Sunday, November 9, 2008 4 comments ++[ CLICK TO COMMENT ]++

The Biggest Unfolding Story Right Now: China

The unfolding story that will impact all of us has nothing to do with USA, but is the fate of China. I had been bearish on China for a while now (that's why I bet against commodities, which I thought relied on the China-to-da-moon thesis.) But even I never thought the situation would deteriorate so quickly.

China is important, even if you don't invest in it, because it is a large player in world trade. If one of the opinions cited below is to be believed, China was selling products below cost and this means costs may rise (although do note that the near-term result will be massive deflation but longer term, costs will rise since products were sold at uneconomic prices.)

There is no shortage of bearish stories on China right now and almost all of them say that China's economic growth has slowed significantly. The Globe & Mail picked up a Reuters story detailing the plight of migrant workers. A lot of investors still don't seem to understand that a high growth rate is needed to maintain order:

The extreme ravages of the global financial crisis have raised the spectre of a further slowdown to 8 per cent – enough to be flirting with recession in Chinese terms.

Most countries would salivate at such growth, but for China it is a tipping point: anything less, experts say, and the economy cannot create enough jobs to keep up with the mass of people – at least 15 million – entering the labour market every year.

“If economic growth fell below 8 per cent there would be tension, social tension, complaints and job losses,” Chen Xingdong, chief economist at BNP Paribas in Beijing, said.

“You can understand why the Chinese government seems to have become desperate about delivering all kinds of stimulus measures,” he added.

IANAE but I think 8% GDP growth will not cause problems. A number closer to 6% is what would lead to a potential collapse of the government.

The problem--it's faced by other countries like India, Pakistan, Vietnam, and so on--is that lower-class workers really get hit hard during recessions. These countries are neither the 'social democrat' states where you have a social safety net, nor are they the 'capitalist' state where legal rights exist, contracts are honoured, and so forth. For example, you are seeing factories in China--no doubt in other developing countries as well--close down abruptly without paying earned wages. If they owed pensions then you can forget about that as well. That's not my notion of capitalism nor is it what would fall under a 'social democrat' state.

I see a lack of understanding of the nature of developing countries among commodity bulls. People have no idea what a 6% growth rate in China will do to commodities. The de-leveraging sell-off you are seeing now in commodities will be a joke. The market has been pricing in high growth for the long term so a small change will cause massive adjustments (just like how long-term bond prices will move a lot with small changes in interest rates.)

Writing for The Globe & Mail, Avner Mendelman, in a bearish opinion piece on China, says the following (bolds are mine):

You see, China, like Nortel and Japan and Soviet Russia, has been selling most things below true cost - which is the direct cost of production plus the cost of capital - and thus lost money on much of what it produced, and so destroyed much of its capital. A company that does so must eventually lay off workers and go bust. China, in my opinion, now faces similar risks, which Mr. Wen finally admitted.

Why does China sell below true cost? Because it is a dictatorship that wants to keep its restive people employed, and so, like (democratic) Japan before it, it keeps throwing good savings at bogus products. I say bogus because if you sell below true cost you create fictitious demand that otherwise wouldn't be there had the product been priced realistically. Thus the large factory you built to satisfy the goosed-up demand cannot be rebuilt once it wears out because you didn't include depreciation in the product's price.

If you have any interest in China, you should read this article because it presents the superbearish case. Who knows how correct the bear case is, but it is important to know of the downside.

It's not clear how bad the situation really is. But nevertheless, we can safely assume that a huge chunk of capital has been destroyed in China on bogus ventures but, most importantly, is not reflected on the books of anyone (especially the banks.) Destroying wealth is bad but it happens; but it is outright dangerous to destroy wealth while presenting financial statements as if nothing has happened. Not only does it create confusion for investors and the government regulators, it also sends all sorts of incorrect signals to the marketplace. If an entrepreneur thought that a bank would continuously give him an interest-free loan, he/she would behave very differently than if he/she knew they had to pay it back--with interest I might add.

I never thought it would happen this way, and I was always hoping it would be a slow transition over decades, but I'm thinking the Chinese government might not survive this slowdown. The government's latest attempt is to pump even more money into fixed infrastructure, which is where most of the waste already is. As Jim Chanos pointed out recently, China's infrastructure looks like it is in a bubble so spending even more money to create jobs is not going to create even more dire circumstances in the future.

Just to be clear, I will note that these are just opinions and there are others on the opposite side. Jim Rogers, in particular, is still bullish and has actually been increasing his Chinese exposure due partly to the government actions. I would like to see someone challenge Jim Rogers regarding some of the issues raised above. Since he is a macro investor, he clearly would understand an infrastructure bubble better than almost any bottom-up investor. So why invest now? The only thing that I have seen him say is that the country will do well in the long run and problems in the shor term are to be expected. Anyone that stopped investing in the US after the Panic of 1907 or the Great Crash in 1929 would have missed out on one of the best investment destinations of the century. I agree with that thinking: one shouldn't ignore China simply because it is facing some problems. But the question I have is, why invest now? Aren't some of these problems inevitable? Are we not seeing a massive misallocation of capital in China?


4 Response to The Biggest Unfolding Story Right Now: China

November 9, 2008 at 11:57 PM

I am short China, and this stimulus package is kicking me in the balls. China up 5% as I write, but they are going lower due to corruption and a growing disenfranchised population that has the concept of revolution ingrained in their culture. So few benefited off the backs of so many. Imagine the heartache of money lost in the promise of the stock market, then housing, money borrowed and money earned from near slave labor in Orwellian factories.

China can only debase its currency to stimulate exports, but consumption in the West is falling too fast due to domestic issues. They have excess capital investment so what are more paved roads going to do? In the end the sun rose in the West for China and it will now set with the West.

November 10, 2008 at 10:11 AM

What are you shorting? The red chips on the Hong Kong market?

Depending on what you are shorting, it looks like a risky bet because their markets are manipulated by the government. For instance, there is nothing to stop them from buying shares in the open market if they wanted to put a floor.

Furthermore, there is huge currency risk in shorting. The Renimbi is thought to be undervalued and, although I don't expect them to do this now (it will kill their manufacturing even more,) they may let it rise.

Overall, I don't like the 'China short' strategy. Seems too risky even if the macro picture is deteriorating...

November 10, 2008 at 1:13 PM

I agree! I've strongly believed that too many people were talking about and investing in China. Being a contrarian, I looked at other countries that weren't being talked about near as much. I was never on the China bandwagon.

I see all the crap we buy from them, and yes they make some good stuff, but it seems like most of the stuff we really don't need comes from them. We've been spending money irresponsibly and unsustainably on stuff we don't need and can't afford.

Also, if they start to pay their workers too well and try to raise the standard of living for their manufacturing base, I think a lot of factories could always move to another country that would be cheaper - it happened to us. It seems manufacturing goes to the cheapest country and there is no reason why it couldn't leave China in the future if they got too expensive.

November 10, 2008 at 2:15 PM

Here is an example of a call by some ex-securities regulator to prop up the stock market. I don't think the government cares about the stock market over there but it still shows the possiblity of the government swooping in and starting to buy shares if they wanted to.

Let's not forget that one of the few times that market intervention has worked was when the Hong Kong government started buying stocks back in the 90's. Governments rarely have much influence on the stock market but it does happen.

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