Wednesday, July 29, 2009 8 comments ++[ CLICK TO COMMENT ]++

Is China going to face serious problems within a few quarters?

Deciphering the strength of the Chinese economy will also play a major role in formulating our view of any future relative strength of emerging. My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors.

— Jeremy Grantham, July 2009 GMO Quarterly Letter

Edward Chancellor, assuming it's the same person, is the author of Devil Take the Hindemost so he knows his stuff—at least when it comes to history. Is there really a risk that China may face serious problems within a few quarters?

The important point, as Grantham suggests, is that this will be a big negative surprise for the markets. The most at risk, as usual, as those overloading on cyclicals (such as commodity businesses or capital goods companies.)

Although some seem to follow China by observing its stock market, that is totally meaningless as far as I'm concerned. The stock market in China is close to early 1900's, or late 1800's, NYSE and resembles a casino more than anything. To see how much of a joke the American stock exchanges were at that time, recall how "serious investors" only invested in bonds during that era. The insiders and wealthy owners manipulated the markets so much that the outsider had little chance. There was nothing like modern insider trading laws and, well, outsiders "invested" on rumours more than anything. Similarly, Chinese markets right now are like that. Most of the listed companies are government-owned with limited float, poor transparency and spread of information, and shareholder rights are well, um, still being developed. You'll see a lot of people investing based on rumours of what the government may or may not do.

The proper thing to observe in China is their economy. Although stock markets aren't correlated very much with economies, I believe the correlation is really high in the case of foreign markets and the Chinese economy. A lot of market participants are betting on high Chinese growth so stock markets in America are influenced by that. Even politicians in developed countries are pinning their hope on countries like China and India these days so all this is widely believed and priced in.

Even if you don't believe in the bear case, you should at least spend some time thinking about whether you are vulnerable if the bears are right. I have been bearish on China (and others like India and Russia too) so I have never contemplated any investment that is tied to those countries (this meant forgoing huge profit opportunities in the last few years.) Yet, recently, I started looking at Japanese stocks and I have started to wonder what will happen to Japan if China faces problems. I have decided to be very cautious about any Japanese investment until I am confident with China.


8 Response to Is China going to face serious problems within a few quarters?

John Y
July 29, 2009 at 11:39 PM

I have to raise a similar question that I raised on Vitaliy's blog: Where did you find the information that "The stock market in China is close to early 1900's, or late 1800's, NYSE and resembles a casino more than anything"? How confident are we this is a fact, not merely an impression?

By the way, I do agree China's economy is dangerously unbalanced and any investor needs to be very very cautious. An analogy is: it's much harder to avoid a crash when you are driving a car at 300kmh compared to just 60kmh. There is no room for error. Any slight miscalculation is fatal. Yet, economic management isn't an precise science.

Sivaram Velauthapillai
July 30, 2009 at 11:17 AM

John Y: "Where did you find the information that "The stock market in China is close to early 1900's, or late 1800's, NYSE and resembles a casino more than anything"? How confident are we this is a fact, not merely an impression? "

That's not a fact; it's an opinion. So, you are right in suggesting it's an impression more than anything that can be proven.

"By the way, I do agree China's economy is dangerously unbalanced and any investor needs to be very very cautious. "

The problem with China is that I am very skeptical that they can run capitalism with their current, totalitarian, system. It has been done on a small scale (Singapore for example) but I am doubtful.

Although I, nor any of the other bears, have any proof, it is likely that capital is being misallocated on an unprecedented scale. This doesn't mean it's the end of China or anything; USA had huge bubbles (railoards in 1800's; credit in 1920's) and recovered.

For example, we keep hearing of empty apartment buildings and skycrapers. Although this has been the case for years, who is paying for all that? Someone is taking losses and since there are tight capital controls, we can rule out foreign capital. So who is sitting on all these potential losses?

July 31, 2009 at 10:52 PM

I read China's GDP is increasing sharply in the last 20 years, every year, even during crisis. Correct me if this is wrong.
They have huge reserves,  I don't see risk of failure if they don't lost the reserves, and they are increasing day after day.

Sivaram Velauthapillai
August 1, 2009 at 11:50 AM

Yes, China has huge reserves (something like $2 trillion). But even this isn't good enough if you are trying to spend your way out of an economic slump. Economies are always much larger than the reserves you have. China's GDP is around $4 trillion nominal. Given how slumps are multi-year events, you can burn through all your reserves after a few years.

So, the fact that China has very high savings is a good thing.

However, in the end, economic growth has to be "real". For instance, Japan had fairly high savings (but nothing like China I believe) before they went into the bust in 1990. Yet, nothing much has happened for years and their government had to issue a ton of debt. Even if the Japanese govt had cash savings (and hence didn't need to issue debt), the end result would have been similar.

In any case, the greatest risk in China is political. I am just not confident that their government can survive if there is a serious economic slowdown...

August 6, 2009 at 2:21 AM

I sold my shares of GXC today (a China ETF) at $68.28.

Just like with my investment in India, this investment took only a couple of hours of research.  Based on attractive valuation numbers, and a forecast of economic growth (while the developed world was selling at a higher valuation, and was forecast to shrink), I picked up shares in GXC near the beginning of Feb 09.

Just like India, I saw this as a nice entry for a long-term holding.  Just like India, the market surprised me and sentiment reversed very rapidly, pushing the shares much higher much faster than I expected.

I only held GXC for 6 months, and just sold for a 70% gain (it was about 6.5% of my portfolio when sold).

In Feb, answering the question "is GXC cheap?" was easy for me (or maybe I just got lucky?)

I now feel that to be confident of an investment in GXC, I would have to have a handle on:
1)  Capital controls, A shares vs B shares vs H shares
2)  PE ratio of GXC (around 17) vs PE of Shanghai Exchange (reportedly 35)
3)  China's Stimulus
4)  Interest rates and economic policy
5)  Possible real-estate bubble
6)  Bank debt from recent record-lending

GXC is only within my circle of competence when it looks really cheap.

I hope to re-invest in China sometime in the next few years at an obviously favorable price.

Sivaram Velauthapillai
August 6, 2009 at 10:27 AM

Congratulations with that pick... China is definitely very confusing right now. I have a bad feeling that someone is going to fall apart but we'll see...

John Y
August 7, 2009 at 2:50 AM

An interesting read from The Economist:

"total new inflows into the stockmarket in the first half of the year were Rmb460bn, the majority of which would have come from fund managers and private investors, rather than from bank lending. Moreover, the Rmb460bn inflow into the stockmarket compares with total bank lending in the first half of the year of US$7.4trn."

Looks like the bubble isn't as bad as I originally thought and Chinese gov is pretty mindful on the risks they're facing.

Sivaram Velauthapillai
August 7, 2009 at 10:52 AM

Thanks for that article John Y. It does alleviate the concern over bad lending. However, bears like me are really more concerned with the potential bubbles in real estate, fixed infrastructure, and the like--that's why I'm bearish on China (it's not because of bad lending going into the stock market or something like that.)  I am of the opinion tha tthe stock market in China is largely meaningless. On top of it resembling a casino, it is less important and less transparent in China.

The most important benefit of a well developed stock exchange is price discovery. I don't think one can draw any conclusions from the Chinese stock market. Everyone keeps looking at it but I personally don't think it provides much of a signal.

Perhaps the key thing to watch is commodities. We'll know how real the Chinese recovery, and indeed the world recovery, is based on commodity price behaviour. This may not help investing in the short run, since the markets will adjust long before it becomes obvious in commodity prices, but it may help in the medium term.

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