Financial Madness

There are two ways to think about China: you can take the optimistic standpoint, and view it as a rapidly growing country filled with opportunity…or you can see it as a ticking time-bomb, just waiting to destroy itself. Justice Litle explores both avenues of thought…

China presents two stories at once. In the long run, the dragon’s rise seems inexorable. It’s hard to imagine anything that could thwart it. In the short run, however, China must deal with dangerous internal weakness, namely a rotten banking system, poor internal controls and a dangerous torrent of "hot money" – speculative capital in pursuit of aggressive returns – that threatens to boil over the economy and unleash massive instability down the road when it withdraws, similar to the Asian currency crisis of the late ’90s.

A divergence of opinion is slowly building as to whether China will make the full transition to free-market capitalism with its current political system intact. Naysayers believe that a top-down, statist approach to governance will never mix with free markets and that the conflicts inherent in China’s uneasy arrangement will eventually tear the leadership apart…or bring about a violent end to free-market reforms…or both at the same time.

In contrast, optimists point to thriving countries like Singapore, where capitalism has flourished under the benign authoritarianism of Lee Kuan Yew and his protégées. (By the way, it’s technically not illegal to chew gum in Singapore; you simply can’t import or sell it legally.) They point out that an arrangement that appears statist and authoritarian is actually more democratic than it looks, because the people willingly endorse the arrangement. The tradeoff is stability for prosperity, and as long as prosperity is delivered, stability in the form of quasi-democracy will be accepted. The optimists see China’s authoritarianism slipping away gradually – just as China’s communism has transitioned from policy to rhetoric – and they see no reason why the transition cannot be carried further without a major dislocation.

Capitalism in China: Financial Mutually Assured Destruction

Only hindsight will prove who is correct, but the stakes are high because of the global turmoil that would follow any political uprising. As of year-end 2004, China had more than $600 billion in U.S. dollar reserves. That is a sum that could effectively tear the financial plumbing system apart, if it were unceremoniously dumped on the markets with such massive pressure in a compressed period of time the pipes would surely burst. Of course, this would be fiscal suicide for the dumpers as well, which is precisely why such a move is not feared. China’s own economy would be sucked into the vortex too, so why would the Chinese put a gun to their own heads?

The theme that applies here is the doctrine of mutually assured destruction, or MAD – but of the financial sort, rather than the nuclear.

A product of the 1950s, the doctrine of MAD essentially states that two parties with the capacity to destroy each other will recognize the folly of hostilities. We liquidate the Soviet Union, they liquidate us and nobody wins. So peace is assured, right? Wrong. The flaw in the theory comes in the form of a question: What happens if one side or the other is thrown into political turmoil, or if the reins are taken over by madmen with nothing to lose?

A Communist Party leadership on the edge of collapse would make a last-ditch bid for stability by any means necessary, which in turn would make it willing to contemplate the financial-Armageddon option, as a form of extreme blackmail, if its hand were forced. If the mandarins feared implosion, they would have the means to not just ask for extraordinary coordination from the United States and Japan, but to demand it… on pain of catastrophic consequences if they were allowed to fall.

But is this a point in favor of the optimists or the pessimists? Obviously, it’s not a pleasant thought to imagine a breakdown in China’s economy sparking massive civil unrest, in turn leading to a "hot war" with Taiwan as a means of distraction and a catalyst for unifying nationalism, which by extension draws in the United States and sets the stage for the grand finale: the financial equivalent of a hydrogen bomb going off as hostilities escalate out of control.

Capitalism in China: The Silver Lining

As a silver lining to this dark cloud, we have a built-in bias for stability on the part of global leaders such as Japan and the United States.

As MAD wisdom dictates, everyone loses if the mandarins lose, and thus everyone has strong incentive to ensure things go smoothly. In this sense, financial MADness works in favor of China’s current political system, rather than against it. As fans of functional plumbing in the global financial system, you and I have a vested interest in the mandarins’ success.

If you’re shaken by the doom-and-gloom analysis, take heart: There’s no point in living in fear, and nowhere to go that can make fear profitable. Bonds are hardly safe in the teeth of rising interest rates, and we’ve seen how quickly cash can depreciate in an inflationary environment. A neutral currency with a physical store of value, gold is the bulwark against any meltdown of the financial system.

As investors in natural resources, we have to incorporate certain principles into our long-term assumptions. One of those assumptions is that the China growth story has a long way to go. China is far from the only market, of course; as the lead exporter and financial counterweight to the United States, it simply demands outsized attention as a key player and bellwether. We can fully expect the storm and gird up for it – but we must also have conviction that the storm will blow over in time and that the natural resource market is still in its early days.

