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Chinese Quest for Shortcut to Greatness
The Chinese economy must be getting out of control, because the Chinese government is doing the unthinkable: It is desperately trying to put the brakes on the economy. When you pump a stimulus package that represents 14% of GDP through a fire hose into an economy, which was already on shaky bubble foundation, in a very short time you’ll have some serious unintended consequences -- you’ll get super bubbles.
To understand what's taking place in China today, we need to rewind the clock about a decade. At that time the Chinese government chose a policy of growth at any cost. To achieve that, it kept its currency (the renminbi) at artificially low levels against the dollar -- this helped already cheap Chinese-made goods become even cheaper than its competitors’. The US and global consumers were eager to buy them. China turned into a significant exporter to the US. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, if China let its currency appreciate, its exports would have become more expensive and the demand for Chinese products would have declined, and its economy wouldn't have grown at 10% a year.
But China isn't your local democracy, and it needed to grow at any cost. So instead, through the government-controlled banking system, China accumulated a couple trillion dollars of foreign reserves in US dollars and euros. This had an unintended consequence: It helped keep US interest rates at very low levels, and lent a friendly hand in the financing of a huge consumption binge by the US consumer (i.e., China’s largest customer).
The more China sold to the US, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. The US consumer was in turn happy to leverage its future (through the “always” appreciating asset, its house) and delighted to consume cheap Chinese-made goods. (I'm not dismissing the role in what took place of many other factors, like lack of financial regulation; missteps by rating agencies, the Fed, and politicians; securitization; etc., but I don’t want to steal the spotlight from China).
This symbiotic match made in heaven between China and the US consumer worked great as long as housing prices kept rising and the financial machine kept multiplying dollars. But all good things come to an end, and great things come to an end with a bang. The financial meltdown erupted upon us, the US and global banks started dropping like flies … well, you know how that story played out.
So now let’s fast forward a year. Today the global economy is stabilizing, thanks to Uncle Sam and various other “uncles” around the world. But the consumers of Chinese-made goods are overleveraged and now deleveraging, unemployment is high, the banks have got religion and aren't lending, and there's not much demand for loans anyway (except from the US government).
Despite this, the Chinese export-based economy, a manufacturer to the world, has clocked growth of 8.7% in 2009. The rest of the world looks at the Chinese growth miracle with envy; it seems that China has got economics figured out. But don’t hurry to trade your democracy for an authoritarian system. The Chinese grass is not as green as it appears. First, China lies. One shouldn't believe all the economic numbers that are put out by the Chinese government. This is the government that magically managed to report 6% to 8% GDP growth in the midst of the financial crisis, when its exports were down more than 25%, tonnage of goods shipped through its railroads was down by double digits, and its electricity consumption was falling like a rock. It's hard to manufacture 8% more widgets with a lot less electricity, and no, China didn't suddenly become energy-efficient during the financial crisis: Electricity consumption rebounded in a few months once the stimulus kicked in.
Despite reported rosy GDP growth, the Chinese economy was contracting during the economic crisis. But don’t be surprised, this is a government that will go to great lengths to maintain appearances to keep its ideology going.
Second, China will do anything to grow its economy, as the alternatives will lead to political unrest. A lot of peasants moved to the cities in search of higher-paying jobs during the go-go times. Because China lacks the social safety net of the developed world, unemployed people aren't just inconvenienced by the loss of their jobs, they starve (this explains the high savings rate in China) and hungry people don’t complain, they riot. Once you look at what's taking place in the Chinese economy through that lens, the decisions of its leaders start making sense, or at least become understandable.
Unlike Western democracies, where central banks can pump a lot of money into the financial system but can't force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The Chinese government controls the banks, thus it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, because the rule of law and human and property rights are nascent in its economic and political system, China can spend infrastructure project money very fast -- if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good.
China has spent a tremendous amount of money on infrastructure over last decade and there are definitely long-term benefits to having better highways, fast railroads, more hospitals, etc. But government is horrible at allocating large amounts of capital, especially at the speed it was done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.
