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Why the China Bulls Should Watch Their Chairs

It’s come to our sleep deprived attention (we’ve got a one-month old in da house) that one Dr Alex Cowie, our colleague who writes over at Money Morning, is sticking it to the China bears. Being the biggest China bear in the office, it’s slowly dawned on your somnambulist editor who the Doc is having a go at.

Which is fine by us. It’s all good natured. And we welcome criticism…even veiled criticism! When someone challenges your position it makes you think about your arguments. That’s especially the case when you make your arguments public, as we’ve done with China’s economy for much of 2012.

As the old adage goes, different views and opinions are what make a market. And while it might be confusing to you that two people in the same office, working for the same company, can have polar opposite views, we would argue that’s exactly what an independent publisher should be aiming for.

There’s no such thing as a ‘house’ view here. That type of straightjacketed idiocy is for large organisations who like to tell their employees what to think. We always chuckle when someone from some ‘institution’ writes, for example, a controversial op-ed piece or something similar in the media. Then as a footnote, they make it clear that the views are their own and in no way associated with their ‘organisation’.

So after cleansing themselves of independent thought, they plug back in to their official position telling everyone not to worry…’these aren’t the risks you’re looking for’…’stay invested’…’things are getting better’…

Such is the nature of the institutionalised financial world.

Anyway, where were we?

Oh yes. China. And Dr Cowie’s bullishness on the Middle Kingdom.

In understanding anyone’s position on anything investment related you have to know ‘where they’re coming from’. We base our analysis on underlying monetary fundamentals and try to gauge the sustainability of the activity derived from those fundamentals.

We don’t want to speak for Alex, but as a rocks and dirt guy he’s just looking at the activity, not the underlying driver of the activity.

Which is exactly what he should be doing. Those in the resource industry need to make hay while the sun shines. When liquidity is abundant, small cap players with strong share prices will raise capital, announce expansion plans, drill, make acquisitions, etc.

The resource sector is a tough business. You need enthusiasm, optimism, boundless energy, optimism, capital (lots of it) and a half-decent deposit…although that’s not always a must.

Our point being that resources types are not glass-half-empty people. They are glass overflowing types…if they see an investment opportunity they go for it. The ‘fundamentals’ – whatever they are – don’t really matter so much because windows of opportunity open and close all the time in the mining space, especially at the junior end.

It’s why Kris Sayce, editor of Australian Small-Cap Investigator, is loving the small-cap sector at the moment. The sun is shining and he’s making hay.

But we look at the fundamentals. And in the Chinese economy, if you look deep down, they are not at all good. China bulls may point to strong economic growth as evidence for their optimism. But as hedge fund manager Kyle Bass said in a presentation late last year:


‘The Chinese banking system has expanded by 50% of Chinese GDP three years in a row. So that’s analogous to the US lending let’s say, lending US$23 trillion into our economy in three years. Through the banks. I’d take the over on 8% GDP growth for all you wanted to bet me if we did that.’

Strong economic growth that is the product of unsustainable credit growth is by definition unsustainable. China’s economy will falter, again, as soon as it exhausts its rather large demand for credit.

Fund manager and bubble spotter GMO recently published a White Paper on China called Feeding the Dragon: Why China’s Credit System Looks Vulnerable. Here are two pertinent quotes (there were many to choose from):

‘Since that date [2009] China’s economy has become a credit junkie, requiring increasing amounts of debt to generate the same unit of growth. Between 2007 and 2012, the ratio of credit to GDP climbed to more than 190%, an increase of 60 percentage points. China’s recent expansion of credit relative to GDP is considerably larger than the credit booms experienced by either Japan in the late 1980s or the United States in the years before the Lehman bust.’

On China’s ‘shadow banking’ system:

‘In the fourth quarter of 2012, nonbank lending accounted for an astonishing 60% of new credit issuance. China’s thriving shadow banking system has much in common with the American version, which thrived before Lehman’s collapse.: trust loans that finance cash-strapped property developers have a whiff of the subprime about them; wealth management products that bundle together a miscellany of loans, enabling the banks to generate fees while keeping loans off balance sheet, bear a passing resemblance to the structured investment vehicles and collateralised debt obligations of yesteryear; which thinly capitalised providers of credit guarantees are reminiscent of past sellers of credit default insurance.’

As far as we’re concerned, the only question is timing. China’s economy WILL have its day of reckoning as all those credit chickens come home to roost. But credit bubbles take a notoriously long time to pop. Long enough to discredit and make fools of naysayers like us, and long enough to wrap a warm blanket of complacency around China bulls and indecisive China sceptics alike.

The other argument often thrown around by the bulls is that China is rising inexorably to world dominance. In XX years it will be the world’s biggest economy and rival the US as a superpower. What’s not to like?

We’d remind you at this point that everyone said the same thing about the US in the 1920s. The superpower at the time, Great Britain, was in terminal decline and the US was the logical challenger. That analysis was certainly correct but you needed a bit of patience to see it work out that way.

First you had the Great Depression and then World War II, both wealth destroying events for investors. While it’s true that central bankers were not as ‘activist’ back in those days, and governments were not quite so ready to spend future generation’s wealth, believing that this time is different is always a risky gamble.

China’s economy, just like the States in the 1920s, is going through a huge investment boom. And just like the States in the 1920s, it holds the world’s largest pile of FX reserves…except in the US’s case it was gold reserves.

So if you’re punting on China’s economic revival, keep in mind that it’s a credit driven revival that will run out of steam at some point. We don’t know when that point is, which is why we’re steering clear of all things related to China’s economy at the moment .

In the meantime, best of luck to my mate Dr Cowie and the rest of the China bulls. I sincerely hope you can find a chair when the music stops.

Regards,

Greg Canavan
for The Daily Reckoning Australia

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From the Archives…

Shale the Conquering Hero!
25-01-13 – Dan Denning

The Nobel Prize for Quack Economists Like Stiglitz
24-01-13 – Bill Bonner

The Real Story Behind Germany’s Gold Recall
23-01-13 – Byron King

At the Mercy of Financial Repressionists
22-01-13 – Dan Denning

Walter Russell Hall: From Rebellion to Bullion
21-01-13 – Kris Sayce

Greg Canavan
Greg Canavan is a feature editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Sound Money. Sound Investments, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
Greg Canavan

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