Musings Report #15 4-13-13 China 2.0 Is in Trouble
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For those who are new to the Musings reports: they are basically a glimpse into my notebook, the unfiltered swamp where I organize future themes, sort through the dozens of stories and links submitted by readers, refine my own research and start connecting dots which appear later in the blog or in my books. As always, I hope the Musings spark new appraisals and insights. Thank you for supporting the site and for inviting me into your circle of correspondents.
China 2.0 Is in Trouble
As noted in last week's Musings, I want to summarize the talks given by Jim Chanos and Michael Pettis at Mish's Wine Country Conference last Friday. In essence, the message each delivered was stark: China 2.0 (with 1.0 being the Communist era of 1949 -1977 and 2.0 being the modernization/globalization era of 1978 - 2013) remains overly reliant on unsustainable growth dynamics.
Michael Pettis observed that he'd spent four years in Haiti earlier in his career, and pockets of poverty in China today equal those he'd witnessed in Haiti. Experienced China hands know the central government takes pains to limit media exposure of this level of poverty, as it reflects poorly on China's claim to being a superpower.
He then described in some detail how the Chinese leadership has created a "no-win" policy choice by encouraging a dependence on fixed investment to fuel rapid growth of GDP. If it shifts income to households to enable more consumer spending, GDP will decline. But if it continues borrowing and spending on increasingly marginal fixed investments, growth will also grind to a halt.
In effect, China has suppressed wages to fuel GDP growth. Financial repression (low interest rates) has further suppressed household income and encouraged misallocation of capital on a vast scale.
Pettis said the Chinese government is pushing a "go west" campaign. While "go west" worked in America's development, it failed miserably in Soviet Russia and Brazil. The difference, he said, is that in America, the private sector moved west and the government simply followed. In China, Russia and Brazil, the government pushed infrastructure west but without private-sector participation. Pettis reported that private sector contractors go west to build the infrastructure and then return east once the work is done.
In Pettis' view, the key metrics are debt and the ability to service debt: if debt is rising but the ability to service that debt (disposable income) is stagnant, then the system is unsustainable. He said this is the case in China: debt is rising but the ability to service that debt is not.
Given the political power of the state-owned enterprises (SOEs), China's political and financial systems do not have self-correcting mechanisms. Such mechanisms require transparency and feedback that is lacking in China. Pettis flatly stated that the PBoC (China's central bank) is insolvent. Debt levels are high and much of the collateral is impaired.
He also noted that pollution is estimated to shave 3.5% off GDP annually, which means that if the 7% reported GDP growth rate is overstated, as many believe, then actual GDP growth after accounting for environmental damage is zero. Choking on China: The Superpower That Is Poisoning the World (Foreign Affairs)
An accurate accounting, Pettis said, might find Chinese GDP is overstated by 30%.
Jim Chanos addressed a number of financial and real estate issues. In the last downturn in the late 1990s, he noted, 40% of outstanding loans in China went sour. People in China only have 15 years' experience owning property, and so they have no experience of either a housing crash or long-term maintenance of housing.
One of the attendees asked: since China's population is ageing, doesn't the overbuilding of residential real estate make sense? That is, invest in housing now, anticipating that in 10 years more national income will have to be devoted to caring for the elderly?
Chanos' response was succinct if a bit exaggerated: "Most of the buildings in China won't be livable in 10 years." His point was that the infrastructure required to maintain buildings is undeveloped in China: most highrise residential buildings do not have a functioning common-area expense/maintenance system in place. If the elevator breaks, there is rarely money set aside to fix it or a person responsible for making it happen.
The quality of construction in China, though greatly improved by some accounts, is still sketchy; Chanos said that when a bridge recently collapsed, inspectors found that the reinforcing bars that were supposed to be in the concrete were missing. This might be an extreme example, but the basic point is that much of the money poured into construction over the past decade has not produced projects that will last 50 or 100 years.
Wealthy Chinese people often visit him in New York, Chanos reported, and there is one striking blind spot in their grasp of real estate: few of the visitors are aware that uninhabited buildings decay. The average middle-class household in China is sinking all their savings into investment flats, assuming real estate will be a durable store of value, without understanding that these empty units degrade. At some tipping point, entire buildings could become unlivable as elevators break down, leaks feed mold, etc.
The store of value is a chimera unless the building is actively maintained, but maintenance is not yet part of the culture.
