Are we in a “new paradigm” which involves inflation being a relic of the past?

Most likely not.

We are simply in a context where monetary base inflation did not lead to consumer price inflation but rather asset price inflation at best, with many economists making the mistake (in our view, at least) of viewing things through the lens of predictability and expecting linear developments. Just like a chef adds a little bit of seasoning until the taste is just perfect, it is expected that central banks will keep expanding the monetary base until “just the right amount” of inflation manifests itself.

In the opinion of the ChinaFund.com team, this perspective is nothing short of delusional. When referring to markets, expecting manic-depressive behavior rather than extreme predictability is always recommended, with pretty much any longer-term asset price chart representing an eloquent example to that effect.

To put it differently, while nobody can predict when we transition from a deflationary to an inflationary environment, we strongly believe the process will be anything but smooth and predictable. On the contrary, we expect “chaos” to be the operative word and for the now-unthinkable to occur: a significant loss of confidence in even the strongest Western currencies, including… of course, the dollar.

Where does that leave China and the renminbi?

Time and time again, we try to make it clear that just because China and the proverbial West are let’s say economic adversaries who are fighting for relevance and influence, it doesn’t mean that whenever the West loses, China wins, especially not as far as short-term perspectives are concerned. On the contrary, given the extreme economic interconnectedness which represents the norm in 2020 (despite a massive build-up of frustration, but that goes beyond the scope of this article), China is actually likely to not only catch the proverbial cold from the West but develop worse symptoms.

Let us not forget that the number one holder of dollar reserves is none other than… drum roll, please… China. As such, it would be short-sighted at best and naïve at worse to assume that China would be greedily rubbing its hands when the dollar loses value. On the contrary, the Chinese renminbi would most likely be in even worse shape at that point in time.

Why?

Simply because whether one analyst or another agrees with this, the United States still represents the world’s number one safe haven destination (the destination frightened investors flock toward during risk-off episodes), whereas China doesn’t even represent a safe haven destination at this point, with Chinese assets firmly in risk-on territory.

Yes, it is true that in just one year of post-Great-Recession easing, the Federal Reserve added more to the monetary base than had existed from 1913 up until the Great Recession. But it is just as true that since then, demand for US dollars has gone up rather than down. While it is correct that the euro has had a good run over the past couple of months, it is still considerably lower relative to its US counterpart than it was prior to the Great Recession.

Let’s just say that until the market grants China its much-desired safe haven status, it would be premature to state that China celebrates weakness in “competing” currencies and on the contrary, it is likely to be worried by them because unlike the Federal Reserve and the European Central Bank since the Great Recession, their Chinese counterpart (the PBOC) also has to worry about inflation every now and then. To put it differently, inflation is (even if not always and even if it isn’t exactly the norm) a CURRENT rather than potential PBOC concern and as such, it would be unwise to believe China is longing for a more inflationary environment.

Finally, there are also those who noticed that China has been adding gold reserves over the years and therefore believe it isn’t as worried about inflation when it comes to Western currencies as we have stated. But in terms of (and this is very important) orders of magnitude, China is nowhere near protected enough by its gold holdings to sleep tight at night while the West were to battle inflation, not by a long shot.

A few important conclusions therefore arise:

1. The demand for dollars should not be underestimated because no matter how aggressively the Federal Reserve eases, there will be no runaway inflation unless and until dollar demand takes a significant hit. Until now, that hasn’t happened but, of course, past performance does not guarantee future results
2. China is not yet considered a safe haven destination by the market and until that happens, not only would is it vulnerable should weakness manifest itself when it comes to Western currencies, the renminbi is also likely to fare considerably worse than the currencies in question
3. While there have been measures taken by China to distance itself from the dollar (from the previously mentioned gold reserves to negotiating renminbi oil deals and establishing renminbi ties to other economies), a fair case can be made that it is still considerably (over-)exposed to the dollar
4. However, conclusions #1 to #3 are not set in stone in terms of the (very) long-term picture and on the contrary, it is anything but impossible for game-changers to occur

Land doesn’t “disrupt” and there aren’t exactly all that many fancy buzz word-laden presentations involving this asset class, so it seemed that land investments had lost their luster in China and beyond. Fast-forward to the hash realities revealed by the 2020 pandemic-generated economic as well as financial crisis and it has become apparent that from many perspectives, the proverbial emperor had no clothes.

Never before had so much time passed between recessions as after the Great Recession and until the 2020 economic crisis (with a recession pretty much inevitable, with some observers even using the term “depression” due to the aggressive GDP contraction and unemployment combination in certain jurisdictions, including the United States) and as such, decision-makers from all around the world were continuously suggesting that the world was in a “new paradigm” situation, with all of the problems which had made the Great Recession possible in the first place fixed and society ready to move on to its glorious future, a future involving anything from autonomous electric vehicles to space travel.

If anything, 2020 has proven that it might be wise to tone our perception of reality down a notch or two because as all intellectually honest market observers were able to find out, the COVID-19 pandemic revealed that the world’s most developed nations (which were on the front line in light of being densely populated and representing major travel hubs, for obvious reasons) ended up failing miserably on the medical front not due to Earth-shattering high-tech issues but rather due to a severe shortage of the most basic supplies: masks, medical gowns and even essential medicine.

Again, most likely the number one “the emperor has no clothes” moment of the 21st century in terms of severity and needless to say, these developments made investors second-guess many other assumptions that were considered quasi-axiomatic. If the world’s most highly-developed medical systems were caught completely off-guard by the COVID-19 pandemic and so many issues were caused due to shortages which could have easily been avoided, what else is it about society as we know it that we thought ran very smoothly but actually doesn’t?

