China Syndromes

No one can deny that China’s role in the global economy has grown exponentially in past years. But for the moment, is it on its way to new heights…or setting itself up for a fall?

China, China…is it a boom getting ready to change the face of the global economic landscape – or a bubble looking for a pin?

The answer may be a little bit of both. And as with everything Chinese, at least seen from our shores, it can also be confusing. Plus, we must deal with the issue surrounding the revaluation of the renminbi.

The London Financial Times gives us this bold headline (in 72 point type): "The Chinese boom is bound to end in tears. But it might not end for another 10 or 20 years yet, with bumps along the way."

But Stephen Roach of Morgan Stanley wrote last week that China is on schedule for a slowdown. "After five days in Beijing, I am convinced that a slowdown in the Chinese economy is at hand. China’s leadership is clearly worried about the risks of overheating. And those worries will likely translate into actions that should result in a meaningful deceleration of Chinese GDP growth over the course of 2004.

"For world financial markets and global commodity markets that are expecting the China boom to continue, a likely soft landing could come as quite a surprise. For China’s trading partners who are counting on open-ended support from the Chinese demand dynamic, a slowdown could come as a rude awakening."

China’s Economic Boom: Heading for a Slump?

Who’s right? Is the China boom just getting started…or is it heading for a slump?

There are any number of ways to spin recent Chinese growth and the prospects for growth in the future. There is no doubt, however, that China is the source for the recent rise in commodity prices of all types.

Last year, China consumed 40% of the world’s cement, 7% of the world’s total consumption of crude oil (surpassing Japan as the #1 importer of oil), 31% of global coal, 30% of iron ore, 27% of steel products, and 25% of aluminum. The pressure on scrap metal prices, copper, tin and zinc are clear. This is from an economy that is much less than 10% of the world’s GDP.

And as fast as China is building infrastructure, it is still behind the curve. There is only 60% of the needed rail network capacity for moving coal from the port areas into the interior.

Last year, China grew officially at 9.1%. Private estimates are closer to 12%. Such growth is unsustainable, if for no other reason than infrastructure cannot keep up with the growth demand.

At 4.4% of world GDP, China overtook Britain at the end of the 2003 calendar year, and will pass France by the end of 2004 or early 2005. Sometime on or around 2010, it will overtake Germany; between 2015-2020, it is expected to overtake Japan to become the world’s second-largest economy. All other things being equal, China would need to grow its GDP 3% faster per year than the U.S. for some 65 years to catch the world’s number one. An improving exchange rate against the U.S. dollar would, of course, shorten this period…and you can count on an improving exchange rate over the next few decades.

China’s economic Boom: Water Shortage

But China is not without its share of obstacles to growth…some obvious, some less so. For instance, the Financial Times had this to say about China’s increasingly chronic shortages of water – the life blood for an economy:

"’China faces a serious problem of water shortages. This has become one of the important factors restraining economic development this year,’ said Wang Jirong, a senior official at the State Environmental Protection Administration (Sepa)…The water shortage reduces industrial production by $28 billion a year, officials said."

Back-of-the-napkin numbers suggest the Chinese economy is roughly $2 trillion, so that would mean water problems cost them over 1% of potential growth. That’s no small amount of rice.

And then there are the many difficulties facing the leadership of China, only a few of which I’ll list here. 60% of the GDP, for instance, is still in the hands of inefficient state-owned companies. This is changing, however: "Huang Xiaoxiang, vice-governor of Sichuan province, says that more than 500 state-owned enterprises in his province are being put up for acquisition or merger this year," reports the Financial Times. "Shao Qiwei of Yunnan says that in his province the proportion of industry in non-state hands is expected to rise to 50% in 2005, up from 30% today."

Privatization is in theory a very good thing. These companies require large loans to prop them up…but going too fast in shutting down inefficient firms could create employment problems.

