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.
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