A Gradual Transition

The Daily Reckoning PRESENTS: Is the Chinese economy overheating – or just chugging along at a healthy pace? Many global investors have been struggling with that question in recent days, but Puru Saxena asserts that China will prove itself as an economic leader over the coming decades – and smart investors should jump aboard now. Decide for yourself…


A gradual transfer of wealth and power is currently underway.  Thanks to globalization and economic reforms, the great wealth divide between the industrialized nations and the “emerging” economies is contracting.  Over the coming decades, I anticipate this process to accelerate.  In other words, I believe the future will bring rising consumption and a higher standard of living in today’s impoverished countries (China, India, Brazil and other “third world” countries), whereas we are likely to witness the reverse in the United States and parts of Western Europe.

Over the past decades, the United States has been the engine of global growth; however its dominance will be challenged in the not too distant future.  If my assessment is correct, China will replace the United States as the world’s single most important economy.  Before you dismiss my claim as a far-fetched fantasy, I want you to consider that China has the biggest population in the world, the largest foreign exchange reserves (over US$1 trillion), a booming economy, an extremely high savings rate and expanding surpluses.  Moreover, its currency is extremely undervalued and China (despite extremely low per-capita consumption levels) has already surpassed the United States as the biggest consumer nation.

Skeptics who doubt China’s role in the global economy should take note of the fact that Europe already imports more from China than it does from the United States.  To top it all, the U.S. is the largest debtor nation the world has ever seen, its debt to GDP ratio is over 400%, it has a negative personal savings rate, its currency is overvalued and its society is heavily dependent on consuming cheap, imported goods.

To be fair, thanks to the Federal Reserve’s expansionary monetary policies over the past five years, U.S. asset-prices have risen considerably; also known as the “wealth effect”.  At the end of last year, the market capitalization of the U.S. stock market rose to a record-high of US$20.6 trillion, matching the value of household real estate, which also rose to a record-high at the same time. On the surface, this may seem like brilliant news, however you must realize that this “wealth illusion” achieved by an ocean of money and record-high indebtedness is only a consequence of inflation.  Moreover, history shows that although asset-prices can come down rather abruptly, debt must always be repaid.  So, I remain cautious of this engineered American “prosperity”.

Today, China has become the manufacturer to the whole world and (at least for now) it continues to sell its merchandise in exchange for U.S. dollars.  Now, some people may consider this an act of stupidity given the state of the world’s reserve currency.  However, in my view, by keeping this game going, the Chinese are simply “buying time”.  Quite simply, they are happy to accept payments in U.S. dollars because this allows them to strengthen their economy further.  In my opinion, the Chinese are extremely smart when it comes to business and they know only too well that they must get rid of their huge dollar reserves which they have accumulated over the recent years.  In fact, this process may have already begun.  Recently, China announced that it plans to diversify between US$200-300 billion of its foreign exchange reserves and is considering an investment in “strategic assets crucial for its development”.  This development is negative for the U.S. dollar and will help underpin the prices of natural resources.

Lately, the United States has accused China of following unfair trade practices.  According to the American establishment, China is guilty of artificially suppressing its currency; allegedly, a key factor behind its balance of trade problem.  I find this rhetoric totally absurd on three levels.

Firstly, over the past few years, China’s imports have grown immensely.  Whilst it has imported a lot of natural resources from Latin America, Africa and Asia to feed its economy, it has not bought much from the United States.  This is not because communist China has a hidden agenda against the “land of the free”, but it has everything to do with the fact that the U.S. is not very competitive.

Secondly, if China was not keeping a lid on its currency and supporting the dollar by investing in U.S. Treasuries, long-term interest-rates in the U.S. would be significantly higher and this, in turn, would seriously hurt the housing boom.  Finally, if China let its currency rise against the dollar, as being demanded by the U.S. establishment, imported Chinese goods would become extremely expensive for the average American, thereby hurting U.S. consumption and its economy.  So, Americans should, in fact, be grateful to the Chinese for helping fund their deficits and overall consumption!

