| Dear Daily Crux Reader,
In place of your Friday Crux PM update, we're passing along a timely and important report from our friends at Casey Research.
The piece is from Doug Casey, Chairman of Casey Research, in a recent issue of The Casey Report. His work is considered required reading here at The Daily Crux.
Doug just took a serious look at the situation in China, and what he's discovered could have a huge impact on markets worldwide.
If you have money in gold, stocks, or commodities, be sure to read on.
Good investing,
Justin Brill
Managing Editor, The Daily Crux
www.thedailycrux.com ------------------------------ A Chinese Conundrum
By Doug Casey There's been a tug-o-war over the last few months as to whether China is in a "bubble" that's about to burst – as the U.S. balloon already has and the one in Europe is now doing – or whether China is still "on trend" to become the world's biggest economic power.
I have spent a lot of time in Hong Kong and have been to China often, starting in 1986, when most people were still wearing simple blue, gray, or brown Mao suits and would give Westerners the kind of amazed stare you might give to a Venusian. I haven't been back to China for a few years, however. I was planning to go last year with a couple of friends, intending to hop a freight in the far west, at Ürümqi, and ride it to Beijing, but decided it would be too hard to accomplish. I was right; my pals found it just couldn't be done. It's a piece of cake, and a lot of fun, in the U.S. – although I've got to say I was once arrested in Utah by a railroad bull. But that's another story, and it's not his fault.
In any event, until recently I was of two minds as to whether China is going to blow up. On the one hand, I'm a longtime China bull. And why should an uptrend of 30 years duration be on the point of changing just now? Trends in motion tend to stay in motion until they stop. That may seem tautological, but it's a way of saying it's hard, and usually dangerous, to pick a top in any market. Especially since many of the fundamentals that have been propelling China are sound.
On the other hand, I haven't been back for a few years and hate to come to a conclusion without a full grip on the facts – not that anybody has such a grip. But it's quite clear to me that some trends in China can't continue. And when they stall, there's going to be some serious tumult.
Let's look at what facts we can, to make some sense of the biggest and fastest-growing country in the world. Reasons China may not be hurt too badly by the Greater Depression, and reasons it may be in real trouble. The Bullish Case Free-market environment – The long boom in China started in 1978 when Deng determined that the next iteration of the Chinese path to socialism would have certain market-based characteristics – Power to the People Puttin' On the Ritz. He shrewdly rationalized throwing Mao's foolish socioeconomic experiments on the scrap heap of history by saying "It doesn't matter if a cat is black or white, as long as it catches mice." He further set the tone by saying something that almost every Chinese wanted to hear but was afraid to say: "To become rich is glorious." Since then the economy in China has gotten ever freer and has turboed through what is probably the greatest boom in history.
The Maoist experiment of 1948-1978 – only 30 years – was just an interlude, likely to be viewed as something of an aberration, in the country's 5,000-year history. Mao was just another emperor, albeit bloodier and more destructive than most.
The fact is that doing business in China (at least for a Chinese) is easier than for an American to do business in the U.S. Taxes are much lower, and regulation is lighter, easier, less crazy, and definitely not in the hands of high-anxiety Puritans. When I hear an American refer to it as "Communist China," I know I'm dealing with someone who's either just ignorant or a Republican living in a time warp. As astounding as this may sound, there's actually more economic freedom in China than there is in the U.S. Astounding and sad.
There's less political freedom, however. But what does political freedom mean to an individual? For some, it's the right to tell your neighbors what they can and can't do. For most, it's the right to cast a meaningless vote for one hack instead of another. And for others, it's an invitation to become one of the hacks. The idea of political freedom is essentially a sales pitch – buy the right to vote for just 40% of your income, and we'll send you freedom of religion at no additional cost.
In practical terms, the only element of political freedom that has value is the right to say what one pleases about those who have political power. That is something the Chinese are denied, because it might compromise the interests of the party elite. Not a pretty or happy fact, but the government of every society on the planet arbitrarily subverts rights and freedoms that are taken for granted in other places or were taken for granted in other times.
The Communist Party in China today is basically a scam that allows its members to skim money from the economy – just like the ruling elite in any other country. So they're very pleased to see the country advance economically, because that means there is more to skim. But they pounce on anything that looks like a political threat, since political power is their only profit center. They serve no useful purpose from an economic viewpoint.
