The True Chinese Economy

The yuan-dollar peg has gone a long way in ensuring constancy. Chinese economic growth – we would argue, all economic growth – ensues under the auspice of a stable currency. But ties to the greenback have recently come with a price.

A dozen or so gun-laden soldiers from China’s People’s Liberation Army (PLA) stood quietly among the customs agents at Lo Wu Station. The KCR East Rail, the commuter train that left Hong Kong at Tsim Sha Tsui 45 minutes prior, pulled in for its last stop. Shenzhen, once a remote Chinese fishing village nestled peacefully at the mouth of the infamous Pearl River Delta, towered in the distance.

My friends and I exited the train onto the long, cracked concrete platform. A drainage stream littered with rusty steel barrels trickled by. On the northern bank, a retaining wall backed by an even more daunting barbed wire fence served to support the numerous lookout posts dotting China’s most traversed southwestern border. This wasn’t the Rio Grande.

Lo Wu is called a "control point." I imagine the Chinese authorities used the Korean DMZ as a suitable inspiration.

Consequently, I saw no need to draw the army’s attention. My friends, Western journalists from Hong Kong, certainly weren’t the red-carpet type. So we hung back, letting the hundreds of Chinese scurry by.

The rush for customs ensued. The soldiers, dressed in their long pea-green military topcoats, suspiciously surveyed the masses. And the masses nudged to and fro, like cattle in a stockyard, hoping to find the most expedient line to re-enter the mainland.

My fire engine red North Face duffel bag drew some stares, but Western garb doesn’t fascinate as much in Shenzhen as it would in the more remote, rural regions of northern China. After all, I should thank some among the Chinese hustling all around me for stitching it together. That’s probably also true for just about every item of pure Americana attached to my privileged self. And if the Chinese didn’t construct the authentic item, they could easily point me to an alley where I could haggle the repro.

Shenzhen, Deng Xiaoping’s first attempt at capitalism, Chinese-style, received the elevated status of China’s first Special Economic Zone (SEZ) in 1980. Seemingly overnight, factories popped up along the hot, humid delta like a nasty, uncontrollable case of Southern kudzu. Naturally, more factories required more transportation. Shenzhen became the world’s fourth busiest port by 2005.

Within 20 years, market reforms turned a relatively remote city the size of Green Bay, Wis., into an industrial and financial powerhouse on par with Chicago.

Wal-Mart shelves and Christmas mornings in the West have been built on a 90-hour, six-day workweek in the East. The last 20 years of growth have produced more than 90,000 export-oriented processing firms on the mainland, with nearly 70,000 based in Shenzhen’s Guangdong province alone.

It’s no wonder Chinese officials fear what a slowdown in the export economy may bring. Domestic growth and stability have risen with Chinese workshops. And make no mistake, the first three long-term domestic priorities on Beijing’s list are and will remain stability, stability and more stability.

The yuan-dollar peg has gone a long way in ensuring constancy. Chinese economic growth – we would argue, all economic growth – ensues under the auspice of a stable currency.

But ties to the greenback have recently come with a price. American policymakers have facilitated a weak dollar. The Fed, for its part, announced another $200 billion injection on March 11. Its most recent funding equals the $200 billion Bernanke set free on March 7. For its part, the dollar didn’t know what to think ($400 billion in four days). Or else, it’s in a rather cruel denial.

For the first time since Word War II, owning U.S. Treasuries is a riskier bet than owning German bonds.

On the basis of credit default swaps, which are used to speculate on a government’s ability to repay debt, the 10-year note reached a record high of 16 basis points on March 12. German bonds traded at 15 basis points, also a record. A decline in these spreads shows improving confidence in the government’s ability to pay…an increase shows the opposite.

"That’s certainly eye-opening," writes our esteemed colleague Chris Mayer. "The market consensus is that you stand a greater chance of default investing in U.S. Treasuries than in German bonds."

