Supervalu and the Wayne Gretzky school of value investing

I once wrote a blog post stating why I did not much like small caps. The comments (and there were many) wound up in a discussion of the seemingly cheap grocer Supervalu. This owns Albertsons and others.

I wrote a separate blog post on it - which further explained why I did not like it. The answer came down to thinking about what the business might look like in five years time. Wayne Gretzky liked to skate to where the puck was going to be. Investors should invest likewise - on how the business might look in three to five years time.

We are five months on. The company has suspended dividends and is aggressively cutting price in its shops. They are also having a major review of costs. To quote:

“Given the economic situation the American consumer is in, a lot of grocery competitors are focused on making sure they have the right value proposition for customers. We needed to accelerate our ability to play in that game.”

When your best strategy is getting into a price-war with Walmart the Wayne Gretzky question answers itself.




John

Disclosure: as explained in the original blog post I have no position in this stock, something I now regret.

Weekend edition: Australian pop stars twenty years later

Someone who was a modestly successful pop star (a number 1 or two and a dozen other chartings) can make a living off old glories for most their life in America. The market is sufficiently big.

But someone of that status has a much harder time making ends meet in music in Australia. You can be privileged to see them with very small (and in this case respectful) audiences.

Below is one of my favourites from my 20s - Angie Hart - who is somewhat younger than me - and was one of the first Australian stars to sing in a really strong Australian accent.



The song is Elvis Costello's (similarly dated) song Shipbuilding - a story about laid-off ship builders in the North of England looking at the loss of tonnage in the Falklands War and thinking they may get a job at the shipyards. "Within weeks they will be reopening the shipyards, and notifying the next of kin". (If you do not know the lyrics they are reproduced at the end of this post.)

When I was in my 20s I was not very conscious of Angie's Australian accent (and I had one this intense). 10 years of talking on phones internationally and listening to Americans in particular has changed the way I speak. I still sound Australian - but not like that.

Here - 20 something years ago - is the song for which Angie Hart is most famous - another cover - this time of a New Order song...



But what I find really strange is that 20 years later the Frente cover of the New Order song has become the way to do it - especially in Asia where it was featured on Indonesian Idol (no not kidding).

And all over YouTube you find Chinese teenage girls in Malaysia or the Philippines or Indonesia or even China singing New Order songs with a deliberate Australian accent. Here is one - there are hundreds of others.

Fame on the internet can be very strange.




John


Shipbuilding

Is it worth it
A new winter coat and shoes for the wife
And a bicycle on the boys birthday
Its just a rumour that was spread around town
By the women and children
Soon well be shipbuilding
Well I ask you
The boy said dad they're going to take me to task
But I'll be back by christmas
Its just a rumour that was spread around town
Somebody said that someone got filled in
For saying that people get killed in
The result of this shipbuilding
With all the will in the world
Diving for dear life
When we could be diving for pearls
Its just a rumour that was spread around town
A telegram or a picture postcard
Within weeks they'll be re-opening the shipyards
And notifying the next of kin
Once again
Its all were skilled in
We will be shipbuilding
With all the will in the world
Diving for dear life
When we could be diving for pearls
[ Lyrics from: http://www.lyricsfreak.com/e/elvis

Central bankers opposed to functioning markets

As I outlined in the kleptocracy post Chinese households save an absurdly large proportion of their income in bank deposits with regulated interest rates earning about 1 percent nominal.

This is an observable fact. The reasons for it (I blamed the One Child Policy and deliberate financial oppression) are less observable - but the fact of these enormous savings is not in doubt.

Inflation is also highly observable in China. Whether you believe the official statistics or not does not matter. Inflation causes observable political disturbance and many companies are complaining about cost pressure.

There is no doubt that inflation rates in China have been above the regulated bank interest rate and that situation has been persistent.

Simple observable fact: one of the biggest savings pools in the world and possibly the largest incremental savings pool in the world (Chinese middle and lower classes) have saved (and are clearly prepared to save) at observable and high negative real interest rates.

My speculation: if there were full capital mobility the market clearing real interest rate for riskless assets globally would be negative because of that large pool of savers prepared to save at negative real rates.  

If this is true then we should not be at all surprised by gilts in the UK at 1.5 percent and inflation at 3 percent. There is no reason at all to think the market clearing real interest rate has to be positive - indeed given the nature of the incremental savings pool in the world there is a reason to think the reverse. Indeed it is just an extension of what Bernanke observed when he talked about an excess of global savings...