As noted above, China also must expand its infrastructure to deal with the growth, which requires capital and materials. More and more people are streaming in from the country looking for jobs, although this trend may slow as new railroad lines into the interior allow companies to set up in the lower-wage areas of interior China.

The Chinese government, from the very top, has made it clear they intend to slow down the growth, which if allowed to continue at the current pace would certainly end up in a big bust. If inflation begins to emerge, the Chinese government would be forced to raise rates, which would likely increase the pressure to the upside on the renminbi.

The government has to worry about a slowdown in U.S. demand, which is the main engine for the global economy. A slowdown would certainly hurt domestic growth, as they do not yet have a strong enough internal consumer base.

"Ma Kai, Chairman of the National Development and Reform Commission, worried that China was close to a critical point when bottlenecks in materials consumption could begin to constrain economic growth," reports Morgan Stanley. "[He] was unequivocal over his concerns about the risks such trends posed to the sustainability of Chinese economic growth. In his words, ‘If such an illogical mode of economic growth is maintained, it will be difficult to keep economic growth at 7%.’ In China, that’s as direct a message as you’ll ever see."

China’s Economic Boom: Market Correction

China may well correct, as do all markets. If the Chinese government does slow the economy down, it should also have a damping effect on their markets, at least for a time.

But in my view, China still has a lot of boom left in it. Yes, there will be "bumps" as the Financial Times noted, but there is going to be a lot of opportunity in that country, especially for those that do their homework and find value in the emerging companies. But investors who blindly buy any stock with a Chinese connection are likely to end up sadder, but wiser…as my friend Steve Sjuggerud noted in these pages last week.

China is a country that could double its GDP and double again in the next 20 years. Japan certainly had its run, although there were bumps. My bet, however, is that we have yet to see the top of a Chinese bubble, which will take decades to develop.

China’s bubble may well be the most spectacular of all bubbles…since the confidence bred from the powerhouse growth China will experience will feed the emotional references that make investors see no end to the growth – the root of all bubbles. Along the way, there will be recessions and a few odd crises, and some serious corrections. Why should China be any different than any other market?

I leave you with a quote from James Kynge in the Financial Times: "Eventually, either an ill wind or a surfeit of domestic success will cause China’s stellar phase of growth to abate or crumble – just as it has in every emerging economy in history. When that day comes, the fall-out may be spectacular. But as things stand, the vigor of Asia’s emerging powerhouse appears strong enough to carry it forward for some time."

Regards,

John Mauldin,
for The Daily Reckoning
March 31, 2004

P.S. I wrote at the beginning of this essay that in order to get a grasp on China’s growth prospects, we must deal with the issue surrounding the revaluation of the renminbi. Indeed, I am often asked when I think that the Chinese government will allow the Renminbi to float, and how far down the dollar will fall when it does?

If you’re interested in learning more about this issue, take a look at my article on the DR website:

Renminbi to Float – Dollar to Founder?

Editor’s Note: John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly e-mail The Millennium Wave Investor. As well as being a frequent contributor to The Fleet Street Letter and Strategic Investment, Mr. Mauldin’s new book, "Bull’s Eye Investing," will soon be available.

Buy? Sell? Slash our wrists?

Last night’s MoneyWeek Roundtable discussion left us numb. Never before had we found so many bears in one place. The negative energy around #1 Adam Street was so great it must have opened graves and raised the undead all over town. Later, we thought we spotted them walking down Oxford Street.

"Nah…they always look that way," said a companion.

The talk began with laments about the dollar…meandered over to the deficits…and thence to India, trade deficits and interest rates. Before the evening was over, it had made its way from the comic to the tragic:

"A war between China and the U.S. is probably the final stage of this cycle," remarked fund manager Jim Mellon. "But that’s when we stop caring about asset values."

Jim seemed like a level-headed guy.

"This period seems to me a bit like the period just before WWI. Then, it was Britain that was the world’s super-power. But it was being challenged militarily by Germany and economically by America.

Now, it is America’s turn to be challenged, Jim believes…by China and India. Not to mention Europe, we might add.

