Thursday, January 22, 2009 0 comments ++[ CLICK TO COMMENT ]++

Story of 2009: China

I'm trying to come up with my macro views and investment plan for 2009 and I have the feeling that the story of 2009 (and possibly 2010 as well) will be China. Regardless of whether China does well or does poorly, it will likely be the story for the next 2 years.

On the good side, if Chinese growth picks up and stabilizes above the 8% magical rate that political analysts estimate is needed to properly manage citizen dissent, then it will have a major positive impact on the markets. Anyone betting on the re-flation thesis will do very well. We may see commodities such as oil recover quickly and head back up towards $100. Broad market stocks will also start rising and China may end up being the story of the year.

On the negative, China will become the main story if it runs into economic problems. Not only will there be the threat of the collapse of the political system, it also likely results in further deflationary forces being unleashed. Commodity prices may plunge further and goods may be dumped on the world market, potentially resulting in trade wars. A re-run of the 1930's, with USA taking on the position of Europe in the 30's, and China resembling the US, would not be out of the question. Investing will become extremely difficult for everyone except the best stockpickers.

The Current State of Affairs In China

The latest GDP number from China indicates that the economy grew 6.8% year-over-year in the 4th quarter (this is roughly zero growth in quarter-over-quarter terms.) Chinese numbers are unreliable but assuming that the government is consistent in its manipulation, this is not great but it's not terrible either.

The country clocked 6.8% year-on-year growth for the fourth quarter of 2008 and 9% for the year. But those figures mask an underlying picture that is anything but rosy for an economy that is just starting to feel the full impact of the global meltdown. In fact the economy registered virtually no growth over the third quarter, and things are going to get a lot worse before they get better. "The situation is quite dire," says David Cui, China economist at Merrill Lynch. "I don't expect us to come out of this any time soon because the global demand situation is so bad."

Cui isn't the only bearish one. David Wong, vice-president of the Chinese Manufacturers Association of Hong Kong, says its members are bracing for a difficult year. "This is unprecedented among our manufacturers," he says. "This is the worst that anyone can remember." Qu Hongbing, China economist at HSBC (HBC) says China could see growth dipping as low as 6%, dangerously short of 8%, widely regarded as the level needed to generate enough jobs to absorb new entrants into the workforce. "Export contraction will only be deeper when global demand continues to shrink, so we'll see more job losses. Consumers will become more cautious. And if this continues, there is a real risk of a downward spiral."


As some of the quoted analysts in the BusinessWeek excerpt above allude to, things are deteriorating in China. I think the 8% growth requirement to maintain stability is exaggerated given that everyone, including the politicians themselves, are guessing. A sizeable chunk of the economy seems to be excluded in many measures of employment, economic growth, profits, and so forth. For example, if my understanding is correct, migrant workers are not counted in employment figures. Similarly, a chunk of the reported profits of Chinese firms are supposedly hot-money inflows disguised as profit.

In any case, it is logical to expect the manufacturing segment of the economy to contract over the next few years. The question is how well the rest of the economy performs. China has huge potential for growth in the service sector but it's easier said than done. One problem for China--applies to countries like India and most ex-Communist states as well--is that a big chunk of the economy is the government sector. As anyone who is an investor or is economically-inclined will quickly realize, governments are not very efficient; nor are they very innovative (innovation usually puts some employees out of work and hence is avoided by most public sector decisionmakers.) The vast majority of the US economy was the private sector in the 30's whereas China's is mostly the government. It is questionable how well the country can grow with a small share in private hands.


China As 1930's USA

I have been influenced by the thinking of Michael Pettis and others, who suggest that modern day China resembles the USA of the 1920's and 30's (Since I claim that China is going to be the big stor yover the next couple of years, you should bookmark Pettis' blog if you are any sort of macro investor.) Here are some of his key comparisons:

As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it....

Compared to the US in 1929 China fares better on some measures, but not all. The first and most obvious is the scale of China’s overcapacity problem. China’s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 – roughly 0.5% of global GDP – but its economy is less than one-fifth the relative size of the US in 1929. Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts....

The second point may be the more important. Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth. When this happens the financial system often responds by taking on excessive credit risk and over-investing.

...


On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk. The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy. In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management. This is one of Eichengreen’s key points. Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain. Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently? Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency. This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.


Economists can be wrong so one should consider all these theories as just that: theories and hypotheses. Nevertheless I would be very cautious with any bullish bet on China. This is particularly important to those bullish commodity investors or those placing heavy bets on the re-flation trade.


Is A Trade War Possible?

The Smoot-Hawley Tariff has been beaten to death and widely considered as a terrible thing so one might assume that trade disputes are unlikely to occur this time around. Is that a good assumption? Let's see what US Treasury Secretary just said:

Timothy Geithner, President Barack Obama’s nominee for Treasury secretary, said the new U.S. administration believes China is “manipulating” its currency....

The remarks on China’s exchange-rate policy may presage a tougher line with the nation that is the biggest foreign investor in U.S. government debt. Former Treasury Secretary Henry Paulson preferred diplomacy over confrontation with China to resolve disputes and, in semiannual reports, refrained from labeling it an illegal “manipulator” of its currency.

“President Obama -- backed by the conclusions of a broad range of economists -- believes that China is manipulating its currency,” Geithner said in the remarks posted on the committee’s Web site today. “The new economic team will forge an integrated strategy on how best to achieve currency realignment in the current economic environment.”


Is Geithner preparing a plan for a trade war? Geithner could just be saying this to get the needed votes for his nomination. But he may also mean it. It is quite possible that the Obama administration will take a much tougher stand against China. Speaking as someone who considers himself as left-leaning, this is typically supported by most of the left wing of the econopolitical spectrum (but not me.) To make matters worse, China is indeed manipulating the currency so a typical citizen will be concerned. However, it is not clear how much this matters. For instance, many who claim that China's currency manipulation makes American workers uncompetitive seem to ignore the fact that Chinese wages are as much as 10x lower. It is doubtful that, even if China didn't manipulate its currency, that wage differentials will be significantly narrower.

I suspect nothing will happen until there is a major move by one of the parties. There is speculation that China may de-value its currency. Recall how I have linked to Michaeal Pettis' view that a de-valuation of the currency is quite similar to a Smoot-Hawley tariff. If the devaluation happens, we may see world trade suffer. The stock market may also crash if China retaliates by selling US Treasuries, and hence driving yields higher. But this is the worst case scenario and I am not investing as if it is would occur--only that I need to be prepared for it.

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