Saturday, June 20, 2009

Chinese Green Shoots Also An Illusion

One of the favourite targets of pollyanish green shootery has been China. I suppose this stems from the ancient ancestor of green shoots: the asian decoupling theory. Naturally, this theory was rooted in ignorance of the primary source for emerging market strength, which was, of course, easy and abundant credit in the west. Now that the latter matter has all but disappeared, taking the former with it in 2008, this same lot appear to be doubling down on their losing bets, hoping for a turbo-charged Chinese-led recovery.

If only it were so easy.

Putting aside mindless platitudes like, "every one of those 3 Billion Asians wants to drive a car like us," the growth engine of China specifically (but all of asia generally) has been on exporting cheap crap to the US. So while consumer credit dries up (and for the first time in decades is actually paid back[!]), unemployment continues its seeming ascent to infinity and balance sheets are otherwise squeezed like a sunday morning orange, it should be no surprise that the first expenses done away with are those which the preceding credit boom allowed them to feast on. Believe it or not, while it is every man's dream to be able to wear a new pair of socks every day, the loss of one's job is typically enough to encourage the odd "laundry day" every now and then. So I'm sorry, Jiao. Your services will no longer be needed.

I typically make it a point not to rely on government statistics (and communist government statistics in particular) to support or refute analysis that can be better done with common sense. Recent data, however, has proven to be both troubling and confusing, oftentimes directly contradicting itself. And it is in such overt contradictions that one can plainly see the Chinese government's paranoia with the current economic situation, rather than the calm confidence they attempt to project.

The best such contradiction is seen in the gap of electrical output and industrial production. Now, I put very little weight on the validity of either of these numbers as an indicator of general economic activity per se, but the fact that the two series tracked each other very closely throughout the boom phase, then miraculously began to diverge while the rest of the world was itself undergoing turmoil would be supportive of the hypothesis that the Chinese economy is not immune to the law of gravity. And then there's always the icing on the cake: China has now discontinued publication of electrical output statistics. Merely a coincidence, I'm sure.

Andy Xie writing for Cajing has an important take on another issue: China's rising demand for raw materials. Without further elucidation, I invite you to read it in its entirety:

China's credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.

Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China's economy by driving asset prices higher.

The current surge in commodity prices, for example, is being fueled by China's demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn't cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

Commodity prices have skyrocketed since March....The weak global economy can't support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying.

Exchange-traded funds (ETFs) alone account for half of the activity on the oil futures market. ETFs allow retail investors to act like hedge funds. This product has serious implications for monetary policymaking. One consequence is that inflation fears could lead to inflation through massive deployment of money into inflation-hedging assets such as commodities.

Financial demand alone can't support commodity prices. Financial investors can't take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time.

Early this year, the six-month futures price for oil was US$ 20 higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn't work.

For some commodities, warehousing costs are low, limiting net losses for financial buyers. Some commodities can be used just like stocks, bonds and other financial products. Precious metals, for example, are like that. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging China's size. They've made everything open to speculation.

There's little doubt that China's bank lending since last December has driven speculative inventory demand for commodities. Chinese banks lend for commodity purchases, allowing the underlying commodities to be used as collateral. These loans are structured like mortgages.

Banks usually have to be extremely cautious about such lending, as commodity prices fluctuate far more than property prices. But Chinese banks are relatively lenient....

The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China's recovering economy. Indeed, the international financial market is portraying China's perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China's imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term....

The iron ore market has been brutal for China, partly due to China's own inefficient system. China imports more ore than Europe and Japan combined. Skyrocketing prices have cost China dearly.

For four decades before 2003, fine iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was plentiful, prices were driven by production costs. After 2003, Chinese demand drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per ton, and the spot price reached nearly US$ 200 a ton in 2008.....

China's local governments have been obsessed with promoting steel industry growth....But the spot market is relatively small, and mines can easily manipulate spot prices by reducing supply. On the other hand, numerous Chinese steel mills simultaneously want to buy ore to sustain production so their governments can report higher GDP rates, even if higher GDP is money-losing. China's steel industry is structured to hurt China's best interests.

As steel demand collapsed in the fourth quarter 2008 and first quarter 2009, steel prices fell sharply. That should have led to a collapse in ore demand. But the bank lending surge armed Chinese ore distributors, giving them money for speculating and stocking up....

What is happening in the commodity market is glaring proof that China's lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business...

As the economy weakened in late 2008, private lenders began demanding money back from distressed private companies. Loans from state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel bank lending into cash for individuals and businesses that were in the lending business. This money may have flowed into asset markets. It is part of the phenomenon of the private sector withdrawing from the real economy into the virtual one.

It's worrisome that businessmen have become de facto fund managers and speculators. This happened 10 years ago in Hong Kong, and since then the city's economy has stagnated. Some may argue that China has SOEs to lead the economy. However, private companies account for most employment in China, even though SOEs account for a larger portion of GDP. Now, the government is spending huge amounts of money to provide temporary employment for 2009 college graduates. If private sector employment doesn't grow, the government may have to spend even more next year. The government is using fiscal stimulus and bank lending to support economic recovery. But the recovery may be a jobless one. China needs a dynamic private sector to resolve the employment problem.