As sure as night follows the day, at some point in the future, when China feels that its economy is strong enough, U.S. dollars, in exchange for the goods China exports to the United States, will not be accepted.  When that happens, you can be sure that the dollar will sink against the Chinese yuan and the American economy will slip into a serious recession.  This is one of the reasons why I continue to avoid U.S. financial assets.

Whether you like it or not, China will provide economic leadership over the coming decades and investors should have a position in this exciting market.  At the moment, the Chinese authorities are busy raising interest-rates and the bank’s minimum reserve requirement in order to curtail the rampant speculation in Chinese stocks and real-estate.  Despite the tightening efforts of its authorities, the Chinese economy continues to power ahead.  In February, Chinese exports were up a phenomenal 52% when compared to a year ago, retail sales grew by 14.7% and industrial production surged by roughly 19%.

It is interesting to note that Chinese money-supply and bank-credit continue to expand at roughly 17% per annum, which is positive for asset-prices.  Nobody knows if and when Chinese stocks will correct, but if we do get a meaningful correction, I suggest that long-term investors deploy a portion of their capital to this impressive economy.


Puru Saxena
for The Daily Reckoning
May 8, 2007

Editor’s Note: If you are interested in learning more about the pitfalls and benefits in investing in the Far East, the best place to do it is at this year’s Agora Financial Investment Symposium, where the topic is “Rim of Fire: Crisis & Opportunity in the New Asian Era.”

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, he is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

The above is an excerpt from Money Matters, a monthly economic publication, which highlights extraordinary’ investment opportunities in all major markets. In addition to the monthly reports, subscribers also benefit from timely and concise “Email Updates”, which are sent out when an important development in the capital markets warrants immediate attention. Subscribe Today!


“‘Tote dat barge! Lift dat bale!’
Get a little drunk,
and you lands in jail!”
-Ol’ Man River

It is Victory in Europe day…another holiday in France.

But that doesn’t stop us. Long-time Daily Reckoning sufferers know that we don’t take holidays; too tiring. Besides, there are always things to be reckoned with. If we don’t reckon with them, who will?

Yes, the world just keeps rollin’ along. It is always different – and always the same.

The Dow hit a new high again yesterday. Massive amounts of phony ‘new wealth’ are being created. What’s this new wealth to do, but chase after the Dow and other assets? And what can assets do but respond…by going up in price?

Then, the poor yahoos see prices rising and come to exactly the wrong conclusion: these assets are becoming more valuable – and safer too. Something has happened that makes the world more prosperous than ever…they think…something that will make anyone rich, if he just gets with the program.

Here, we offer not so much a counter-view, but simply gratuitous insults and ridicule.

A financial asset is merely a tool for making money. Imagine it as a factory or as a hotel or as a computer program. What is it worth? Only what it can produce. It doesn’t produce more just because people pay more for it. Just the contrary. The more dollars you have to pay to buy the asset, the less productive each of your investment dollars becomes! Whereas, a dollar will produce 20 cents of revenue when the asset is priced at 5 times revenues, it will only produce 5 cents of revenue when the price of the asset rises to 20 times revenue.

The value of the asset has remained the same. What has happened is that the value of the money you used to buy it has gone down.


C’mon, do we have to explain everything? Because there is more capital now chasing the same capital assets. Inflation, in other words…inflation of the money supply…has caused prices to go up.

What makes this bout of inflation particularly agreeable is that it never makes its way down to the hoi polloi. The price of labor is being held down by the globalized market. So the proles who lift and tote, never get a raise…and never get their hands on all this money. It’s not cost-push inflation, led by increasing labor rates, in other words. It’s asset-pull inflation, a completely different kind. It’s money that the average working stiff never gets his hands on. So, he never takes it and uses it to buy cereal and milk. And he never forces his employer to raise prices.

Instead, this money stays with the people who invented it – central bankers, hedge funds, private equity funds, venture capital funds. It remains like the chips on a Las Vegas gaming table.

