Commercial Loans Blog

Economics:  A Huge Deflationary Tidal Wave is Coming Out of the China in Just Six Weeks

Posted by George Blackburne on Wed, Apr 15, 2020

Dead cat bounceDon't get caught up in this dead cat bounce in the stock market.  To those of you unfamiliar with this old financial saying, a dead cat bounce refers to the fact that even a cat will bounce if it falls from a high enough building.  Please be assured that no sweet, little kitties were hurt in the writing of this article.  Cisca and I have four cats, and they are reasonably decent employers.  Haha!

 

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The stock market fell a whopping 30% from its all-time high a few months ago.  It was never going to fall straight down, and this current rebound is probably nothing more than a rally in a bear market.  Elliott Wave Theory suggests that markets go up gradually in five pretty big waves, and they fall in three larger, faster waves.  These waves are also called legs.

I believe we are likely see the second big leg downwards in the U.S. stock market in the next six weeks.  The reason why is because a deflationary tidal wave is gaining strength in China, and it is poised to drown the rest of the world.  

Money is being destroyed din China at a prodigious rate.  Money can be destroyed? Huh?  What?   At the end of this article, I will explain how it happens; but for now, assume that China has erected huge blast furnaces, and prisoners are shoveling thick stacks of 100 yuan notes into these furnaces by the truckload.  Money in China is being destroyed.

 

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"Okay, George, even assuming that money can be destroyed (really?), how does this affect me?"

For the past few years, Chinese manufacturers and consumers have been a wonderful new market for raw material suppliers (think copper and iron miners) and manufacturers around the world.

If Chinese manufacturers and Chinese consumers soon will have no money left to buy raw materials and consumer goods (those darn prisoners keep burning it), mining companies and manufacturers around the world will soon have lost their second largest customer.  Their sales and profits will plummet, and the value of their stock and your retirement savings will fall precipitously.  Layman's translation:  Stocks markets worldwide are poised to take another huge dump.

 

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The Coronavirus Crisis has traumatized small Chinese business owners.  Did you know that sixty percent of the people in China work for small businesses?

These small business owners have been forced to keep paying their rent and their loan payments to the bank, but their sales have plummeted because so many people have been locked indoors.  Most of these small business owners have burned through huge chunks of their savings.  

If you owned a small business, and you had just spent the last of your savings, would you be in the mood to borrow even more money from the bank in order to expand your business?  Of course not!  And therein lies the problem.

 

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I will explain why further below, but did you know that if a bank takes in a $1,000 loan payment and can't find a willing borrower to whom to re-lend it, that a whopping $20,000 gets sucked out of that country's money supply?  Twenty thousand dollars gets destroyed!  The Multiplier Effect works in reverse to the tune of 20:1.  Note, the starving prisoners didn't even have to use their blast furnaces.  The money just disappeared.  

So Chinese small business owners burned through their savings.  They definitely don't want to borrow more money to expand their business right now.  At the same time, since the very start of this crisis, these small businessmen have been sucking money out of their savings and sending it to their banks for mortgage payments and business loan payments.

These banks have been raking billions of yuan in the form of loan payments, but the banks themselves are scared.  Loan losses are way up.  Even if they could find a ton of brave, qualified borrowers, the banks in China are far too frightened and traumatized themselves to lend much money.

 

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So billions of yuan worth of monthly payments have been flowing back to Chinese banks, but that money is not being re-lent out into the Chinese economy.  Twenty-to-one, bucko's.   (Most of you are much too young to remember the show, Happy Days, starring Ron Howard as Richie Cunningham, the classic, lovable, 1950's-era, Every Man.  Whenever Richie got a little too full of himself, he would call people, "Bucko."  Twenty-to-one, bucko's.  Haha!

But this is serious, guys.  Whole mountainsides of money are being destroyed in China.  Soon the Chinese consumer will have far less money to buy iPhones, Tesla's, GM cars from the U.S. and fancy perfumes, fashions, cosmetics, and wines from Europe.  

Chinese companies will also suffer painful declines in sales, which will lead to layoff's, which will lead to even less demand and even more layoff's.  It becomes a self-feeding negative cycle, like the water speeding up when you flush.

 

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The horrible thing about deflation is that is a very difficult cycle to stop.  Prices will start to fall, as companies, desperate for income, slash pries to the bone.  And once prices start to fall, why buy a new car, a new bicycle, or a new phone today?  Why not hold out for an even lower price.  Deflation can be awful.

And as Chinese companies sell fewer washing machines, the demand for cooper and iron plummets.  Mining companies in Australia, South America, and Africa get gut-punched.  This Coronavirus Crisis has the potential to get awful.

Folks, I am 67 years old, and what little I have saved for retirement, I cannot risk in the stock market right now.  This dead cat bounce may last another five to six weeks; but soon the analysts and the smart money will start to realize that there are few places, other than cash, to hide when the Chinese Deflationary Tsunami comes crashing on our shores.  

 

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A financial writer for Apple News has caught a glimpse of the building deflationary tidal wave; but I assure you that China's new, free, spending vouchers are like using a pea shooter against an M1A1 tank.  They aren't going to be near strong enough against the Multiplier Effect working in reverse (20:1).

How Money is Destroyed:

Deflation?  How is deflation even possible?  Why would anyone ever burn $100 bills?

Currency is just a tiny fraction of a country's money supply, only about 10%.  The vast majority of a country's money supply consists of the proceeds of bank loans.

 

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For example, your bank loans you $1,000 to buy three used desks and a computer.  The seller of that equipment deposits the proceeds of that $1,000 sale into his bank.  The bank keeps around $50 in reserve (5%), and then it loans out $950 to a barber.  The barber spends the $950 for a new cutting chair and some good electric razors.  The $950 end up in the next bank, and this next bank keeps $47.50 in reserve, and it lends out $902.50.  The third bank receives this deposit, keeps $45.13 in reserve, and lends out $857.37.  

And so on.  By the time the cycle is complete, that $1,000 new loan resulted in an increase of the money supply of a whopping $20,000 (20:1).  This is the Multiplier Effect and the miracle of fractional banking.

The problem is that the Multiplier Effect also works in reverse.  If a bank gets scared and fails to re-lend a $1,000 loan payment, a whopping $20,000 get sucked out the money supply.  In effect, $20,000 is destroyed.  Yikes.

 

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Think I am an idiot?  I wrote my book, The Reverse Multiplier Effect, in late 2006, right before the deflationary crash of 2008.  At the time, few people believed that deflation was even possible.  Ah, geez, this coming financial crisis has the potential to be awful.

 

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Topics: deflationary tidal wave