Total Implosion of the Chinese Economy

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There are at least three scenarios we know of that could blow up this little moment of global financial tranquillity. There are probably more. But those are the unknown unknowns. In today’s Daily Reckoning, we’re going to focus on the known unknowns. They are the things we know could be bad. But how bad is what remains unknown.

Why this three part thought experiment? Well, just because our analysts are in agreement that the cautious way forward is to surf the liquidity in the markets higher, your editor is, at heart, a massive worry wart. Plus, all these disaster movies about the end of the world must be affecting our state of mind, or amplifying its natural tendencies.

We’re always worried about the worst-case scenario, always thinking of the things that could go wrong. This just seems like a prudent way to prepare. It will be better if these things don’t happen. But let’s just assume they will and work backward from there. And then let’s figure out what you can do – if anything – to avoid getting wiped out again, and maybe even making a buck or two on it.

First cab off the rank is the total implosion of the Chinese economy. This might be bearish for Aussie resource stocks. But how likely is it to happen?

Well, not very likely if all you were looking at is the raft of official data released this week. Retail sales in China were up 16.2%. Industrial output was up 16.1%. And exports, even though they were down 13.8% in October, decreased at the lowest rate in ten months. Fixed asset investment for the year is up 33.1% over last year’s pace.

You could take all of these as signs that China is leading the world to recovery and managing itself quite well. It should achieve 8% GDP growth. That’s the growth rate that China’s economic planners reckon the country must achieve to maintain high unemployment. And high employment rates promote political stability – valued above all else by a regime that makes free market gestures but still is run by old school communists.

What’s more, if you take up the question we asked a few weeks ago – when is it in China’s interests to allow its currency to strengthen – the answer is starting to emerge: when a stronger currency keeps inflation in check. China’s currency managers are making noise about letting the Yuan strengthen against the dollar.

But it’s not to please Barack Obama, who visits Beijing this month. A stronger Yuan, among other things, gives Chinese consumers more purchasing power. That might slowly reduce the contribution exports make to Chinese GDP (and to forex reserves which are then recycled into U.S. Treasuries.

Or it could all fall apart more quickly than anyone expected. Why?

China has massive over capacity in steel and cement. Granted, these two materials are quite literally the building blocks of industrial society. But according to Bill Powell in Fortune Magazine, China has enough spare production capacity in the cement industry to meet annual cement demand from India, Japan, and the U.S….combined!

This fact would be consistent with a country that’s massively over-investing in fixed assets to achieve high rates of employment. And then there’s steel. China’s own National Development and Reform Commission says the country will have 250 million tonnes of excess steel production capacity by the end of next year.

Chinese steel production is approaching 600 million tonnes per year. But its current demand is around 350 million tonnes. That means it’s either planning to put the rest of the world’s steel makers out of business by dumping cheap steel on to global markets…or there is massive overcapacity and inefficiency in the steel sector.

Either way, it’s probably a good idea to consider the possibility that China’s investment binge is more fragile than it looks. In short, the bear case on China is that, “the Chinese have dangerously overheated their economy, building malls, luxury stores and infrastructure for which there is almost no demand, and that the entire system is teetering toward collapse.”

Naturally this would be bad for Australia, whose economy is lately coupled with China’s prosperity. It would argue for reducing your allocation to common stocks, raising your cash position, and not taking the China growth story at face value.

Next cab off the rank is global rush to refinance debt while interest rates low. Moody’s reports that there is $10 trillion of bank debt maturing between now and the end of 2015. What’s more, the average maturity of bank debt fell from 7.2 years to 4.7 years over the last five years.

This means bank debt (like sovereign debt, especially in the U.S.) is getting more interest rate sensitive. Not only do banks have to roll over a lot of debt in the coming years, they may have to do so at higher rates (assuming they can find takers for it.) Moody’s is not confident.

In a research note published to clients, and also on the FT’s Alphaville blog, Moody’s analysts wrote that, “credit costs should continue to put banks’ earnings and profitability under considerable pressure, which might cause investors to seek additional risk premia, as governments gradually exit from the direct support they have so far provided. In other words, we see weaknesses on both sides of the balance sheet, and we are concerned that the risks associated with both assets and liabilities may fuel each other, cause losses and undermine investor confidence.”