Officials in Beijing must keep shaking their heads. China holds more than $387 billion in Treasury securities.

For China, a weak dollar makes critical imports (wheat, corn, iron and soy) more expensive. Expensive imports mean higher prices. Higher prices mean more inflation. More inflation means less stability.

Chinese Premier Wen Jiabao addressed the equal and opposite reaction on the other side of the planet.

"The primary task for macroeconomic regulation this year," he decreed, "is to prevent fast economic growth from becoming overheated growth and keep structural price increases from turning into significant inflation."

In his annual policy speech to China’s legislators, Wen clearly labeled rising commodity prices and the subsequent food shortages as China’s No. 1 policy issue for 2008.

So Beijing finds itself in a bind.

Going forward, yuan appreciation would certainly help alleviate rising prices (commodity imports would be cheaper). Export dependence, however, has thwarted this policy. On the other hand, protecting the export industry by enforcing a close yuan-dollar peg only intensifies further inflation as the dollar continues to slide.

In the meantime, Beijing has turned to price controls. But price controls are nothing more than a short-term stopgap. Price controls disincentivize ample production. Shortages ensue. Prices, therefore, rise even higher.

Beijing may have hope. China’s appetite for consumption keeps growing. We see signs that China’s GDP growth is no longer so export dependent.

According to The Economist, "The World Bank’s latest China Quarterly Update suggests that net exports contributed only 0.4 percentage points to GDP growth in the year in the fourth quarter of 2007. Overall GDP growth slowed only modestly (to 11.2%) because of faster growth in domestic demand, which contributed an impressive 10.8 percentage points."

These recent numbers suggest that the Chinese economy appears to be transitioning into a sustainable form of adolescence. Achieving a more proper balance between domestic production and consumption should enable Beijing to gradually allow more currency appreciation as a means of fighting inflation.

What that will mean for the American consumer remains to be seen. Political threats of more American protectionism combined with a rising yuan won’t do much to alleviate John. Q Public’s pain. If anything, he’ll have to spend more of something he already doesn’t have.

On the other hand, companies with assets denominated in Chinese yuan should see a boost. Companies earning profits from people with money to burn (the Chinese) shouldn’t do too badly, either.

And I’ve found a company that satisfies both conditions.

This company owns the franchise to manufacture, market and distribute the products of the Coca-Cola Co. And we’re not just talking 7-Elevens on Hong Kong Island. This company also distributes Coca-Cola products in Taiwan, as well as in 11 states in the U.S. and seven provinces in mainland China. This represents a total franchise population of over 420 million people, or, if you prefer, 6.4% of the world’s population.

And that’s just the tip of the iceberg.

At Free Market Investor, we’ve warned investors to be very cautious on stocks reliant on American consumers. We stressed shifting focus from companies that produce luxury items (such as Apple, Starbucks or P.F. Chang’s China Bistro) to companies that provide staples (such as Altria Group, Budweiser, Coca-Cola, Exxon or Johnson & Johnson).

Even if John Q. Public lost his house and credit card, he’d use that last $20 to buy what he needs. The list would read something like this: toilet paper, Diet Coke and a pack of smokes.

Every month brings us closer to this reality. In February, over 223,650 American homeowners filed for foreclosure. On top of that, unemployment insurance applications increased nearly 20-fold. Investingwise, that puts us back to the basics. Forget the MacBook Air and start thinking consumer staples.

For investors, companies that own or produce revenue streams from tangible assets (rental income), consumer staples (Coca-Cola) or natural resources (oil and natural gas) should prosper. Finding a single company – a conglomerate – capable of producing cash flow from all three seems even better.

That’s the beauty of many conglomerates. Conglomerates often operate within a diversified group of income-producing industries. Meaning revenues aren’t tied to any one particular division. Diversified income streams typically strengthen a company’s margin of safety.