Don’t expect global growth (and thus global demand) to progress in a straight line. There will be setbacks and corrections along the way as China, Asia as a whole and emerging markets in general step back from their trajectories to consolidate and retrench. With this in mind, we want to bring the same attitude to our core positions that China brings to its strategic maneuvers for ensuring energy supply: conviction grounded in a long-term perspective.

Capitalism in China: Farsighted on Energy

China’s leadership is particularly farsighted when it comes to energy. With the challenges that will face it in coming decades, it will have to be. China’s population of cars and trucks on the road is estimated to balloon from 20 million now to 120 million by that time.

Given these monster trends, it only makes sense that China is spending billions on alternative-energy investments. Whether oil maintains recent peak prices or comes off in a temporary demand slowdown, the case for alternatives as part of our core position is rock solid.

As it is China’s destiny to grow, it is also its destiny to import massive amounts of oil. It simply does not have enough petroleum reserves available to meet internal demand, and it never will. So China is turning to coal on a large scale… but not without a price. At the moment, coal meets about two-thirds of China’s energy needs. It is also causing significant pollution and logistics problems: coal is dirty, inefficient and costly to transport, which is why they are turning to coal-liquefaction plants.

Coal is a solid organic material made up of large, complex molecules containing mostly carbon, plus small amounts of hydrogen, sulfur, nitrogen and oxygen. Raw coal also contains moisture and solid particles of mineral matter (ash). The aim of direct coal liquefaction is to break coal down into smaller component molecules, then to add hydrogen, creating lighter and more stable oil molecules. The process simultaneously removes sulfur, nitrogen and ash, resulting in a clean liquid-fuel product.

The advantages of a "clean coal" product are numerous. For one, less dependence on imported oil. While it’s estimated that oil will need to remain above the $35-per-barrel range in the long term for this technology to be cost effective, that projection is hardly a stretch. Given conservative projections, permanent shifts in the structure of demand and gradual depletion of proven reserves, $35 is clearly a solid floor for oil, barring a deep global recession or depression.

Transforming coal from bulk to liquid will also improve the logistics of delivery. Rather than clogging the nation’s transportation routes with railroad cars and flatbed trucks loaded down with bulky coal deposits, as China is forced to do now, direct transmission pipelines can be built. Less stress on the transport system, fewer logistical hurdles to overcome and smoother distribution over time will all contribute significantly to a much-needed efficiency boost, lowering China’s capital-intensive cost of growth.

Last but not least, clean coal in liquid form will be easier on China’s ravaged environment. Eight out of the top 10 most polluted cities in the world are in China. As the dragon grapples with severe water shortages, acid rain, toxic rivers and throat-burning smog – and all this with 20 million cars on the road, rather than the 120 million to come – environmentally friendly technologies will become paramount.

Regards,

Justice Litle
for The Daily Reckoning

May 12, 2005

Liquid coal has huge appeal outside China, too. Over the last 12 months, energy companies in the United States announced plans to build over $100 billion worth of new coal-fired power plants. And U.S. coal production is about to hit a record 1.2 billion tons…with Peabody Energy Corp., America’s biggest coal producer, promising to double its production by 2010.

Liquid coal will play a huge role in the future of China, the United States and India. And you could make a fortune on the right investments.

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)

We have been thinking big thoughts. We have tried to think little ones…but they have a habit of getting together when we turn our back. Then, they are big again.

The U.S. trade deficit narrowed in March. Economists applauded the news yesterday. They said the lower dollar was finally doing its work – the imbalance was being corrected. But a lower dollar is supposed to correct the trade imbalance by boosting exports…not by reducing consumer spending on imports. No export increase was spotted.

But then we notice another little item from yesterday – consumer spending in April fell. Consumers are having a hard time keeping up with rising expenses; that’s the real reason the trade deficit shrank.

This item, too, glommed on to Monday’s shocker – that wages took their biggest drop in 13 years. All of a sudden, little thoughts were big ones. They were all connected into one repulsive blob: We are getting poorer. Americans earn less, so they spend less, the boom in consumer spending is ending…a bust must be coming.

In today’s press comes another little bit of news. The Bank of England will have to cut rates soon in order to fight a slowdown. Retail sales are down. Factory output is down. And even house prices are going down.

We watched as this cluster of facts swirled around our U.S. group, like Jupiter’s’ moons. Now, we had an even bigger thought: the whole Anglo-Saxon world is in trouble. It is showing up in England first; it will arrive in America on the next boat.

