Thursday, November 6, 2008 0 comments ++[ CLICK TO COMMENT ]++

Will China face a hard landing?

One of the big topics of discussion, one that hasn't entered the mainstream focus yet, is the near-term future of China. I think we can quibble about the details of the US economy or the European economy but we kind of know what is going to happen (what we don't know is the degree.) But what about China?

China is important because it is one of the few stabilizing forces right now. If it also falls down, the world economy will be worse off than even the popular bearish views. From an investment point of view, if China ends up with a hard landing, capital goods exporters (e.g. Siemens, G.E.) and commodity businesses (e.g. ExxonMobil, Rio Tinto) would get absolutely killed. The current commodity price declines would seem mild compared to what would happen if China faces an economic crisis (note that the market is only pricing in a world slowdown right now, rather than a hard landing in China.) You are literally talking about prices possibly back down to what they were 5 to 10 years ago. There would also be political ramifications which I'm not going to get into.

Some think a hard landing is almost inevitable for China. We can include economists such as Nouriel Roubini in that camp, along with investors such as Jim Chanos and Jeremy Grantham. Then we have some who think the slowdown won't be drastic. Lastly we have some, such as Jim Rogers, who are agnostic to the outcome and are investing heavily through the uncertainty.

Yves Smith of Naked Capitalism summarizes the contradictory outlook from Nouriel Roubini and Bred Stetser in this post. If you have an interest in China or macroeconomics, it's worth reading that post for a contrarian non-consensus view.

Superbear Jeremy Grantham is also concerned about the possibility of a hard landing in China. In the first part of his October 2008 Quarterly Letter, Reaping the Whirlwind, he entertains the possibility of a hard correction in China (skip to the section Like a Bear in a China Shop on page 7): amateur economist could summarize
and simplify the Chinese economy as 39-37-37: an
astonishingly large 39% of the GDP is capital spending,
37% is internal consumption, and an amount equal to
37% of GDP is exported. (These numbers do not sum to
100 as we are not using exports net of imports because
we are concerned with the vulnerability of total exports
to a weak global economy.) The U.S., in comparison, is
19-70-13, disturbingly on the other side of normal; 70%
consumption compared with 57% in both Germany and
Japan, for example, and nearly twice that in China. China’s
mix is of course an utterly unprecedented one, and comes
with great advantages in booming times. Now, however,
we might ask: how do you stimulate the building of a new
steel mill when rows of mills are sitting empty? How do
you increase exports into a global economy that is not just
slowing, but is unexpectedly very weak? And are they
good enough at stimulating local consumption to have an
impact on such a small percentage of GDP in the face of
a negative wealth effect from declining stock and housing
prices in their local market?

Simple old “Econ 101” thinking would suggest that their
capital goods sector will have a bigger drop than the rest
of the economy, and that export growth rates might slow
from very large to even nil or worse. The one openended
offset might be in Keynesian or Rooseveltian
government spending, upping their already massive
infrastructure spending by A LOT. (This is a specialized
economic term.) And they will surely do some of that.
On balance I find myself more and more convinced that
GMO 8 Quarterly Letter, Part 1 – October 2008
this is becoming our #1 disagreement with consensus.

I would say that the biggest difference between the China superbears and the bears--this discussion does not include the China bulls since we are looking at the downside--is the size of the export economy. It is also very difficult for non-professionals (or possibly even professionals) to know how "good" the Chinese economy is. On top of fictitious economic numbers published by the government (think Iraq and Bush administration,) no one knows how profitable Chinese firms really are. The accounting cannot be trusted and market signals, such as stock price performance, cannot be relied upon (the stock market is more akin to a casino over there.) Markets such as the bond market is very small or non-existent so that's also not helpful.

I personally don't have a strong view of China either way. I have been bearish due to what I perceive as bubbles in real estate, manufacturing, and infrastructure. But whether that leads to a correction or a massive bust is hard for me to say right now. Furthermore, unlike many other commentators or investors, I am very concerned about the political system. The market is in love with the political apparatus right now but I don't like the system so I don't feel comfortable investing there (investors love the system because totalitarian systems can be highly profitable for investors. Financiers, businesspeople, and others made a lot of money in Nazi Germany and Fascist Italy in the 1930's but it was a terrible system. Similarly, a lot of people are in love with Singapore but I would neither want to live there nor invest there without strong protections.)

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