Unfortunately you cannot produce negative real returns on riskless assets unless you allow some inflation.

Central bankers however do not see it that way. Mario Draghi (European Central Bank) still thinks inflation is an ill to be avoided - rather than necessary for market clearance. Mario Draghi is anti-market - and anti-market clearing. He is not the only offender.


I have a follow up post to begin to explore investment and social implications.

For comment.



John

Duties morality and short-selling: Part 2

Almost everyone said that I should tell the old man in the last post that he had lost his life fortune and that his advisor was a crook.

Only one person suggested I watch reruns of the Godfather for advice.

Does it change your mind if the crooked advisor is mafia?

What if there is only a 5 percent chance of him being mafia?

What if you plain do not know?







John

Disclosure: a journalist is going to do it for me - or at least sound the victim out. Seems safer that way. At least for me.

Duties, morality and short selling

I am involved in a short that has mostly collapsed. Take it as read that the company and its accounts were almost entirely fraudulent.

The stock however squeezed a fair bit along the way. Had you "played" the stock you could have made considerable money. But you had to understand that when it spiked it was a short-squeeze and short-squeezes are made to be sold.

The short squeeze happened when an elderly man who was rich from a successful mid-sized business started buying the stock aggressively. He purchased over 10 percent of the company - and more than 20 percent of the float. His purchases were well in excess of 10 million dollars - and on market value now he would be down $8-9 million (having been up considerably along the way).

Given this was a fairly easily determined fraud there was a large short interest - and some of those shorts were so big in the stock they had to buy back as the stock went up (short positions alas get larger as they go against you). So the shorts lost some. Short squeezes do that.

The old man lost, and some short sellers lost. Almost all the longs lost too. The only winners were a few short sellers with positions small enough to sit out the squeeze (which fortunately in this case includes Bronte), a few "players", and of course the insiders. Fidelity was a big loser losing tens of millions of dollars.

The insiders were crooks who sold stock more or less continuously. The insiders carved out something like 40 million of neat profit. All fraudulently obtained. Victims included the old man and Fidelity.

I did a fair amount of research into this elderly man. He wasn't usually a big-swinging stock player - instead he was an investor who had been successful in his normal line of business (a form of retailing) and took his (excessive) confidence into the stock market. Much worse though - he was being privately advised by someone who had previously accepted a ban from the securities industry for selling pump-and-dump securities to his own clients. The old man was being advised by a crooked advisor.

However only recently - and after the old man had lost most of his life savings - did I work out the advisor was a crook. Telling the old man now will just deepen his sadness. On paper he has $1-2 million worth of the shares left - but they are not saleable. If he tried to sell them the stock price would collapse to below a penny. He could - if lucky - get out 50 thousand dollars on the way down.

I know what it is in my interest to do. That is follow the crooked advisor to his next victim and short that stock too.

But I don't know what it is my moral duty to do. Do I tell the old man he has been had (and risk retribution from the advisor)? Do I hope he can salvage the last 50 thousand dollars from what was his 10 million plus dollar life savings? I told the regulators but nothing much has been done. (They don't tend to follow leads like that from short sellers. They perceive we have an interest in telling stories.)

I have now more or less covered the stock. I do not have any particular interest in future moves in this security which already trades well below $1.

Should I ring the old man? Would you?



John

Coronado Biosciences is not exactly kosher

Crohn's disease is an autoimmune bowel disease (or maybe just an immune deficiency) which has symptoms ranging from abdominal pain to diarrhoea and other unpleasantness. It is a disease that I associate with Orthodox Jews of European - particularly German origin and I always thought of as an inherited genetic disease prevalent most strongly amongst Orthodox Jews.* Wikipedia says that it is more common amongst Ashkenazi Jews but they also suggest wider incidence (which somewhat upsets my story). Perhaps my preconception that it is a disease more prevalent among Orthodox Jews in New York probably has as much to do with the original description (at Mt Sinai Hospital).

Coronado Biosciences - now listed on the Nasdaq - is researching a treatment for Crohn's (and possibly a few other autoimmune diseases including the big-daddy of them MS). The technology is all licensed. To quote the original prospectus:

All of our product candidates were in-licensed from third parties. Under the terms of our license agreements, the licensors generally have the right to terminate such agreement in the event of a material breach by us. Our licenses require us to make annual and milestone payments prior to commercialization of any product and our ability to make these payments depends on our ability to generate cash in the future. These agreements generally require us to use diligent and reasonable efforts to develop and commercialize the product candidate. In the case of CNDO-201, the company from which we sublicense CNDO-201, OvaMed, licenses CNDO-201 from a third party, UIRF, in exchange for annual and milestone payments, patent cost reimbursement, royalties based on sales and diligence obligations. Our rights to CNDO-201 are, therefore, also subject to OvaMed’s performance of its obligations to UIRF, certain of which are outside of our control. For example, upon our acquisition of this license from Asphelia, we paid certain overdue patent cost reimbursement obligations to UIRF.   

