The economic and financial market situation in China is far worse and more complicated than most in the financial media appear to be aware.
Last summer the primary concern among U.S. investors with long holdings in Chinese ETFs and ADRs was how low they would go as the stock markets there corrected.
As the Chinese stock markets declined, there was a simultaneous and increasing reduction in the value of Chinese foreign reserves.
The general meme in the U.S. media is that this process is good for Chinese equities and bad for U.S. Treasuries because the proceeds from the liquidation of U.S. Treasuries held as foreign reserves are used to counteract the economic slump there. The thinking is that this process not only will be positive for stocks but also will cause upward pressure on U.S. Treasury yields and thus debt capital costs to the U.S. government and consumers.
It is true that the Chinese are liquidating foreign reserves at an accelerating pace and that the reserves have declined from about $4 trillion in value to about $3 trillion in the past year.
However, this is not a proactive plan by the Chinese government or People's Bank of China to implement and fund countercyclical stimulus measures that will support the economy or stocks.
This is foreign capital flight, and that is really bad.
Somewhere between a third and half of the value of Chinese foreign reserves is made up of capital brought into China by foreigners, either for the purpose of making substantive investments in manufacturing facilities or for similar foreign direct investment (FDI), or for the purpose of speculating in and trading Chinese equities, called hot money or hot money flows.
China benefits from this capital flow into the country because it creates jobs and economic activity overall and increases the chances of the country smoothly making the transition to a technology- and services-based economy from a manufacturing economy.
Most important, however, is that without a continuous and increasing flow of foreign direct investment it will be impossible for China to make that transition and it will be caught in a middle-income trap.
Foreign investors, most of which are from the U.S. but also are from Western Europe and Japan, only bring money into the country for real investment if there is consumer demand for the goods produced back home.
The consumers of goods produced by companies financed with foreign direct investment are not principally the Chinese. The goal of many of these companies ultimately is to transition away from exports and to serve the needs of Chinese consumers, but that is not the case yet.
The trillion-dollar drop in foreign reserves in the past year is so large that it cannot be made up solely of hot money that perhaps temporarily is leaving the country after investors took losses in the stock market rout last year, although that money surely has left.
This is real foreign direct investment that is leaving the country and is requiring the PBOC to cash out the exiting investors by way of liquidating U.S. Treasuries that have been held in the foreign reserves account.
The contraction in global demand, overcapacity in production and elimination of the labor arbitrage advantage China offered producers is causing many investors to reduce investments in building capacity for exports.
The demand for goods in China is not yet robust enough to provide the opportunity to divert investments into production for the Chinese, so the money exits the country and either is repatriated to the owner's home country or more likely parked in a Caribbean bank to avoid repatriation taxes.
The banks then buy the U.S. Treasuries back for their depositing customers.
That's why the Caribbean banks are the third-largest foreign holders of U.S. Treasuries and why the selling of Treasuries by the Chinese does not result in upward pressure on Treasury yields.
This process is also part and parcel to the middle-income trap.
The most important question any investor who wants to take a long position in Chinese equities needs to consider is how long the Chinese government will allow the lifeblood of China's economy, foreign direct investment, to flee before introducing capital controls in an attempt to prevent it.
I think that event is quickly approaching and would be consistent with historical precedence by previous Chinese administrations.
The outflow will cause the Chinese to feel abandoned and disrespected by the leaving foreigners, emboldening the leadership to enact measures to prevent the flight.
When those actions instead intensify the desire of foreigners to flee, the Chinese authorities will respond in xenophobic fashion, seizing foreign-owned assets, deporting the foreigners and restricting or suspending stock market action.