A Far-East Fiasco?

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This post is a guest contribution by Vitaliy N. Katsenelson*, author of Active Value Investing: Making Money in Range-Bound Markets and director of research at Investment Management Associates.

I often start my mornings with egg, cheese and turkey sandwich at Panera Bread. This morning was no different. While reading newspapers on my Kindle, sipping hazelnut coffee (I know I just lost respect of the true coffee drinkers), I started with yesterday’s FT, an article on China piqued my interest. China plays a very important role in the global economy and thus I pay close attention to it. I started reading:

“The benchmark one-year lending rate was cut by 27 basis points to 5.31 per cent, while the one-year deposit rate was lowered by the same amount to 2.25 per cent.”

This is not surprising news, but shows originality – China doesn’t want to be like the US, thus it cuts interest rates in multiple of 27 basis points, not boring 25 basis points.

“The government estimates more than 10m migrant workers have lost their jobs so far, while 6.5m university students will enter the workforce next year.”

China is unlikely to escape the fate of developed countries, it faces rising unemployment. This raises a question – will it lead to political unrest? High unemployment in China is very different than high unemployment in the US or Europe. Unlike in the developed world, there is not much of a social net in China. In the US if you lose a job, you may be forced to shop at Wal-Mart instead of Target and you have to downgrade to basic cable – only 50 channels, sorry.

I am oversimplifying, but we got unemployment benefits and many other government programs that will not allow one to starve. That is not the case in China, its safety net is in infancy, therefore high unemployment may mean hunger for many and political unrest. Chinese government knows this well. Unless it comes up with social net very quickly, it will stimulate the hell out of its economy that goes far beyond the stimulus it announced – this means more government spending. (I hear that the previously announced stimulus was just a reshuffle of normal government spending.) The next news makes things even more difficult:

Chinese exports collapsed in November, contracting 2.2 per cent year on year after seven years of double-digit growth, while industrial output growth slowed to 5.4 per cent from 8.2 per cent in October.”

Though economists still forecast 5% GDP growth next year in China, above statistics put that forecast in doubt. But even if 5% GDP growth forecast is right, as I’ve discussed in the past, due to the unique nature of Chinese economy (it has tremendous operational and financial leverage) it can only function in two modes – forward and backward, there is little middle ground. At the low growth speeds, and 5% is low for China, the manufacturing part of the economy simply chokes up and starts losing money. Thus the following news makes a lot of sense and simply scary:

“China’s foreign exchange reserves, the largest in the world, apparently fell in October for the first time in five years, according to an official from the State Administration of Foreign Exchange.” [emphasis added]

Published economic numbers are very likely not describing a true economic reality in China. Despite economic growth, for the first time in a long time, China feels a need to dip into its piggy bank – foreign reserves. But here is a scary part – that piggy bank is mostly in the US dollars.

The US Government is printing a lot of money at the moment to deal with our own problems, printing press may not be inflationary in the short-run (although definitely inflationary in the long-run) as velocity of money is declining – banks are barely lending and consumers are deleveraging and are reluctant to borrow. But if  the Chinese economy continues to deteriorate – a likely scenario as the deterioration just started – Chinese government will stop buying US Treasuries and even worse it will start digging into its US reserves. Since there are no other natural buyers (in size) of the US debt our interest rates may actually skyrocket, the US dollar drops against Chinese currency, while our inflation may still remain low. This is bad for China twice:

1. High interest rates means even lower economic growth from the US and thus even lower consumption of Chinese made goods.

2. China cannot afford weak US dollar – its US dollar reserves are worth less and more importantly its product becomes more expensive for the US consumers.

Here is another thought: all this is taking place while long-term government bonds at the lowest rates ever (or close). Long-term US government bonds are likely the most overpriced asset in the world, period!

* Vitaliy Katsenelson is author of Active Value Investing: Making Money in Range-Bound Markets and director of research at Investment Management Associates. He is also an adjunct faculty member at the University of Colorado at Denver, Graduate School of Business where he teaches Practical Equity Analysis and Portfolio Management. Vitaliy, a CFA charter holder, received both his degrees – bachelor of science and master of science in finance – from the University of Colorado at Denver, where he graduated cum laude.


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9 comments to A Far-East Fiasco?