We are seeing a dark side to the lending surge as commodity speculation hurts the economy. More lending may lead to higher commodity prices, threatening stagflation. Cheap loans benefit overseas commodity suppliers, not necessarily the Chinese economy. Lending policy should consider this self-inflicted damage.

Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don't expand.

This lending surge proves China's economic problems can't be resolved with liquidity. China's growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China's exports have collapsed, there will be no income growth to support investment growth. The government's current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.

If exports remain weak for several years, China's only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.

Putting money into speculative investments isn't totally irrational. It's better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That's an illusion. The lending surge may have created more problems than it resolved.

Why do I have a feeling that Andy Xie's analysis will also soon be discontinued by the Chinese Government?

I have another theory of what China is planning to do with their stash of industrial commodities. And it would have more to do with an observation of Richard Koo, who offers that the most effective use of capital to combat economic stagnation is through military expenditures. I don't necessarily agree - expending resources solely for the purpose of destroying capital does not provide the grounds for economic health - but I don't often agree with Chinese policy.

My hypothesis remains as offered in late 2007:

The Chinese stock market continues to defy gravity but is another one of those things that can’t go on forever. The same can be said about the Korean Kospi, Brazilian Bovespa, Indian Sensex and other emerging stock markets. A consumer slowdown in the US and rising input costs means these economies will need to re-tool their manufacturing base to maintain the same levels of profit growth. A synonym for re-tooling the economy is ‘recession’, and emerging markets aren’t any more immune to the business cycle than we are. This doesn’t mean they go back to living in mud huts. It means capital is redeployed to more efficient uses. This sudden realization of mortality will mean big declines at some point. I think that day will come in 2008.

As in the US and around the world, the early part of this re-tooling has been met with stern opposition from the government. This postpones it rather than prevents it. And China's phony economy is no more legitimate than the US's phony economy. As Andy Xie points out, attempts to make it "more phony" in order to mask this transition is going to make the process more difficult, not less. And so China teeters on the brink of collapse. Whether this collapse is acknowledged by the government spin-doctors in Beijing is irrelevant to me.

The law of gravity has not been repealed. Not in Vancouver. Not in New York. Not in China.

Disclosure: Long Parachutes

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Anonymous said...

How does this weigh in on the inflation/deflation debate?

Would it be possible that the U.S. experiences monetary contraction, while other countries are subjected to heavy inflationary pressures?

Matt Stiles said...

Anonymous - Please see my recent post "No way out"

In my opinion, it depends on how significant foreign denominated loans were/are in China.

Occdude said...

Matt as usual some key observations and also some notable ommissions.

First, I agree with your assessment that the Chinese are bound to experience a recession and in fact the Chinese are currently trying to "ease" monetary policy which confirms the fact that they're experiencing deflationary forces, probably well in excess of what we know. This is solely due to their manufacturing capacity which is geared towards unproductive trade with us, much as the Japanese made the same mistake of mistaking money for economic growth. The Chinese though, aren't keen to repeat the mistakes the Japanese made (in fact the Japanese aren't keen on repeating the mistakes of the Japanese) so, they need to have very tough recession as they re-tool for profitable external and internal trade. The difference though between us and them is that they have a significant productive capacity which merely needs to be reconfigured to accomplish that goal. They also have the SAVINGS to do it as opposed to us who have neither the savings NOR the industrial capacity.

Thats why decoupling is not a myth, it's a LONG TERM outcome with short term manifestions of global recession as the transition takes place. Dont bet on a resurgence of American power unless we figuratively die and are reborn.

Finally, this isn't going to take a long time to accomplish. You basically need a substitute for the dollar as the first action and everything that flows from that will set the groundwork for the next recovery. Industrial capacity has flexibility and can be converted much the same way we did pre world war 2 and post world war 2 (from civilian to military and vice versa). Human capital is extremely flexible and is not even worth mentioning. Commodities are less flexible and need to be sensibly allocated, if they continue on their current course of unprofitable trade with us, then it will dig a much deeper ditch for them. Keep the dollar front and center, as we engage in unlimited stimulus our trading partners are going to have an "uncle point" and that will be kaput for the buck. Actions now are building for that scenario with the bond market shooting a salvo across our bow, meetings (that Americans are banned from) with BRIICK nations that are pondering the dollar paradox, but I assure you, they will not let this go on forever, they will drop the buck and take the pill sooner than you think.

Occdude said...


I'm working on a thesis that has the Hong Kong dollar as suitable store of value. One, it's kept undervalued. Secondly, it has a dollar peg so it hedges deflation. And finally it hedges a currency crisis.

I see very little downside with the Chinese currencies, namely the Hong Kong dollar. In fact when I did a comparitive analysis of an ETF that tracks the Yuan, it was EXTREMELY stable during the deflationary period we had. I compared it to the gold, oil and dollar bullish etfs and it seemed like the only one that maintained stability.

