Big Trouble in Big China

I might as well get this out in the open.....

I'm afraid I'm not a believer in the following hypotheses:

• China will save the world from the current economic malaise


• China will take over the world and will surpass the USA by 20XX (insert your favoured year)

There are 4 key reasons for this:

1) Central Planning

China is a centrally planned economy. One thing I know for sure (having worked for the UK government) is that central planning doesn't work in the long run.

The bureaucrats are assessed on the basis of meeting centrally planned targets (which can be perfectly sensible) but what is not taken into account is that the bureaucrats game the system to meet the targets. I could go into a lot more detail on this but I hope you get the gist.

2) Export and Property Boom

Since the millennium, the Chinese economy has been driven by 2 things; an export boom and a property boom. Both are symbiotic and unsustainable.

The export boom relied on exporting 'stuff' to the developed economies (mainly the USA)

China has much lower labour costs than developed markets, but as the economy boomed, the State sought to keep Chinese costs low by holding the renminbi at an artificially low peg to the US dollar.

Which all seems fine - exported goods stay cheap and developed market consumers keep buying........but it assumes that consumers want to keep buying.

Unfortunately, the rise in developed world saving rates over the past year indicate that consumers want to save more, although consumption levels have been kept relatively high by the various stimulus packages and interest rate cuts in developed markets.

There is no longer a growth market for exports and it is unlikely to come back soon as developed market consumers have had a serious fright.

The property and construction boom had sensible origins as a fast growing economy needed housing and infrastructure. However as in the US and the UK it became vastly overheated, with speculation rife.

The Chinese economy has proved resilient to date because the state planners effectively ordered the state owned banks to dramatically loosen lending criteria. Being good bureaucrats they have done exactly that but have given little regard to quality of these loans.

The effect of this has been to reignite the property and infrastructure boom. This is isn't healthy because it needs a continued flow of new loans.

3) Universal Bullishness

Almost everyone I meet professionally is bullish on China (and emerging markets in general). This is always a bad sign. When I raise the above objections, I am usually bombarded with demographic and relative wealth statistics that 'prove' China must catch up.

In other words people have fallen in love with the long-term story without recognising that there is "many a slip betwixt cup and lip". The only aim of the Chinese elite is to ensure they remain in power.

I remember from 20 years ago, all sorts of stories about Japanese and German economic miracles and how Japan in particular was going to surpass the US. It didn't happen although it was a commonly held belief at the time.

4) The USA is the only military superpower

The US is the only global military superpower. There isn't an example in history of a military power voluntarily ceding economic power. I know the Chinese army is huge but modern wars aren't decided by who has the most troops.

You may not agree with me but consider this; a huge proportion of the Chinese 'wealth' is held in instruments denominated in US dollars. US dollars are not some naturally occurring scarce resource - the purchasing power of these dollars is under the monopoly control of the US government.

Huge reserves of someone else's paper currency is not the sort of wealth that allows the development of a rival superpower.

Stock Market

The Chinese stock market had a major bubble that peaked in 2007. If you look at the graph it looks reminiscent of the NASDAQ during the dotcom era. This implies a lot of bad decisions were made based on silly assumptions, that can't necessarily be unwound quickly.

Strangely, intelligent commentators don't often comment on the original Chinese bubble. They just focus on the strong rebound since last October (after an c80% drop).

I don't think it is possible to reflate a burst bubble. My reasoning is quite simply that too many participants have learnt from the recent bubble, which limits the upside.

The recent Chinese stock rally cannot continue indefinitely, it is built upon the shaky foundations of unlimited bank lending.

Those who like to comfort themselves that they are investing for the long-term are deluded. The US is still top dog and will not relinquish that status without a fight.

In the beginning.......

I'm a voracious reader of financial market blogs and I've decided to start publishing my own thoughts.

Of course, this may not be of interest to anyone but my intention is to hopefully generate some discussion that will either reinforce or challenge my thinking.

I've worked, covering equity markets, for about 11 years. I don't pretend to have seen it all but it has surprised me, that even in this short period I have seen history rhyme several times (to paraphrase Mark Twain).

In the last couple of years, I have come to realise how movements in all asset classes are interdependent. I thus attach a great deal of importance in attempting to understand the macro environment and the relative attractiveness of all asset classes. Currencies are particularly important.

The most important but most difficult part is to try to anticipate the next development.

I have come to conclude that to successfully participate in the financial markets, one has to accept that anything can happen - the laws of physics do not apply! If enough people believe something it will happen.

It is also important to remember that the most money in the world is managed by intermediaries and is chasing relative performance. Thus silly situations can persist.....