As such, it was only a matter of time until the economy in general and especially the financial system in particular entered the spotlight. All of a sudden, it seemed that many of the companies which were perceived as being on a surefire way to success no longer looked all that glamorous and the same way, especially in light of the unprecedented monetary as well as fiscal stimulus measures that were taken, asset classes which seemed to have lost their luster all of a sudden became interesting again.

Among them… of course, land.

As trillions upon trillions of dollars were injected into the financial systems as well as “real” economies of country after country, market participants came to a realization that is ultimately a matter of common sense, yet had been all but ignored for years: while central banks can print unlimited quantities of fiat currency, there is no such thing as an entity that can “print” millions of acres of land, for example. Therefore, investor after investor ended up realizing that perhaps gaining at the very least a bit of exposure to this asset class might not be the worst idea in the world.

This, however, is a very slow process.

Expecting land prices to soar after these realizations would be nothing short of naïve, especially given the severely deflationary forces that are in play in light of the fact that economies were forced to essentially shut down for unprecedentedly long periods of time. If anything, threats pertaining to the risk that existing land investors end up being forced to liquidate to cover various expenses outweigh threats pertaining to the risk that there will be a sudden rush to buy land… that is most definitely not how things work.

No matter how logical a certain investment option may seem given a certain context, in our example land in the context of unprecedented monetary as well as fiscal stimulus, it oftentimes takes a fair bit of time until the market catches up. A textbook recent example to that effect was represented by precious metal prices in the immediate aftermath of the Great Recession. Initially, despite the fact that all of the conditions necessary for precious metals to thrive seemed there, prices initially corrected right alongside stock prices until finally heading north, with all-time highs being reached back in 2011.

Why?

Simply because immediately after a financial panic, the market enters full-on survival or deleveraging mode and as such, cash becomes king for a while, with most of the other assets seemingly correlated, as investors are forced to liquidate in a desperate attempt to seek refuge in cash positions. As time passes and the dust settles, with the world gradually wrapping its head around what happened and what the longer-term implications are, things change.

We believe the exact same principle will be valid when it comes to land prices and as such, there is no time like the present to position yourself accordingly by deciding what kind of exposure to this asset class it makes sense to seek and putting together a battle plan. While the ChinaFund.com team specializes in Chinese assets and primarily caters to the needs of clients in this direction, we will happily help with pretty much anything else pertaining to wealth management and should you be in need of assistance, we are only an email or a message away.

1. The fact that China’s education system is still far from optimal, despite the fact that impressive progress has been made. In many regions of China, there are still issues with basic literacy and as such, expecting the average Chinese saver to properly understand today’s ultra-complex realities would be unrealistic. For more information about China’s education system and how it compares to various Western counterparts, we would recommend reading the article we have dedicated to this topic by clicking HERE
2. The fact that various dimensions of China’s financial system tend to have an above-average percentage involvement of so-called “retail” investors compared to professionals, with the Chinese stock market being a relevant example in that direction. Once again, we have dedicated an entire article to this topic, one which can be found HERE
3. The fact that the average Chinese citizen doesn’t exactly have as much access to let’s call it “less than curated” investment information. Say what you will about Western financial media outlets but compared to the information level of the average Chinese investor, Westerners seem light years ahead. While it is true that gaining access to the “real” Web by for example bypassing the Great Chinese Firewall is hardly impossible, it is fairly safe to assume that Chinese savers are at a disadvantage compared to their Western counterparts
4. The fact that from a cultural perspective, there is hardly anything in the way of tradition that has been reinforced historically speaking. To put it differently, older generations have been far too “busy” with subsistence to care all that much about being wise savers, with them hardly having enough wealth at their disposal for dedicating a lot of time to such endeavors to make sense

The list could continue indefinitely but the bottom line is this: Chinese savers can, at this point in time at least, be considered at a disadvantage compared to their Western counterparts. However, make no mistake, this most definitely does not mean that Western savers have it easy. On the contrary, as discussed in other articles as well, savers in general have been systematically punished all over the world due to “paradox of thrift” implications: simply put, the worldwide economic system needs perpetual debt-fueled consumerism to sustain itself and savers stand in the way. This, however, is a topic that goes beyond the scope of our article.

Suffice it to say that the current status quo revolves around governments and central banks from all over the world (with China not representing an exception) engaging in currency debasement one can consider unprecedented in terms of sheer contagion (to use a term more and more common in 2020). To put it differently, one cannot exactly seek refuge in Country B’s currency if Country A is in full-on debasement mode for the simple reason that the Country B’s of the world are engaging in precisely the same behavior. As such, even for sophisticated savers, protecting their purchasing power at the very least and especially enhancing their wealth becomes a problematic goal, with many of them feeling as if they have absolutely nowhere to hide.

Fortunately, this is not true. In fact, we have dedicated a fair number of article to explaining, from A to Z, what savers from all over the world can and should do to protect themselves, with many more articles on the way. Unfortunately, doing so is anything but easy and from the perspective of an unsophisticated Chinese saver who is looking for a “quick fix” solution, the entire equation seems unbelievably confusing.

The end result is therefore likely to involve an extremely large transfer of wealth from those who are not properly prepared/hedged to those who are. Historically speaking, the average citizen is usually on the losing end of such transfers of wealth and the less sophisticated they are, the more affected they are likely to be.

The implications of this reality should be more than obvious: the fact that the proverbial Chinese dream may end up being under siege. Long gone are the pre-2010 days of what seemed to be sustainable double-digit GDP growth, with straightforward international trade dynamics and much-needed domestic infrastructure spending. Fast-forward to the 2020 framework and we have even the Communist Party of China admitting that double-digit growth represents an unrealistic goal, major trade tensions between China and many trading partners that are so frustrated with the trade deficits their countries keep experiencing that they consider China the spoiled child of globalization and infrastructure-driven growth which can only take you so far… an amazingly complicated equation.

