By Vitaliy N. Katsenelson | 6 March 2010
Denver, Colorado— 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; it needed to grow at any cost. So instead, through the government-controlled banking system, China accumulated a couple of 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 (ie, 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 home) and delighted to consume cheap Chinese-made goods.
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 and, well, you know how that story played out.
So now let's fast-forward a year. Today the global economy is stabilizing. But the US consumers of Chinese-made goods are now deleveraging, unemployment is high, US banks aren't lending.
Despite this, the Chinese export-based economy 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, 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. 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 just 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, China can spend infrastructure project money very fast— if a school or hospital is in the way of a road the government wants to build, it becomes a casualty for the greater good [[no arguments: normxxx]].
China has spent a tremendous amount of money on infrastructure over the 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. [[If government building of infrastructure could support a vibrant economy, then Japan would be experiencing an economic boom which had lasted for 20 years— instead of the reverse!: normxxx]]
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 the Chinese keep building skyscrapers even though the adjacent ones are still vacant. Though Chinese economic growth in the past was very high, more recently 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 still 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 consumption of 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 has amplified problems that already existed to financial-crisis levels. China is a less shiny but far more drastic version of Dubai. There has been 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.
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. 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 an economic 'cycle' only existed in a singular, half-wave form, and the only movement we had in the economy was one of happy expansion. If there were no full (economic) 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, 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 is no shortcut to greatness— not in politics, not in personal life, and certainly not in economics.
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China Could Fall Into A Great Depression
By Dr. Steve Sjuggerud | 17 February 2010
Is it possible? Could China be on the brink of a Great Depression? Most experts would say, "No way". They would point to China's trillions of U.S. dollars in reserves as their Exhibit A and say, "Case closed."
Countries use reserves to back their liabilities like their currencies. Think of it like having a huge balance in your savings account. If you've got all that cash, you're not likely going under, right? But one expert recently made an interesting case for a potential Great Depression in China, even with its trillions of dollars of reserves.
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The two cases where countries rang up reserves of a similar magnitude to China are the U.S. in the 1920s and Japan in the 1980s. Pettis says, in both cases, the high reserves "were symptoms of terrible underlying imbalances" in those countries. So those reserves were ultimately "useless" in protecting those countries from a bust.
The U.S. and Japan stories are similar. The U.S. in the 1920s and Japan in the 1980s had "sharply undervalued currencies, rapid urbanization, [[cheap credit: normxxx]] and rapid growth in worker productivity," according to Pettis. Both of those great booms were followed by massive busts. Stock markets fell 80% from peak to trough. Japan's stock market peaked around 40,000 in 1989 [[on the wave of cheap credit and massive increases in exports and and manufacturing capacity.: normxxx]] Today, over 20 years later, it hovers around 10,000. The U.S. crashed in 1929, and didn't recover until World War II. [[The stock market didn't fully recover until around 1954.: normxxx]][[Zounds! Does sound a bit like China, doesn't it?: normxxx]]
China is seeing the same things the U.S. and Japan saw during their boom years. The booms ended up fueling the creation of too much credit… This led to excess capacity… which then created the "lost decades" for the U.S. and Japan. China could easily end up down the same road.
To be clear, Pettis isn't predicting a depression in China. He says, "The fact that the U.S. and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched does not necessarily mean that China too must have a lost decade or two". He's simply warning about ignoring "obvious historical precedents".
As an investor, whenever the crowd all believes one thing, I look for the opposite case. If there's a strong argument to be made in the opposite direction, there's usually little downside and significant upside in betting against the crowd. The consensus opinion is that China is at no risk of collapse because of its great hoard of reserves. But Michael Pettis' story of the imbalances in the U.S. in the 1920s and Japan in the 1980s is thought provoking.
Is a Chinese depression coming? Michael Pettis shows us that it sure is possible.
Normxxx
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