtobereliablebutwecannotattesttoitsaccuracy.Opinionsexpressedinthesereportsmaychangewithoutpriornotice.JohnMauldinand/orthestaffsmayormaynothaveinvestmentsinanyfundscitedaboveaswellaseconomicinterest.JohnMauldincanbereachedat8008297273.