To state that the average Chinese saver feels overwhelmed would be a severe understatement and if history is to be any indicator, more or less obvious forms of civil unrest become pretty much unavoidable. As it was, many citizens were frustrated with the various inequality problems that sprung up in the aftermath of China’s economic growth story and while more recent administrations such as the Hu Jintao and nowadays Xi Jinping ones have done more than past administrations to tackle this issue, it becomes abundantly clear that innovative solutions are required in order to preserve the “socialism with Chinese characteristics” status quo. Because, make no mistake, a hefty price will need to be paid if the average Chinese saver becomes discontent with the status quo in a manner that leads to frustrations piling up, one the current Chinese administration can most likely not afford, especially given the “tricky” international context that dominates public discourse pretty much all over the world.

We’ve written about the reasoning behind bailouts, why some companies are considered systemically relevant, why even approaches in the realm of the Universal Basic Income are being implemented to kickstart consumption among the general public and the list could go on and on. To put it differently, enough content to fill mountains of pages has been dedicated to how the authorities are putting out various fires.

But what about… well, the collateral damage dimension?

What about the stereotypical responsible saver, an unsophisticated market participant but one who has usually been rewarded for his willingness to defer current consumption so as to save for a rainy day. From every imaginable moral perspective, being a saver makes perfect sense. Why not build a nest egg so as to protect your family? Why engage in reckless and unsustainable credit-fueled consumption by spending money you do not have on things you do not need? Why not be “responsible” instead?

Whether we are referring to measures that have been taken to combat the Dot-Com Bubble, Great Recession or 2020 crisis, the elephant in the room in terms of collateral damage-related common denominators is relatively easy to spot: the fact that time and time again, traditional savers have been harshly punished.

How?

Through the continuous reduction of interest rates, to give the most obvious example, a reduction of such a magnitude that the days of saving money for retirement and living to a significant degree from the interest you earn during your golden years are long, long gone. Instead, it seems as if governments and especially central banks are considering traditional savers the proverbial bad guys and therefore continuously working on more and more unorthodox punishments.

Why?

Simply because, as counter-intuitive to the point of peculiar is may seem, the traditional saver is actually the number one enemy of the current worldwide economic model. An economic model which needs perpetual growth to sustain itself and at this stage in the game, that perpetual growth can only be credit-fueled.

To put it differently, we are in a clear “paradox of thrift” situation. As the name alludes to, the bottom line is this: as far as our current system is concerned (yes, even in China), behavior types which revolve around being financially responsible in the traditional sense (deferring consumption, setting money aside for a rainy day and so on) can be a great choice for an individual but if too many people were to engage in this type of behavior, the result would be disastrous for society as we know it.

Critics of consumerism believe the end of the current worldwide economic model would be a good thing, whereas the other side and especially decision-makers who do not want the world to proverbially crash and burn on their watch tends to be on the other end of the spectrum, believing that we need to do “whatever it takes” (to borrow the phrase which became iconic after being used in the right context by the former European Central Bank president Mario Draghi) to preserve the status quo. From the perspective of today’s decision-makers, traditional savers aren’t a category of market participants that deserve or need to be saved, they are a threat to the system as we know it and as such, can and should be considered collateral damage.

The elephant in the room in terms of implications is this: the days of “passively” living off interest are long gone, with savers being effectively forced to embrace a more active approach so as to not only preserve but also enhance their wealth. In an ideal situation, governments and central banks would love nothing more than for savers to embark on a consumerist journey, thereby aggressively contributing to much-desired economic growth. If that is not possible, then they should at the very least buy assets such as shares rather than hoard money under the proverbial mattress or keep it in a bank, expecting to generate something worthwhile.

An important question arises, however: aren’t too many monsters being created in the process?

To put it differently, a valid case could be made that the actions of governments and central banks are creating massive distortions, distortions we can consider unprecedented in terms of how ubiquitous they are. Make no mistake: from China to Japan, from the European Union to the United States, savers are being literally trampled on pretty much everywhere.

The effects?

Primarily the fact that bubble after bubble is being created so as to counter the effects of the previously popped one. From tech stocks which crashed and generated the bursting of the Dot-Com Bubble to measures aimed at jump-starting the economy but which also inflated an even larger bubble, the real estate one that brought us the Great Recession. Fast-forward to the present, with us living in an environment where we cannot help but notice that we are surrounded by bubbles. Furthermore, we also know that no matter what happens, the authorities will do everything they can to preserve the status quo.

Until when?

Most likely until the market ultimately decides that enough is enough, with a deflationary crash being followed by “more of the same” in terms of solutions (lower interest rates and greater injections of capital) but eventually also by the market putting an end to it all through a massive inflation-generating loss of confidence in status quo currency systems altogether. While nobody can predict the future and/or guarantee that this will happen after the 2020 economic crisis, what we can and do clearly state is this: with each cycle, the probability that something “breaks” in terms of confidence in currencies goes up and as always, we are doing our best to have all bases covered.

They forged online sales through their mobile app to make investors believe that they were more popular than they actually were. We wanted to take a deeper look at what happened in this scandal, how it can impact investors like yourself and how things re likely to unfold moving forward.

Without further ado, let us take a look at Luckin Coffee and what happened when it comes to their recent scandal.

What Is Luckin Coffee?

Luckin Coffee was one of the top coffee brands in China and was drawing comparisons to the global coffee giant Starbucks, with “selling points” such as the fact that:

➢ As of early 2020, the company had about 4,506 stores
➢ They opened their first store in 2017
➢ They are headquartered in Beijing
➢ As of late 2019, they had approximately 8,485 full-time employees and 8,160 part-time employees
➢ Their highest valuation was $2.9 billion (although that has plummeted significantly)

What Happened?

