I have been doing lots of research for this blog on China because most people’s idea on China I had found to be just too simplistic and comfortable.  From those who hoped China would be the saviour of the West to those who saw China’s growth story as having played itself out and was now a big sell.  I decided it was crazy to form bold and fixed ideas about China when it was a country so large in size and population that unlike NZ (every 1422^nd person is a Kiwi) it contained nearly one quarter of the global population.

Furthermore, when a country as large as China takes its economy from a GDP of $US342 Billion to $US4.4 Trillion in as little as 20 years, at an average growth rate of 13.6%, maintaining a savings rate of better than 35%, then they are obviously doing something quite different to the West.

Clearly when China wants to make a move their political control is so concentrated they are able to move rapidly and without public debate. If central government decides to do something, they just do it, and largely without argument.  So they are not only very large and increasingly powerful they are also very manoeuvrable.  This makes them very unique and not easy to comprehend from a Westerner’s perspective.  We are so used to commerce being dominated by large public companies that understanding a country that has close to 50% of the productive economy as State-Owned-Enterprises is not that easy, particularly when public reporting is not an obligation.

So I wrote to a financial writer I have come to know, based in Hong Kong, and asked her opinion.  She is fluent in both Mandarin and Japanese, has a considerable reputation in both countries, and whilst she was too busy to answer my questions herself gave me the blog-sites of some Westerners writing about China with some insight.

Accordingly I have spent the past 3 weeks emerged in reading about China, and have had my eyes opened quite significantly.  As I had thought China is so large and complex that quick opinions account for very little, nevertheless I found out some very interesting facts on my way to writing this.

I had already understood that China had spent nearly $US700 Billion of stimulus money and increased bank credit by over $US1.4 Trillion from late 2008 through 2009, but it was interesting to find where that went.  The most surprising was the realisation that China has sacrificed its SME’s much the same way as the West by focusing its stimulus funds on the large SOE’s.

So in a sense they too have managed to establish a large sclerotic group of companies who have been identified as ‘too big to fail’, and are therefore not subject to market efficiencies.  (This means that during 2008 20% SME’s failed and a further 20% went near to failure – these latter firms have clawed back but remain vulnerable to a further shock.)

This is precisely as flawed as the Western model where the paradox is just as evident – saving jobs now by preventing large companies failing has had the unintended consequence of starving the job-creating sector of credit, and therefore their means for creating new jobs in the future. The numbers are near to the West with small business creating 80% of the jobs in 2008, along with 60% of the GDP, and paying 50% of tax revenues. “Less than 20% of small businesses have access to bank loans – this is unreasonable given their contribution to the economy and their pressing need for funding” – Yin Zhongqing, deputy director, Financial/Economic Affairs Committee NPC.

The fact that over $US 1 Trillion of additional credit has ended up in the property sector and stock market is clearly a problem, and in some areas it is clear that factories have been built that will not be used, etc. Anecdotal evidence I read on the blog strings suggest building jobs halting unfinished and people not being paid for their work. Further Jack Rodman in the South China Morning Post warns that the banking system’s true exposure to real estate may be much higher than officially recorded, and could exceed 40% of bank lending.  Most of that lending is policy-directed with an implicit government guarantee. Few of the empty factories, office buildings and hotels etc. are meeting their interest payments, but loans are being rolled-over rather than being foreclosed upon. Clearly a vacancy rate of  up to 40% in office buildings in some areas is of great concern.

As Rodman says “Bank exposure to the real estate sector has been at the root of previous financial crises worldwide – 40% is the same level of total loan exposure reached in Japan in 1989, when it was believed Japan would dominate the economic landscape for decades”

Nevertheless the Chinese Government are right watching this closely and not ignoring the evidence and have already begun to tighten short rates to signal their willingness to move sharply should they decide credit growth is a problem.  That’s not to say that they don’t also use the jawbone to influence events, but behind that is the very real willingness to act, and sharply. Accordingly after talking about their concerns for a number of months authorities have now altered the bank’s reserve ratios to crystallise the point, and this week have halted some banks ability to lend for a period.