So the stock holders (those that participated in the recent capital raise) get to fund the development of someone else's drug and have to make milestone payments based on the success of that development.

I will leave it to readers to work out the nuances of that disclosure.

I am more interested in the treatment. Here is how it is described in their latest prospectus:

TSO, or CNDO-201, is a biologic comprising Trichuris suis ova, the microscopic eggs of the porcine whipworm, for the treatment of autoimmune diseases, such as Crohn’s disease, or Crohn’s, ulcerative colitis, or UC, and multiple sclerosis, or MS.

The treatment comes from porcine whipworm - that is a worm that lives in pig intestines.

That is an obscure ingredient. You would think they breed pigs for it - but no a subcontractor of OvaMed breeds the pigs and CNDO pays OvaMed for that. This is the same OvaMed they are licensing the drug from. Here is the disclosure:

We have contracted with OvaMed to produce and supply us with all of our requirements of TSO. OvaMed’s contractor inoculates young pathogen-free pigs with T. suis from a master ova bank and harvests the ova which are incubated to maturity and are processed to remove any viruses and other pathogens. Ova then are processed and extensively tested to assure uniformity. They are then used to repopulate the master ova bank and are processed further by OvaMed into a final formulation of the drug product that is a clear, tasteless and odorless liquid. OvaMed manufacturing is conducted at one facility in Germany.

This disclosure leaves out the really funny detail. Here it is:

Mature T. suis produce ova that exit the porcine host with the stool, however, ova are not infective until incubating in the soil for several weeks, thereby preventing direct host-to-host transmission.

So get this - Coronado Biosciences is a company testing a drug to treat a disease prevalent amongst New York Orthodox Jews where the drug is extracted from pig stools.

And you get the messy relationship with OvaMed thrown in for free.


It is not exactly Kosher.


Either this does not work or the Old Testament God does not exist or, if the Old Testament God does exist he has a wicked sense of humour.




John


*There are other inherited autoimmune disorders linked to people with other origins. Coeliac disease is of Anglo-Celtic origin. Behçet's disease is sometimes called Silk Road disease and has higher incidence in people of Turkish and Middle Eastern origin.

China and the shiny stuff

In my kleptocracy post I described how the range of investments available to the median Chinese family is limited. They can't take their money offshore (unless they are rich enough to afford casino junkets). The local stock market is rigged. There is no worthwhile mutual fund market. They can own see-through apartments. But their main saving mechanism is bank accounts and life insurance contracts (life insurance being a bank account proxy).

Rates are regulated - low. Inflation is high and ex-ante the return to Chinese savers is negative.

Despite negative real returns Chinese save in huge quantity. This may be because of the "four grandparent policy" as described in the kleptocracy post or because of gender imbalance (as described in the follow up post).

Whatever: in China we have huge quantities of savings at ex-ante negative real returns in some sense compelled by local social and political structures.

This pool of savings (part of what Ben Bernanke once described as the "excess of global savings") has global implications - and these will be explored in a forthcoming posts.

But here I state the obvious.

If you were forced to save huge amounts of money at negative real rates of return wouldn't gold look attractive?

There is no data I would trust on how much gold has been socked away by middle-income Chinese. Being a kleptocracy where government officials expropriate land, hydro dams and any other private assets they take a fancy to, the gold buried under the house is hardly going to be declared to official statistics collectors.

But it is there in some quantity.

Gold is a market I have studiously taken very little interest in. I agree with Warren Buffett - that it has no real return over very long periods and is thus unattractive. But in China no-real-return is a good return and until recently I had not thought about that clearly.

If people have a decent knowledge of the non-official gold-market in China please leave it (anonymously if you wish) in the comments.

Observations on gold demand in China now and in the future

I have no knowledge of the specifics of middle income people trading gold in China.

But I do note that inflation in China (with regulated low interest rates) is likely to be strongly positively correlated to gold demand in China.