Luckin Coffee was being hailed as the Starbucks of China (a major comparison considering Starbucks has a market cap of about $86 billion, compared to Luckin’s highest valuation of $2.9 billion). They went public last year on the NASDAQ and their shares were surging due to what appeared to be strong sales growth:

➢ They raised almost $600 million through their IPO
➢ They raised another $800 million in January 2020
➢ In April, they announced that $310 million of their sales (about half) for the final three quarters of 2019 were faked
➢ An independent investment firm apparently discovered this by sending 1,500 people to sit in stores and count transactions. Luckin was forced to come forward after this

Apparently, a lot of their orders were taken online via their mobile app, and the company considered technology to be at the core of their business. Luckin had claimed to be disrupting the coffee industry using “artificial intelligence and big data analytics”. These were some of the claims that inspired investors to believe that they could take on a company such as Starbucks on a global scale.

Since the company placed such a high emphasis on technology and most of their sales were going through their mobile app, it was relatively easy for the business to inflate them. However, this scam fell flat after the previously mentioned private investment firm sent people to sit in stores. After that, it became clear that not nearly as many people were coming into stores to pick up orders as Luckin was making it seem.

Directly after the news, the stock plunged 80% and is down nearly 93% for the year 2020. Shortly after the announcement, the Nasdaq decided to delist the company.

What Has Luckin Done?

As this scandal was disclosed in April of 2020, it’s already been several months since the news broke to investors. Since then, Luckin has taken measures to protect their employees, investors and business as a whole. Two of those steps are:

1. Removing CEO Jenny Zhiya Qian and Chief Operating Officer Jian Liu from the company and naming a new CEO (Jinyi Guo). This move is not exactly surprising, as a new face to the company will help with the short-term public relations equation
2. Contemplating liquidation – Liquidation is just the process of pulling the proverbial plug and selling everything possible to cover all debts and repayments to lenders and investors

Right now, there is a lot of damage done to the Luckin Coffee brand and it is still uncertain whether they will continue operating at all. Their shares have been delisted from the NASDAQ and were halted for over a month. They are also facing investigations from several different regulatory bodies in both the U.S. and China.

It’s no understatement to say that the company is in a heap of trouble. However, they were also a fairly large company (despite the fake revenues) and bankruptcy could put almost 16,000 people out of work. This situation will most likely take a while to straighten out and for leadership to determine the best path of action

What Can We Learn From This?

From the perspective of an investor, this is a great example that you always need to be highly critical when examining businesses. It’s not enough to simply read a prospectus or annual report and take it at face value. It’s important to remember that the people who put together investor relations documents have a vested interest in making themselves look as good as possible.

Here are a few good things you can keep in mind when making investment decisions:

1. Perspective – Does what the company says make sense when compared to other companies in their industry? It’s easy to get caught up in investor hype around certain companies but also important to stay grounded and make sure euphoria doesn’t take over
2. Trustworthiness – Do you trust the people who are leading the company? Do they have a track record of dependability?
3. Reason – Is the company shooting too high? Do they have growth projections that are realistic? Or are they wearing rose-colored glasses? In Luckin’s case, they were projecting to open more stores in 2 years than Starbucks has in two decades

Anne Stevenson-Young from J Capital research stated on CNBC that, “It’s a great morality tale. It seems to me that those of us who spent time in China could see from very early on that Luckin was inflating its numbers. Luckin was a company that was terribly interested in memberships and in tokens, and in the visible growth of foot traffic to the stores — but not in actual revenue,”

This is also a good example of how it can pay to take on the advice of experts. If you’re just a standalone investor, you might not have the time or resources to get critical insight into businesses like Luckin Coffee. On the surface, it might seem like a great investment at the time. However, to the insider’s eye, there might be several red flags.

Consulting with an industry professional can save you a lot of time, stress and (most importantly) money. If you have any specific questions regarding investing in China, please don’t hesitate to reach out to our team via email or phone.

Looking Forward

Scandals like what happened with Luckin Coffee are an investor’s worst nightmare. It’s also even worse that it came from a country such as China, where transparency is already questionable. It is widely believed that, in China, the government influences private companies to bend their behavior to the whim of the government. The government has also been known to not be 100% transparent with the rest of the world either.

One example involving a lack of transparency is represented by the recent coronavirus situation, where most scientists believe that China was not fulling releasing the data that they had available.

It also came at a non-ideal time considering the rising tensions between China and the U.S. in regards to the current trade war. Business people on both sides want to engage in trade, as there are plenty of opportunities. However, situations such as the Luckin Coffee debacle destroy trust on both sides and will unfortunately lead to a less open investing environment.

However, there is a bright side to what happened. Now that a scandal like this has occurred on a U.S. exchange, there is a much stronger push for foreign companies to be fully audited before being able to list their shares to the American public. Hopefully, this means that these scandals will become less and less likely. In 5-10 years, a situation like what happened with Luckin Coffee might be considered laughable. To that effect, measures are already being taken.

In fact, the Securities and Exchange Commission is contemplating banning all Chinese companies from listing on U.S. exchanges altogether. This bill received bipartisan support in the Senate and would make it even harder for U.S. investors to get access to Chinese companies. However, it would also protect U.S. investors from being exposed to fraud.

A move like this could also be seen as a win for the Hong Kong stock exchange. Since Chinese companies will no longer be allowed to leave for the larger U.S. exchanges, more will be listed on the Hong Kong exchange. In the short-term, this will be bad for Chinese companies because they won’t be able to raise as much capital during their IPOs. However, in the long-term, this will help Chinese exchanges catch up in size to those in the United States. This will just create an even more bullish investing environment in China.

We hope that you’ve found this article valuable when it comes to understanding what happened with Luckin Coffee and how things might change moving forward. If you’re interested in reading more articles related to China, please visit our blog and/or the “New Here?” section of ChinaFund.com.