Chinese society, which is essentially very conservative, honors a dictum not to break anybody's rice bowl. That's why there are restrictions on Internet access, just as there used to be on putting up subversive posters. Change is dangerous – especially for fat cats in the party.
The party's control isn't a good thing, except in providing stability. The alternative would be China breaking up into multiple states, or prolonged chaos, or a new regime with its own priorities.
But if we look at things from a purely economic viewpoint, the environment for the Chinese entrepreneur/businessman is far friendlier than that in the U.S.
No welfare – There is no state welfare system in China – no equivalents of Social Security, Medicare, unemployment compensation, or the like. This is a doubly good thing. First, there's no mechanism for extracting capital from the productive sectors of society, for moving it from savers and entrepreneurs and into the hands of bureaucrats to, almost inevitably, misallocate. Second, it ensures everyone knows he's responsible for himself and, especially in rural areas, his extended family.
The various "safety net" schemes in the U.S. guarantee nothing but the U.S. government's bankruptcy and the ruin of large parts of the U.S. population who have come to rely on government. China is ahead of the game here. And its lack of a welfare system has encouraged another huge plus – a high savings rate.
High savings rate – There are, you'll recall, two things that underpin a society becoming wealthy: savings and technology. But savings – producing more than you consume and setting aside the difference – is by far the more important. China is justifiably lauded as having an extremely high savings rate, and as times get tougher, that's only going to become more ingrained. It augurs well for the country's future.
Education – Most of the Chinese population are still poor, ignorant peasants living at just above a subsistence level. But that was true of the Chinese in Hong Kong and Taiwan only a couple of generations ago. Education and self-improvement are central to the Confucian ethic that has informed China for the last 2,500 years; it's again being given free rein with the economic liberalization of the last 30 years. The U.S. used to have something quite similar, the Protestant Work Ethic, but it's been pretty well subverted by the ethos of the Consumer Society – which is still decades in the future for China.
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------------------------------------ The point here, however, is that the Chinese who go to college overwhelmingly take courses in math, science, and engineering – unlike their U.S. counterparts, who tend to take courses in things like English Lit, Gender Studies, Sociology, Psychology, Business, Economics, Law, and the like, which range in value from being meaningless wastes of time to actively counterproductive. In fact, students in U.S. colleges taking hard sciences tend to be foreigners from the Orient, and after graduation most of them are going home where the opportunity is, not staying in the U.S.
A preponderance of the top scientists and engineers in the world used to be Americans. That's changing. Over the next few decades, these people will mostly come from China and other cultures in Asia.
Low wages – A Chinese worker (and to a lesser degree, a Chinese scientist or engineer) makes a small fraction of his U.S. counterpart. That, combined with an overall better business environment, means China will outcompete the U.S. for many years to come. Two things will – inevitably and certainly – change along the way, however: the average Chinese wage will rise, and the average U.S. wage will fall. This will greatly augment Chinese power. What it means for the U.S. is highly problematical but not germane to our present discussion.
No foreign wars or military adventures – It's hard to be accurate with the numbers for military spending, since governments often bury those expenditures in other categories. But the Chinese seem to spend only $75 billion a year on their military, and they don't have bases in any foreign lands. By contrast, the U.S. is now bankrupting itself with an annual military budget of upwards of $1 trillion annually – more than the rest of the world combined.
These are some of the main reasons China has boomed, and why, everything else being equal, it should continue booming. But everything else is not, in fact, equal. The Bearish Case
Real estate – This was the area that first really set off the alarm bells for me. It's one thing to read press reports; but I prefer to make judgments based on my personal experience. When I first moved to Hong Kong in 1986, it was quite inexpensive by world standards. No more. Almost nothing is cheap in Hong Kong, and real estate prices in particular are out of sight. An apartment I know well, with great location and an excellent view but in a very old building, cost US$40,000 in 1986; it sold for not quite US$1 million last week – about $1,500 a square foot. The Hong Kong property market has long been one of the world's most volatile, but never to this extent.
The situation is the same throughout China, however. Residential construction has been concentrated on the high end, because that's where the profits are, at least during good times. Builders assumed that everyone was going to continue making fortunes in stocks and property forever. As a result, there's a glut of high-end inventory, and people have been buying extra apartments for speculation. Some say the situation isn't out of control because the banks now may lend only 80% for primary homes and 60% for second homes. But these loans are made on inflated prices (apartments in Shanghai and Beijing go for US$500 a square foot and double to quadruple that figure for Hong Kong); prices are said to have gone up over 50% just in 2009.