Look forward to what you think, Cheers.

mannfm11 said...

China is cooked. The whole thing is voodoo from the start. It really doesn't occur to people that they can't create their own credit to trade around the world. It is why the BRIC's are trying to create some kind of paper game between them, but whose paper do you want? Anyone really believe India, China, Russia, Indonesia or Brazil is going to recreate the IMF and the world currency market?

China rides because there is a world banking system telling the world it isn't so. I believe it was reported that something along the lines of 45% of the Chinese economy was geared to export production and that side of the equation is down something like 30%. In the US, the cry is to get back consumer demand. How does consumer demand help the US economy? It doesn't. But, the entire financial stack of bricks is contingent on the Chinese economy going on. This isn't so much the US spending more money than they can send China as it is keeping the entire system that created China in the first place going.

All this speculation, all this hoarding of commodities has to have an exit strategy. I recall the S&L mess here in the mid 1980's. They ran the price of land to the moon. The only thing they could do was build on the land because the bigger fool couldn't buy them out because they were the bigger fool. The result was a collapse in the housing market due to an intentional oversupply in an attempt to solve the problem of price they created. The same happened in the commercial market and though DFW has been the fastest growing large market in the US, some of these projects never got near what they were built to be. The Downtown office space has to this day never been occupied.

The next game in China will be to make something out of this stuff, which will only swell the mess created. At some point the facilities to store stuff will spill over and the buying will have to stop. The Chinese government could order more lending, but at some point this would reverse the trade game against them. Remember the world runs on dollars, not Yuan and though the reserves seem big, I find it highly doubtful that the Chinese reserves would even liquidate the capital that is sure to take flight.

There are more green shoots, stuff like continued 600K claims for unemployment being cheered as good news because they aren't 674K they were at the peak. You might check to find out that we didn't have a week of unemployment claims in excess of 600K in 2008. The best of 2009 is still worse than the worst of 2008.

I believe the biggest crime is the fact that messes like these are caused by credit and the fractional reserve system and they are trying a fractional reserve solution. What is not being recognized is that all this socalled printing is nothing more than a creation of more liabilities. More liabilities in a system that already can't service the liabilities it has are not going to solve the problem, but keep the problem in front of us. The fact that oil is $70 a barrel in light of stockpiles around the world overflowing is not a good sign. The suppliers will keep on supplying. You might remember that we had plenty of oil at $20 to $25 a barrel for a long time and the story that it costs more than that is just that, a story. Long term we aren't going to sustain the demand that created $70 oil and we won't need the supply necessitated by such demand so the price will be lower on the margin.

The worst economy in the world is very likely going to be in East and South Asia. Stephen Roach and Mortimer Zuckerman were on CNBC this week and neither of them were buying the idea that China was going to raise the level of the world. These are 2 pretty smart guys and their reasoning was sound. I have never bought this idea.

mannfm11 said...

Occdude, I guess the demand credit can be collateralized and produced in Hong Kong? There is a lot more to trade than putting ink on paper. The productive capacity of the US would stun you if you ever went somewhere besides Wal-mart.

occdude said...


China has 1 billion souls, so demand is no problem, they could consume 1/3 per capita of what we consume and still make have room for growth. As far as credit, they have an astromical savings rate, so who needs credit? If they stop lending us money and use that money for their own consumption then they have it licked. And if we produce so much how come we have a STUNNING trade deficit with the rest of the world?

It's absurd to think that a section of the world that has a high investment of capital even if currently mal-utilized and a population that is intelligent, frugal and relatively politically stable is going to be the worst area in the world economically.

No, they've done their time. They understand what we've forgotten, that things are not a matter of opinion and it's better to have money than to not. While we're worried about raising the living standards of polar bears, they're trying to raise the standard of living for their people.

Lets be honest, fractional reserve banking, dollar hedgemony and inflation has made the West exceedingly flabby and vulnerable to a "lean and mean" challenge from the Far East.

Matt Stiles said...

Don't think China will rule the world in my lifetime. But I do think they will increase their standard of living over time - as will the entire world as we make productivity advancements.

Part of my beef against China is ideological. They're communists. While they were astute enough to ride the coattails of the US spending binge, I can't help but think that their paranoid government will eventually do something colossally stupid. I do realize that in many senses they are more capitalistic than the US now, but one good geopolitical or economic shock could change all that, causing 'flight of capital.' Their leader was on TV the other day rambling on about the 10th 5 year plan or something. Eventually they'll screw up. Just like the soviets. Socialism is an impossibility.

Combined the BRICs make up for a whole 11% of world GDP (I think I have that right). While that is sure to rise, it takes a hell of a lot more to have a positive effect on the overall world economy - and as mentioned they're not immune to our ills by any stretch. They'll emerge in better shape, but their crisis will feel just as bad as ours.

From an investment standpoint, I prefer South America. Far more politically stable (the big economies) and they are in a Generational Awakening Era.

Matt Stiles said...

I couldn't make it through this whole thing, but there seems to be some pretty good points scattered throughout.

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