1. From China to the West, economic systems are not able to withstand a “real” recession, we are simply in a far too over-leveraged environment for the idea that “the market will reach an equilibrium state” to be consistent with the goal of the system in its current form surviving. To put it differently, the market may very well be able to sort itself out but should that be allowed to happen, it would be overly-optimistic at best and naïve at worst to assume the economic system status quo can be preserved
2. The entire world seems to be determined to avoid systemic disruption scenarios and as such, countries left and right are embarking on ultra-aggressive stimulus journeys. In a previous article, one meant to tackle the question of whether or not China is hopping on this trend, we have made it clear that not only is China more than willing to hop on, a compelling case could be made that as far as the post-pandemic stimulus trend is concerned, China may have very well been the initiator
3. Compared to the Great Recession where central banks were in the spotlight and central bankers ended up being considered heroes by those who believe the day was saved (much less so by those who state that the can was simply kicked down the road in an unsustainable manner), the market has made it clear that this time around, it expects a symmetrical reaction from governments as well… monetary stimulus correlated with equally aggressive fiscal stimulus, in other words

The third quasi-axiomatic statement warrants further attention, in our view.

First and foremost, why do we consider it quasi-axiomatic?

In our view, it would be pointless to waste additional time explaining our reasoning in light of the fact that the statement in question has already been validated empirically. To put it differently, central banks have once again stepped to and have tried to grab the market’s attention through swift and aggressive monetary policy. In the Federal Reserve’s case (even if this came after a very persistent push from Donald Trump), this action consisted of suddenly cutting interest rates by 50 basis points, followed by an equally swift additional cut which took rates back to zero. Furthermore, record-breaking liquidity was provided by the Fed, anything from unprecedented repo market action to unlimited quantitative easing and the elimination of reserve requirements.

Needless to say, few experts would have been able to predict this level of aggressiveness. On the contrary, let us not forget that in 2019, the Federal Reserve had embarked on a monetary tightening course and those who “dared” assume that zero-bound rates and additional QE would be on the table so soon have oftentimes been ridiculed. Furthermore, it was expected that eventually, other central banks would be forced to follow suit.

The exact opposite happened.

And the elephant in the room is represented by precisely the so-called tightening that took place and especially the magnitude of it. The idea that central banks lower rates in certain scenarios is hardly new. After the Dot-Com bubble for example, Alan Greenspan lowered them from 6.5% all the way down to 1% but by the time the Great Recession hit, at least they climbed back up… not to 6.5% again zone but to the 5% one, a reasonable enough development. In the aftermath of the Great Recession, the market demanded more action and as such, interest rates were lowered all the way to zero in the US and even went negative in other jurisdictions. Furthermore, while they did eventually climb back up, this happened only very timidly so, with the 2020 situation finding them nowhere near the 5% level they were at prior to the Great Recession.

When analyzing the European Union and Japan, with their negative interest rates, the situation seems even more dire and it does not take a monetary policy expert to understand that under current circumstances, a compelling case can be made that central banks aren’t in a splendid situation in terms of ammunition.

Can interest rates go slightly negative in the United States?

Sure.

Can they go even further into negative territory in the European Union and Japan?

Of course.

But, realistically speaking… just how low can they go?

In theory, there is nothing in terms of bureaucratic framework stopping the let’s say Federal Reserve from lowering interest rates all the way down to 99% but that would be pointless in light of the fact that literally nobody would remain willing to keep money in the banking system and as such, it would immediately implode.

In other words, the average individual would most definitely not tolerate that aggressive of a rate reduction, we believe it is fair enough to consider this statement once again quasi-axiomatic.

Would they tolerate -70%?

No.

-50%?

No.

-25%?

No.

The list could go on and on but upon realistic reflection, it becomes rather obvious that the “bare minimum” in terms of what the average citizen would tolerate in terms of negative interest rates is a lot closer to today’s realities than to double-digit ones. For this reason if nothing else, we have no choice but to acknowledge that in 2020 and beyond, the limits in terms of how low central banks can go will become apparent. As a conclusion, it should therefore be expected that this time around, the burden of taking decisive (to the point of unprecedented) action is very likely to be placed on governments, with the fiscal stimulus dimension being in the spotlight to a much greater degree than in the Great Recession days.

Other countries followed suit (with many even let’s say out-bidding China) and in light of the fact that all players are embarking on a journey involving increasingly aggressive not just monetary but also fiscal stimulus, an important question arises… the elephant in the room, if you will:

Can’t there be consequences?

And, unfortunately, the answer is a resounding yes.

Those who have paid attention to the post-Great-Recession developments will most likely be quick to point out that despite record-breaking monetary stimulus (less so on the fiscal stimulus front, with monetary stimulus most definitely leading the way) and despite many economists claiming that alarmingly high inflation was just around the corner, those fears haven’t materialized… on the contrary.

As such, why should we be concerned this time around?

In the opinion of the ChinaFund.com team, perhaps the number one aspect market observers need to understand is that economics is not arithmetic. In other words, we cannot simply keep “adding a bit more” stimulus until we eventually have excessively high inflation, only to then quickly reverse course to enough of a degree that the problem goes away. In a way, similar to controlling the flow of tap water. Once again unfortunately, things do not exactly work this way.

Why?

One word: confidence.

The name of the game is understanding that markets are not algorithms or robots. If that were the case, we could simply tweak inputs in a linear manner until we get to the desired results. However, that is not how things work because there is the, drum roll please, human element involved. As such, markets tend to be far more emotional than the average observer gives them credit for, with the business cycle making that crystal-clear. From roaring bull markets where irrationally exuberant investors make recklessly risky choices to depressing bear markets where irrationally frightened investors are too scared to pull the trigger despite ample asymmetrical opportunities being right in front of them. Again: if markets were comprised of robots, asset prices would simply move in a linear manner but that is just not the case.