On the cover of one of this week’s newsmagazines is a story about China. It is the world’s second super-power, the piece tells us. We don’t doubt it. But now our little system of connected thoughts has turned into a galaxy. We look all the way back to the 18th century…when Britain and America stole a march on the entire world. While the Chinese were still tilling their fields with wooden hoes, the Anglo-Saxons were building mechanized looms…and steam engines…and then railroads…and skyscrapers…and airlines. They worked like mad…saved their money…and built up a base of capital that sent them racing far ahead their potential rivals. The Chinese…the Indians…there were vast groups of the world’s population that had plenty of manpower. What they lacked was capital, know-how and a market culture that rewarded risk taking and innovation.

The British pushed their advantage around the world. By the end of the 19th century, a quarter of the map was pink – indicating the British Empire. But then came a "fat tail" event – WWI. And Wilson began talking about democracy and independence. And then the colonies wanted their independence…and the empire was soon too expensive…and too difficult to hold onto. And so America stepped in…with a new kind of empire…a soft empire of good intentions and bad economics. Now it is America that bears the costs and comedy of empire.

Under cover of the new Pax Dollarum, the whole world began to industrialize. The Chinese found they could build factories, too…better ones. Newer ones. Cheaper ones. They could save too. And work hard. And soon the whole world economy was globalized. In the new division of labor, the Anglo-Saxons borrowed and spent, fixing up their houses and selling them back and forth to each other…and the Asians saved their money and invested it in factories. And now, Alan Greenspan can no longer control his own economy. He can lower interest rates in the United States…and the Bank of England can cut them in the United Kingdom…but the results are no longer what they hoped for. Cheaper money consumers to spend money, but the stimulus ends up benefiting producers in China, not consumers at home. The more Americans consume, the poorer they become…and the more the factories of Asia reduce their unit costs and expand still encourages their market share.

With less money to spend, the consumer economy can no longer keep up pretenses. Greenspan is trapped. He needs to "normalize" rates to encourage saving and investing, otherwise the economy cannot really grow in the future. But he needs to lower them too; otherwise the economy might collapse now.

Eventually, the jig will be up. Old empires of the Anglo-Saxon world – England and America – will pass away, like empires always do. They will realize that they cannot continue living in the past…or at the standard to which they have become accustomed. This should not bother you, dear reader. Americans will still find jobs…perhaps as tour guides to groups of Chinese taking in the sights in North America.

But it’s the fat tails you have to watch out for. Empires do not always die gracefully.

"You have two choices," Genghis Khan said at the gates of Samarkand. "You can submit to me…[I will only take your wealth and sleep with your wives and daughters]…or I will kill you all."

More news, from our team at The Rude Awakening:

————–

Eric Fry, reporting from Manhattan…

"When GM bonds skidded last week, a few hedge fund managers ended up with tire tracks across their backs…and some nasty injuries…"

————–

Bill Bonner, with more notes about various things:

*** A rumor flew around Wall Street yesterday. "Some big hedge funds are in trouble. They didn’t expect the way GM and Ford bonds are being written down. There are some huge derivative positions that are coming unhinged."

We did not know what to make of it. How could anyone be dumb enough to be surprised by the automakers’ bonds? Everyone knew it was coming.

But when everyone knows something, no one knows anything at all. And when traders, investors, speculators, and average Joes all know the same thing – especially when it isn’t true – it has a way of "blowing up."

Colleague Dan Denning handed us a little passage from a book entitled "Liquidity Black Holes:"

"Episodes of high volatility reflect not a market adjustment to a more stable position, but a market disruption: where price changes no longer help to clear a market, but help to destabilize it…where they [markets] break down." (For more on this, see our site.)

Fait tails happen, dear reader.

*** And it’s not only the automakers that have gotten themselves into major trouble…

Late Tuesday, a bankruptcy judge in Chicago approved the transfer of $6.6 billion of United’s pension obligations to the government’s Pension Benefit Guaranty.

Delta Airlines isn’t looking any better, with $3.15 billion that they have to pay into its employee retirement plans over the next three years – and that’s in addition to the $450 million it will pay this year.

Karim Rahemtulla predicted these pension pains almost two years ago:

"In the eighties, the U.S. teetered on the verge of exporting the majority of its manufacturing to third-world countries. Other countries quickly caught up: in the nineties, the Japanese could crank out a car in half the time of American companies, and the Chinese were finally getting the hang of capitalism.

"Back home, things changed, too – for the worse. The giant corporate handouts in the form of lucrative retirement pensions persisted for many of the largest industrial companies. But the money stopped flowing in at the same rate and with the same margins.

"The result? Deficits in the pension plans."

The Daily Reckoning