Saturday, July 5, 2008

China Syndrome

Today we turn our attention to China - certainly the most celebrated economy in the world today and possibly the most celebrated ever. Yet China's contemporary economy may be the most unbalanced in the history of the planet.


The Problem
Though it is hard to find reliable numbers, most sources agree that capital investment in China accounts for
over 40% of GDP. Frankly, this is a terrifying and unprecedented number. For reference, Japan during their boom years was typically around 30% of GDP and never exceeded 35% for long. During the Roaring Twenties, fixed investment in the US economy averaged less than 20%. Looked at a bit differently, about 42% of China's economy is based on ------ the expansion of the economy. This creates tremendous momentum but also huge potential for disaster. Essentially, everything will be fine as long as everyone there believes the economy will continue to expand at a breakneck pace and invests accordingly. This is virtually the definition of a pyramid scheme. Does anybody see anything wrong with this picture? Does this perhaps sound familiar? It should since the psychology is the same as every bubble in history.

So what could go wrong and how would it likely play out? I'm going to use post-war US recessions since that is an example most readers can relate to and gauge the seriousness. In reality, the US economy is relatively stable and mature so I would expect volatility to be much higher in China, not to mention the bubble nature of current investment levels. During its post-war recessions, US capital spending declined between 10% and 30% - with the extreme value being achieved in the 1980-82 period. This is simply the impact of over-investment during the preceding boom and the sudden realization of that fact and the resulting over-capacity during the recession.

The most likely trigger for a fall in China's capex is weakening exports. They don't even have to stagnate to trigger real problems, much less fall. When the current investment pattern is predicated on rapid and continuous growth, material decline in the growth rate should be sufficient to kick off lower capital spending. An event the magnitude of 1980 would cause a direct hit of 12% of GDP in China in addition to any multiplier effects and that is hardly unthinkable. Keep in mind that exports themselves account for 33% of Chinese GDP so any outright decline there would be a real problem for them - likely triggering a minimum 20% fall of GDP. Frankly it will be difficult for them to avoid it given the economic and political climate in their trading partners.

This would be just the result of inflated current investment combined with a typical cyclical decline in demand overseas. We don't need a replay of the Great Depression for China's economy to suffer horribly. From 1929 to 1932, capital investment in the US economy fell by over 90%. Given the much higher weighting of such spending in China today, the result of such an event would be literally unthinkable.


Dichotomy
You might ask why China's currency is doing so well if their economy is so vulnerable? And that would be a fair question, though we would point out that the Shanghai exchange is down over 50% in less than a year, so some markets are reflecting probable severe damage to the economy. But the answer to the currency issue is the one that we often give - perception lags reality.

It's usually a pretty good bet that the locals will know their market better than those who are far away. This is just common sense. In China, only local buyers can participate on domestic stock exchanges and they have obviously gotten a lot more cautious since the Fall. However, the currency market is subject to outside forces despite the nation's currency controls. Essentially, the locals have started to sell China while the foreigners are still buying. We have long believed that there is a hot money problem in China since their currency reserves have been growing a lot faster than their trade surplus would suggest. In addition, the reported surplus itself looks pretty squirrelly.

The hot money problem has recently been recognized by the government and some of the financial press. Here's an example from the Financial Times:

Given that the inflows far outstrip trade and direct foreign investment, China appears to be receiving vast amounts of speculative "hot money".
The FT article goes on to cite an estimate of $150-$170 billion of hot money flowing into China in the first 5 months of 2008. This money is coming in despite the collapsing stock market and despite the fact that the Yuan is losing domestic purchasing power at a rapid pace - far faster than the currencies the money is coming out of certainly. This is the virtual definition of speculative money flow. The FT continues:
China has two big attractions for foreign investors - interest rates are higher than in the US and the currency is expected to appreciate.
Of course real interest rates in China are hugely negative - 400 basis points or more due to high and rising CPI. This is a far worse situation than in the US or Eurozone. And why is the currency expected to appreciate? Why because everyone THINKS so. Kind of reminds of the tongue-in-cheek description of a celebrity as "some who's famous for being well-known." What it boils down to is herd-animal behavior. The herd is going over there, they must know something. Let's follow them, the grass must be better over there. Mooooooo.

One final clip from the Financial Times:
But government officials also believe that illegal transfers are taking place - through foreign companies declaring that funds are for direct investment and then putting the money in the bank and exporters exaggerating the value of overseas revenues in order to bring in extra funds. (As an aside, economists point out that if fraudulent export receipts really are widely used to bring in hot money, China's politically troublesome trade surplus would actually be much lower than thought.)
Prior to 2005, China's trade surplus never exceeded $50 billion on an annual basis. It hit $100 billion that year and roughly $250 billion in 2007. The dollar peg was dropped in mid-2005 and the surplus began to grow explosively at the same time, soaring through the period of the stock bubble. The monthly surplus peaked in October 2007, the same month as the stock markets did worldwide - including China's. Since the suspected route of the hot money is fraudulent trade or investment deals, we cannot know with certainty but the timing of the flows is highly suspicious.


Suspicions
Here at Financial Jenga, we are automatically suspicious of consensus, orthodoxy or any widely-held belief unless there is strong evidence to support it. The meme of unstoppable growth in China does not meet that test. While that country has many strengths, they appear to already be discounted and then some. The massive imbalances create vulnerabilities and the economy appears to be just as much a bubble as anything in the West - perhaps more so. In this case, the bubble is in factory investment, not housing but tremendous over-supply is already present, with more being created. The Wall Street Journal recently published a front-page article about factories closing down as overseas demand falls and China's manufacturers become uncompetitive due to rising costs. We've already discussed the implications of that scenario. We have long believed that China today is very comparable to Japan 20 years ago and we see nothing to make us change that hypothesis.