The more time you spend being involved in various markets, the more you notice that the confidence element is crucial time and time again. Therefore, it oftentimes matters more what people believe reality is rather than how things “actually” stand. This state of affairs can be confirmed by a wide range of investors who were “right” about a certain trend but hopped on too early, using too much leverage. As such, by the time the market caught up and they were indeed proven correct, their capital was long gone. As the saying goes, the market can remain irrational longer than you can stay solvent.

Once confidence is gone, whether for rational or emotional reasons, the rug is essentially pulled, no matter which asset or asset classes we are referring to. From bonds and shares to currencies themselves, “value” is driven by confidence to an alarmingly high degree. This makes any kind of prediction pretty much impossible, in light of the fact that as Isaac Newton himself pointed out, predicting the madness of the crowds isn’t the easiest or more rewarding of endeavors.

This term bears repeating: “rug pull” situations.

A lot of investors make the mistake of believing that even if confidence is lost, this will happen in a gradual and controlled manner, with them having more than enough time to react and position themselves properly. What they do not realize is that when confidence is eventually lost in a meaningful way, it all becomes a bit of a musical chairs game, with everyone rushing toward the exists and… well, there not being room for all of them. In the end, those who were too slow to react realize that the music stopped and there are no chairs left whatsoever or, to put things differently, that they are left holding the proverbial bag (illiquid assets or assets at such low prices that it makes little sense to sell at that stage) and hoping for a miracle.

Make no mistake: the very same principle is valid as far as confidence in anything from currencies, to governments, to central banks and even the “system” itself is concerned. The 2020 situation itself made it quite clear that while not lost, confidence in central banks has diminished quite a bit, with the market essentially demanding that monetary stimulus is matched by equally aggressive fiscal stimulus. As such, yesterday’s heroes (central banks, for example) can easily become today’s clay giants.

Can we be certain a post-2020 systemic confidence loss moment will occur?

Of course not.

Can we “predict” when it is likely to happen?

Even less so.

What we are, however, fairly confident (no pun intended) in is that should confidence loss scenarios unfold, it would be fairly naïve to assume that we will be in for a controlled demolition. On the contrary, expecting the entire process to be chaotic is the wiser approach in our view and furthermore, we firmly believe it would be irresponsible not to take such scenarios into consideration as far as the risk assessment dimension of your strategy is concerned. As always, the ChinaFund.com team of experts is here to be of assistance with just that, simply get in touch by visiting the Contact section of our website and we will do our best to help.

This is because banking (loans and credit) is one of the main drivers for economic growth. Additionally, a country’s central bank is usually responsible for monitoring things like the money supply and rates of interest. How a country handles its banking can have repercussions throughout its economy.

In this article, we will dwell a little bit on how the banking system in China works as well as analyze the reforms they’re planning on implementing.

How Central Banking Works

If you’re not familiar, a central bank is defined as a financial institution given privileged control over the production as well as distribution of money and credit for a nation or a group of nations. This essentially means that the central bank is in charge of printing money for a country. They can either add more money to a country’s money supply or take money out of it.

Just like commercial banks lend money to consumers so they can get access to the capital they need, central banks lend money to entire countries or governments. In this way, the policies that a central bank implements can have a ripple effect throughout the country.

1. A central bank is different from regular banks because they alone have the ability to print money. Regular banks are only able to issue liabilities, such as checking deposits. When governments want to start new projects or implement changes, they will often call on the central bank to print the money necessary (this is usually a popular alternative to raising taxes)
2. Another feature of a central bank is its ability to control the country’s interest rate. The national interest rate is the rate at which banks can borrow money from each other. Central banks also influence consumer interest rates. For example, policies that the central bank implements will impact whether you’re able to get a reasonable mortgage on a house

The lower the interest rate, the easier it is for people to receive loans.

Commercial banks (like the one that you use) are responsible for making loans to citizens.

Central banks are responsible for making loans to commercial banks and even governments (although this is just one of their responsibilities).

Let’s take a look at how the United States handles their central banking.

What the U.S. Does

In the United States, the central bank is called the Federal Reserve. The Federal Reserve, despite the official-sounding name, is not actually a government agency and is comprised of 12 regional banks. One of the main reasons that you should be aware of the Federal Reserve and their actions is because they directly impact the interest rate in the United States.

1. When the Federal Reserve lowers interest rates, it can lead to more opportunities for investors because lowering the interest rates makes it easier to get access to a loan. A drop in the interest rate is usually followed by a spike in stock prices
2. However, when the Federal Reserve decides to raise the interest rate, it makes it harder to get access to financing. This will generally lead to slower economic growth
3. As an investor, it’s important to be aware of what the current interest rate is (approximately) and what the Fed’s plans for the future are. This can give you an advantage over other investors

Apart from just controlling the interest rate, the Federal Reserve is responsible for the rate of inflation in the United States. Inflation is the steady increase in the price of goods over time. Essentially, it is the reason that a hamburger in 1950 only cost 20 cents but today, that same hamburger costs $16. As an investor, it’s important to be aware of the inflation rate and always make sure that you are hedging properly so as to protect yourself.

If you were to just keep your cash in a bank account (or, worse yet, stuffed under your mattress) for too long, then your dollars will lose purchasing power. If you’re not careful, inflation can drastically decrease your net worth over time.

Let us now examine China’s central banking system and potential reforms that they might implement.

China’s Banking Reform Explained

China’s central bank is called the People’s Bank Of China. It’s currently one of the largest central banks in the world, with over $3 trillion in foreign exchange reserves. The PBOC was established in 1948, following the communists’ party’s dominance in China. The PBOC is currently responsible for funding public companies along with setting interest rates, regulating financial markets, issuing the Renminbi currency for circulation, regulating interbank lending and monitoring foreign currency exchange.