  • WE are all doomed……..our fore fathers are rolling over in their graves. Ron Paul why have they foresaken you 🙂 The beat goes on, but the tune is beyond twisted. Even the small brains get it now, myself included….we are all screwed because we gave up the constitution. We gave away our freedoms that they fought so hard for in creating this country…

    Revolution and dead bankers is the only answer…………

    God bless America…..may we all remember the cry………

  • Victor Berry

    While commodities prices are down, it’s a good time to buy rope because soon there may be a shortage of it.

    And in honor of Abraham Lincoln’s birthday, I will say the only good Republican is a 200-year-old Republican.

  • Lee Bush

    Our safety net is made in China. So. What else is new?

  • Vern

    The Chinese are known for:

    1. Saving a large portion of their earnings,

    2. Being strongly family oriented, and

    3. Knowing how to live on a meager income.

    They do not have a strong gvernment-sponsored safety net, but their non-governmental safety nets are diverse and resilient. In tugh times they are more likely to live off savings than accumulate debt.

    So which nation (China or the USA) is best positioned to emerge from the worldwide recession stronger than the other?

  • The likely scenario is that as China continues to experience economic weakness, their ability to purchase U.S. Treasuries will diminish, and they will begin to tap larger amounts of foreign exchange reserves to fund domestic shortfalls. The combination will mean more USD flooding currency markets, and demand weakness for Treasuries. Both will work together with Federal Reserve printing to drop the USD.

    History shows that as societies become stressed they become increasingly aggressive. Let’s hope this is not the case.

  • The folowing comment was received from Paul C. Sandison, Social Scientist:

    Vitaly N Katzenelson’s article raises more questions than it answers.

    Firstly, I will deal with the implied problem for the US if China reduces its holding of dollars. The present US monetary and fiscal policy is intended vastly to expand the money supply, thus weakening the dollar and therefore the demand for the dollar coming from outside the US. This would make more dollars (liquidity) available within the US so the people there spend more at home, hopefully kickstarting failing US production and sales. Also, the policy is intended reduce the demand for US Treasury bonds in order to prod investors to come out of the bond closet and invest in equities. So if China holds less dollars and is less inclined to buy Treasury bonds, that would be a confluence of US and Chinese policies, not an antagonistic position.

    Secondly, to the implied problems for China. One would need to know more about why exactly 5% growth is a problem for the Chinese economy. It would also be necessary to know whether China has a conscious new policy to reduce dollars, e.g. by holding other currencies or by purchasing more gold or silver in advance of an increase in the value of these metals, or whether the reduction in dollars is entirely due to falling exports. China almost completely avoided the Great Depression partly by holding sufficient quantities of silver, and it would not be an unlikely proposition for China to do the same this time.

    Whatever the reason(s) for the reduction in dollar reserves , there are ways for China to mitigate the coming imbalances which a reduction in growth and exports can cause, and these measures are actually what any country, not least a centrally directed capitalist economy, can take. For example, costs associated with the mad dash expansion of Chinese industry to enable the entire Chinese population to reach the affluence of the US middle class in one generation can be slowed, until the economy is once again able to increase its annual growth.

    In other words if a high growth rate, until recently about 9%, has been needed to fund new infrastructure to cope with the rapid expansion and diversification of China’s areas of production, and national production now declines due to the present global recession, then the costs of for example building 1.5 new coal-fired power stations a week will be reduced accordingly since not as many new ones will be needed.

    The other macro-economic imbalances can be mitigated by other means. Due to the US Fed and the US Treasury throwing away the rule book and feverishly printing money to fill their self-inflicted liquidity gap, there will eventually come a point when the dollar will inflate rapidly and lose its value against other currencies. The US would no longer be able to afford cheap imports, e.g. from China, to the same extent.

    As I see it China, although renowned for cautious and almost minute moves, will then be forced to unpeg the renminbi from its current ratio to the chosen currency basket in which the US has a heavy weighting, and re-peg at a higher rate, in order to maintain the same effective relationship with the dollar. The advantages to China with this policy will mean that its enormous loans to the US will maintain value in renminbi, an understandable move since half the US foreign debt which is now some trillions, is to China. For China to allow that to depreciate in value would be like throwing away half the family silver.

    The present high savings ratio by China is due to hundreds of millions of individual Chinese families, a good proportion of which are pretty poor by any standards, saving in the absence of a pension and other insurance systems in China. The huge Chinese population will get pretty mad if they find their meagre savings which they have slaved away to achieve in their lifetime, suddenly halving in value. Neither the US or Chinese government can afford that outcome. It is not an option.