A retrenchment to the levels of a year or two ago will put both buyers and lenders under water. We've seen how this drill plays out in the U.S. I have no doubt the same kind of hanky-panky, inflating values and incomes that went on in the U.S. is happening in China. Apartments sell for 15 to 20 times the average income, which is unaffordable and therefore unsustainable.
Some argue it is sustainable because the "average income" in China is skewed by the impoverished masses, in that only about 10% of the population (which is still 130 million people) can be considered truly middle class. But even the cheapest new construction, in second- and third-tier cities, apparently goes for $100 a square foot, which is a stretch for those living in the boonies of a poor country. It's a stretch for most Americans…
The residential market is an accident waiting to happen, as far as I can tell. But the commercial and office market collapse will be far worse. You may have heard of the South China Mall, outside the industrial city of Dongguan, which is about 40 miles from Guangzhou. It's the largest mall in the world, with 1,500 shops, all but four of which are apparently empty and have been since the thing was opened in 2005. It was financed almost entirely by bank credit, which simply won't be repaid.
What happens to mistakes like this? After they deteriorate enough, they're generally torn down, if there's enough capital to turn the land into something productive. Otherwise they're left standing and simply become ruins. The loans are total write-offs. It's a pity it was built on fertile farmland, something at a premium in China.
Another spectacular example is provided by the city of Ordos, Inner Mongolia. The South China Mall was financed privately; Ordos is a gigantic ghost town built by the government, where no one can afford to live. Or has a reason to live in or even go to, other than curiosity. This is the type of thing you can expect from China's $585 billion "stimulus" package.
The biggest problem, however, is in China's office sector; here the numbers boggle the imagination. Something like 2.6 billion sq. meters (approximately 30 billion sq. ft. – or about 1,100 square miles) of office space are still under construction. That amounts to about 25 square feet for every man, woman, and child in the country. This is apart from the fact that vacancies are, according to official figures, already in the 20% range.
But it's not just that most of the capital here has been wasted, there's nothing to be done with these buildings, and the loans to the banks won't be repaid. These buildings will be about as useful as the Egyptian pyramids, but much less picturesque and a lot harder to keep up. All this construction entails continuing maintenance costs. In other words, it can be argued that the capital used to overbuild would better have been piled up and burned. At least then it wouldn't constitute a large and continuing drain every year.
It's all been done with bank credit. Insane booms don't occur in cash markets. People tend to act much more prudently when it's all their money, rather than that of a faceless and stupid bank.
Bank credit and bad loans – As mentioned above, apparently trying to take a lesson from the American property disaster, the Chinese have put restrictions on the amount of debt that can be used to buy a first or second residential property. That would be unnecessary if there weren't a surfeit of credit emanating from the banks – US$615 billion in 2008, something like $1.5 trillion in 2009, and early figures for 2010 are running twice the rate of 2009. The M-1 money supply was up 35% in 2009.
That credit boom is behind the fact that the three largest banks in the world by market capitalization are Chinese. Locals may point to it with pride, but to me it seems more like the kiss of death to an economy when its banks reach that position. That's because bank caps fluctuate based on the size of their assets, their reported profits, and the tenor of the stock market. All these things are cyclical, but they expand, in a leveraged way, with the amount of money in circulation – at least until the bubble breaks.
Before the collapse of Japan's economy in 1990, it had the biggest banks. Before the collapse of the U.S. economy, it had the biggest banks. I suspect China is in the same position. Perhaps even more so, because its banks don't do international business; they concentrate on the home market. The loans they've made financing factories selling consumer goods few can afford to buy will be written off. The loans financing the construction of hundreds of unoccupied office buildings across the country will be written off. But I suspect nobody will really know how bad it is until it all comes unglued. If there's one thing China doesn't have, it's transparency.
A lot is made out of "transparency" these days; it's a newly fashionable concept, considered an automatically good thing, like "democracy." Transparency sounds good – who could be opposed to seeing clearly what's going on? But in point of fact, it is really just a gentle way of saying "lack of privacy." Transparency is a good thing when we're talking about public institutions, but it's only meddlesomeness and busybodyism regarding private entities.