Even if you concede that Moody’s might be overly-dire now to make up for its non-existent warnings about the risk of sub-prime related debt, you have to take the warning seriously. In fact, in a report released last weekend, the IMF said banks were not out of the woods yet at all and remained at risk.

Its analysts wrote that, “Banking systems remain undercapitalized, suffering from impaired legacy assets and, increasingly, non-performing loans. Deleveraging pressures will likely remain a constraint on bank credit for some time. Activity in securitization markets remains dependent on public sector support. Moreover, large public interventions have transferred risk to sovereign balance sheets, raising market concerns that have abated somewhat recently.”

We’ll get to the sovereign balance sheets in a second. But in your financial disaster preparations, spare a thought for the banks. Serious problems remain. And if you’re looking for where risk resides in the financial system today – the next AIG, or Mrs. O’Leary’s cow if you prefer – you might not have to look any further than the banks.

But as the IMF noted, a great deal of private sector risk has been transferred to the public sector via bailouts, loan guarantees, and other schemes. This exposes sovereign borrowers like the U.S. and the UK to interest rate shocks (increased borrowing and debt service costs). But more importantly, these countries already faced fiscal dilemmas with ageing populations.

There is not much detail to add to this point. We’ve covered it before. But it’s the best reason to own gold and tangible assets (your house, vodka, cigarettes). All the world’s paper currencies are drowning under a sea of public sector debt that’s becoming increasingly unsustainable. And this has happened at just the point where the Western welfare states will begin spending more money on caring for ageing populations.

Where will the money come from? Between a China meltdown, a bank implosion, and the rising risk of sovereign debt default, there are at least three known unknowns that worry us right now. And don’t even get us started on the unknown unknowns.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. The most explosive aspect of derivatives is when they are concocted around an underlying one way demand. You can always be certain that the counterparties have no clothes in those cases. Such is the situation with interest rate swaps that the banks are allowed to pretend that they have in place forward coverage for their long lending. When short rates are zero, what sort of real & rational punter would be the counterparty?
    When you look into the detail of the subprime you find intermediaries packaging the securitisation for retail consumption but you find that these intermediaries were out to the banks. The same degree of separation that they are doing again with interest rate swaps.

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  2. Oh what the heck, here are some other unanswered questions…

    China has factories the world needs and now relies on – what would we do without them? It has a massive army which it has no apparent use for and which needs upgrading. It is stockpiling for who-knows-what … sanctions perhaps? It has a growing population which it needs to put somewhere. It can produce as much gold as it needs or wants – much more than it currently does. It looks like, financial numbers aside, China is in a good position. That’s the worry, perhaps, because others might not tolerate this situation.

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  3. “as governments gradually exit from the direct support they have so far provided”

    Maybe there is no exit, perhaps we’ll be stimulated right up until we all have a seizure.

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  4. One possible place for China to expand is into its old maritime provinces that it surrendered to Russia back when Chinese Gordon was making his name. Discord between China and Russia? I can think of at least one world power that might see advantage in that. And which has an established track record in manipulating global events to suit its interests. One would have to guess the chinks and russkies are awake to that possibility. If they were truly smart they’d adopt the attitude you have lots of people who need land and resources and we have a shortage of people but more land and resources than we can use anytime soon. So let’s amalgamate and form a very big, populous, land, water and resource rich new country called Chinussia – And really give the West something to think about. Problem being that both countries are pretty ethnocentric from what I can make out? We’ll see I guess. But either way, it isn’t shaping up to be a boring century! :)

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  5. It’s the Chinese kind of Interesting, Ned.

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  6. Keep smiling Dan!

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  7. History suggests that Communist Party will go the way of the Qing dynasty.

    That is why I am looking for China to descend into anarchy/civil war, in the aftermath of the bursting of the government-finance bubble.