Inflation in China is clearly declining right now (which is very bad for Chinese gold demand). However I do not think that falling inflation in China is likely to be sustained. Low inflation would result in the collapse of many State Owned Enterprises (and probably the regime) - and the regime is the hand that holds the printing press so to some extent inflation is a choice for the regime. They will print. And print. Their very lives depend on it.



John

Follow up to the China kleptocracy post

The China kleptocracy post has received a lot of comment - mostly favourable. It was my first post to get 100 thousand views. I would like to thank all that commented on it (especially Paul Krugman who was good for about 35 thousand page views).

Only a few of those views are from China. My post was blocked by the Great Chinese firewall.* That said, within China the people who have been in business there for more than a decade were mostly in agreement. The people who have been there a couple of years were less in agreement. Bill Bishop (who I read and respect) was in the less in agreement group.

I will not name the people in agreement because many have to live in China.

My thesis was

(a). The savings rate in China was abnormally high driven by the one-child policy,
(b). The options for investing those savings for most the population were extremely limited - mostly bank deposits.
(c). The bank deposit market was rigged so that deposit rates were consistently below the inflation rate.
(d). That repressed interest rates were mainly used to subsidize state owned enterprises and that
(e). This funded the widespread looting of State Owned Enterprises by party officials.

Demographics is outside my field of expertise and I received (and expected) most criticism on the demographic point. The first bit came from my business partner who thought that the high savings rate and the property boom came in part from the (extreme) gender imbalance in China. The gender imbalance is another artefact of the one-child policy - where selective abortion and infanticide produce a large shortage of female babies and (later) eligible women to marry. This drives male preening behaviour - and the most successful preening behaviour for a man is to be rich and to own property. This is an extension of the men-will-do-anything-for-sex argument - and in this case "anything" is own apartments and big (negative return) bank balances.

Unknown to me this was the subject of a serious academic paper by Shang-Jin Wei - a professor of finance and economics at Columbia University who supports the men-will-do-anything-for-sex argument with lots of fancy econometrics.

There was little objection to my argument about limited options for saving in China. That seemed self-evident - however those limited options are being undermined by capital flight. The Chinese are washing an incredible amount of money through Macau. That money is being saved outside the Chinese banking system - and is thus not subject to extreme financial repression.

There is also little objection to my suggestion that bank deposit rates are rigged below the inflation rate. China dropped the regulated bank deposit rate recently as the inflation rate declined. However - and it was the point of my post - negative real interest rates are declining in China because inflation is declining.

The fourth point - that the repressed interest rates are the main source of subsidy for Chinese State Owned Enterprises was backed up very strongly by Michael Pettis. There are other sources of subsidy. For instance tobacco is largely provided by a State Owned monopoly and tobacco use is not subject to much social sanction making the tobacco company unbelievably profitable (and hence able to pay very high salaries and benefits to senior staff). Indeed Michael Pettis points to a Mainland think-tank - Unirule which suggests that monopoly and direct subsidies have accounted for as much as 150 percent of the profitability of the State Owned Enterprises over the last decade. Pettis himself calculates that repressed interest rates may have accounted for another 400 to 500 percent of total profitability over this period.

Monopoly profits and financial repression are a subsidy from the household sector. Pettis thus states the obvious - five hundred to six hundred and fifty percent of SOE profits come from a subsidy from the household sector.

Absent subsidy the SOEs are staggeringly unprofitable. In a market economy a business that goes from making X per year to losing X per year usually fails or closes pretty quickly. A business that goes from making X per year to losing 5X per year crashes and burns very rapidly.

Absent the subsidies the whole SOE sector with its current expense base crashes and burns very quickly. By far the biggest subsidy is the subsidy of being allowed to borrow at repressed interest rates.

This of course leads to the fifth part of my argument. That was that the expense base of the SOEs was the (looted) income of Communist Party apparatchiks. Here surprisingly the New York Times came to my rescue with an article about the difficulty of economic reform in China. Reform in this article really meant reform of State Owned Enterprises. The difficulty was that:

Publicly controlled enterprises have become increasingly lucrative, generating wealth and privileges for hundreds of thousands of Communist Party members and their families.

That is - of course - precisely my point. And the Times goes on to say that the Government is moving to stifle debate on anything that challenges this status-quo.

Deflation of course will challenge the status-quo anyway. If 400-500 percent of the profitability of SOEs comes from financial repression then the end of financial repression will result in the collapse of the State Owned sector and the collapse of the wealth and privilege led by "hundreds of thousands of Communist Party members and their families". I suspect that the centre would find it increasingly hard to control their regional elites and the regional elites would revolt. [Revolution is almost always an affair of the second-tier elite versus the first-tier elite - the masses rarely drive it. This would be no exception.]