That said, there's about zero transparency in the Chinese government or its state-owned enterprises, both corporations and banks. Although most industrial enterprises have been privatized over the last 30 years, it's estimated that 25 to 40% of the urban workforce is still employed by SOEs. These companies are by nature inefficient, corrupt loss-makers, kept alive by giant loans from the banks. They're unlikely to be cleaned up and privatized at this point, because most of the workers would have to be let go and, at this juncture, that's absolutely the last thing the Chinese government can afford; it could have a disastrous effect on social stability.
And what of the loans to these SOEs, which also represent the savings of Chinese workers? Well, I fear most of their capital has been dissipated and misallocated – basically destroyed and no longer exists. It's unknown how big a disaster this might be, but it's probably huge. So the government has apparently (taking exactly the wrong lesson from Wall Street, of course) packaged up the bad loans to SOEs into new entities to make it look like the banks are unaffected.
I don't know where consistent figures are available on these things. But it's academic, because they'd be completely untrustworthy. My guess is that most of the banks in China are soon going to be bankrupt.
Exports to a non-existent market – The Chinese middle class have been buying their share of locally made electronics, clothing, and what-have-you; that's clear from a walk down the street in any Chinese city. But the vast majority of it has been made for export; that's how the reported $2.4 trillion has accumulated. The Chinese economy was built for export-type products. The world is still going to want and need some of these things, but not nearly to the degree it did during the long boom. Most of the tens of thousands of factories catering to the export market are going to be closed, many of their owners bankrupted, and most of the workers unemployed. Unemployed people tend to be unhappy people.
Press reports indicate there are about 100,000 serious riots every year in China, and this has been the case for a decade. (It's a mystery why China isn't a power in ice hockey or soccer.) If enough people lose their jobs or their savings, anything could happen. The country's 1.3 billion people have a number of distinct cultures and different languages – even among the majority Han. The Tibetans and the Muslims in the far west are actively separatist.
One encouraging factor is supposed to be that China has overtaken the U.S. as a car manufacturer, turning out over 13 million vehicles last year. Will they find that many buyers this year and next? I wonder.
$2.4 trillion of FX reserves – Some make the case that any country sitting on $2.4 trillion of foreign currency (over a trillion in U.S. paper alone) has to be in good shape. In addition, there's relatively little government debt (accurate numbers are iffy, but it's almost all owned domestically, issued in yuan, primarily by local governments). But there are some problems.
First, all those FX reserves are just the paper issued by other governments. Dollars, yen, euros – all of them are hot potatoes for different reasons, none has any fixed value, and all of them are circling the drain at different speeds and trajectories. Is it possible the Chinese could get stuck with most of it when the game of musical chairs ends? Quite possibly. They could wind up holding 2 trillion Old Maid cards, and I expect that would make them quite unhappy.
Second, much of the money that is invested is likely to be frittered away. To reduce the amount of foreign paper on their books, the Chinese are apparently spending these reserves as quickly as possible on foreign resource assets. But how competent will the bureaucrats be in acquiring things they don't have a personal interest in? Or perhaps they do. I expect there's a fair amount of bribery that's gone on, from the sellers to the bureaucrats closing the deal.
Third, a lot of those reserves may be needed to keep the SOEs and the banks afloat.
The Chinese government is in a tricky situation. It doesn't want to continue accumulating dollars since their eventual fate is clear. And doing so just amounts to subsidizing America's interminable foreign wars and unsustainable levels of consumption. But if they try to get rid of their super-sized dollar reserves, they could set off a panic among all the other holders of such debt; it could result in a complete collapse of the dollar and perhaps the start of a hyperinflation. And anything that decreases America's consumption of the bric-a-brac from Chinese factories will result in more bankruptcies, bad loans, and unemployment.
This is one reason China is purchasing the 200 tonnes (+/- 6.4 million ounces) of gold from the IMF. It's also why, I suspect, the government has encouraged citizens to buy gold, which is easily available from many thousands of shops all over the country. The complete destruction of the national currency in the '40s under Chiang Kai-shek was instrumental in Mao winning the civil war, and they don't want to see that happen again.
How will it end? Well, anything that must end will end. And I don't see a happy ending. The yuan will probably maintain value better than other major currencies, for what that's worth, partly because it's underpriced now (based on purchasing power parity), partly because the Chinese can sell dollars to buy back yuan to maintain its value, and partly because the government appears somewhat more conscious of the dangers of hyperinflation than officials in the U.S.
