I’ve long believed that there is a good chance that either the next mega-crisis – or the one after that – will start in China. More particularly it will feature a mismatch between hard business realities – some crisis – and the desire of the Communist Party to show that it is omnipotent. It isn’t, and it will make exactly the same kind of mistakes as every other ordinary capitalist government. Trying to control national economies is hard enough in small, relatively closed economies – imagine how difficult it is in massive mega economies? All those Chinaphiles are, in my book, deluding themselves that the good bureaucrats have found a new paradigm. They haven’t – they are just fooling people.

So, it is against this backdrop that I always make a point of reading Beijing based economist Michael Pettis and his superb newsletter Global Source Partners. You can subscribe at http://www.globalsourcepartners.com/

Last months note has two fascinating snapshots of a bureaucracy running scared from awkward facts. The first is that although we in the West are transfixed by the HNA scandal and its $94 billion of debt, maybe we should be focusing instead on another financial conglomerate with deep State influences. It’s called Huarong and is one of the biggest of the clean up based asset management companies. It, in turn, is linked with ICBC, China’s biggest commercial bank and the largest in the world by assets ($4.0 trillion as of 2017year-end). According to Pettis “during its first six years of operation, when it played its primary role in cleaning up ICBC prior to ICBC’s April 2006 IPO, Huarong purchased RMB 1.4 trillion in bad loans from ICBC.”

But Huarong isn’t just a useful state-backed clean up entity. It’s also well known “for the aggressiveness with which it set up a series of not-always-transparent joint-venture asset management companies. These companies were able to use the Huarong name and its funding strength to raise money, usually in the form of short-term debt, which was invested in a wide variety of assets, mainly equity in Chinese companies listed in China and abroad and in real estate investments in China and abroad.”

Huarong also reportedly has extensive holdings of assets in China and abroad either directly funded by the firm or by “asset managers financed by Huarong, and partly because of the precarious nature of the ways in which these assets have been financed. My understanding is that there is extensive balance-sheet mismatching, with long-term assets – mostly equity and real estate – financed by a great deal of short-term debt.”

What a familiar tale. Hmmm… A duration-based mismatch…where have we heard that story before? And we know of course what can happen afterward as this asset mismatch ripples through the system, forcing other investors to rationalize their positions.

But I think much the most interesting snippet comes at the end of his newsletter when Pettis speculates that all the scandals in China might be metastisizing into a bigger blowup. Pettis suggests that there are “a new set of rumors emerging that suggest that there are problems in Zhongnanhai (the leadership’s private living and working compound in the center of Beijing) and renewed factional fighting. The rumors suggest that these were set off at least in part, or exacerbated, by the latest national scandal to infuriate Chinese households – the discovery in the past month that vaccines shipped to hospitals and schools aimed at protecting hundreds of thousands of Chinese children were substandard and perhaps even harmful. They may have also been exacerbated by the disappearance earlier this month of the chairman of a Shanghai wealth management firm whose customers included some very wealthy and important people.”

According to Pettis these rumors matters because of China’s near-term economic outlook which might reduce “ the ability of Beijing to impose difficult but needed measures to control credit expansion. Meanwhile, the public travails of Huarong are likely to be quite interesting and will give us some sense of how Beijing’s fight against borrowing and mis-spending will develop. Perhaps by the end of the third quarter, we will have a better sense of just how serious Beijing is in getting debt under control.”

One could of course at this point suggest that President Trump has picked the right battle, at the right time. He’s pushing the Chinese to open up access just at the moment when they are most vulnerable.

Except that when a Populist leader such as Trump and Xi do go head to head, neither side likes to be seen to be caving in. My worry is that President Xi, sensing his vulnerability might decide to turn aggressive and stir the nationalist pot – and along the way try to prepare his people for real economic gain in order to preserve national honor.