Regards,

Christopher Hancock
for The Daily Reckoning
May 14, 2008

P.S. We doubt the world will stop consuming Coke. Investors holding Coca-Cola stock seem to agree. The company trades for 22 times earnings and 6.31 times book. And lest we forget, Berkshire Hathaway, Coca-Cola’s largest shareholder, holds a respectable $11.8 billion stake.

However, distributing Coca-Cola products to more than 420 million people is just one of the world-class businesses the Hong Kong conglomerate we are looking at engages in.

Christopher Hancock has spent the last two years doing investment research primarily focused on emerging markets, specifically China and Hong Kong. After working with Citigroup in Hong Kong on the challenges and opportunities associated with the forthcoming RBM flotation reform, Christopher left many of his friends behind and decided to return to the States to pursue a career in equity research.

Christopher’s desire to work for an independent firm led him to Agora Financial, where he now is the editor of Free Market Investor. Christopher travels extensively and utilizes his contacts across the globe to recommend the best international investments in the world right now for his subscribers.

Ben Bernanke, too, says the crisis is easing.

But he went on to say that the situation is still "far from normal."

What is far from normal, we wonder? The Dow went down 44 points yesterday, leaving stock prices about where they’ve been for the last 10 years…nothing abnormal about that.

Consumers are still spending money, too. And since they don’t really have any money to spend, they’re still borrowing. A report in yesterday’s news tells us that one in ten baby boomers has to borrow money just to pay everyday expenses.

But here’s something unusual: house prices went down in two-thirds of America’s cities, according to Bloomberg. In Cleveland, half of all subprime mortgages end in foreclosure.

Houses are America’s number one asset…and the cornerstone of most families’ financial plans. When they go down…so does the consumer economy. At least, that’s our working hypothesis. So far, houses are down about 13%. The economy is down too – but not dramatically. The latest GDP growth figure came in at 0.6%. With the population growing at 1%, that means the average person is getting poorer. So our hypothesis is working…marginally.

Nothing very exciting happened in the markets yesterday, so we will use today to spin out a broader version of contemporary economic history.

Let’s begin with another working hypothesis – give a man a license to counterfeit currency and he will stay up all night printing new bills. In effect, when the Nixon Administration cut the final link between gold and the dollar, in 1971, the feds could print all the counterfeit money they wanted. Normally, you’d expect the dollar to become worthless.

That is exactly what we expected in the ’70s. But then a few things happened that saved the dollar…and seemed to prove that our working hypothesis didn’t work anymore. Paul Volcker was brought in to protect the dollar. This he did – by driving up interest rates and bringing on the worst recession since the ’30s. But then, other things took over…the Reagan/Thatcher Revolutions…deregulation of industries…the rejection of central planning…the collapse of the Soviet Union…the Chinese renaissance…Wal-Mart…the Internet…just-in-time inventory systems…and globalization.

All of these things tended to increase productivity and lower prices. The biggest thing was probably in the labor market, where hundreds of millions of new workers came into the modern economy (who would slave away all day for less than a tenth the typical wage in America) and reduced the cost of labor and finished product.

We wondered how much ‘just-in-time’ inventory systems saved consumers. In the latest Grant’s Interest Rate Observer we find an estimate from Fred Smith, founder of Federal Express:

"In 1980, logistics costs – including the carrying costs of inventory, plus warehousing and transportation costs – were about 17% of GDP. Last year, they were about 10%."

"Fast cycle logistics," he says, reduced costs by nearly a trillion dollars a year.

But wait, there’s more…after Volcker cast out the devil of inflation, interest rates could come down. Thus, began a quarter century of falling interest rates and increasingly accessible credit. This eventually produced the absurd and pernicious consequences we describe here in The Daily Reckoning. Just as teenaged kissing leads to petting…which leads to…well, you know how it works, dear reader…success leads to complacency which leads to excess. But the long bull market in bonds (bonds go up when interest rates go down) also vastly increased the supply of capital available for new industries…and caused an explosion in output capacity.