Even so, I think the odds of a financial debacle in China are high, and its consequences could include political, social, and military turmoil. Because the same thing is happening elsewhere around the world, it's likely that the Chinese, too, will blame the free market for what has been caused by their government's interference in the market. But this, sad to say, is true most everywhere.
Big trends have long seemed to have a global aspect, starting with the fact that all over the world after the last Ice Age, at about the same time, people started moving into towns and cities and taking up agriculture. The same is true of the start of the Bronze Age, the Iron Age, etc. It gives some intuitive credibility to the so-called 100th Monkey theory. More recently, though, it's interesting how in the late '60s China, the U.S., and Western Europe – the three areas of the world where things "happen" – all simultaneously went through social convulsions. Then, starting in the early '80s, they all liberalized their economies at about the same time. Now they're likely to be the three big epicenters of the Greater Depression.
But all these things are actually somewhat tangential to the actual reason China is heading for a fall: the business cycle.
The Business Cycle – While you may find it hard to believe, extravagant booms followed by crushing busts don't form a part of the unfettered free market; rather just the opposite is true. That's because booms and busts are caused mainly by currency inflation and secondarily by tax and regulatory policies. The early part of China's long boom, say from 1978 to about 2000, was basically sound. It was financed by domestic savings and foreign equity investment and directed toward basics in an economy that was decades behind the times.
But, notwithstanding the comments I've made above, China is a long way from an unregulated free market. The Chinese government has always tried to direct the flow of investment and credit, and since the crisis started in 2007, it's taken some extremely foolish steps. Their "stimulus" program at 4 trillion yuan (US$585 billion), relative to the size of their economy, is bigger than that of the U.S. Worse, since they can more effectively tell their banks what to do than the U.S., they've created a gigantic credit bubble.
The Chinese stock market is grossly overpriced due to all the hot money they've created; stocks are trading at about 27 times trailing earnings and many urban Chinese are actively involved in it, lately even being allowed by the regulators to do so using margin.
When any economy expands as rapidly as China's, for as long as it has, lately with speculative loans and under political direction, you can be assured it's carrying huge distortions and huge misallocations of capital. I've explained this phenomenon at length in my books and in past editions of this letter, so I won't go into it again here. How to Play It First of all, if you have any property in China or Hong Kong, I'd hit the bid, yesterday if possible. The market resembles nothing more than Wiley E. Coyote just before he realizes he's walking on air. A collapse in Chinese property will almost certainly have spillover effects on other markets in the Orient. As I've mentioned before, I think real estate in most parts of the world is a dead asset class for many years in the future. But if you've been thinking about an apartment in the Orient, there are likely to be some bargains in the next few years.
Second, the consequences for most commodities are likely to be grim. Prices of industrial metals have floated on a rising tide of demand from places like Dubai and China for years. It's over in Dubai and nearly over in China. Worse, there are stories of many Chinese having stockpiled large amounts of metal, especially copper, as a speculation. As demand falls, that material could be forced onto the market at exactly the wrong time. Base metals and base metal stocks impress me as a bad bet, at least until this shakes out.
Third, Australia and Brazil are two places that have profited handsomely from the long boom in China, supplying the Chinese with massive amounts of raw materials, including coal and iron ore. That's likely to come to an end for quite a while, with negative fallout for both economies. Brazil, especially, has been too hot for too long.
Fourth, a major upset in China is not going to help the earnings of companies anywhere – or their securities. And it's certainly not going to help the dollar or Treasuries, which will both see a lot of selling from China. Of course, their fate is pretty well sealed anyway, but this is another nail, railroad spike-sized, in their coffin.
Fifth, recognize that one of the few beneficiaries of a global monetary crisis is going to be gold. The fact it's quadrupled from the lows of a decade ago is trivial in the context.
When will China hit the wall? The chances are excellent it's happening now. One additional reason it seems to is that the Economist and Forbes both recently published articles on China assuring us that all is well. Magazine articles are historically great contrary indicators at major turning points.
Crux Note: Each month, Doug and his team bring subscribers of The Casey Report unique analysis and investment insights you won't find anywhere else. We consider it "must read" research for staying one step ahead of the markets. If you're not reading The Casey Report, click here to learn more. |
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