China-Russia on Treadmill to Growth Crushing Chanos Bubble Bets

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By Dian L. Chu, Economic Forecasts & Opinions

President Barack Obama and Russian President Dmitry Medvedev signed the biggest nuclear arms pact in a generation last week. The so-called New START is hailed by Obama as a major step to show the world that the U.S. and Russia have mended their troubled relationship.

Meanwhile, Russia and China have also formed alliance to help each other increase their clout in global affairs, as visiting Chinese Vice President Xi Jinping who met with Medvedev in Moscow last month indicated. Xi is expected to succeed President Hu Jintao in 2012 as China's top leader.

Old Foes = New Allies

Russia has watched China's continued economic growth and advancing political clout with a mix of awe and unease. Nevertheless, economic and trade cooperation between the two countries has grown quite steadily  in recent years. 

The final settlement of their 4,300-km shared border in July 2008, after more than 40 years of dispute, also helped spur the advancement of bilateral cooperation.

An Economic Paradigm Shift
Presidents Hu and Putin have moved quickly on an agreement to enhance mutual political trust and advance pragmatic cooperation, and signed agreements totaling $1.6 billion in the technology, energy and infrastructure sectors.

China is already Russia's largest trading partner. The annual bilateral trade volume has increased from a few billion dollars back in the 1990s to $58 billion as of 2008.

Underneath the geopolitical and trade pacts, this newly elevated Sino-Russian alliance seems to also suggest the beginning of an economic paradigm shift for both countries.

"A Huge Fiscally Dysfunctional Iceberg"
China used to consider the euro as a top option to diversify its massive reserves from the dollar, but has grown quite wary of the euro zone debt situation.

Zhu Min, deputy governor of the People’s Bank of China, last month told a conference in Hong Kong that he viewed Greece as just the tip of a huge fiscally dysfunctional iceberg, one likely to swallow up growth opportunities in Europe for several years to come.

“Unsustainable” Sovereign Debt Levels
Elsewhere, among the established and generally considered “low risk” countries, national debt and deficit has reached an unsustainable level. The U.K, at 14.2%, and U.S. with 11.92%, now rank No. 8 and 14 respectively based on budget deficit percentage to GDP in 2010 by country.

As a comparison, the already bankrupt Iceland and Ireland--one of the "I's" in PIIGS countries--rank behind the U.S. at No. 9 and 10, respectively.

Typically, a “sustainable debt” is one that grows slower than the GDP over time. This is part of the rational that the European Union requires its member countries to keep budget deficits below 3% of GDP as it is the general assumption of a long-term growth rate.

Crisis Transferred - Banks to Governments
In essence, the 2008 financial crisis has been transferred onto the government’s balance sheet from banks’ making the sovereign debt quite possibly the next major crisis across the Europe, the U.S. and U.K.

This has set off alarm bells among the developing countries, which typically have significantly lower levels of debt.  That alarm signal partly prompted Zhu Min stating:

“The U.K. is weak. America itself is weak, because in a two-to-four-year horizon, U.S. debt will climb to 110% [of GDP] and stay there for a while…Now they find nobody can save them.”

Counterbalance - Great Hope for Investors
Realizing the risks of the Western economy, it is logical for the neighboring China and Russia to be looking to each other for economic and trade alliance, in addition to expanding domestic consumer demand.

The World Bank last month raised its growth forecast for China this year to 9.5%, while Bank of America Merrill Lynch projected Russia, the world’s biggest energy supplier, is poised for a growth rate of 7% this year.

This new level of cooperation between the two Eastern powers would be good news for investors as they form a counterbalance to the West, which is facing serious fundamental problems that could lead to a total financial disintegration.

Treadmill to Growth Crushing Shorts
Lately, contrarian investor Jim Chanos is once again making headlines proclaiming “China’s treadmill to hell...will break this year and the bubble will pop.”

It is quite understandable how Mr. Chanos may have some sense of anxiety, since his fund--Kynikos--is shorting mainly Chinese developers and construction suppliers as disclosed in his latest interview. These sectors probably have not shown as much downside as he’d envisioned, primarily due to promising economic data coming out of China.

Buy On The Dip - Real Estate
All countries, including China, go through the normal up-and-down business cycle, which is nothing catastrophic as suggested by Mr. Chanos. As such, China's economy and real estate sector could have a correction and cooling-off period ahead with Beijing attempting to rein in liquidity and inflation.

Nevertheless, with strong long-term growth prospect intact, buying on the dip via Chinese real estate related investment vehicles would fit nicely into a balanced long-term portfolio.

Yuan, Ruble, Gold & Metals
With the euro looking in dire straits even with the $61 billion EU-IMF Greece bailout pact, sterling in worse shape than the dollar, China will likely diversify more into gold, other developing market currencies, and promoting their own currency as alternatives.

From that perspective, yuan and ruble could vastly appreciate against the dollar over time just from the sheer growth and relative stability. Precious metals, gold in particular, and base metals could also benefit.

Commodities in general seem to have fully priced in a V-shaped recovery; nonetheless, it is still advisable for investors to allocate about 5% through physical holding, physical ETFs and/or longer-dated options, as part of a well-diversified portfolio.

Hot Now - Russia Bonds
Meanwhile, analysts estimated many dedicated emerging markets funds have set aside plentiful cash in order to snap up Russia’s first foreign-currency bonds since 1998. A record $18.8 billion had flowed into emerging debt funds in the first quarter for the new bond.

Russia’s government said last year it may borrow as much as $17.8 billion abroad in 2010 to help its budget deficit and establish a new benchmark for corporate borrowing.

Investors interested in Russia should bear in mind that the country’s revenue and GDP growth tends to be more sensitive to the volatile crude oil market, as discussed in my earlier article - "Sovereign Risk and the Price of Oil."

Rethink and Be Prepared
In light of a plausible Western economic and dollar crisis, an event China and Russia, the de facto leaders of the developing world, seem to be actively preparing for, it is likely that China and Russia would weather just one such financial tsunami better than others.

That possibility warrants investors to rethink the conventional wisdom of associating established economies with lower risk and position portfolios accordingly.

Economic Forecasts & Opinions