"I just visited a factory in China. In this immense building were thousands of women assembling batteries…rechargeable batteries…by hand. You could have done it easily by machine. In fact, they had the machines there. But at 35 cents an hour, the company found it cheaper and more efficient to do the work by hand. You just can’t imagine how awful this work was…tedious, boring…But these women worked six days a week at it.

"The Americans say, well, ‘they can have those jobs…we’ll develop new Microsofts and new technologies…’ But there is no reason why the Asians can’t come up with new technologies of their own. This is not like in the industrial revolution. Britain and America were protected from foreign competition because it took so long…cost so much money…and so much expertise was needed to duplicate the factory system overseas. You needed the whole chain of raw materials supply, engineering support, transport and distribution to make the thing work.

"But these new technologies can be exported in 2 seconds. Everything they need to exploit them is already in place. And it’s already happening…

"There is just no reason why an American worker should continue to earn $40 per hour…and a foreign worker just 35 cents an hour. Most likely, the foreigner is better educated and more disciplined. We’re going to see a great leveling of wage rates around the world…"

In the meantime, here’s more news from…er, London:

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Dan Denning, heretofore a denizen of the DR Paris HQ, now based in the British capital…

– Your London correspondent looks all around him for signs the financial endgame has begun – that the great blast-off in precious metals prices and the great sell-off in the financial economy has started.

– Yet he doesn’t seem too see many signs on the Dow. In fact, the Dow has climbed a nifty little three percent since flirting with sub 10,000 on March 24th. And in his favorite proxy for the financial economy, the S&P 100 (OEX), there’s been a similar 3.4% gain in the last ten days.

– The stock market is worried about stocks. But if Mr. Market looked around, he might notice that we live in a more dangerous world, where political events exert an influence on economic events and the price of raw materials. This is bullish for tangible assets, bearish for financial ones.

– Back in my old Parisian haunts last week, lunching on cold lasagna in Napoleon’s tomb with my 20-year-old nephew, we saw at least one sign that we live in a new era – one where stock prices won’t be immune from external events. A frantic Frenchman with a walkie-talkie came running into the room, babbling in French faster than I could keep up. Finally, in English, he said, "You must get out, now." And so, out we went.

– It turned out to be a false alarm. But it was just a few days before the French regional elections…and we were dining near a major symbol of past French imperial glory. And it WAS not long after the bombings in Madrid.

– Fortunately, nothing happened. But even yesterday, as I sent my nephew off in a cab to Heathrow in the morning, we were both contentedly unaware that over 500 British police were arresting eight suspects that appeared to be building some kind of fertilizer bomb…either that, or setting off a green revolution in London.

– While borders tighten, travel bottlenecks, and European and American politics lurch towards the more authoritative (left or right, take your pick), the stock market – seemingly oblivious to these new threats to the world’s economic order – potters along and waits for Friday’s jobs report. The Dow added another 0.5% to 10,381; the S&P and Nasdaq both put on 0.4%.

– But frankly, all the intrigue in the market right now is in the oil and precious metals market. As Bill writes above, the MoneyWeek Roundtable convened last night in the boardroom of RAB Capital, down on the Strand. We came up with a surprising consensus: With so much money in the system, investors who want to be in the market have to be "tactically bullish" but "strategically bearish."

– What hot tips came out of the meeting, you ask? "Buy Uranium," one analyst declared. "Buy real estate around Kiev," said another.

– The consensus, however, was to buy energy and precious metal stocks – especially oil. Despite oil prices nearing 13-year highs, OPEC is considering production cuts. Today, we learn Saudi Arabia has thrown its support behind the production cuts, which would almost surely cause American gas prices to go even higher…all throughout the Presidential campaign.

– Want to own assets in a country that is not dependant on the U.S. consumer and is also a great oil/energy proxy? Russia, says the Roundtable. Yes, Russia, where forex reserves are large, and energy reserves even larger.