    Corruption is a major factor in comparing today with yesterday, as this news snippet reveals:

    * Richard Spencer, Daily Telegraph London, “Chinese civil service swells to 46 million”, AFR, March 9, 2005, p.11:

    China now has 46 million government bureaucrats new statistics have revealed. While the country is used to outdoing the rest of the world for sheer numbers, the explosion in officialdom is alarming the ruling Communist Party.

    Its excessive and corrupt bureaucracy was regarded as one of the principle causes of the decline of imperial rule.

    Yet there are now 35 times as many people on the government payroll, even as a proportion of the population, than at the time of the collapse of the Qing dynasty in 1911. Corruption aside, today’s civil servants are also expensive, requiring official cars and holidays masquerading as training sessions and receptions…

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  8. Accountants figures (and as you continually point out – so are those of economists) are wonderful; they can be manipulated to show what is required, or twisted to hide the truth –

    Having had the opportunity to visit China recently, and to compare the current development to what was happening two years ago; there is no comparison between the two-

    Our political leaders talk of robust development and the spin off this will provide to our resources industry; however as you have succinctly promoted the argument in a number of your newsletters, the current increase in demand may be for stock piling rather than continued production.

    Tis a pity that our leaders travel first class and live in five star hotels, with their host’s showing the places that suit their dialog.
    – Living in the apartments that most city folk occupy, travelling by bus allowing a true picture to be gained and visiting the rural countryside all provide a different perspective.

    Facts are –
    -in provincial villages the increase in uncompleted dwellings and the decrease in the occupation of completed dwellings – why ?
    – Is the decrease in occupation due to a movement of the population to the cities ?
    – Is the increase in house construction a Government initiative to bring the population back to the country to increase the level of food output ?- Yet modern agricultural machinery is working side by side with the oxen plow, requiring less farm laborers ?
    – In crops of potato that were inspected with Government officials, they indicated that yield levels had not increased with partial mechanization, only the number of workers, and in comparison to the developed world yields were still about half, but with the disclaimer that it was difficult to obtain a precise translation, and that there is also a difference in the way areas and volume is measured.
    – Now to the cities where the transformation was more pronounced!
    Two years ago, high rise construction sites had building laborers scrambling over each other like bees in a honey pot. –
    This year, it appeared that many buildings were in “mothballs”, whilst others had a “skeleton” workforce. True, there were the one-offs that were in full production mode, mainly high rise apartment blocks, which I would cynically suggest could be just the fodder that was presented to our leaders by their hosts.
    It was also common knowledge that the Government had provided large sums of money to banks, and what better way to produce a return for the banks than to have developers selling to overseas clients.
    True, there were Chinese professionals purchasing these expensive apartments, and also true that on face value, the average citizen was still affluent (by Chinese standards), but also anecdotal evidence suggesting that the affluence could be a change from the habit of prudence and saving for the future attributed to the Chinese, towards a society living on debt.
    It was commented more than once, that University Graduates had to compete with a least eighty other applicants for a single job, and not even in their field of study.
    Two years ago, the “motorized tricycle” was the domain of the uneducated male, both young and old, today there are many operators that appear to be young educated females – (not able to find a job ??)
    The only thing that remains the same are the contradictions that the Chinese have posed to the West for decades.

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  9. I tend to be pretty relaxed about China and have stopped trying to predict what will happen there because I see things only through Western eyes. Sometimes we just need to sit back and admit we haven’t a got a clue :) What I would say is that the North Asian nations seem to be slowly working out their differences and are quite aware of the economic clout they can wield together.

    Having said all that, the data I am seeing suggests that Chinese demand for commodities may cool a little next year, so I am not sure why the RBA is so optimistic.

    Greg Atkinson
    November 12, 2009
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  10. Dynasties and dictatorships have been the dominant form of government throughout human history.
    The verdiect is still out on capitalist democracies. Will they self-destruct as the public votes for increasing largess from the public purse, until the country is bankrupt?
    Certainly possible if you consider what has happened in the state of California.