    Destroying people’s life savings is always totally repugnant. There is however a great geo-political difference between the Bernie Madoff event and the blows about to be experienced by the Chinese who have saved in US Treasury Bonds. Bernie Madoff might get off lightly in a PC mad, litigious USA for filching 50 billionaires’ private savings, but other realities apply when an incompetent US government and Central Bank, by their shocking management of its own economy in the last decade and shocking economic and environmental leadership of the world, is now seen to reduce the life savings of more than a billion people who have not lived a life of luxury but the exact opposite.

    China has theoretically a tricky patch to negotiate at this point. It can adopt a weaker renminbi through a re-pegging in order to save the value of the savings of its population. However this policy has a downside which must be balanced out. A weaker renminbi will mean Chinese imports will be more expensive if China buys from any country which has not also allowed its currency to devalue. These might include many of the emerging economies selling resources and commodities, some of which like South Africa have stable financial systems due to a wise early tightening of credit rules some years ago. Thus higher import prices will put a further brake on Chinese growth. Also, machines and other specialised equipment bought from developed countries such as Sweden, France and Germany will become more difficult to afford, in some cases prohibitive.

    The EU population and its cumbersome Council of Ministers system (now called the European Council) used for the adoption of new policies, appears to have no idea of the awaiting debacle for its industrial exports, and indeed, considerable innovation and flexibility will be necessary for their economies to survive. The EU house itself will have to adopt huge changes or see itself changed. The democratic deficit involved having such a cumbersome executive which is also hopelessly out of sync with the functions and lack of capabilities of the European Parliament will have to be satisfactorily addressed.

    At the present time, the composition of members of the European Council is a distilled result of internal national elections to the national parliaments – a completely separate process from the direct elections from the member countries to the European Parliament. The European Council has been likened to the Greek myth of the Lernean Hydra, finally vanquished by Hercules. The Hydra originally had 9 heads, but every time a head was chopped off, two appeared in its place. The European Council now has 25 members (each a head of state of a European country, and meet once a month) and there are still states queuing to join the EU.

    Every time a new country joins, a new head of state appears along with all the others. The old English idiom ‘too many cooks spoil the broth’ is more than apt to describe a dysfunctional organisational system sporting a chaotic cybernetic control system. The EU political structure is disjointed, with an executive which does one thing, if anything at all, and a Parliament which does another. The executive level is not one, but many executives at variance with each other and as an executive function is thus completely unfit for purpose. The members can say one thing at the European Council and then quite easily do another thing at home. During the coming turbulent times, the ability to act quickly, decisively and effectively with responsibility and accountability, will be required of the executive in at least two areas, economy and defence. Simply put: the EU executive capability to act quickly, robustly and sustainably is not there.

    In addition, the European Central Bank (ECB) rule book alone will have to be radically revised, since the longer the ECB tries to maintain high interest rates with the vain idea that it can resuscitate the lost cause of the EU Stability Pact, the more difficult the adjustment to economic reality will become in the coming weeks and months. The Stability Pact tries to impose limits on members states for spending, savings and investment, while the real truth is the Pact cannot work within the present constitutional structure and democratic deficit in the EU. More tellingly, the Stability Pact has been routinely abused and disregarded by the EU’s own its member states, in particular by the ones which had threatened great fines and consequences for those which did not hold to the limits! The ECB is flogging a dead horse, and economic forces have their own ways of completely destroying hubris just as they did in the United States and the United Kingdom. Even the unsatisfactory state of affairs of the ECB mandate and its current separation from reality will be tested to destruction in the coming storm.

    To make matters worse, the UK alone is about to become the self-inflicted poor man of Europe with a probable decline in GDP of 15% in the space of a few years and with the possible complete loss of its financial centre, something which partly hinges on whether its banking system survives. The accumulated debt of the UK is now 4,5 X its GDP. This debt is now greater than at any time since the massive debt incurred through the spending in the Second World War.

    The UK government, like the US, now owns practically all its banks, but the UK tax base is rapidly diminishing and it is ultimately merely a question of time before the UK government cancels its debt payments. The UK decline has been so rapid and so deep , due to a boom and bust government which has put aside nothing for lean years and mounted an ever greater deficit for over a decade, that for the UK at least, there is the overhanging risk that the recession will actually become a depression and the negative growth will continue not for 24 months but very much longer. It will be interesting to see how the present EU structure survives these events.