Higher output at lower cost = deflation.

And let’s not forget oil. The basic ingredient in modern economies – petroleum – fell in real terms from the mid-’70s almost all the way to the war on Iraq.

Let us look, briefly at the oil market. When the United States invaded Iraq, we were told that $10 oil was right around the corner. Then, as the war went from triumph to tribulation…the oil price rose. Still, the war’s backers believed they had done good. Higher oil prices couldn’t last, they said. The National Review said oil was a "bubble" in ’04, when it was at $50 a barrel. Then, Steve Forbes said it was a "bubble" at $70 a barrel in ’05. Now…a Goldman expert says it will go to $200 a barrel.

Success leads to excess. Sooner or later oil really will be in a bubble…and sooner or later the bubble will pop. But when? At what price? China is doubling its use of the slick liquid every seven years. In the United States, there are 480 cars per 1,000 people. In China, there are only 10. And China could be the world’s largest automaker in just a matter of months. Our advice to Americans: fill up your tanks.

In the meantime, we return to our short version of U.S. contemporary economic history:

With prices stable or actually falling, over the last 20 years, central bankers felt they could ‘stimulate’ the economy whenever it needed a little more pep. The most memorable example, of course, followed the micro-slump of 2001-2002, when the Greenspan Fed dropped rates down to 1% and held them there for over a year. But the printing presses ran hot for many, many years. Over practically the entire period, from the late ’80s to ’08, the U.S. money supply increased at an average annual rate of about 8% – or about twice as fast as GDP growth.

And now, we are in a period which many take for normal. Our financial Vesuvius has rumbled several times in the last quarter century – the crash of ’87, recession of ’93, the Asian crisis and collapse of LongTerm Capital Management in ’97 & ’98, dotcom crash, and bear market of ’00-’02, recession of ’01-’02, and finally the credit crunch of ’07-’08.

Once again, the ground is shaking beneath our feet. And once again, people are wondering if they should head for shelter. ‘Don’t worry about it,’ say the pundits. ‘It will pass…just as it always does. This is just normal…"

If our hypothesis still works…inflation will blow its top soon.

*** Gold retreated $15 yesterday. Oil bounced back to $125. And in April, food prices rose 0.9% – the most since 1990.

Yesterday, we mentioned that clothing prices were on the rise. Today, the Wall Street Journal says shoes are taking a hike upwards.

Here in London, inflation is at its highest level in six years. In China, 8% consumer price inflation is spooking the financial authorities. And import prices in the United States jumped 1.8% in April.

Why would imports be going up so fast?

Ah…glad you asked. Because that is what is really not "normal" about the latest tremors. For 20 years, inflation has been held in check by the group of happy events we described above. But what will hold it back for the next 20 years?

China used to export deflation, as the economists put it. Now, with prices rising in the Middle Kingdom, it has no choice – it must export inflation. With inventories at 30-year lows – there are no price cuts coming from there either. Wages are rising. Raw material prices are soaring. Food is out of control.

But wait, there’s more…

Remember the great credit expansion of the last quarter century? For 25 years, the cost of money got cheaper and cheaper and cheaper…to the point where the Fed was lending money at negative real rates (and still is!) In 1982, the yield on a 10-year Treasury note was nearly 16%. Today, it is under 4%.

But now, money is becoming more expensive. If the credit cycle has turned, as we think it has, lending rates will go up with inflation. And the cost of money…along with the cost of other essential components…will drive up prices for nearly everything.

What will the U.S. consumer do? He has little prospect of higher wages – not with so many billions of people willing to work for less. His main asset is falling in price. Credit is getting tighter. And his cost of living is going up – maybe sharply up.

This time he won’t be able to borrow his way out. This time, more credit…lower rates…and more inflation won’t help him. This time, inflation will hurt him.

Until tomorrow,

Bill Bonner
The Daily Reckoning