– The most intriguing observation from last night’s meeting – and one which is already showing up in market prices – is that certain nations of the world (say…China) may be hoarding commodities. Why? Can the global supply of raw materials keep up with global demand (especially oil and energy in Asia?)?

– In a world where all currencies are only relatively valued, is the best reserve asset of all a tangible asset? You must know the answer I’m inclined towards…and it’s very good news for gold, which looks as strong as it has in months. Mother Nature’s reserve asset rallied $4.60 yesterday to close at $421.

– If you’re looking for gold stocks to buy, the Roundtable made an interesting point. If tangible assets are rising in value, then gold companies with a lot of gold STILL IN THE GROUND are a great investment. In fact, gold companies with large, un-mined deposits might be even better "call options" on rising gold prices than a mature gold mining company in full production. There’s hope for South African miners, after all.

– Or you could look at silver. As one Roundtabler said, "Silver is the most manipulated metal in the world. It’s a buy. $50 is a reasonable target."

– "Fifty dollars?" another asked. "Would you like me to pick a bigger number? Not a problem."

– Though the hard asset markets may have monopolized the Roundtable’s thoughts last night, we note that the currencies market received a minor revelation yesterday. "Japanese export firms had a rotten end to the financial year," writes Adrian Ash in today’s DR UK edition, "as Mr. Market has apparently decided that the BoJ has ceased and desisted with its forex intervention – for now, at least.

– "Having bounced between Y105.5 and Y105.9 in European and U.S. trade yesterday, the Almighty Dollar cracked when Tokyo opened for business today. It crashed through Y105…tumbled straight through Y104…and now stands almost 2% down at Y103.8."

– Does the dollar’s sudden fall against the yen herald disaster? Of course, there’s always the chance the Almighty Dollar and the American financial economy may only gradually degenerate, like a devoted alcoholic with a failing liver. This would be the soft, slow-motion depression your regular editors at the Daily Reckoning have so often written about.

– On the other hand, it’s never too soon to prepare for the end of the financial economy, whether it arrives tomorrow or not. That said, the rain clouds have finally broken in London and the sun is shining. It’s the last thing you’d expect to happen at the beginning of a delightful spring. Uh oh…

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Bill Bonner, still in London…

*** What about interest rates, stocks, inflation, and real estate…? we asked our investment Roundtable group.

"The real problem throughout the Anglo-Saxon world – Australia, America, Britain and the rest of it – is that people have no fear of debt," said Robert Catto of Williams de Broe. Not only have they no fear of debt, he explained, they seem to have no respect for it whatsoever. They take it on lightly, even frivolously, refinancing their houses and running up credit card obligations as though they will never have to pay them back.

Now, almost all financial assets are overpriced – all bid up by debt-backed buyers. The next big thing will surely be the shrinking of this debt bubble, with everything that goes with it – price collapses, mark-downs, write-offs and workouts.

When will it begin? No one knows…

*** Is there a bubble in the real estate market, Smart Money magazine asked Sir John Templeton. You bet, said the old man. Twenty percent of people with mortgages are likely to lose their homes when the bubble bursts, says Templeton.

*** Oh…and there’s Ben Bernanke in the news again. What joy! What will he say next? In his latest attempt at comedy, the central banker told an audience that the Fed had to fight stable prices with all the ink and credit at its disposal. "Very, very low inflation is bad for the economy," said he. In fairness, he also said that very, very high inflation was bad, too. Can we count on Bernanke & Co. to keep the level of inflation just right…not too high…and not too low? We wouldn’t want to bet on it.

*** "I think I’ve figured out what is wrong with English women," said a worldly colleague yesterday. "They all seem to want to be mums. You know…they put on dowdy clothes…and look kind of frumpy, comfortable. Like mums. Or grandmums. They’re not like the women you see in France or Italy who try to keep up appearances even as they get older. You see older women in Rome, for example, who look quite sexy and stylish. But here in London, even young women have a middle-aged look to them…like women in America."