A Report on China's Bust?

Could be interesting idea, no? All kinds of fun geopolitical and macroeconomic angles. It sure would be fun to write. We could bring out the Mutually Assured Destruction angle again, with the twist that an imperiled Beijing would have nothing to lose…

Re ways to play it, precious metals and defense stocks come to mind… maybe US based manufacturing, or companies with less exposure to Asian supply lines… no doubt some other off-beat ideas could be drummed up…

 – Justice

From Barrons:

What Could Go Wrong With China?

CHINA INSPIRES SUPERLATIVES, especially from Westerners marveling at its space-needle high rises, landscaped highways, chic shopping centers, Shanghai bullet train and sprawling new industrial complexes.

And its economy is on fire, expanding at a nearly 11% annualized pace in the first half alone. Indeed, since 1978, when Deng Xiaoping set China on a capitalist course by decollectivizing its agricultural sector, the nation has averaged annual GDP growth of nearly 9%. Likewise, in the past 25 years or so, China has, in the words of the University of Michigan's Kenneth Lieberthal, undertaken "urbanization, marketization, privatization and globalization" with unprecedented speed. And there's no reason why China can't continue to grow at a 9% rate for the next 15 to 20 years, adds old China hand Loren Brandt of the University of Toronto. No wonder an air of triumphalism can be detected in the Middle Kingdom. Asians and indeed many Westerners feel that this century will see China become the globe's pre-eminent economic power.

Goodness knows that China skeptics, like the venerable publication the Economist, have looked silly after predicting China's collapse and devolution into fragmented warlord-run economies. Nearly all the economists, academics and other experts that Barron's recently spoke with are bullish on China's prospects. And, certainly, no multinational business can afford to ignore the allure of the world's largest market, with a population of 1.3 billion, or the value of China as a low-cost site for producing or sourcing goods.

YET, THE SINO-EUPHORIA is overdone. The extraordinary transformation of China from peasant-rich Maoist autocracy to economic behemoth have unleashed economic, social, environmental and political forces that could prove profoundly destabilizing. A lot could go wrong with China.

One difficult issue facing Beijing is a rapidly aging population, particularly given that the country's abundant labor force has long been the bulwark of its economic miracle. The looming labor shortage is largely a result of China's one-child policy, propounded in the 'Seventies to counteract the ruinous population gains encouraged by Mao.

The oft-expressed fear of many Chinese bureaucrats is that their land will grow old before it grows rich. That worry is justified.

According to Bill Overholt of the Rand Corp., China's work force will begin to gray rapidly in 10 years. By 2050, the ratio of China's active workers to retirees will become among the world's worst, with the aged — meaning people at least 60 years old — rising to more than 400 million (from 120 million in 2003), and comprising more than 30% of the population, versus 10% now.

China could counteract some of the ill effects by increasing productivity and continuing to shift redundant farmers to manufacturing jobs.

Asian competitors Korea and Japan face a similar demographic problem. But China is far poorer than either of them, and will be in an earlier stage of development as it confronts its demographic crisis. And China's social safety nets are badly frayed. Many workers have no pension protection.

Unlike in Maoist China, where health care, miserable as it was, was paid for by the government, individuals now must pick up the tab. Decent health care now is unavailable, or is beyond the means of many. There are some 650,000 HIV sufferers living in China, according to the World Health Organization, and its food markets feature live creatures, some exotic, caged next to one another in an environment some think helps spread ailments to humans. The country has been hit by outbreaks of both avian flu and severe acute respiratory syndrome, or SARS, in recent years.

China's pell-mell economic growth has come at a fearful environmental price. Elizabeth Economy, director of Asia studies at the Council on Foreign Relations and author of the 2004 book The River Runs Black: The Environmental Challenge to China's Future, can recite the costs by rote. About 300 million Chinese drink contaminated water, with some 190 million being sickened by it each year. Experts estimate that around 400,000 Chinese annually die from breathing polluted air. According to the World Health Organization, five of the 10 most polluted cities in the world are in China.

Likewise, China has the entire package of other environmental problems — acid rain, deforestation, serious soil erosion, silted reservoirs and growing carbon-dioxide and sulfur-dioxide emissions. And it's rapidly building dozens of coal-fired power plants that will make matters worse.

