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Beating a Dead Horse
I know, I may sound like I’m beating a dead horse – how much printer cartridge can one spill over China? – but I have a very high burden of proof to overcome. Let me demonstrate it by this analogy: Let’s rewind 20 years. It is 1989 and I am writing that the Japanese economy is on the verge of severe decline. I’m facing a lot of skepticism. Most people are calling me crazy and throwing heavy objects at me. After all, the Japanese are on top of the world. Their economy has been a consistent grower for decades, with a rate of growth that trumps that of the US and Europe. Japan has the manufacturing thing nailed – they are simply better and more efficient at it than us. Magazines and newspapers swarm with stories about Japan, how hard working they are, how unique their culture is (we of course, feel inferior, as lazy Americans). Japanese exports significantly exceed their imports, generating huge capital-account surpluses – they are swimming in dollars and buying up America. Every other restaurant in Hawaii serves sushi and menus are in English and Japanese (not Spanish). I may be exaggerating with the last part, a little, but not much.
So, in 1989, who am I to poke holes in Japanese grandness and predict their malaise. Japan could do no wrong. Of course, we know how that story played out: a bust of a major banking/real estate bubble, a contracting economy for almost two decades, accompanied by deflation, ballooning debt, etc.
Fast-forward, and China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot).
Since China can do nothing wrong, everything I write about it is met with skepticism. Today China projects to the world a similar image as Japan did in the 1980s. My personal favorite is the incredible spectacle of the Chinese Summer Olympics opening ceremony: the elegant, wonderfully choreographed performance by fifteen thousand people, the marvels of modern technology (the 500-foot LCD screen comes to mind here), the virtually unlimited budget of the Chinese government, and seven years of preparation created a spectacular event that will be hard for any nation to follow. (I feel bad for Russia and England, who will be putting on their Olympic spectacles next).
Lately, the Chinese economy has been impressing us with its growth: it was growing when the rest of the world was contracting, fast. But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending.
However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is. I’ve written a lot about this (here and here). Instead I’ll quote James Grant, the publisher of Grant’s Interest Rate Observer. Jim is providing the latest issue of his newsletter free, and I encourage you to download it and read his article on China – it is excellent! (Full disclosure: I’ve never met James and have not been recruited to plug his newsletter).
Here are a few quotes from his article – many things you’ve heard from me before, but he finds a way to say them better:
“In the 1930s, Western intellectuals persuaded themselves that the Soviet economic model was depression-proof. Today, not a few investors marvel at the vigor of the modified communist economic model of the People’s Republic.
“A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”
I think this chart, also excerpted from Grant’s Interest Rate Observer, tells the full story of the quality of China’s latest growth and its lending habits (lending has doubled over a span of a few quarters!):
“The Shanghai A-share market jumped by 65% in the first half, to a level that fixes its value at 31 times trailing net income, up from 12.8 times at the October lows. Chinese M-2 was 25.7% larger in May than it was a year before.
“Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember … Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’ Drexel failed when the junk market did.
“It’s no small thing that China is especially enamored of the shot-and-a-beer-for-breakfast approach. Nothing about China is small or insignificant nowadays, since the Chinese economy is actually growing. It might, indeed, account for 74% of worldwide GDP growth in the three years to 2010, the International Monetary Fund estimates.”
Finally, the most important part:
“Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.” [emphasis are mine]
Need I say more?
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley 2007). To receive Vitaliy's future articles my email, click here.
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Yup! Very good..very insightful.
As one who lived and traded in Japan in the 80's and 90's, I can tell you that you are absolutely correct in stating that you would have been lambasted had you questioned the inevitability of Japan controlling the world. That is the very reason why the Dai Boraku (crash) was so profitable on the short side. Stubborness, arrogance and disbelief. And yes, I took severe abuse, even within my own firm, for going short January 1990.
China has many similarities, though a few differences noted above. Of the similarities, the Chinese really buy into the Middle Kingdom/Our Time has Come thing. Most refuse to believe it can end. Eight percent ad infinitum.
China has better demographics than Japan (except for an absurdly skewed maleness to their reproducing age population), and far more natural resources (including a lot of strategic industrial metals and minerals). Absent a further deterioration in the northern water problem, China has the potential to be calorically self-sufficient, which is a potential plus.
Other than the ravages of the Cultural Revolution, though, China is so heavily weighted towards young people that most only know economic expansion and optimism. Recession or worse would come as a complete shock, and the reaction they might have is unpredictable. Japan, even in 1989, had many folks who recall the deprivations of the war years, so they were better prepared for the Lost Decade, which was a walk in the park in comparison.
While China attempts to either make everything normal again (export led economy) or tries to create a consumer class, the jury is still out on the country's future. Dashed expectations would be a terrible thing to see in 1.35 billion people, no matter how large the internal security apparatus. China also faces the potential rude awakening regarding the limits of fiat currency creation, just as the US and Europe do.
So will China rule the world? I'll take the other side of that trade, though I am not sure if there will be winnings to collect.
