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Is it possible? Could China be on the brink of a Great Depression?
Most experts would say, "No way." They would point to China's trillions of U.S. dollars
in reserves as their Exhibit A and say, "Case closed."
Countries use reserves to back their liabilities... like their currencies. Think of it like having
a huge balance in your savings account. If you've got all that cash, you're not likely going
under, right?
But one expert recently made an interesting case for a potential Great Depression in China,
even with its trillions of dollars of reserves...
"Twice before in history, a country has, under similar circumstances, run up foreign reserves
of the same magnitude," says Michael Pettis, a former Wall Streeter and Columbia professor
who now teaches finance in China. "Both cases turned out badly for long investors, and
brilliantly for anyone dumb enough to have [bet against the markets]."
The two cases where countries rang up reserves of a similar magnitude to China are the U.S.
in the 1920s and Japan in the 1980s.
Pettis says, in both cases, the high reserves "were symptoms of terrible underlying
imbalances" in those countries. So those reserves were ultimately "useless" in protecting
those countries from a bust.
The U.S. and Japan stories are similar. The U.S. in the 1920s and Japan in the 1980s had
"sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity,
" according to Pettis.
Both of those great booms were followed by massive busts. Stock markets fell 80% from peak
to trough. Japan's stock market peaked around 40,000 in 1989. Today, over 20 years later,
it hovers around 10,000.
The U.S. crashed in 1929, and didn't recover until World War II.
China is seeing the same things the U.S. and Japan saw during their boom years. The booms
ended up fueling the creation of too much credit... This led to excess capacity... which then
created the "lost decades" for the U.S. and Japan. China could easily end up down the same
road.
To be clear, Pettis isn't predicting a depression in China. He says, "The fact that the U.S. and
Japan had terrible decades following periods during which they had amassed levels of reserves
that China has subsequently matched... does not necessarily mean that China too must have a
lost decade or two."
He's simply warning about ignoring "obvious historical precedents."
As an investor, whenever the crowd all believes one thing, I look for the opposite case.
If there's a strong argument to be made in the opposite direction, there's usually little downside
and significant upside in betting against the crowd.
The consensus opinion is that China is at no risk of collapse because of its great hoard of reserves.
But Michael Pettis' story of the imbalances in the U.S. in the 1920s
and Japan in the 1980s is thought provoking...
Is a Chinese depression coming? Michael Pettis shows us that it sure is possible...
Good investing,
Steve
P.S. To read more of Michael Pettis' work, go to www.mpettis.com.
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