You see, dear reader, money creation is no longer in the hands of the central bank authorities alone. Banks no longer control the credit cycle. And gold no longer controls international money flows or relative currency prices. The whole system is out of control.

But here, another footnote is needed. A dollar may have a dull life…or an exciting one. An old-fashioned cobbler makes his dollar the dull, old-fashioned way…by working for it. That’s the way wealth used to be made – by toting, by schlepping, by busting your behind…or your brains. In our opinion…this brand of ‘old-fashioned wealth’ – wealth that’s based on tangible assets, with no bells, whistles or sexy back-stories, is the best way to make your money. We like to invest in easy to understand companies with a strong, steady and predictable cash flow and a competitive advantage. So what if they aren’t touting the cure for cancer – we actually prefer it if the company we’re investing in is overlooked by mainstream money…that way the price isn’t artificially pumped up by brokers. (To find out where we think the smart money is going.

But this new wealth is different…it seems to materialize out of thin air, as if by magic.

Our old cobbler would put his old-fashioned dollar into a box…and let it sit there until an emergency, at which point it would rush out to his rescue like a volunteer fireman. But our new-model dollar – in the Age of Mammon – has ants in its pants. The thing won’t sit still for a minute. Anon, it jumps into a hedge fund, for example, allowing the manager to borrow 20 more of its brethren, with only that lone buck as collateral.

And then, the manager might take his new found money and buy up the cobbler’s business, against which he could now borrow another $20 and pay a special dividend to the hedge fund, which he would immediately put into A Shares on the Shanghai exchange…from where, using the shares as security, he would borrow yen and exchange them for New Zealand dollars…that he would then place in NZ bonds paying 7.5%.

Meanwhile, the cobbler’s old business would go public at a P/E of 20…so now every single little dollar the cobbler makes has a capital value of $20…and the people who own ‘shares’ in the cobbler’s business now have a financial asset. And the cobbler now feels rich and feels he should earn more money for running his business. And his wife wants to upgrade the kitchen and bathrooms. And his children tell him that he should get a condo at the beach. “It can only go up in value,” they say.

You see? Money gets around a lot more than it used to. And everywhere it goes it is as welcome as a fat Christian in a lion’s den.

But all this wheeling and dealing still rests on, well, heeling. The toting and lifting is just the same. The cobbler is still gluing new heels on old boots and earning a dollar doing it. What has changed is the financial world, not the real, economic world; (that changes too, but that’s another story…)

Always and everywhere, money talks. And when a real mania gets going, it yells and screams…and bids up prices as the players get more money to play with.

This is what some economists call the ‘financialization’ of the economy. Things that previously had modest value are put ‘in play.’ Pretty soon, people think they are getting rich…as their assets rise in ‘value.’

But that ol’ man river just keeps rollin’ along.

More news:


Addison Wiggin, reporting from Los Angeles…

“The almighty consumer continues to fuel the US economy. Consumer Credit ballooned to $13.5 billion in March – $8 billion more than in February. Spending on credit is up nearly 7% for the past 12 months to a whopping $2.4 trillion dollars.

“Why?  Blame the housing bubble. As home buyers can no longer count on the rising value of their homes to keep up their spending. They’re turning to credit cards to keep up with the Jones’s.”

You can read the rest of this story, and find out what 5 currencies are set to leave the greenback in the dust…what Charlie Munger thinks the “dumbest idea” ever is…and more in today’s issue of The 5 Min. Forecast


And more thoughts:

*** “The US and world economies have already received a good stiff dose of inflation,” our friend Nate Lewis tells us.

“It could be remedied by appropriate action by the Fed and other central banks. In practice, this would likely mean rate hikes, although there are other, more effective methods. In 1969, to counter incipient inflation, Fed chairman William McChesney Martin took action that drove short-term rates to 10%. In 1974, Fed chairman Arthur Burns’ anti-inflation policies took rates to 13%. In 1980, Fed chairman Paul Volcker’s anti-inflation policies took rates to 14% or higher. In 1989, Fed chairman Alan Greenspan’s anti-inflation policies took rates to 9.5%. The political support for such policies today is virtually nil, especially considering the wave of adjustable-rate mortgages coming due over the next three years.