Hey there Anonymous,
That's more or less what I was getting at above - I was unsure of China's resource potential, but its relatively young, relatively male, relatively agrarian population gives it great scope for quite rapid GDP growth even without capital deepening.
At the moment, China suffers from a very low relative level of capital per worker: most workers are agrarian and regional agriculture is not capital intensive. There is a wage differential between urban and rural areas, despite central planning (and let's just accept that central planning will never stop workers from being paid in accordance with their productivity - it may change the FORM of payment from wages to 'black wages').
This wage differential will cause people to relocate to cities in search of better lives (as people did in England during the Industrial Revolution), urban wages will fall [I know, seems impossible given their levels] and the industrial production system will become temporarily more labour intensive. Profits will rise and enable investment in plant and equipment to return to a capital-labour ratio closer to the optimal. Falling albour availability in the outlands will cause wages there to RISE (as they did in England during mass migrations to towns) and - one hopes - agriculture will re-capitalise and become more efficient (otherwise the labour drain will see the same shortages of 'corn' as were seen following the urbanisation of western labour forces).
A simple exercise is - triple the industrial population (higher productivity) and reduce the rural population (low productivity) by 10%: you get an unambiguous boost to output and also to growth. The agrarian populaiton in China is, as you know, MASSIVE.
None of this will unfold on timescales which are of importance to traders (I'm a trader now myself, but I retain an interest in economics resulting from 10 years in an institution). But I pegged China and India as the Next Big Thing back in 2000. At this point in time the Next Big Thing is Africa, so long as governments there are smart enough to cartelize.
Cheers,
GT
GT'sMarkert Rant
One thing about China (which Krugman - in his one piece of genuine insight - pointed out about 'the Tigers' in "The Myth of Asia's Miracle" from 1997)... it still has a massive labour force which is largely agrarian.
As Krugman's 1997 article pointed out about Asia, TFP was (slightly) negative in Asia during the period when all those Yanks were buying books telling them to manage like a daimyo and to bow to exchange business cards.
What everybody missed was that the rapid growth in industrial output (and GDP) had been largely due to a large-scale migration from rural-agrarian (low productivity) to urban-industrial (higher productivity) jobs by a large chunk of the labour force. But the K/L ratio FELL, as growth in the capital stock rose slower than growth in the urban industrial labour force.
China still has a long way to go with that side of things - if they got to the stage where they could produce capital goods internally (thus enabling an increase in capital stock without a degradation of their external balance), they could keep absorbing all that internal labour migration without the K/L ratio going down.
China is currently securing longer-term access to raw materials, with deals struck on relatively favourable terms (in the event that the Yuan decoupled from the USD and appreciated sufficient to bring China's trade into balance, the terms of their recent deals would be astonishingly good, even in the face of a collapse in external demand).
I have no strong idea of China's internal sources of raw materials (at the moment China doesn't need to do much internal exploration - they can use their strong external surplus to strike deals with, e.g., Australia), but I'm prepared to bet that a country as big and relatively-unexploited as China would have more than we currently realise.
Not saying your thesis is wrong, mind you, but that the consequences might not be as dire as they were for Japan. After all, China is transforming in a way that Japan wasn't, and Chinese demographics aren't as bad as Japan's were in the 1980s.
That said: I would love to find an instrument that would enable one to short commercial property in Shenzen.
Cheerio
GT
GT's MArket Rant
A great experiment is underway and oldtimes don't believe it can be succesful. That is can debt expand faster than GDP forever?
I insist on holding on to the small probability that it can, even though I am an oldtimer.Why not? It has been working for 25 years. Why not at least another 25?
China is a good petri dish because their system is closed to a large degree. Hell, we are on the verge of doing it successfully again after a brief foray into negative growth. If the semi state US banks can survive just fine with XX trillion of non or partly performing assets then the Chinese banks sure as hell can.
no-one has bet the farm on the merits of the Chinese miracle as much as Australia.
With Chinese commodity stockpiling, a massive stimulus in the form of cash handouts, monetary policy swinging from restrictive to accomodative in a matter of months and a banking system bailed out with government guarantees they have registered flat GDP growth. It is little known in the real worls but some of the States are essentially bankrupt.
What happens next ?????
The US economy is collapsing and China's economy is wound deep into the US economy. Both behaved as if it would never end.
'behaved'... think the d is a bit redundant...; - )
'behaved'... think the d is a bit redundant...; - )
I feel embarrassed. I found your book brilliant but I disagree with this article and think China has paid very close attention to what happened to Japan.
?!?!?!?!?!?!?!?!
Care to elaborate? As another who has been making the analogy between the unstoppableJapan of 20 years ago and the China of today, I'd like to be shown what I might be missing.
I painfully underwent economics training at the Univ. of Chicago, during the time that "The Sun is Rising." Honest (postgrads) folks would teach us the models on how Japan would then reach parity, followed by leveling, and then stagnation. I remember (as a teenager, 25 years ago) thinking that this was very interesting...
I still think it is very interesting, and in fact, an underlying truth of our free-trading, debt-fueled system.