If you’ve frequented this blog before, then you probably know that the Chinese economy has been growing at breakneck speed over the past 40 years. In 1978, China implemented changes to their economy that allowed it to transition to more of a free market structure. This transition has led to amazing economic growth. However, their banking sector has not had the proper regulations to keep pace. This is important because the banking sector and the economy go hand in hand. Here are just a few manners in which this tends to occur:

➢ The banking sector is responsible for granting loans to consumers to assist them with large purchases (auto loans, mortgages, etc.)

➢ Banks are in charge of lending credit which, above all else, helps grow the economy. Credit is vital because it gives entrepreneurs the resources that they need to create new businesses. Once they’ve built a new business, they have created industries, profits and jobs were there previously was… well, nothing. None of this is possible without the credit offered by the banks to get the ball rolling

➢ Banking, when done irresponsibly, has the capacity to crash other industries. For example, subprime mortgage lending is what led to the 2008 Financial Crisis in the United States

Recently, China’s banking industry was combined into 4 commercial banks which controlled approximately 50% of China’s lending:

1. The Industrial and Commercial Bank of China
2. The Bank of China
3. The Agricultural Bank of China
4. China Construction Bank

Having the industry consolidated into just 4 banks that dominate has stifled competition, which leads to less efficiency and effectiveness. It also means that it’s tougher for smaller and mid-sized companies to get loans because the Big Four banks focus mainly on large state-run organizations.

At the same time that these 4 commercial banks were created, three state-owned policy banks were instituted:

1. Agricultural Development Bank of China (ADBC)
2. China Development Bank (CDB)
3. Export-Import Bank of China (EIBC).

Since 1994, these policy banks functioned with the purpose of handling policy-related lending pertaining to central government plans and each of the three state-owned policy banks has a distinct mission.

Economists have been urging China to reform their banking sector for years now and are afraid that it is a ticking time bomb. The Chinese leadership has pledged that reforms are on the way. Mainly, they agreed that they will be opening up the Chinese banking industry for foreign financial institutions and improving the investment climate.

Coronavirus Updates

The Brookings Institue believes that COVID-19 context represents the perfect time to accelerate China’s transition toward open financial markets.

Now that the majority of China’s citizens are middle-income earners, they will need to depend less on investment and more on innovation and productivity growth. As the pandemic rages through the country, China will inevitably borrow whatever is needed to stave off depression. However, once they’ve weathered the storm, there will be even more of an incentive to institute reforms because risks will increase during this stimulus-heavy time.

A few manners in which China could implement reform would be to:

1. Carefully introduce more flexibility into interest rates and the exchange rate
2. Encourage the creation of more private financial institutions (foreign and domestic) to help diversify lending
3. Turn to capital account liberalization last because this represents the most difficult dimension

It will be interesting to see if and how China reforms their banking infrastructure. It’s an important topic to stay up-to-date on because any potential reforms have the capacity to increase or decrease the investment-related potential of the country.

We hope that you’ve found this article valuable when it comes to understanding the most recent banking reform initiatives associated with this jurisdictions and for further clarifications, our team of experts is at your disposal.

As the crisis spread to other nations, the exact same principle was valid.

In the United States, the Federal Reserve very quickly lowered rates back to zero, ensured that the financial system has more than adequate liquidity (unprecedented repo operations, for example), eliminated reserve requirements and essentially embarked on a journey of Quantitative Easing. Furthermore, in light of the fact that the market was not satisfied with monetary stimulus alone, a lot was done on the fiscal side as well, including yet another record-breaker: $2 trillion in fiscal stimulus, anything from bailing out airline companies to sending the average citizen a $1,200 check.

In the European Union, it is worth noting that as disaster struck, interest rates were already in negative territory but still, the European Central Bank did its best to assure markets that it also plans to be aggressive, with measures including an additional 750 billion EUR in bond purchases. Unfortunately, when it comes to the EU, the fiscal stimulus dimension (and to a lesser extent the monetary one) tend to be trickier in light of the fact that political consensus which is extremely difficult to achieve is required. More often than not, creditor nations such as Germany and the Netherlands are less than eager to contribute to the bailouts that need to take place in debtor nations and as such, just like in the context of the sovereign default fears that took center stage a few years ago, a frustratingly bureaucratic back and forth dance ends up taking place.

But still, even in more complex (in terms of consensus) jurisdictions such as the European Union, nobody dares question the idea that bailouts and unprecedented action are a necessity in light of the fact that, in an effort to combat the COVID-19 spread, drastic containment measures have been implemented, with the end result being that when it comes to a wide range of industries, economic activity essentially ground to a halt.

An important question arises, however: what happens next?

Time and time again, the ChinaFund.com team has made it clear that there is no such thing as an expert who can predict the future and those who claim otherwise are either ignorant or downright charlatans. The best our team or any other team of experts can do is take several steps back and with a cool head, try to assess a wide range of possibilities in a probabilistic manner: instead of trying to determine what WILL happen, the name of the game is trying to figure out what is more LIKELY to happen or, in other words, what the most probable outcome is (with there being no guarantees whatsoever that even highly probable events will unfold).

Right off the bat, we want to make it clear that we are dealing with a deflationary force that can be considered nothing short of crippling. Compared to the economic activity shutdown situation of 2020, the Great Recession seems like a walk in the park and precisely therein lies the problem: the worldwide economy can most definitely not “afford” an extremely severe recession. The Great Recession alone risked crippling the financial system and as such, the authorities in pretty much all jurisdictions do not want to take any chances with the 2020 situation, which risk being quite a bit worse.

Therefore, from bailouts to ultra-dovish monetary policy, all countries are throwing the proverbial kitchen sink at this problem, especially in light of the fact that most economic thinkers with decision-making power tend to lean strongly Keynesian at this point in time. And in terms of prescriptions, Keynesianism makes it rather clear that when economic activity takes a hit, the authorities need to step in so as to create demand.