Donald H Rosen, one of the recommended China writers, had the following points to make about the possibility of these construction excesses and the export slowdown causing a Western-styled malaise – Whilst he certainly sees 2010 to be a year of significant adjustment for the Chinese, and some pain, he makes the following interesting observations:

China is clearly ‘front-loading urbanisation’ with the idea that the acceleration of this trend will take up the excess property, bringing with it an increase in domestic consumption which the country sorely needs to reduce dependence on the West.   With less than 45% of Chinese being urbanised against the near 80% average in the West clearly there is some distance to go.  Secondly that while this would in Western conditions create even greater over-production and over-capacity Rosen makes the point that China is simply missing much of the depth of social infrastructure that the West takes for granted such as teachers, doctors and white-collar jobs in the manufacturing sector; the increase of which will bring higher consumption without adding to the present over-capacity.

However the greatest immediate problem that China appears to have is an alarming increase in capital inflows of money looking not for a productive home but betting on the revaluation upwards of the currency.  This, the Chinese fear, will exacerbate the already over-stoked economy, and make it difficult to manage liquidity. Interestingly it is not only foreigners making this call, but private Chinese money previously hoarded offshore is also returning to the country.  The average call is for a revaluation of 10% although the reading I was directed to suggested a more modest 2-3% which will hardly satisfy the West.

The problem of relative currency valuations is hardening attitudes everywhere, particularly in Europe, as the rise in the Euro is significantly hampering the recovery prospects of the entire Euro-bloc with particularly Germany and France making unhappy noises.  It’s hard to see why the Euro is so favoured, but clearly this is largely a vote against the US dollar rather than a vote for the Euro, but it is severely cramping the competitive prospects of European exporters. Of course with China in lock-step with the US dollar the dollar weakness has helped China to compete, even given the global pie is significantly smaller.

An article written by Paul Krugman, who is extremely influential in both the US and Europe, calls for outright protectionism against China and refers to their ‘mercantilist’ trading policies as fundamentally ‘predatory’. Now I know Krugman has lost some of his lustre in contrarian circles for his promotion of more ‘stimulus spending’, but there is no denying he is the most influential US economist of the moment.  My suspicion is he is the go-to-boy when significant changes in US policy are in the pre-ordination phase, and it wouldn’t surprise me in the slightest to see 2010 bring a quite nasty trade war.

In fact he suggests exactly this – “The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise the very mild protectionism it’s currently complaining about will be the start of something much bigger” – now you can’t be blunter than that!

Actually I first wrote about the impact of exporting jobs to low-cost nations in 2005, as it seemed to me ridiculously short-sighted to expand your short-term profitability by first taking jobs off your own citizens and handing them out to somewhere cheaper.  This is a further example of the paradox of solution, where the companies’ solution is quite contrary to the needs of the country.

The greatest problem that China appears to have in the longer term is WATER – they don’t have much, and the supply of potable water particularly is dwindling fast.  A figure I noted from past reading suggested only 45% of the population had a reliable supply of safe drinking water. However as with other problems identified they tend to face these head on, and not push them onto following generations as a first choice, as has become the pattern in the West.

• So from the WSJ “China Real Time” site – China, in its first-ever nationwide water resources survey will attempt to quantify just how much water it has, how much it needs and how much pollution is part of the flow.

China’s water supplies are meagre and dwindling, threatened by waste, pollution and chronic drought. Global warming is blamed for shrinking the big Tibetan glaciers that feed most of China’s main rivers. All this is happening just as China’s wealth is increasing demand for more water – for irrigating food, propelling hydropower, and manufacturing of all types.

However the greatest problem the West has with China is undoubtedly their contribution to both climate change and global pollution.  I find however that it is impossible to single them out on this, because if collectively we had not demanded the production from their vast manufacturing base then their easily apparent pollution would have been considerably less. This has allowed the West to wag its judgemental finger at China but is hardly a realistic position.  Pollution is a global problem, this is a closed system we live in and if our demand is solely determined by price then short-cuts in environmental behaviour should be a given.

And so there has been bad behaviour, but again I wrote about this in my essays from 2005/6 as the problem of excess pollution has been alive and kicking for decades and will remain until economics has the courage to place environmental and social depletion in the equation along with the present financial figures.  We cannot make true progress unless we are prepared to count all the costs of that progress as well as the benefits.  In my view we need to count the rate of depletion of non-renewable resources too as this knowledge would assist in the appropriate pricing models to ensure scarce resources are not wasted cheaply.

So on balance what do I think about China’s prospects for 2010 and onwards?

