Sunday, November 1, 2009

China : When the Driver of the World Economy Is A Speculative, Drunk, Riverboat Gambler

It is our opinion that China today is circa Japan in the late 1980s when it was a manufacturing powerhouse and seemed poise to continue its rise to superpower and world domination.
Jim Grant, Grants Interest Rate Observer: 

China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot)…Today China projects to the world a similar image as Japan did in the 1980s… “

Richard Bernstein, former chief investment strategist at Merrill Lynch, says China’s economy is overheating and that investors should avoid its stock market. “China is an immense credit bubble that's going on right now,” he tells CNBC.   "They have massive overcapacity and their solution to that problem was to build more capacity over that," says Bernstein, now CEO of Bernstein Capital Management.
 “A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”

Lately, the Chinese economy has been impressing us with its growth…But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending.
However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is. 

“Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember … Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’ Drexel failed when the junk market did.

“Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.

Today, Chinese economic growth is the force pushing the global economy and stock markets. The quality of this growth, however, is low as it is predicated on massive (forced) lending and is unsustainable. As and when Chinese growth finally slows, the impact will be felt in many, often unsuspected places.

We believe that China’s pulling in the reins will impact commodity markets, commodity producers and commodity exporting nations. Combined with our expectation of deflation in the intermediate term, this will severely impact commodities.  Let’s take oil, for instance. As incremental demand from China slows, oil prices will suffer and impact the Russian economy in particular.  China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation.

Finally, we are bearish on China because of the enormous amount of overcapacity that currently exists in the country.  China’s manufacturing capacity was structured for a leveraged U.S. consumer and a leveraged world.  As the world delevers, China as the exporting nation faces a difficult transition given it’s excess capacity.  Like the U.S., it is desperately attempting to reflate its economy and continue growth is because it sees the difficult adjustment that lies ahead.   

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