In our case, this is done by essentially flooding the system with liquidity, to the point of… yes, essentially “printing” the money that is used to bail out companies, help households and generally speaking try to re-ignite the economy. It has been done to combat the Great Recession and inflation has been anything but problematic (on the contrary, it was consistently lower than the authorities had hoped), so what could possibly go wrong?

In our opinion… a lot.

The main difference, this time around, lies in what happens with the money that is “printed” or in other words, whether or not it finds its way to the “real” economy to enough of a degree to generate inflation problems. After the Great Recession, while it is true that trillions were indeed created, a lot of that currency ended up “stuck” as banking system reserves or, at best, found its way to various assets and generated asset price rather than consumer price inflation.

At this point in time, however, “Main Street” demands a much larger piece of the stimulus pie and more likely than not, it’s going to get it. From China to the United States and even European Union, we are and will continue to be dealing with unprecedented injections of liquidity pretty much everywhere: from the banking system to the rest of the financial sector, from ultra-large corporations which will bailed out to households that now demand the same treatment.

As such, much to the surprise of many colleagues who are stuck in a “deflation-only” mindset, the ChinaFund.com team would like to end this article by asking a rhetorical question: does it not make sense, this time around, to dust off our inflation books as well?

A textbook example of the latter is represented, of course, by the Mortgage-Backed Security fiasco which led to the Great Recession, which at its very core had to do with:

1. Wall Street greed, with commercial banks offering mortgages to pretty much anyone with a pulse, then selling those loans to investment banks that packaged these mortgages so as to create so-called Mortgage-Backed Securities, which were then sold to investors
2. The greed of the various entities which were involved in the process, from credit rating agencies which were excessively generous to insurance companies that didn’t plan for systemic shocks which would lead to average consumers defaulting on their mortgages en masse
3. The greed of the average consumer, who took advantage (or so they thought) of the fact that obtaining loans was ridiculously easy and bought homes they couldn’t realistically afford, took out additional loans to live above their means so as to impress the Joneses and the list could go on and on

As can be seen, we are looking at a financial crisis generated by greed, primarily the greed of the financial sector, with all it encompasses.

Is the 2020 situation similar?

When it comes to certain manifestations, yes.

For example, the fact that asset prices have crashed represents a common denominator which makes many observers wrongfully believe that we are dealing with the exact same phenomenon, when in fact… we are not.

What we have now, in China as well as elsewhere, is a downright economic crisis brought about by the fact that in the aftermath of the Covid-19 panic, the worldwide economy essentially froze when it comes to many key industries. Tourism took a devastating blow, transportation was also hit incredibly hard and shocks were felt across the system, with for example February 2020 auto sales falling by a whopping 92.5 over in China and similar trends manifesting themselves in other countries.

Think of it as the difference between a financial crisis brought about by financial sector greed and which ultimately led to a recession and a full-scale economic crisis brought about by a white/black swan (a pandemic, in our case), which led to economic activity grinding to a halt in many cases and among other things, risks generating a financial crisis as well.

Needless to say, we are dealing with more than just differences pertaining to nuance.

By understanding these differences, observers will ultimately realize that gone are the days when central banking “superheroes” such as Alan Greenspan and Ben Bernanke could step in and proverbially save the day through aggressive monetary policy choices alone. At this point and beyond, the market demands a correlation between even more aggressive monetary policy than before and, very importantly, unprecedented fiscal policy.

In a “primarily monetary policy” paradigm, central banks can lower interest rates and flood the financial system with liquidity, liquidity various economic actors can take advantage of in one way or another. Companies can access cheaper financing and among other things even buy back their own shares, individuals can take out loans at “bargain basement” interest rates and the list could go on and on. In a nutshell, the name of the game is making financing more and more affordable, with the private sector hopefully stepping in and taking it from there.

But in situations such as the one we find ourselves in, the private sector has been paralyzed by fear as well as current losses/uncertainty and as such, even if central banks make financing more accessible than before (with an important caveat being that financing had already been more than accessible, for reasons covered in a wide range of ChinaFund.com articles), there will be no demand from the private sector. As such, a powerful “monetary + fiscal policy” duo is required, with the government stepping in decisively through measures which range from directly helping affected industries such as airline travel with various forms of aid to stepping in through public spending (infrastructure spending, for example) so as to fill the demand gap left by a frightened private sector.

How do countries respond?

In China, things are actually fairly straightforward and as such, the authorities are far more likely to respond in a strong “fiscal + monetary stimulus” fashion decisively due to the far more centralized and undemocratic nature of the political system compared to the West. As strange as it may sound, increased centralization and even the absence of democracy, despite representing major issues in other areas, can sometimes work in favor of the country in question. To put it differently, it is not at all difficult in China for Xi Jinping to decide on a course of action and then swiftly implement said plan.

On the other end of the spectrum, we have the European Union as a textbook counter-example. There, in light of the fact that we are dealing with several countries with in some cases completely different cultures as well as political systems, finding a common denominator when it comes to both monetary and especially fiscal policy represents a Herculean task. This became apparent in the European sovereign debt aftermath of the Great Recession, with EU leaders frustrating markets repeatedly through what was perceived as depressing inaction (with Northern European creditor nations being less than thrilled about the prospect of having to provide assistance to poorer Southern European debtor nations).

It remains to be seen what happens next but this much is certain: markets demand strong action on both the monetary and this time also fiscal stimulus front. Should this monetary and fiscal stimulus not be provided or be perceived as inadequate, we have more than valid reasons to believe that little mercy will be shown in terms of asset price action. As such, the price that is being paid for let’s say the current US share price action needn’t be underestimated.