The central government in Beijing has begun to pass decent environmental regulations. It's just that at the provincial, county, municipal and township levels, party officials and their business buddies are so hell-bent on delivering economic growth and jobs that these regulations are largely ignored. Lax environmental regulation is an enticing comparative advantage that China offers to foreign multinationals considering building production facilities there.

Michigan's Lieberthal says a recent government inspection of 500 new water-treatment facilities showed that fewer than half had ever been turned on. Apparently, local apparatchiks were only too happy to accept government financing to build the plants, thereby creating jobs and kickbacks, but didn't want to spend local tax revenues on running them.

According to Lieberthal, water quality and availability is likely to become a constraining factor on China's economic growth. Severe water shortages exist in China's north, which boasts two-thirds of the country's arable land, produces half of its grain and is home to much of its manufacturing and population. Deserts are growing around Beijing, and the city's water table is dropping rapidly.

The government has plans to spend more than $60 billion in the next 50 years to divert water from the Yangtze River in the south to the North China Plain. But pumping costs may make the diversion systems uneconomical to operate, says Lieberthal. The water that would be pushed northward through one of the proposed canals is laced with agricultural runoff and heavy metals, and therefore would be of little use, he asserts.

One way to alleviate the problem would be to raise the price of water, which today is close to zero, to reduce squandering. That, however, could prove socially destabilizing. Agriculture uses nearly 70% of all of China's water, so many farms would become too costly to maintain, pushing more rural people into overcrowded cities.

Yet another source of unrest is the growing corruption, at all levels of government, that has been unleashed by the nation's economic surge and embrace of a market economy. Graft leads to a misallocation of resources, as projects are built for reasons other than economic merit. And tales of officials buying $2,000 suits, cruising around in limos and spending huge sums at clubs and casinos incite those most corrosive of emotions — envy and resentment — among the hundreds of millions of China's have-nots, particularly in impoverished rural regions far from the booming coastal cities.

THERE'S LITTLE MYSTERY as to why corruption is flourishing. The pie has grown immensely in the past 25 years or so, and everyone wants a slice. In addition, the de facto decline of
communism removed the fear of denouncement and draconian punishment meted out by the party. China also has relaxed travel restrictions, meaning that ill-gotten gains now can be transferred abroad more easily. Finally, reform caused much political and fiscal power to pass from Beijing to lower levels of government, providing increased opportunity for predation.

Result: a free-for-all of corrupt greed that's even been reported in China's press, which, despite being censored, is less restricted than it was in Mao's heyday. Party cadre have benefited mightily from the privatization of state-owned enterprises, often installing themselves or relatives in executive posts in the new companies. State assets have frequently been sold to the favored at ridiculous knock-down prices. The party's stranglehold over business licensing and land-use permits has become a huge source of pelf. Smuggling, the sale of lucrative offices and bribes from real-estate developers are common.

These days, local party officials are increasingly seen at the high-roller gambling tables of Macau and even Las Vegas, replacing the Japanese Yakuza gangsters as a favored clientele. A Wall Street economist, who requests anonymity, says that the Chinese bankers he regularly meets brag of real-estate investments in Vancouver and secret bank accounts in Australia.

Pei Minxin, a China-born scholar who is director of the China program at the Carnegie Endowment for International Peace in Washington, D.C., has called his native land a "neo-Leninist, decentralized predatory state" that ultimately may be stymied in delivering sustainable economic growth because of poor public services, social tensions and inadequate protection of property rights.

CHINESE SOCIETY REMAINS a potentially combustible mix, despite nearly three decades of strong growth in gross domestic product per capita. For one thing, income inequality has surged to banana-republic levels from the grim and brutal egalitarianism that existed under Mao.

The Great Helmsman and his cohorts periodically purged developing elites, culminating in the unleashing of the Cultural Revolution in the late 'Sixties, which led to the humiliation and death of many professionals and high party officials branded as "bourgeois counterrevolutionaries." Mao glorified peasants and workers, even as he kept them firmly under his thumb.

Today, the many poor in the countryside and in run-down city neighborhoods have their noses rubbed in their abject state by breathless TV coverage of the rich and famous in Beijing, Shanghai and Hong Kong.

Then there are 100 million or so workers from rural areas who have come to the coastal cities to scrape together a precarious existence in construction and day labor. They are much exploited because of their illegal residency status.

Add to the disenfranchised the 60 million or so who've lost their jobs as a result of the downsizing of state-owned companies (whose output now accounts for about 30% of GDP, versus 70% 10 years ago).

