China Redux
September 15th, 2006
I wrote an article in July 2005 titled “China Speed — Running Into the Great Wall”, making a case that Chinese economic slowdown will send that great country into a severe recession. Last month I updated that article adding some minor twists. I found an interesting counter point to my article on this website that I thought I should share with readers:
The post, written by Vitaliy Katsenelson,
VP with Investment Management Associates and a teacher of equity analysis at the University of Colorado, entitled, “The Great Bubble of China?” posts China is “living through one of the greatest historical bubbles.” Katsenelson sees China as a manufacturing country built with high interest debt. He sees China’s fall occurring due to factory overcapacity, a rise in the cost of money, and/or a slowing U.S. economy.Katsenelson even has titles for the books he sees being written after the fall: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2.” The author’s investment advice is to take your money out of commodities and to forget about investing in Chevron (CVX), Exxon Mobil (XOM), or Conoco Phillips (COP). Katsenelson equates the idea that all companies need a China strategy to the idea in the late 90s that all companies needed an internet strategy.
Call me part of the bubble, but I disagree with Katsenelson on all points. China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising and even if they were not, I could see manufacturing tailing off and stabilizing, but I cannot see it crashing. If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising. On top of this, China’s advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.
I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China. Secondly, the U.S., though obviously of huge importance to China, is not everything. Thirdly, though I do believe there will be a slowdown at some point (there has to be!), a slowdown is not a crash. It is interesting to note that in this post from June, 2005, entitled, China Speed — Running Into the Great Wall,” Mr. Katsenelson said pretty much the same thing he is saying now.
So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?”
I was glad to see interest in the article and it got me thinking more about the discussion. Let me try to reply to every point made:
“China is a manufacturing country now, but it is rapidly
diversifying from that. Its consumer and service sectors are rapidly rising… “
I actually agree with this statement, at least in part. China is likely to transform to a broader economy over the years, but it will take time. And with manufacturing making up such a large sector of the economy, it will take awhile (decades) before the services sector will be able to make meaningful contributions to the economy.
“I could see manufacturing tailing off and stabilizing, but I cannot see it crashing.”
“If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising.”
Business Week had a small article last year making the case that China saw some double digit wages in inflation, but I think this is not true for the whole economy, but more common in specific industries. If the Chinese economy implodes, I don’t think the wages will be rising, the implosion will be deflationary for China and the rest of the world. I agree that if labor costs in China become high enough, companies will start looking for a cheaper alternative.
“China’s advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.”
“I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China.”
This comes back to my point of leverage - China has plenty of that. A U.S. slowdown will decrease incremental demand and depending on the amount of the U.S. slowdown it may be enough to decrease incremental demand to send many Chinese producers into red. Also, something I did not mention in the article is the bad loans are a real issue in China, a number I saw was 40% of GDP. Once the economy slows down they’ll come to the surface.
“It is interesting to note that in this post from June, 2005, entitled, China Speed — Running Into the Great Wall,” Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?”
As I mentioned in my article “But, as with any bubble timing, the pop is very difficult, Bears are usually too early to call it and Bulls are usually too late to see it.” I really have no idea when it will take place. The Chinese government plays a very large and important role in China’s economy, thus it may postpone the crash by intervening. But the longer it intervenes the great the decline will be. I have no idea when it will happen, but I am aware of the risk and thus we structure our firms portfolios accordingly, trying to minimize our exposure to a slow down in the Chinese economy.
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10 Comments Add your own
1. ChinaLawBlog | September 15th, 2006 at 3:15 pm
You make a lot of good points and your analysis is sound.
I would have much preferred if your analysis were not so good so that I might step in and “enlighten” everyone as to how things really are. But, when you get right down to it, I think all of our disagreements are of degree, not kind.
I do not see it taking as long as you do for China to diversify. I do not see China becoming a software outsourcing center within 5 years, but I do see its economy becoming much more consumer and service oriented in that time.
I also think you are right to point out the bad loans as I see that as a potential weak spot, but I think your numbers on that are too high. I have heard, for what it is worth, that only around 8% of the loans are considered, “bad.” Of course, who really knows?