As for the "if we build it, they will come" narrative that underpins the China Bulls' case, Chanos said that there is already 15 sq. meters of empty space per capita in China, meaning that there is 135 sq. ft. of empty interior area per person in China, and another 10 billion sq. meters is under construction.
Housing is already astronomically high in terms of the average urban annual income--the annual income/cost of a flat ratio is higher in China, even in 2nd and 3rd tier cities, than in high-cost locales such as London and New York. Most of China's populace cannot possibly afford the tens of millions of flats being built or sitting empty.
Chanos also noted that repression is not just financial; China spends more on internal security than it does on its military.
An estimated $2.7 trillion in private wealth has left China in the last decade. This is roughly 22% of China's $12 trillion GDP. What does this say about the leadership's faith in their system?
As a matter of "face" and policy, China's leadership focuses almost exclusively on GDP growth; GDP is the tail wagging the dog, Chanos noted, and it leads to highly unproductive allocation of credit and capital to projects that will never earn the cost of that capital.
The easiest way to boost GDP is to put a shovel in the ground--build something, anything. That has been China's strategy for 20 years, and it is now yielding diminishing returns.
Add all this up and you get a clear picture of a government and economy that is incapable of making the kind of structural reforms that are needed to make growth sustainable. Since Pettis is a professor at one of the most prestigious universities in China, he is circumspect about what might happen if the leadership's "rebalancing" fails. Chanos believes cement, copper and iron ore will collapse in value once China's building boom slows.
My conclusion is that despite the many differences between China and the U.S., their basic problems are remarkably similiar: an economy that increasingly serves a tiny Elite, and a political/financial system that is incapable of meaningful reform.
Market Musings
One particularly fascinating aspect of the market is how the "fundamental story" that's supposed to explain the market's rise or decline changes in an often-nonsensical manner. Consider the "gold will decline" story: the reason why gold is falling,the story goes, is that the U.S. economy is strengthening, and as a result interest rates will start rising and quantitative easing will cease. Once this happens, investors will dump gold for higher-yielding bonds.
OK, fair enough. Yet today, the story that supposedly explains gold's dramatic plummet below $1,500 is that retail sales dropped. Wait a minute: weak retail sales means the economy is not strengthening, it's weakening, right? So shouldn't gold go higher? Nope--weak retail sales caused gold and oil to be dumped.
Does this make sense? No. If gold is a safe haven in times of uncertainty and currency devaluation, then why is gold dropping like a rock as the global economy is roiled by uncertainty and currency wars are raging to depreciate all currencies?
The "gold is weakening because the global economy is recovering" story makes no sense. If the economy is in fact strengthening, then all this money-printing will likely trigger inflation, which would push gold higher. Or if the economy is weakening and currencies are being actively devalued, then gold should also rise as a safe haven.
The quasi-official explanation is the risk has been banished and the search for yield is causing investors to sell gold to buy dividend-paying stocks. That this yield-chasing has led to bubbles that will pop and unleash risk is ignored. Selling gold only makes sense in a world where risk, inflation and volatility have been banished, and chasing yields is risk-free because stocks and bonds will never be allowed to decline.
Is that an accurate description of the world? I don't think so.
Meanwhile, the gold miners are at levels last reached when gold was $700/ounce, less than 50% of its current value. This suggests a major bottom is being put in here on the miners' valuations.
What I am doing: wait for a tradeable trend to develop. Trying to short the stock market is iffy here; a risk-averse strategy would be to wait for a decline and a pop back up to a lower high, then scale into a short position.
What I would do if I were managing $1 billion: buy gold miners, anticipating a pop to at least $1,620 resistance, then re-evaluate at that level.
The best thing that happened to me this week
Our friend and neighbor surprised us with two beautiful strawberry shortcakes. C'est incroyable!
From Left Field
Woah: 500 free lessons guitar--donations accepted, of course; I didn't sign up, but downside for beginners looks low
Yes, count calories: Simple Science Fitness--calculator for how many calories you have to consume to maintain or lose weight.
(some of the) Humans of New York (via Maoxian) 653,000 likes on Facebook--mostly residents of NYC? Interesting collection of snapshots, most accompanied by snippets of dialog or quotes from the photographed folks.
“If we are facing in the right direction, all we have to do is keep on walking.” -Buddhist Saying
Thanks for reading--
charles