    Why the detour into Europe? Again, a sharp and possibly long economic decline in Europe as a whole will mean less EU imports of goods from China even if the renminbi is devalued. So Chinese exports will suffer. Also, China is now a net importer of food. With a weaker renminbi, food imports by China would be more expensive and due to the lack of social security or unemployment insurance there, it will have to introduce new benefit payment distribution systems to keep its population alive. I.e. the introduction of at least some minimum support like food coupons for the poorest who have no savings at all is a vital policy element or the government will face a revolution.

    Even though most of China’s proletariat is first generation and can return to the country village and try and eke a living off the land again, the latter case only theoretically applies where that is still possible, i.e. where land and water has not been usurped for industrialisation.Yet the very reason for China switching from being a net exporter of food to a net importer has been attributed to the lawless appropriation of land and water by new industries. Therefore, even where it would be possible for the peasant labourers to return, the outcome for the average redundant worker and family in China will be very tough without state support. During the difficult period of the 1990s, when Russia was faced with imploding industries and mass unemployment, many Russians admittedly returned to the family dachas to grow one crop a year of cabbage and fruit, but the average longevity of the male population still fell to the low forties during those difficult years, and Russia suffered a net decline in its population.

    Without state support, the dislocation, suffering and starvation with sharply rising unemployment involving tens of millions of Chinese wandering back to their home villages, some of which no longer exist, would be traumatic and almost certainly cataclysmic.

    Even though increased government expenditure in the form of transfer payments would mean less over for savings, which is ultimately what drives growth in an economy, a wise China would however see this crisis as an opportunity. Since the government has the power of planning and direction of research and new products, something which only comes about in the West political-economic process through bumps and quirks in the market and quite often not at all, China could adopt a twin approach to the systemic utilisation and production of alternative energy systems.

    Firstly it could stimulate the growth of alternative industrial energy production on a massive scale, involving all the modern possibilities already waiting for large scale production like wind, wave, tidal, thermal, and solar. Secondly it could plan and execute a rapid transition to electric vehicles and hydrogen vehicles. The latter would mean less reliance on imports and therefore an improved trade balance.

    For example, through painstaking research, a British engineering research firm has recently discovered a revolutionary technique for a small home unit, run on electricity, to separate water into hydrogen and oxygen. The car tank is then filled with hydrogen and the car runs on hydrogen. The only product to come of the combustion is water.

    If China were to achieve large scales of production with these techniques, it would not only improve its trade balance to afford social insurance for its people and provide new alternative jobs for those lost in the present crisis, but China could also export the new technologies and their related products to the rest of the developed world. That would be a fitting conclusion to the endless and maddening dithering by the countries of the developed world which have had most of the above alternative energy technology systems available and economically feasible for over 30 years but through an appalling short-termism and lack of imagination in industry and a complete lack of political leadership in government, have largely just sat on their hands. Indeed, that hopeless flock of sheep are still waiting for God or the market to tell them what to do.

    Finally, as a bonus to their own people and the world the present Chinese problem with severe air pollution would hugely reduced, and gradually eliminated with the ultimate successive dismantling of its coal power stations.

  • Paul C Sandison

    Perhaps I should add that South Korea has already shown the way and produced its own alternative energy systems in the following categories; wind, wave, tidal, thermal and solar, and is also experimenting with a variety of energy-saving applications such as recovering the energy from the braking in its underground trains, as well as using ethanol, etc. Many projects are joint ventures with technology firms in the developed world. So no prizes for guessing what would happen to the trade balances of all the countries which do the same instead of importing oil. The race to the top has begun!

  • Frank W

    About the only asset class in demand at present is shorter term Treasuries. At times some of these have been paying 0% or even less. If the Chinese do manage to make more available and thereby push up rates slightly, this will only result in more demand and buying of them. Most foreign governments are not interested in longer term Treasuries. If the Fed doesn’t do what it is threatening to do, namely buy them, then long-term rates will not decline and may even firm somewhat. A firm positive yield-curve slope is stimulatory for the economy.

  • […] Making Money in Range-Bound Markets and director of research at Investment Management Associates. – Investment Postcards from Capetown     (think about this … with UST rates at record lows, this would be a […]

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