Anyway, you obviously know your stuff and it has been interesting discussing this with you so I am going to do another post on this on my blog.
Thanks.
2. Vitaliy N. Katsenelson, CFA | September 15th, 2006 at 3:30 pm
I took the bad debt $900 billion figure from Ernst & Young report assuming Chinese GDP is at $2.2 trillion we get bad debt at about 40% of GDP. Who knows if that figure is right or not, but either way it is high.
3. Bill Lindeman | September 16th, 2006 at 8:18 am
I am an American living in China. Thanks for the great article.
4. Vitaliy Katsenelson | September 16th, 2006 at 9:24 am
Thank you
5. Skip Reith | September 17th, 2006 at 7:36 am
Interesting article, and I agree that China could easily implode. Some of the factors keeping the implosion from happening:
1. The Chinese government continues to interfere with the economy, tying to keep it strong
2. US interest rates are high, keeping the dollar high, allowing Chinese imports to be low priced
3. Vietnam, Philippines, both Koreas, Japan, and other Pacific Rim countries are all feeling the competitive byte of China, and are all responding
4. The Chinese government attempts to keep the Yuan weak, again allowing the Chinese product to remain at a low price so they can continue to do exportation
Managed economies do not have the flexibility of open markets, and modern economies need to be nibble in order to compete long term. While China is doing better than Russia at managing the economy, Russia is a warning of what can happen with a managed economy.
The US economy is showing signs of a recession. If that happens, and interest rates decline, the dollar will weaken significantly. This will reduce the economic advantage China has versus the US, affecting the Chinese ability to competitively sell into the US market. Those countries with a significant trade surplus with the US (such as China) will feel the effect of a low dollar much more than those with a small surplus.
While China has a labor cost advantage versus the developed nations of the US and Europe, they are actually at a cost disadvantage versus Vietnam and North Korea. If anything happens to Kim Jong-il, then North Korea could become a major economic factor versus China.
The Chinese Government purchases huge amounts of dollars and Euros in order to keep the Yuan relatively weak versus these currencies. I will point out that during the ‘70s and ‘80s Japan tried the same tactic and it did not turn out so good for them either.
So, these factors, combined with the bad debt you mentioned, a weak (but at least growing) economic and physical infrastructure, and a more economically and politically aware population all will contribute to the ultimate popping of the Chinese bubble. And, the problem with a managed economy is that the managers will not see the pin that will pop the bubble. They may protect that bubble from many sources (for example, diversification away from manufacturing), but no bureaucracy will know all of the sources of problems (or all of the potential solutions).
The bottom line is the burst will come, just like it came to Japan, Russia, Europe, the USA, the Pacific Rim, South America, and everywhere else. The more managed the economy, the bigger the burst, and China is a seriously managed economy. So, the pop will come, and it will come hard.
Now, the question is one of timing. Because of the economic control and significant economic momentum, the Chinese economy still has some life in it. I would be surprised if the pop happened in less than five years, but I would also be surprised if they lasted more than ten years. Japan’s economy should have burst somewhere around 1981 – 1982, but they managed to hold on for many years before the burst came. The kind of burst we will see with China is like the one that happened to Japan and Russia – the collapse of an economy that is controlled to a more or less extent by the government (or government like oligarchy). These types of collapses tend to take a while to unravel, versus bubble popping in an open market, then tends to happen quickly.
However, the original premise of the article is that the coming collapse of the Chinese economy makes investing in commodity-based companies (like Exxon, Chevron, or Southern Copper) risky. A collapsing Chinese economy would kill the commodity markets, and these companies’ stock would all suffer. However, given the likely fact that the collapse is several years in the future, and that not only is China doing significant infrastructure improvement, but so is Vietnam, India, and others, commodity prices will remain strong for a while yet. While we see a softening of commodities now, the commodities will rebound and test (if not break) the highs of earlier this year. When they do, the stocks of these companies will all rebound significantly, and also test and break their highs.
Skip
6. Edward1 | September 29th, 2006 at 10:28 am
Vitaliy, your forthright discussion with someone who takes ussue with you is a testament to your strength in analysis and research. In contrast, President Bush’s tactic of calling critics “unpatriotic”, instead of just trying to refute their arguments on the merits of those arguments (or lack of merits), testifies to his weakness.