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  11. Interesting article about the lack of American business in Iraq:

    http://www.nytimes.com/2009/11/13/business/global/13iraqbiz.html?pagewanted=1&_r=3&ref=business

    guess things didn’t turn out as they hoped economically as well.

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  12. It is interesting to note the excessive stock piles of key materials in steel and cement occuring in China. Can history provide us with an answer or view of what happened when this situation occured.
    Was it Germany back in the mid -30’s? I am suspicious of the outcomes. Maybe we are to see some muscle flexing in the not to distant future. On my last visit to Myanmar it was interesting to note 3 modern warships with Chinese flags anchored in Yangon harbour. Has the rising sun moved on its axis ? Interesting to say the least

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  13. China’s miracle is cheap labour and mass exports, there were probs before this as stated by Phil. The miracle of the Aus economy is derived from the China miracle. The Japanese miracle has stalled. Western economies have been showing us the way, all flawed miracles.

    Aus is susceptible to re-colonisation due to its terra nullius ineptitude.

    tar and feathers
    November 15, 2009
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  14. tar and feathers, I like your comments, but I think Australia is less easy to invade than it might seem to you. Not saying it won’t happen, but it’s a very defensible land. It’s a unique place – rich, but full of disappointments and difficult challenges in the future, but we need to take into account historical wars (and what they showed even then about Australia), the continuing role of US military (which has been fighting rather muted wars recently, I would say), and who actually lives in Australia – and why. There is a lot that isn’t known to the public about how Australia works, and an even more about how the world works that people have forgotten about or never understood. Do you think that everybody is as stupid as the politicians? The time for invading Australia was 100 years ago, not today. Too hard now, unless there is a deliberate deal done in advance. Otherwise, China or anyone else might get its hand on it, but the rest of the body will be blown away.

    Also, western economies are not exactly flawed miracles (Europe I am sure will prove to remain resilient).They are at a turning point, but again, only deliberate destruction will bring them down. If it weren’t for the failure of rule of law in the US (applied to the government, the federal reserve and wall street), then that nation would have continued to rise from strength to strength. It has amazing intellectual, military and natural wealth. Though some important aspects of it are in decline, if there was a clean up at the top and the re-establishment of the rule of law by government over private companies, the federal reserve and wall street in general, then the US would turn herself around. Of course we can see that obviously this is not the plan.

    As for Japan, it’s not a stalled miracle. It’s just reached a point where people there are well off, and without more land acquisition, there are not many options for explosive internal growth, yet it is a long way from becoming a failed state(!). I think Greg does offer very good insight into that. Add to that Japan’s allegiances which are not going to change any time soon.

    The future is uncertain, and there are many possible paths – not all of them will work out – as always the world feels its way forward. There are going to be regional conflicts, but militarily, most scenarios end in stalemate.

    Prosperity depends on controlling corruption (rule of law and fair law), political stability and an economic system of rewards for achievement (admittedly, all in decline in the US). But establish it anywhere and you get prosperity.

    The problem the world faces is not China, or Russia, or the US, but a nation-less community of individuals who want to establish a central world ruling body. It could go very right, but because of the problems you describe (that everywhere there is crappy government and nowhere is corruption being curtailed) it is more likely to result in universal misery … perhaps in the name of Science, I wouldn’t be surprised.

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  15. I strongly suspect my house got hit by a thief a while back – Someone I’d trusted [marginally] – Although it took me a while to trust him to even that degree. And he’d put considerable effort into getting me to trust him enough to allow him into my house where he could steal my most valued stuff.
    So I’m pretty sure he is a thief now – Even though I don’t like to accuse others without proof – But he has told me he steals from others. Hasn’t specifically said he stole from me – But rather has dared me to prove that he does. Protected by the “innocent until proven guilty” doctrine – OK.

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  16. A thief is a thief!

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  17. Geopolitical uncertainty is a certainty and the US and UK treat us as the end user of financial decadence eg Mayer stealing hundreds of millions from Aus tax payers is located itself in the UK Cayman Is….EU is fed up with the UK’s stealing practice….Aus never learns eg we were the end user in HIH

    Militarily we are just easy clients not allies to these bloody rogues and the buyer beware is just never apparent to our leaders when we purchase military stuff from US and UK and others.

