THE
BEAR'S LAIR The
coming China crash By Martin Hutchinson
While the Chinese stock market, as
measured by the China Securities Index 300, is
down 18% since October 16, that follows a period
of almost two years, since January 1, 2006, during
which the CSI 300 soared 535%. Chinese economic
growth is currently running at more than 11% and
the big money is convinced that it will continue.
At the same time, the country’s foreign exchange
reserves have grown to US$1.4 trillion, the
largest in the world.
A crash would appear
to be imminent!
Bears on China have been
common for the last decade, and their
track record has not been
good. To take just one unfair example, Henry
Blodget, the former Internet genius, wrote in
Slate in April 2005: "You've probably been
daydreaming about the fortune to be made in
Chinese stocks. Well, keep dreaming ... you'll
eventually conclude that you could have done
better selling insurance in Toledo." That was
about six months before the Chinese market took
off, and if anybody has made 500% on their
investment by selling insurance in Toledo during
that period, I haven't met him.
To see why
a crash may be coming, it is worth examining the
behavior of the China Investment Corporation, the
US$200 billion sovereign wealth fund set up by the
Chinese government in September. Now $200 billion
is a fair chunk of cash; you could almost buy all
but three US corporations with that (at today's
prices, ExxonMobil, General Electric, Microsoft –
there are four or five others including Google
that barely top the bar.) Six weeks ago, the power
of sovereign wealth funds was celebrated and China
Investment's moves into the market were awaited
with bated breath.
Well, so much for that.
A third of China Investment's portfolio is to be
invested in Central Huijin Investment Company, a
purchaser of bad loans from the Chinese banks, and
another third will recapitalize China Agricultural
Bank and China Development Bank, to shape them up
for privatization. About $3 billion of the fund
was invested in the private equity manager
Blackstone in May - that may have bought China
useful political contacts, but it is now worth $2
billion. And the remainder is being invested very
carefully, primarily in US Treasury securities -
which are also losing money steadily in yuan
terms.
The lackluster investment strategy
of China Investment exposes a central flaw in the
Chinese economy, its lack of a rational system of
capital allocation. For more than a decade,
Chinese state-owned companies have made losses and
have been propped up by the banking system. Since
2004, loss-making state-owned companies have been
joined by overbuilding municipalities, erecting
white-elephant office blocks in attempts to turn
themselves into the next Shanghai. None of these
losses have resulted in bankruptcy; instead the
cash flow deficits have been covered by the
Chinese banks. As a result, these banks have an
enormous volume of bad loans $911 billion at May
2006, according to a later-withdrawn estimate by
Ernst & Young, which must surely have
ballooned to $1.2 trillion to $1.3 trillion now.
That explains why China Investment is
somewhat unaggressive in its international
investment strategy. China's $1.4 trillion of
reserves will in fact almost all be required to
prop up the banking system when the inevitable
liquidity crisis occurs. If the banks are to
survive, China Investment will have to be followed
by six more sovereign wealth funds of equal size,
each of which will have to abandon its attempts to
take over Exxon or Google and pour its money down
domestic rat-holes.
A $1 trillion problem
in subprime mortgages has caused even the US money
market to seize up and has required frequent
applications of sal volatile by the Fed. Since
China's economy is around one fifth the size that
of of the United States, the Chinese banking
system's bad debt problem is in real terms about
five times that of the United States, or about 40%
of its gross domestic product.
We have
seen this movie before; the Japanese banking
system's bad debts after 1990 totaled around $1
trillion, about 30% of Japan's GDP. The result was
the bursting of the 1980's bubble and a period of
little or no economic growth that lasted well over
a decade. Admittedly the Japanese authorities made
matters worse by refusing to face up to their bad
debt problem and issuing more government bonds to
fund witless Keynesian public spending schemes.
Nevertheless, we can have very little
confidence that the Chinese authorities, once the
same problem stares them in the face, will do any
better. After all, at least one of the alternative
policy mixes, that tried by Herbert Hoover and the
Federal Reserve in 1930-32, proved very much
worse. Per capita US gross domestic product was no
higher in 1940 than it had been in 1929, as in the
Japanese case, but in the interval it had declined
by a horrifying 28% and had recovered very slowly.