Lastly, a major flash point has become the seizure of land and housing by the state for infrastructure and real-estate developments. The Three Gorges Dam project alone displaced more than a million Chinese, many of whom complain of being inadequately compensated.

Even official Chinese government reports — which notoriously underplay such things — show that the number of demonstrations, riots and protests last year rose to 87,000, from 32,000 in 1999. That was 10 times the official tally of a decade ago.

Of course, the Communist Party remains firmly in control. After the Tiananmen Square riots of 1989, the government has been ruthless in crushing any challenge to its authority, whether from the Falun Gong religious movement or unhappy peasants in Quangdong Province. China's Ministry of Public Security is said to employ more than 30,000 people just to monitor the Internet and suppress the flow of potentially anti-regime ideas.

CHINA OPTIMISTS CLAIM that, in a decade or so, a burgeoning middle class inevitably will bring democratization and create a civil society. But Asian countries like South Korea and Taiwan made the leap from authoritarianism to multiparty democracy only after their per-capita income was two to three times higher than China's now is. And they didn't have to deal with a social and political legacy as brutish as the one left by Maoist China.

Even many China bulls worry that social unrest could threaten the party's grip over the nation, leading China to chaos. Observes Toronto's Loren Brandt: "In Chinese history, small, seemingly isolated, events often take on a life of their own, such as the demonstrations leading up to Tiananmen Square. One can never be sure about the tipping points, and that may be why press censorship has recently been tightened and the life of public intellectuals in China is so [figuratively] short."

Perhaps most ominous is China's runaway investment boom, built on soaring credit growth.

In the first half of this year, fixed investment grew by more than 30%, double the pace of nominal GDP expansion. And all of this occurred in an economy that in the past four years put more than 40% of GDP into infrastructure, high-rise apartment buildings, industrial parks, office parks, shopping malls and manufacturing equipment.

"No nation in Asia or elsewhere during its takeoff period even came close to this investment frenzy. China's in a territory that has never before been traversed," observes economist and Chinese banking expert Nick Lardy of the Institute of International Economics.

China is awash in liquidity. The Chinese are prodigious savers, socking away up to 25% of disposable income. Large trade surpluses with the U.S., some $60 billion a year in foreign direct investment in China and some hot money have brought Beijing's foreign-currency reserves to around $940 billion. Add to that the multiplier effect of China's central bank defending its undervalued currency by issuing yuan to sop up U.S. dollars. The excess liquidity is pouring into China's largely state-owned banking system, which intermediates about 75% of the nation's capital.

Under the best of circumstances, investment booms like China's often end badly because they induce over-capacity, followed by profit crunches, and ultimately widespread bankruptcies.

THE BULK OF the financial risks in China reside in its banking system. It remains shaky, despite meaningful efforts by Beijing to reform the system by injecting new capital, taking over some nonperforming loans and permitting foreign owners to buy minority shares in several major institutions. Still, the bulk of the loans are being made for policy reasons, rather than sound credit motives. Provincial and party cadre and their henchmen typically call the tune in their local areas, exploiting the decentralized structure of Chinese banking. Bribery, embezzlement and fraud remain staples.

The central bank is largely hamstrung in making changes in monetary policy to rein in credit growth. It recently boosted the level of reserves that banks must have. But it can't make more than largely symbolic boosts in lending rates for fear of killing the economic growth the country needs to foster employment; the jobless can be kindling for a social conflagration. Beijing's attempts to cool overinvestment in Shanghai real estate, the steel industry, motor vehicles and the like have been largely ignored by local officials.

No one really knows the size of the nonperforming- loan problem in China. Official estimates are around $200 billion. But in May, the accounting firm Ernst & Young reported that China had about $900 billion in bad loans. The total included borrowings on banks' books and at asset-management companies that the government had established to take over older bad loans. It also included loans that Ernst deemed likely to go bad soon.

The Many Faces of a Behemoth — C
lockwise, from top left: Goods-laden ships symbolize China's export clout. The surging economy has fueled car sales, worsening congestion. It's also led to a building boom. The economic gains come as China continues facing internal political tensions, like those leading to 1989's Tiananmen Square massacre. Also there are health dangers, like the ones posed by avian flu and SARS in recent years.

The Chinese government branded E&Y's findings "absurd and incomprehensible" — $900 billion would equal about 40% of China's GDP — and the firm withdrew the report a day after issuing it. Yet Ernst, by virtue of its position as auditor of China's largest bank, the state-owned Industrial and Commercial Bank, would hardly seem to be a naïf.