“Indeed, many Fed-watchers have expected the Fed’s next move to be a reduction in policy rates. Whether this turns out to be correct or not, this expectation alone suggests that the trend toward further decline in dollar value will continue. It may not show up in the dollar/euro or dollar/yen rate – the dollar didn’t fall much against foreign currencies in the 1970s either – but it would show up in the dollar/gold rate. Following our worn – but useful – 1970s roadmap, a move to $1000/oz. or beyond would probably be accompanied by a blooming of full-on 1970s-style inflation. It could happen by the end of this year.

“Gold never really ‘goes up.’ It simply holds its value while the values of other things are collapsing due to inflation and currency devaluation. Many times, in the 1960s or 1990s for example, it is the most useless of assets, sitting inert and generating no income. In inflationary periods, this inertness of value is gold’s most admirable quality.

“It seems these days like a lot of people can’t help blurting out the H-word – hyperinflation. I am one of them, and I notice that the normally levelheaded Marc Faber has his episodes as well. We are far from such a scenario at this time, and by any reasonable standard, the likelihood of such an outcome remains extremely remote. I take this premature anxiety as a sort of premonition, the way some people feel an earthquake in their knee before it happens. There is something going on that we haven’t seen before. The U.S. dollar is apparently being rejected worldwide, partially as a result of the unpopularity of U.S. foreign policy. How this all plays out remains to be seen, but a certain amount of preparation might be worthwhile if that tingling-knee thing turns out to be right.”

Being prepared in the face of dollar weakness is always a safe bet…and the best way to hedge those bets? Hang on to your gold.

Nate has teamed up with our own Addison Wiggin on a book that looks specifically at these issues of inflation…the U.S. dollar…and of course, gold. We’ll have more to come from the soon-to-be released book, and Nate, in coming months. Stay tuned…

*** “How do you get anything done?” asked a colleague from the United States. “It seems like there’s another holiday every week.”

It was a good question. We had no good answer.

“The answer is that things don’t get done,” Elizabeth volunteered. “That’s the trouble. And that’s why this election was so important. It was a clear choice, between someone who wanted to continue in the direction France has been going for the last 20 years, and someone who offered something new.

“I’m not saying that Sarkozy is a Maggie Thatcher. He’s not. He’s in favor of protectionism and government intervention. But this is France…who isn’t? But at least he understands that the country has to let people work…and let them make money…or it won’t be able to afford all these social welfare benefits.”

Liberte. Egalite. Fraternite. No one really cares about liberty. They toss out the word like a gum wrapper; they know it has no value. And no one knows what fraternity means. But equality has a way of sticking to their fingers.

There are two forms of equality. There is ‘equality before the law,’ otherwise known as equality of opportunity. And there is ‘equality of results.’ As a society matures, it generally shifts from caring about the first kind to worrying about the second. When people have the same opportunities, the results are very unequal. One man squanders his time; another uses it diligently. One saves his money; another invests it. At first, the differences are barely noticeable. But they build up like compound interest.

Then come the calls for equality of results. People want a ‘fair share’ of what other people have created. They want to redistribute the wealth. They want a New Deal. Of course, the deal they end up getting is only ‘fair’ if you like the results. And when government intervenes to distribute wealth, few people are satisfied. Either they feel they did not get enough or that others got too much.

What’s more, the act of taking money away from the people who earned it, and giving it to people who did not, has a discouraging effect on individual enterprise. Economies slow down. Less wealth is produced. Gradually people come to recognize that the new system of redistribution and regulations is making them all poorer. Then, they demand a new set of reforms.

That is what seems to be happening in France.

Sunday night, in Paris…demonstrators burned cars and rioted. Hundreds were arrested. Sarkozy is a law and order guy. It will be interesting to see how he reacts to the provocations that are surely coming.

The Daily Reckoning