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

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.

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

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.