To be sure, China has plenty to show for its pedal-to-the-metal investment surge, including many first-class highways and port facilities, a sine qua non for a country in which exports constitute nearly 40% of GDP. Likewise, its industrial sector has become dramatically more productive, prodded by heavy investment and the competitive lash of foreign goods, imported or made by foreign joint-venture companies in China.

STILL, CHINA IS dogged by its chaotic past in industrial development. Its markets are fragmented, not permitting domestic companies to achieve the economies of scale to be true global competitors. According to the Carnegie Endowment's Pei, a government survey showed 23 provinces had their own washing-machine makers, 29 had independent television makers and 27 had independent auto makers. It will be a long time, if ever, before Chery Motors, Haier (appliances) and Lenovo (computers) reach the international pre-eminence of, say, Toyota.

Then, of course, there are the intellectual-property and copycat problems. Multinationals operating in China have found that piracy seems to be the primary core competence of many of their local competitors. Of course, Japan followed a similar course earlier in its development.

Finally, geopolitics could inhibit China's triumphant march to economic supremacy. Many China boosters make much of the nation's recent charm offensive against the outside world. Indeed, economist and China consultant David Hale of Chicago maintains that Beijing has no choice but to be a solid global citizen, because no other nation relies more on exports. He expects China to pass both the U.S. and Germany as the biggest exporters in three to four years.

Over the past 20 years or so, China has attracted more than $600 billion in direct foreign investment from around the globe. The presence of factories, real estate and other Chinese assets owned by companies based in Japan, Korea, Taiwan, the U.S. and other lands, some argue, is a big deterrent to any truly nasty actions against China — think import quotas or punitive tariffs here — by those nations.

A SIMILAR ARGUMENT often is made about U.S.-China relations. It says that because China, by buying Treasury securities, has become important in financing the U.S. current-account deficit, protectionist measures wouldn't fly here, regardless of which party controls the White House or Congress. That argument hinges on the proposition that nations always act rationally — a somewhat questionable proposition.

In fact, protectionist sentiment and economic nationalism do threaten China. Politicians in the U.S. and Europe continue to carp that China is taking advantage of its trading partners by refusing to push the value of its currency up to its proper level. The U.S.' $100 billion trade deficit with China is offered as Exhibit A of China's obstinacy.

Add to that the international scrum over access to crude oil and other commodities. In less than a decade, China has become the largest consumer of iron ore, copper, aluminum, nickel, lead and zinc. And it's fast closing in on the U.S. as the biggest user of oil.

True, China's appetites reflect its status as the most populous nation and as a huge global factory, annually churning out half of the world's photocopiers, TVs, cellphones, toys, DVD players, digital cameras and textiles.

But critics grouse that China is anything but an efficient user of commodities. It, for example, consumes three to four times the amount of energy as the U.S. to produce a dollar of GDP. And China's hunger for commodities has caused it to cozy up to what the West considers rogue nations like Iran, Sudan and Venezuela.

FRICTIONS MAY ONLY intensify if China's growing economic might makes it Asia's hegemon in the years ahead. John Mearsheimer, a political scientist at the University of Chicago, has asserted in Foreign Policy Magazine that an "intense confrontation" between the United States and China is "inevitable" in 20 years if China continues to grow at its current pace. (Similar predictions about Japan and the U.S. were made in the decades before the two nations went to war.)

Other foreign-policy experts brand Mearsheimer's contention ludicrous. "So John wants to consign several hundred million Chinese to improper diets and poverty because of his geopolitical view," grouses the Rand Corp.'s Overholt. "China, in fact, has been far nicer to its neighbors in recent years than either India or Japan."

Whatever the case, China remains a nation of contradictions — "Wal-Mart with an army," as British economist Robert Skidelsky so aptly described the country in a recent New York Review of Books article. It's a socialist state without a social safety net for much of its population. China saved Communism by embracing capitalism. It transmogrified Mao, the world's biggest mass murderer, into a profitable commercial brand whose visage appears benignly on tee-shirts, mugs and other souvenirs sold to tourists.

Yet Beijing remains capable of blatant thuggery in the name of maintaining peace and social order. Idealism and nationalism jostle daily with rapacity and naked self-aggrandizement, as do political stability and potentially explosive unrest. That's what makes China so unpredictable.

The Daily Reckoning