7. Madharry | November 8th, 2006 at 1:12 pm
InterIesting blog thanks,
I think that global demand for energy increases sharply irrespective of a slowdown in china. so I am heavily invested in the energy arena. I wish though that I could pick a certain winner in the fuel cell business as I expect that to become a large supplier of energy needs to china. Any ideas?
8. Kirk England | December 21st, 2006 at 4:20 pm
I agree with the bubble. I will add that there is currently an Asian bubble not just one in China. Interestingly, you discuss everything at length but put very little time into what has caused this excees capticity. Central banks across the globe have flushed the world with liquidity. What do yo do with cash? You spend, borrow, and save it. As the US consumer spends to the point beyond his savings he borrows. This is lent to him by Asia. Asia keeps him comforatbley borrowing by reinvesting in everything under the sun in the US as foreing investment. Anyone recall the 1990’s and Japan? Interest rates went to nothing but no one could borrow. Why? Banks wouldn’t lend to an overleveraged society. As was stated earlier, we in the US have a negative savings rate. TOTAL debt (not just govt) is 250%+ of GDP. Asian economys have already used the magic bullet in 1996-97 devaluing their currencies. The world will not buy it next time around because it doens;t address the root cause. Easy credit and over capacity
9. Yeyang Jin (Bruce) | January 19th, 2007 at 9:17 pm
As you discussed above, China indeed has bubble because some fields are over invested such as real estate, metal metallurgy industry, and some investments in these over invested fields are support by loan from bank. However, whether bubble can slow down an economy fatally or bring a recession should be base on whether the bubble can be absorbed by the economy.
I think China always can absorb the bubble because of its huge domestic market and government market control, even though I am worried about slump of real estate, which is far beyond people’s income (average house price is 20-25 times as average yearly income).
Manufacturing sector: the rapid economic growth in east coast China in last decade was induced by export processing, the most content of FDI (foreign direct investment). In east cost, foreign manufacturers are 40% of total manufacturers, and therefore foreign capital undertakes 40% of fix cost. Moreover, compared to other low labor cost countries, China has better industrial chain, more skilled workers, and stable political environment, thus, most manufacturers will still choose China. On the one hand, even though US growth slows down and the oversea demands decrease, China has 1.3 billon people who bring huge demands and these demands will grow rapidly with economic growth and with cheaper technology import, on the other hand, the weak economic of US will boost demands on cheaper products. Furthermore, China has focused on readjusting industrial structure, and it is easy for small private manufacturers and small subcontractors to adjust product type. I think there is enough time and manufacturers still have price reduction space for them to adjust, on the other word, to absorb the bubble in capital intensive industry.
Debt: I only think in some specific fields (normally they have high return rate and are not monopoly industries) such as real estate have very high financial leverage. In 2006, the government and central bank restrict banks to offer loan to real estate companies with high debt ratio and press banks to call in loans. In fact, Chinese government and central bank always prevent bank loans from inflowing over invested industries. High financial leverage of monopoly industries is commonplace, and, I think, high leverage will not induce big problem in monopoly industries, yet it is still very difficult for individual (except house mortgage) and small enterprise to get bank loan. Thus, most small manufacturers and small subcontractors are self-financed.
Who knows what percentage the real bad loan is? The most of bad loans of banks are from the loan to nation owned Companies, which have very bad operations. Due to high saving, decreased ratio of new bad loan and good profit on House mortgage, past bad loans are being absorbed. With the IPO of four largest nation owned banks, the censorship of loan is stricter and more normative.
Inflation: Although the real estate price doubled in last 3 years, yet because high competition in low-tech products, and efficiency improvement, the prices of necessary commodities did not increase a lot, that is, the reason for low inflation.
Finally, the Chinese market is highly controlled by the government. When Chinese economic growth will be threatened, China will restrict market entry for foreigners.
10. Kirk England | January 24th, 2007 at 9:06 pm
“I think China always can absorb the bubble because of its huge domestic market and government market control,”
As soon I see an increase in China’s GDP and a decrease in exports, I’ll buy that. As of right now, there is no merrit to the Chinese consumption thought
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