If China faces the choice between a decade of
stagnation, as in Japan from 1990-2003, and a
decade of economic collapse, as in the United
States from 1929-1940, it will rightly prefer the
Japanese alternative.
It may not however
have the choice. One of the factors that kept
Japan out of real trouble in the 1990s was
continued strong growth in the US and world
economies; thus its magnificent export industries
were able to continue growing, albeit at a slow
rate, and provide a certain amount of traction for
the economy as a whole. However, China will find
it difficult to do the same, since the next decade
does not seem likely to be a period of robust
world growth. Far from it. The United States seems
fated to endure at least a few years of very
sluggish growth due to its housing market crash,
and Britain appears to be in a similar mess, so
even relatively robust growth in the resurgent
economies of Germany and Japan may not be
sufficient to keep Chinese exports growing.
At that point, China will have two
alternatives. It can allow the banks to work their
way out of their bad loans, condemning the
domestic economy to probably a decade of little
growth and extremely tight credit (high Chinese
savings would alleviate this problem, but they
will be trapped in the Chinese banks because the
authorities foolishly do not allow Chinese
citizens to invest abroad). Alternatively, it can
inject more or less its entire foreign exchange
reserves into the domestic banking system in order
to recover its bad debts, which would allow the
Chinese economy to continue expanding, but at a
cost of devastatingly high inflation from the
additional money pumped into the system (the $100
billion plus of Chinese bank initial public
offerings carried out in 2006-07, pumped into the
domestic economy, already appears to be worsening
Chinese inflation and China Investment’s $130
billion will doubtless further aggravate the
problem.)
We have seen societies with low
economic growth, very high inequality (as China
has now) and persistently high inflation; they are
collectively known as Latin America. Since China
also has much of the corruption that bedevils
Latin America and its government lacks any genuine
understanding of the free market and is
increasingly dominated by special interests, it
may indeed be fated to follow a Latin American
growth path for the next few decades, with a tiny
entrenched elite enriching itself at the expense
of the disfranchised masses. That would be the
worst possible outcome for the Chinese people, but
it is not by any means impossible.
Many
observers of the current US financial market
downturn comfort themselves with the thought that
the world now has more than one growth engine, and
that China, with four times the US population, can
because of its very high growth pull the world
economy along sufficiently even when the US
stalls. However, if China is about to incur the
inevitable backlash from its recent debt and
equity bubbles, during which practices have
flourished that have no place in a
well-functioning free market, then we may be
entering a world in which the two main growth
engines of the last decade are both broken. Growth
in such a world will be truly sluggish and
inflation high, as the world struggles to cope
with the effects of an excess of cheap money now
grown toxic.
The problem with major
recessions is that they tend to produce foolish
political reactions. In the United States, it
seems likely that a major recession if we have one
will produce resurgent protectionism and an
aversion to world trade, which to the voting
public will appear to have been responsible for
the loss of millions of good US jobs without any
corresponding gains to the living standards of the
majority. Japan, bless it, remained admirably
politically stable during its sluggish decade, and
eventually found a leader in Junichiro Koizumi who
was able to lead it back into renewed growth.
In China, there can be no assurance
whatever that a populace whose living standards
have suddenly stopped improving will not turn to
violent nationalism and/or counterproductive
economics. Since the country is not a democracy
and not likely to become one, the authorities are
likely to react to hardship as did Vladimir Putin
to the chaos of late 1990s Russia, imposing even
more draconian repression and seeking a military
adventure abroad to occupy the masses of
disaffected youth and distract the public from its
new poverty. That too would produce a future in
the West far worse than would be cased by a mere
domestic recession.
Bears who weary of
observing the chaos in the US financial markets
can cheer themselves up by looking at China. There
will be more than one source of the oncoming world
downturn!
Martin Hutchinson is
the author of Great Conservatives
(Academica Press, 2005) - details can be found
at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