    Next we got the bond market collapse and our super which the World will steal. Look its going to be every nation for itself…..China cannot change its socio economic structure to produce a large middle income group it takes decades and lots of energy and materials….

    BTW Aus will NOT resist any take over of its soil, we can be relegated to a smaller area, it won’t be that bad (it sort of stinks that our leaders have betrayed us). China cannot be allowed to mothball most of its expensive manufacturing…..to bring Chinese population to social global equity, Aus and the West will need to slash its wage structure.

    The cost of energy materials can only be reduced if the goods derived are manufactured locally on the Australian continent and then shipped to EU and US etc. This would increase Chinese profits for wealth distribution, that distribution includes Aus land and wages.

    tar and feathers
    November 16, 2009
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  18. “That’s the growth rate that China’s economic planners reckon the country must achieve to maintain high unemployment”

    Er… you mean, employment, right?

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  19. Dan D : China will not implode IF it follows a policy of steady PRIVATISATION of state owned businesses including banks, steel & aluminium works, railways, airlines, mining, shipping etc. Privatisation is IMO likely to happen and it will be accompanied by the pseudo-privatisation (outsourcing) of many core public sector activities. At this level, the Government of China may follow a classical/Austrian economic approach.

    Transposed over this will be a the greater emergence of a (military styled, low pay ) government labour corps which may well supply certain services to private institutions. Transposed on top of this will be Communist party rhetoric with carrots dangled at industry to further support high level R&D and international academic collaboration. Once these measures are under way, the Yuan could well be unteathered to follow a floating peg.

    Workable legislation to underpin economic activity including some proper companies law is a key enabling requirement. For this my guess is that China will copy Singapore’s legislation.

    You may qote my actual name if you would like to take this idea further (to either agree or disagree). A quick history lesson looking at how German industry expanded and strengthened from the mid to late 1930’s provides the policy road map. It’s all happened before.

    If China elects not to follow a privatisation approach then yes, it will implode. Economically and socially.

    Cheers

    Coffee Addict
    November 19, 2009
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  20. Here is a useful link in support of my China hypothesis. The paper by Germa Bel outlines and analyses German privatisation privatisation policies during the 1930’s.

    http://www.ub.es/graap/nazi.pdf

    Coffee Addict
    November 19, 2009
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  21. Hi Coffee Addict,

    I will read the article when i have time. Was just thinking though, in that fascist country, private companies really either toed the line with the Nazis or were put out of business. Will print and read.

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  22. CA, I have scanned this paper but need to re-read it line by line. I worked for a private company that emerged in the 20’s and 30’s in Germany that was founded by a future Gauleiter for one of Germany’s largest cities and was particularly interested in that history. My understanding of the National Socialist’s views of businesses was principally one of private businesses operating under a concession system but with strong anti trust and competitive bidding with protype evaluation wherever possible for all state tenders. Small engineering shops for components & craft excellence were encouraged. There appears to be a heavy reliance on “reprivatisation” to make the case in the article and my experience was more with emerging & innovative industries that were sort of “born national” in the German sense based on sponsorship from financiers and govt. The family I worked with were Weimar bootleggers who went on to help design the Autobarn system and to be a plank in the national logistics system that was the envy of the west. The Reichsbarn also had its state owned Schenker freight forwarding running partner and both remained state owned for the rest of the century (which makes for a poor case in point), but the state funded roads were open to private carrier running.

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  23. Like all out of control runaway trains China is on borrowed time just like Wiley Coyote running furiously mid air over that deep, deep canyon.

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  24. Dan I think your comments about Japan are correct. The economy is not stalled but you eventually get to a point where the growth slows. Also people tend to forget that some deflation in Japan is caused by the economy being so competitive.

    As for China, they are having their day in the sun and good on them. But it will come to an end at some point and another “economic miracle” will take over. Sadly I doubt it will be Australian though.

    Greg Atkinson
    December 16, 2009
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