Infrastructure and real estate projects are where you get your biggest bang for the buck if your goal is to maintain employment, because they require a lot of unskilled labor; and this is where in the past a lot of Chinese money was spent. This also explains why, in 2009, new floor space constructed was up 100% and residential real estate prices surged 25%. And this explains why they keep building skyscrapers even though the adjacent ones are still vacant. To make things worse, before the financial crisis and enormous stimulus, China was already suffering from what I call late-stage-growth obesity, inefficiencies that are a byproduct of high growth rates sustained for a long period of time. Though Chinese growth in the past was high, in its late stages the quality of growth has been low.
For example, in an echo of past Chinese government asset-allocation decisions, China built the largest shopping mall in the world, the South China Mall, which is 99% vacant years after construction. China also built a whole city, Ordos, in Inner Mongolia, on spec for one million residents who never appeared.
The inefficiencies are also evident in industrial overcapacity. According to Pivot Capital, Chinese excess capacity in cement is greater than the combined consumption by the US, Japan, and India combined. Also, Chinese idle production of steel is greater than the production capacity of Japan and South Korea combined. Similarly disturbing statistics are true for many other industrial commodities. The enormous stimulus amplified problems that already existed to financial-crisis levels. China is a less shiny but more drastic version of Dubai.
There is speculation that the Chinese consumer will pick up the demand slack for the US and European consumers who are deleveraging and buying fewer Chinese-made goods. This may happen, but it will take decades. The US and European consumers are two-thirds of much larger economies. The Chinese consumer is only one-third of the Chinese economy, and its purchasing power is significantly undermined by the undervalued renminbi.
We look at China and are mesmerized by its 1.3 billion people, its achievements of the last decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. This was the case with railroads in the US in the late 19th century: The railroads were supposed to change the landscape of the US, and they did, but that didn't prevent a lot of them from going out of business first and investors losing money. The Internet was supposed to change how we communicate, and it did, but in the process it generated a tremendous bubble, followed by the loss of wealth for many. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we’ve got a bubble on our hands.
Everyone wants a shortcut to greatness, but there isn’t one. It would be great if the word (economic) cycle only existed in a singular form, and the only cycle we had in the economy was happy expansion. If there were no cycles, there would be no painful recessions. But as heaven couldn't exist without hell, or capitalism without failure, economic expansion can't exist without recession. China has been trying to bend the laws of economics for awhile, and with the control it exerts over its economy it may seem, at least for a short while, that the laws of economics work differently in China. But this is only a temporary mirage, which must be followed by huge pain and drastic consequences. No, there's no shortcut to greatness, in anything, not in politics, not in personal life, not in economics.
P.S. The last paragraph on "shortcuts to greatness" doesn't just apply to China (though China, through much greater control of its economy, took it to a new level); it applies to the US, Europe, and Japan as well. Over the last several decades our respective governments intervened in free markets and actively tried to manage the business cycle – only expansions, or just mild recessions – and for this we are paying today.
More articles on China can be found here.
- The case for Pfizer »
- Welcome to Another Lost Decade »
- Barron’s: Economic Steroids Are Toxic, Too »
- Q&A with FT:Investing in Range-Bound Markets »
- Dubai’s Shot to the Moon »
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. 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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Great article
Best yet for tieing together money value --and economic heath --- among nations
Rumor has it that China was buying , not only infrastucture, but also commodities, with the super abundance of $$$
Check out copper's recent price moves
Looks like a buyer may be exiting
http://www.kitcometals.com/charts/copper_historical_large.html#1year
Hoho there's some kind of resurgent ZH interest in China's well-being of late? Anyway it's always refreshing to read a (fairly) objective article.
Well, seeing how people keep harping on China's "malignant efforts" in keeping the US interest rates low (for extended periods, too), i decided to try to sound wise by introducing our fellow readers to a chinese proverb; however, in my attempt to bing for an acceptable english translation, i came across some hilarious results (as usual):
????????????????
http://zhidao.baidu.com/question/90087650.html
(^the 'best answer' is a complete joke - scroll down to see more truthful answers. The correct translation should be: "Zhou-Yu beats Huang-Gai, one is willing to hit and the other willing to bear." To further understand the historical origin, the curious reader can refer to:- www.italki.com/knowledge/wiki-36+Strategies+Strategy+No+35.htm)
Economists are generally a bunch of steady turncoasts but I wonder how smooth their transition to their new jingo is going to be.