Well it is unlikely they will escape any second dip in global fortunes during the 2010/11 period as we all face the reality of vastly increased demand for funds from sovereign sources to cover fiscal deficits while the resets of existing private debt will also be at historical highs.  This will be the major topic for financial markets throughout 2010 however China is the one nation with a clearly different profile – they will be spending savings while the rest are spending borrowings, and most Western chancellors would like to have that problem rather than the one they now face.

Secondly while China will one day run into the demographics of the ‘one-child’ policy they still have vast scope to keep moving people towards the cities as they develop further away from the former peasant economy.

And the big question – can they keep it all together and avoid social breakdown among the disenchanted? I have to say the more I read the more I was impressed about their comprehension of what they are doing, and the awareness of the errors of the West. It remains quite a paradox to see them doing what they can to develop their controlled form of capitalism, whilst Western countries, almost without exception, develop economies that increasingly represent the ‘socialist evil’ they have tried so hard to defeat.

Even given the sharp reduction in entrepreneurial activity in the former bubbling areas of Hong Kong and Shenzhen, a recent study by Hugh Thomas, a Chinese University finance professor and director of the school’s Centre for Entrepreneurship finds that “while the quantity of entrepreneurialism may be falling, the quality of those businesses is now higher than before: ideas are better thought-out, businesses are higher up the value chain and growth expectations are more promising.”  So again one has to concede, they appear quite aware of where the next trend is coming from and are already moving to be a major participant – quantity and price may no longer work, but quality finds its markets in the end.

So provided they can manage the impact of their rather loose credit policies they still look to me to be the country best prepared for what 2010 and beyond might bring.

Sleep well,

Wayne Lochore

I see Japan as a self-volunteering economic litmus test – everything they did and got punished for during the last 20 years the rest of the world is copying.  Japan would maybe argue that they were not such a thing, and the West would claim not to be copying anyway, but I find the symmetry quite amusing.

In an essay from 29.01.2005 I suggested we would get either a major and immediate financial collapse or a Japan-like decline over a longer period.  Although I was a bit early on the first one it appears a major part of the global economy may be getting both options in sequence. However it’s rather decent for Japan to join us in our economic travels, don’t you think?  For there is no question that the last 20 years of near zero growth, massive and persistent fiscal deficits, a significant decline in savings and worsening demographics make Japan as vulnerable as any of the other developed nations to a further tour of the track.

I often think about just what it was that made Japan so economically significant, because they had few advantages in resources at all.  The major thing they had was a hard-working loyal workforce who was looked after by their employers for life. Work was more family-like that generally it is in the West.   They were very innovative in their own developments, and great improvers of others. They’d also had their country destroyed as a result of WWII and had little option but to work very hard to recover. However looking at their stock market my own observations suggest it was partly their loyalty and exaggerated self-belief that destroyed their financial model – let me explain.

I was working in the markets during and after the 1987 crash, and watched with disbelief as the Japanese gathered themselves together and set about restoring the upwards march of their stock-market.  Throughout the stunning move up to 39,000 it was obvious from the market action each day that the market leaders were being ‘pumped up’ each night before the close.  If a market is being driven up towards the close, particularly Fridays, traders get wary to be caught short late in the day, so the market gets easier and easier to move.  This was happening most days, and it kept on happening too.  I’ve seen it many times in many markets; it’s done all the time, but this was truly relentless – more impressive even than the Dow these days!

The end result is that many companies became very over-priced and very inter-twined with each other, and when all of a sudden the market didn’t want to go up anymore it sprung back like a bungee attached to the ground.  Major shareholdings that honourable and loyal cohorts had in one another (and partly because of that loyalty) effectively couldn’t be sold. Anyway there was no buyer, so they went down the tubes together, and the country has never recovered from it.

Now I know what it feels like to be caught in a major holding that is far too big for a market, but generally only for a few days at a time; it’s terrible, it really is.  But I’m not talking about the tortuous times you can’t make up your mind to take a rational action – just can’t pull the trigger – I’m talking about the situation where you know you’re going to get killed and literally can’t do anything about it!  I watched and watched over a period of months and years to see when Japan would finally bite the bullet and start unwinding their cross-shareholdings, but they really never did. And in the early days of that collapse the Japanese valuations were so high when compared to the hammered Western markets there was no-one internationally big enough or strong enough to make a difference anyway.