However in the face of that the centre would do anything to keep the inflation rate high. Ben Bernanke might not literally be prepared to throw dollars out of helicopters. The Central Committee - they might go there...



John

*I have been informed by someone that blogger is always blocked in China. The Chinese people who were telling me they can't get the blog usually get it via a virtual private network.

Distractions: winter in Sydney

It is mid winter in Sydney - and the surf has been too big and the water a little cold for me. But the sun was out and I went to Cape Solander to watch. Cape Solander is the notorious surf break also known as "ours".

This was the wave of the day:



I do not know who the surfer is.

A little less plausibly the small-wave surfers have had some fun in Sydney Harbour:




Here is a little bigger at Cape Solander. I showed this video (and similar) to a surfing hedge fund manager. His response in two words: no bid.













John

The Macroeconomics of Chinese kleptocracy

China is a kleptocracy of a scale never seen before in human history. This post aims to explain how  this wave of theft is financed, what makes it sustainable and what will make it fail. There are several China experts I have chatted with – and many of the ideas are not original. The synthesis however is mine. Some sources do not want to be quoted.

The macroeconomic effects of the Chinese kleptocracy and the massive fixed-currency crisis in Europe are the dominant macroeconomic drivers of the global economy. As I am trying a comprehensive explanation for much of the world's economy in less that two thousand words I expect some kick-back.

China is a kleptocracy. Get used to it.

I start this analysis with China being a kleptocracy – a country ruled by thieves. That is a bold assertion – but I am going to have to assert it. People I know deep in the weeds (that is people who have to deal with the PRC and the children of the PRC elite) accept it. My personal experience is more limited but includes the following:

(a). The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US,

(b). The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been to make Chinese statutory accounts less available to make it harder to detect stock fraud.

(c). When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.

This however is only the beginning of Chinese fraud. China is a mafia state – and Bo Xilai is just a recent public manifestation. If you want a good guide to the Chinese kleptocracy – including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.

China has huge underlying economic growth from moving peasants into the modern economy

Every economy that has moved peasants to an export-orientated manufacturing economy has had rapid economic growth. Great Britain industrialized at about 1 percent per annum. It was slow because all the technology needed to be invented for the first time. During the 19th Century US economic growth – once started – ran about twice the rate of the UK. They copied the technology which was faster than inventing it. Later economies (eg Japan, Malaysia, Thailand, Korea) went later and faster. As a general rule the later you industrialized the faster you went – as the ease of copying went up. In the globalized internet age copying foreign manufacturing techniques and seeking global markets is easier than ever – so China is growing faster than any prior economy.

This fast economic growth – which would happen in a more open economy – is creating the fuel for the Chinese kleptocracy.

The one-child policy drives massive savings rates

The other key fuel for kleptocracy is a copious supply of domestic savings to loot. The reason Chinese savings levels are so high is the one-child policy.

In most developing countries the way that people save is they have multiple children hopefully to generate a gaggle of grandchildren all of whom are trained to respect their elders. Given most people did not live to old age if you did you became a treasured (and well cared for) family member.

This does not work in China. Longevity in China is increasing rapidly and the one-child policy results in a grandchild potentially having four grandparents to look after. The “four grandparent policy” means the elderly cannot expect to be looked after in old age. Four grandparents, one grand-kid makes abandoning the old-folk looks easy and near certain.

Nor can the elderly rely on a welfare state to look after them. There is no welfare state.

So the Chinese save. Unless they save they will starve in old age. This has driven savings levels sometimes north of fifty percent of GDP. Asian savings rates have been high through all the key industrializations (Japan, Korea, Singapore etc). However Chinese savings rates are over double other Asian savings rates – this is the highest savings rate in history and the main cause is the one-child policy.

Low and middle income Chinese have very limited savings options

The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country.  So they can't invest in any foreign assets.

Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.

What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.

Bank deposits and life insurance as a savings mechanism in China

Bank deposits rates are regulated. You can't get much different from 1 percent in a bank deposit. Life insurance contracts (a huge savings mechanism) are just rebadged bank deposits – attractive because the regulated rate is slightly higher.

This is a lousy savings mechanism because inflation has been between 6 and 8 percent (but is now lower than that and is falling fast). At almost all times (except during the height of the GFC) the inflation rate has been higher – often substantially higher – than the regulated bank deposit (or life insurance contract) rate.