Dubai: Dubai was growth unchecked and unspurred by government. Dubai and China are moon and sun on this point.
Malinvestment: it can be suspected that China is ill at ease to the reality that the gigantic mine named the Earth can enter a declining phase in extraction output in a near future.
Maybe they consider that accumulating real wealth now when real wealth is still plenty is better than waiting for real wealth to decrease to start the process.
Pegging the Huan to the USD: the free marketeer lingo half packaged. Would in a fantasy land of free market a currency achieve reserve currency status? The USD being the reserve currency of the world is the main reason China is pegging their currency to the USD. Cause: obvious.
The best is still the story that the outsourcing of jobs was due to a money manipulation.
Nah. Outsourcing of jobs is due to one principal factor: spatial segmentation in terms of wealth.
The US has kept building up wealth on its soil for decades. As such, the price to live on the soil of the US has increased absolutely and relatively.
It is madness to claim that two car workers with similar work output can live one in the US, the other in China.
If you bring that to the scale of the US, it is like claiming that a car worker should be able to live in Flint, Detroit or on Park Avenue, NYC.
There is going to be a depopulation process in the US as such a wealth territory can no longer hope to harbour people whose work output cant earn people a livehood in some third world countries.
These US people will have to move as their work output cant no longer earn them a position in the US. No money manipulation in this, no banker trick.
Age is by the way not that an issue for China as they are going to experiment the very same themselves. China being such a behemoth in Asia that they will tap in their asian satellites to absorb their ageing population.
What is going next will certainly not be pleasant for many, many countries in the world but China might not be the one taking the biggest hit.
I agree that China lies and is anti-democratic, but there are a couple of arguments presented in the article that are incongruous.
1. The suggestion is made that peasants who moved to the cities in search of higher-paying jobs during the go-go times will starve (this explains the high savings rate in China) and riot.
I suggest that the vast majority of peasants (who were starving when they were peasants in the countryside but nevertheless didn't riot there), will return to the countryside if they lose their city job & their former meager subsistence living since they know what rioting will accomplish - see Tiananmen square.
The suggestion of massive civil unrest in China in response to an economic downturn is based merely on hope or wishful thinking and not on a cold hard examination of the history of the country & its oppressive if necessary leadership.
2. Suggestions that some consequences of China's economic decisions over the years were unintended & not foreseen seems naive or alternatively ignorant/arrogant.
China is a command, not demand/market economy that is controlled by a small group of political elites dedicated to communism & propagation of, if not increase in, the ruling class's own power. They are certainly prone to errors in judgment like the rest of us, but to suggest that they didn't realize that keeping their currency artificially low & reinvesting all those US dollars in US treasuries to keep US rates low & US consumers racking up more debt to buy Chinese goods is underestimating the Chinese.
They have become the manufacturing plant to the world, and thus quickly established themselves as an increasingly important global power, while having the world's richest country massively indebted to them.
Despite all their problems, & I don't wish to minimize their scale or severity, they are better positioned to withstand a bubble than the west & will emerge from this crisis stronger, thus increasing their sphere of influence among the fast growing, emerging markets while the west's continues to decline.
great summary, i agree
"this helped already cheap Chinese-made goods become even cheaper than its competitors’"
-- you do realise that the majority of these "Chinese-made" goods were made by US and European multinational corporations (MNCs) who set up their manufacturing bases there don't you? Why are you not blaming the MNCs? The "competitors" you mention are/were the other low cost manufacturing countries in Asia, Mexico, etc. This wasn't a strategy developed by the Chinese government ... it was a strategy developed by the MNCs as they looked for low-cost manufacturing bases to drive down their production costs. For the Chinese government, this was obviously a positve development as it allowed them to grow their economy and raise employment, just as Japan, Taiwan, Korea and the Southeast Asian countries had done before them. The Chinese government knew this and thus put in policies and built the required infrastructure to attract the MNCs. Also, for the MNCs setting up production in China 10-12 years ago, it wasn't just the low-cost manufacturing, they all saw the potential for China to become a huge market in its own right at some stage and wanted to build their presence there.