(Strangely, even within the broker offices I’ve been in, no-one ever wants to discuss the reasons and psychology behind these massive Bear moves – they don’t want to be contaminated by the thoughts somehow.  But I’ve always found it just as interesting to play Bear markets as I have Bull markets.  To me it makes no difference – the worst market for a trader is a market that refuses to go anywhere – they’re boring and chew your trading capital up week by week without ever giving you a chance to make a bit back.  In fact when the opportunities do come finally as often as not you’re so ‘gun-shy’ you miss them anyway.  So you won’t see me showing the attributes of a ‘perma-bull’ because I’m not one – from a trading perspective I don’t care which way they move as long as they move.

My experience is that markets invariably move about 20% too far in both directions; only the middle 60% of any move is real, and justified by valuations; the ends are generally more about emotion and either fear or excitement depending on which way they are heading.  I can’t understand why you’d not want to trade these rapid reversal markets regardless of which way they look like moving.  Being religiously committed to one side of the market and never venturing onto the other seems just foolish to me, and anyway is very likely to wed you to a view that is one day going to prove disastrously wrong, and you’ll be too blind to see it coming.)

Although it’s outside my remit, the same massive over-valuation occurred in Japanese Real Estate – it’s probably true that this was a far greater ‘bubble’ scenario and I never quite understood what happened in the process of unwinding this.  However some time back I read a very authoritative article on this, and kept a copy. I read it again the other day and for those who are interested in more detail of what happened and how it happened then look up the following story “The Japan Baloney” by Nathan Lewis. It really does destroy a few commonly held myths.

Anyway back to big-picture Japan – they’ve had a very tough 20 years and there’s no reason while they won’t get some more of the same.  They are looking at four really big problems all coming together at the same time, with two of them impossible to change quickly. Demographically they are looking at a continuing falling population which has been falling for a long time already; their Public Debt is already greater than 200% of GDP, and heading sharply higher.  Those two are very tough to change quickly, maybe impossible.  It’s a significantly non-cosmopolitan country, with hardly any outsiders represented when compared to the West; so they could bring in younger outsiders to alter the demographics, but would they?

Public Debt is near impossible to correct quickly – it can be changed to a lower trajectory over a period, but a reversal in trend is unlikely. Populations get addicted to fiscal deficits even when they are bigger that the country can maintain. Further I suspect the debt has a larger negative potential than generally thought, as much of the borrowing has been at low interest rates and a global stretching in interest rates as a consequence of Sovereign demand is close to being a given for 2010.  This may be a bigger factor for Japan than many imagine – I’ll certainly be watching this one.

The last 20 year’s slippage also includes the savings from the ageing population – they’re now pretty much broke, and of course no longer vigourous enough to help any recovery of the situation, and to improve their savings level and that of the country. To the contrary, because they live so long they will be a long term drag on the economy.  Part of the Japanese miracle was funded on the savings of exactly this group of aging citizens – their savings funded the economic growth as they saved for retirement, providing funds to Japanese companies, and the production was gladly purchased by the West.  It was the virtuous circle that we’ve seen repeated with the Chinese and the West since the decline of Japan.

The 4^th big one is the very industrial production that created the miracle – the concentration on big-item capital goods, (which the buyer can easily cancel, as has proved). This was a brilliant strategy and a brilliant story while the West so gleefully purchased the production and made Japan the exporting powerhouse of most of the second half of the 20^th century. But most people in the West have discovered suddenly they have everything they want and anyway have been able to feed their desires far cheaper from China. The vulnerability here was illustrated most graphically by the 44% year-on-year collapse in exports to January 2009, when exporting effectively ceased for a period.  Things have recovered somewhat since then, but are unlikely ever to return to the days of old. (The ‘jobs-for-life’ culture will make this quite a difficult transition too, making many of the largest Japanese companies ‘too big to fail’ but maybe ‘too big to save’ at the same time.)

While I have little doubt that Japan will nevertheless one day find its way out of this combination of troubles, I really don’t think I want to be the Japanese Minister of Finance – no, I think I’ll just flag that one thanks!

Sleep well…..

Wayne Lochore

p.s. A few minutes after I finished this piece I received a 2010 predictive essay written by Ambrose Evans-Pritchard of the London Telegraph who is of the view, among other things, that Japan will be the catalyst for a significant mid-2010 correction as markets focus on excessive sovereign debt exposure amid rising interest rates.  He predicts a flip from deflation towards hyper-inflation in Japan as a result.