In other words real returns for bank accounts are consistently negative – sometimes sharply negative.

You might ask why people save with sharply negative returns. But then you are not facing starvation in your old age because of the “four grandparent policy”. Moreover because of the underlying economic growth (moving peasants into a manufacturing economy) there are increasing quantities of these savings every year. This is the critical point – the negative return to copious and increasing Chinese bank deposits drives a surprising amount of the global economy and makes sense of many things inside and outside China.

The Chinese property market as a savings mechanism

Chinese people have very few savings mechanisms. The major ones (bank deposits and their life-insurance contract twins) have sharp and consistently negative real returns.

Beyond that they have property.

Bank deposits have sometimes 5 percent negative returns. If you got 1 percent negative returns from  property – well – you would be doing well. Buying an empty apartment and leaving it empty will do fine provided you can sell the property at some stage in the future.

It is commonplace amongst Western investors to view the see-through apartment buildings of China as insane. And they may be a poor use of capital. But from the perspective of the investors – well they look better than bank deposits.

Negative returns on bank deposits and the Chinese kleptocracy

Most Chinese savings however are not invested in see-through apartment buildings. Bank deposits still dominate. The Chinese banks are the finest deposit franchises in human history. They can borrow huge amounts at ex-ante negative real returns.

And those deposits are mostly lent to State Owned enterprises.

The SOEs are the center of the Chinese kleptocracy. If you manage your way up the Communist Party of China and you play your politics really well may wind up senior in some State Owned Enterprise. This is your opportunity to loot on a scale unprecedented in human history.

Us Westerners see the skimming arrangements. If you want to sell kit (say high-end railway control equipment) to the Chinese SOE you don't sell it to them. You sell it to an intermediate company who on-sell it in China. From the Western perspective you pay a few percent for access. From the Chinese perspective – this is just a gentle form of looting.

And it is not the only one. The SOEs are looted every way until Tuesday. The Business insider article on the spending at Harbin Pharmaceutical is just a start. The palace pictured in Business Insider would make Louis XIV of France (the Sun King) proud. This palace shows the scale (and maybe the lack of taste) of the Chinese kleptocracy.

A normal business – especially a State Owned dinosaur run by bureaucrats – would collapse under this scale of looting. But here is the key: the Chinese SOEs are financed at negative real rates.

A business – even a badly run business – can stand a lot of looting if it is (a) large and (b) funded at negative real rates.

Those negative real rates are only possibly because there are copious bank deposits available at negative real rates to State controlled banks.

The cost of funds in China and the willingness to hold foreign bonds

The Chinese Government (and the banks are part of the government even though they are listed) has access to seemingly unlimited bank deposits at negative real costs.

When you have copious funds at a negative cost a lot of investments that look stupid under some circumstances suddenly look sensible. US Treasuries look just fine. Don't think the Chinese are going to stop holding Treasuries. The Treasuries yield far more than they pay the peasants. The Chinese make a positive arbitrage on holding low rate US bonds.

Monetary threats to the Chinese establishment

The Chinese kleptocracy – and indeed several major trends in the global economy – depend on copious quantities of savings at negative expected rates of return by middle and lower income Chinese.

There are two core threats to this system – one widely discussed – one undiscussed.

Inflation (widely discussed) is known to produce riots and demonstrations in China – and is considered by Westerners to be bad news for the Chinese establishment. And there are good reasons why the Chinese riot with inflation – the poor who save because they are going to starve – get their savings taken away from them.

But ultimately the Chinese establishment like inflation – it is what enables their thievery to be financed.

The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate - well that is a completely different story.

The real threat to the Chinese establishment is that the inflation rate is falling - getting very near to the 1-3 percent range.

Low Chinese inflation rates will mean reasonable returns on savings for Chinese lower and middle income savers. Good news for peasants perhaps.

But that changing division of the spoils of economic progress will destroy the Chinese establishment (an establishment that relies on a peculiar and arguably unfair division of the spoils). The SOEs will not be able to pay positive real returns to support that new division of spoils. The peasants can only receive positive real returns if the SOEs can pay them - and paying them is inconsistent with looting.

If the SOEs cannot pay then the banks are in deep trouble too.

All because the inflation rate is dropping. Maybe they can stop it dropping. The Chinese establishment has a vested interest in getting the inflation rate up in China. Because if they don't all hell will break loose.

Unless the Chinese can get the inflation rate up expect a revolution.



John