"The more China sold to the US, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down."
-- so what you're saying is that China was setting interest rate policy in the US, not the Fed?? Is that even possible? This statement is a similar to others stating that a world "savings glut" led to low interest rates in the US. Taylor (the chap who developed the Taylor rule and used by Bernanke recently to argue that the the Fed's (low) US interest rate policy did not cause the housing bubble) showed in a recent paper that this was unlikely.
Well, yes.
The Fed sets the overnight rate but (prior to the late unpleasantness of QE) had no direct control over the long end of the curve.
So yes, the Chinese had more effect lowering e.g. mortgage interest rates than the Fed did.
I believe this is what Vitaliy was refering to. He can chime in if he likes.
I'd like to know what Taylor's argument against the "savings glut" hypothesis is.
In China and Asia in general construction quality is suboptimal and therefore economic life greatly under performs. New buildings with accelerated depreciation schedules. Build them all over again sooner than you think.
Some posters seem to view vacancy in China as positive, while in the developed world we know its clearly negative. Kind of a joke. Its negative and will impact China as this unsustainable level of fixed investment eventually becomes a major drag on GDP. Of course we will have to speculate on the true impact as the GDP number keeps "growing" at the target rate.
+1
Fixed assets that don't produce a positive cash flow are a drag on society. In essence, China has built an enormous amount of capacity that produces no cash flow. Anyone have a definition of bankruptcy anywhere?
In China and Asia in general construction quality is suboptimal and therefore economic life greatly under performs. New buildings with accelerated depreciation schedules. Build them all over again sooner than you think.
Some posters seem to view vacancy in China as positive, while in the developed world we know its clearly negative. Kind of a joke. Its negative and will impact China as this unsustainable level of fixed investment eventually becomes a major drag on GDP. Of course we will have to speculate on the true impact as the GDP number keeps "growing" at the target rate.
Moneymutt is onto something.
Our Fed is too dependent on nuance, and then overreacts. They exacerbate the cycles by their alternations between tentativeness and drasticness.
China had put brakes on previously, with huge reserve requirements etc over the last few years...Elliot Wave guys have a nice summary of this....yes this action is different than 6 months ago but no so different than 2 years ago..from my view centrally planned economies can be hugely mistimed and mismanaged because one error in judgement is inflicted on everyone, everywhere but it does seem those doing monetary policy are timing things fairly well in a contrarian way...they put the brakes on when things were red hot and loosened up at the right time, now are reapplying the brakes in way US regulators would never do. And our hybird of the Fed and the markets as a herd have been just as bad or worse in their ability to inflict economic harm for all doing the wrong thing at the wrong time.
So China may have issues, but I'm not betting they are worse than ours.
You write: "But government is horrible at allocating large amounts of capital, especially at the speed it was done in China."
Wall Street's bubblemeisters misallocated *trillions* of investor dollars over the past 10 years to finance egregious mortgage and CDS bubbles.
So China has a few ghost cities -- not a problem. They have 700 million rural citizens who need better housing, utilities, schooling, transportation and services.
Master Bates,
I may :)
fiat money is the shortcut to greatness or should i say the mirage of greatness.....the real question is what happens to the US when China's bubble bursts. do they make their people consume more and at faster rate then we anticipate or do they continue to feed the pig that is the US and buy more USTs for recycling?...either way my bet is with agriculture and precious metals
In 15 years' time, the median Chinese will be older than the median American. The working age population will peak in 5 years' time. Despite growth rates in excess of 8% (hmmm...), China will be the first country in modern history to get old before it gets rich.
Vitaliy -
I wish that you were still a graduate finance professor at UCD. I was looking forward to taking your class, because I look forward to all of your articles on ZH. I'm only a junior there now, so maybe you'll go back to teaching by the time I'm in grad school?
no offense Master, but I always suspected you were kind of green behind the ears. Now I find you're kind of brown around the nose to boot.
Clean analysis. Shortcuts. Simple and precise explanation.
I'd be curious what you think about the upward pressure on the yuan.
Shortcuts always have a cost.
Enjoyed.