By Martin Hutchinson | 7 December 2007
A crash would appear to be imminent! |
Bears on China have been common for the last decade, and their track record has not been good. To take just one unfair example, Henry Blodget, the former Internet genius, wrote in Slate in April 2005 "You’ve probably been daydreaming about the fortune to be made in Chinese stocks. Well, keep dreaming….you’ll eventually conclude that you could have done better selling insurance in Toledo." That was about six months before the Chinese market took off,and if anybody has made 500% on their investment by selling insurance in Toledo during that period, I haven’t met him.
To see why a crash may be coming, it is worth examining the behavior of the China Investment Corporation, the $200 billion sovereign wealth fund set up by the Chinese government in September. Now $200 billion is a fair chunk of cash; you could almost buy all but three US corporations with that (at today’s prices, ExxonMobil, General Electric, Microsoft— there are 4 - 5 others including Google that barely top the bar.) Six weeks ago, the power of sovereign wealth funds was celebrated and China Investment’s moves into the market were awaited with bated breath.
Well, so much for that. A third of China Investment’s portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks, and another third will recapitalize China Agricultural Bank and China Development Bank, to shape them up for privatization. $3 billion of the fund was invested in the private equity manager Blackstone in May— that may have bought China useful political contacts, but it is now worth $2 billion. And the remainder is being invested very carefully, primarily in US Treasury securities— which are also losing money steadily in yuan terms.
The lackluster investment strategy of China Investment exposes a central flaw in the Chinese economy, its lack of a rational system of capital allocation. For more than a decade, Chinese state-owned companies have made losses, and have been propped up by the banking system. Since 2004, loss-making state owned companies have been joined by overbuilding municipalities, erecting white-elephant office blocks in attempts to turn themselves into the next Shanghai. None of these losses have resulted in bankruptcy; instead the cash flow deficits have been covered by the Chinese banks. As a result, the Chinese banks have an enormous volume of bad loans— $911 billion at May 2006, according to a later-withdrawn estimate by Ernst and Young, which must surely have ballooned to $1.2-1.3 trillion now.
That explains why China Investment is somewhat un-aggressive in its international investment strategy. China’s $1.4 trillion of reserves are in fact almost all required to prop up the banking system, when the inevitable liquidity crisis occurs. If the banks are to survive, China Investment will have to be followed by six more sovereign wealth funds of equal size, each of which will have to abandon attempts to take over Exxon or Google and pour money down domestic rat-holes.
A $1 trillion problem in subprime mortgages has caused even the US money market to seize up and has required frequent applications of sal volatile by the Fed. Since China’s economy is around one fifth the size of the United States’ the Chinese banking system’s bad debt problem is in real terms about five times that of the United States, about 40% of its Gross Domestic Product.
We have seen this movie before; the Japanese banking system’s bad debts after 1990 totaled around $1 trillion, about 30% of Japan’s GDP. The result was the bursting of the 1980s bubble and a period of little or no economic growth that lasted well over a decade. Admittedly the Japanese authorities made matters worse, by refusing to face up to their bad debt problem and issuing more government bonds to fund witless Keynesian public spending schemes.
Nevertheless, we can have very little confidence that the Chinese authorities, once the same problem stares them in the face, would do any better. After all, at least one of the alternative policy mixes, that tried by Herbert Hoover and the Federal Reserve in 1930-32, proved very much worse. Per Capita US Gross Domestic Product was no higher in 1940 than it had been in 1929, as in the Japanese case, but in the interval it had declined by a horrifying 28% and had recovered very slowly. If China faces the choice between a decade of stagnation, as in Japan from 1990-2003 and a decade of economic collapse, as in the United States from 1929-1940, it will rightly prefer the Japanese alternative.
It may not however have the choice. One of the factors that kept Japan out of real trouble in the 1990s was continued strong growth in the US and world economies; thus its magnificent export industries were able to continue growing, albeit at a slow rate, and provide a certain amount of traction for the economy as a whole. However, China will find it difficult to do the same, since the next decade does not seem likely to be a period of robust world growth, far from it. The United States seems fated to endure at least a few years of very sluggish growth due to its housing market crash, and Britain appears to be in a similar mess, so even relatively robust growth in the resurgent economies of Germany and Japan may not be sufficient to keep Chinese exports growing.
At that point, China will have two alternatives. It can allow the banks to work their way out of their bad loans, condemning the domestic economy to probably a decade of little growth and extremely tight credit (high Chinese savings would alleviate this problem, but they will be trapped in the Chinese banks because the authorities foolishly do not allow Chinese citizens to invest abroad.) Alternatively, it can inject more or less its entire foreign exchange reserves into the domestic banking system in order to recover its bad debts, which would allow the Chinese economy to continue expanding, but at a cost of devastatingly high inflation from the additional money pumped into the system (the $100 billion plus of Chinese bank initial public offerings carried out in 2006-07, pumped into the domestic economy, already appears to be worsening Chinese inflation and China Investment’s $130 billion will doubtless worsen the problem.)
We have seen societies with low economic growth, very high inequality (as China has now) and persistently high inflation; they are collectively known as Latin America. Since China also has much of the corruption that bedevils Latin America and its government lacks any genuine understanding of the free market and is increasingly dominated by special interests, it may indeed be fated to follow a Latin American growth path for the next few decades, with a tiny entrenched elite enriching itself at the expense of the disfranchised masses. That would be the worst possible outcome for the Chinese people, but it is not by any means impossible.
Many observers of the current US financial market downturn comfort themselves with the thought that the world now has more than one growth engine, and that China, with four times the US population, can because of its very high growth pull the world economy along sufficiently even when the US stalls. However, if China is about to incur the inevitable backlash from its recent debt and equity bubbles, during which practices have flourished that have no place in a well functioning free market, then we may be entering a world in which the two main growth engines of the last decade are both broken. Growth in such a world will be truly sluggish and inflation high, as the world struggles to cope with the effects of an excess of cheap money now grown toxic.
The problem with major recessions is that they tend to produce foolish political reactions. In the United States, it seems likely that a major recession, if we have one, will produce resurgent protectionism and an aversion to world trade, which to the voting public will appear to have been responsible for the loss of millions of good US jobs without any corresponding gains to the living standards of the majority. Japan, bless it, remained admirably politically stable during its sluggish decade, and eventually found a leader in Junichiro Koizumi who was able to lead it back into renewed growth.
In China, there can be no assurance whatever that a populace whose living standards have suddenly stopped improving will not turn to violent nationalism and/or counterproductive economics. Since the country is not a democracy and not likely to become one, the authorities are likely to react to hardship as did Vladimir Putin to the chaos of late 1990s Russia, imposing even more draconian repression and seeking a military adventure abroad to occupy the masses of disaffected youth and distract the public from its new poverty. That too would produce a future in the West far worse than would be cased by a mere domestic recession.
Bears who weary of observing the chaos in the US financial markets can cheer themselves up by looking at China. There will be more than one source of the oncoming world downturn!
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Normxxx
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