The Coming Volatility In China
"China must maintain stable and relatively fast growth to create jobs and safeguard social stability." - Chinese communist party premiere Wen Jiabao, November 1, 2008
Two of the major themes we embraced since the inception of this blog has been the anticipation of expanding global volatility and a coming crisis in China. Neither have disappointed. To date China has delivered with a total collapse of its equity markets and we are witnessing the greatest global volatility since World War II. But, I'm going to continue to beat the drum because we are going to see an every expanding environment of volatility for quite some time. In other words, we are not just witnessing an unwinding of financial assets. Something we said would happen before it actually happened. Now that the Wall Street crowd has finally mastered the obvious in hindsight and at the expense of their clients, many of these rear-view seers are now telling us there will be an end to the unwinding. How clairvoyant. But, what many fail to realize is this is much more than an unwinding by financial firms. It is an unwinding by individuals, nonfinancial firms and countries. The financial markets are simply a microcosm of the world around us. Financial markets are giving us a glimpse at future global instability. At social and economic volatility.
Now that we have seen the implosion of Chinese equities, the headlines out of China over the past few months are of reassurance. From news that the Chinese banking system is safe (As we highlighted when the world was infatuated with China, China possibly has the most unsafe banking system on earth.) to policy decisions meant to stimulate the economy, the communist leadership's message remains upbeat. Or, that is what they want outsiders to believe. We have a hard time getting political honesty out of a democracy so what else would one expect from a communist propaganda machine? When did anyone ever hear of trouble inside of the Soviet Union or other police states? That is, until they collapsed and the lies and deceit of the state were exposed for all to see. China has missed its opportunity due to the complete incompetence of the communist party. It will suffer the greatest of economic crises because of it. If there is anything to learn from this cycle, it is that government can offer limited assurances to anyone. Especially when their policies are not directed at benefiting the sovereign. A communist or police state therefore has absolutely no ability to oblige.
Even though we have highlighted this paradox before, I find it interesting that no one is talking about the poster child for central planning, China, attempting to stimulate its economy when we are told by official ministry of propaganda statistics that its GDP is still growing at nine percent. Isn't that a little nonsensical? Chinese officials have been cutting interest rates as aggressively as anyone recently and just passed a $586 billion stimulus package. I do believe this is the largest stimulus package of any major nation since World War II. It is somewhere around 15-20% of GDP. Comparatively, the U.S. would have to pass a $3 trillion package. If one really compares the underlying trade in the U.S. economy, a U.S. stimulus plan would comparatively be near $7 trillion. Reality is more likely that China's real GDP has been contracting significantly for some time. First as inflation ravaged growth at a frenetic pace. Then as the economy started to collapse. Wealth in China will continue to be destroyed at a rapid clip. Regardless of state statistics, China has already lost substantially more wealth than the $586 billion it plans to spend in stimulus. This massive attempt at saving their own economy is exactly what we wrote would happen as they draw down their accumulated reserves. And, it helps cement the process whereby we have said China will eventually be in no position to keep buying U.S. Treasuries. Globalization is finished. And, for practical purposes we can say forever. That may be thirty years or one hundred years. But, re-ignition of any globalization is so far off that it's completely irrelevant and so are any attempts to save it.
How many steel mills or countless other pet projects were built in China because the local communist party official's brother wanted one for his community? Why did he want one? Because he could. And, unlike a market economy where a business decision is generally made via reasonably rigorous market-based metrics, and capital is typically raised in a transparent bond market demanding a profitable business plan, in China financing was undertaken with loans from the increasingly insolvent banks with nary a thought as to business viability. Or whether the loans could ever be paid back. Not that the brilliance of U.S. mega banks has been anything different in the last twenty years. But, then free markets have never described Wall Street and, therefore, the financialization of the U.S. economy has put the market-based economy under siege here as well. With undue influence by lobbyists it's not surprising the trade agreement between the U.S. and China was heavily influenced by financial interests in the U.S. In other words, many of the same dynamics in China are shared around the world. What would one expect with a globally woven economy equally benefiting the Wall Street elite and China's communist party?
China's often ridiculing tone towards the U.S. has clearly changed for now. It's new position now appears based in fear. In fact, the tone has now been replaced with a call for peace and harmony to solve the international crisis. One should not underestimate the reasons for this change in tone. There is absolutely no altruism in their position. It is based purely on attempts at self-preservation.
It seems many prognosticators are starting to foretell of an end to this environment and a return to economic normalcy in the second half of 2009. Couple this with the announcement of China's massive stimulus package and now is as good a time as any to crank up our rhetoric. In other words, to again take a counter view. With that said, let's put some scope to our voluminous discussions on China and its potential for collapse. This paragraph is going to appear insane before you are finished reading it. But then so have some of the other outcomes we anticipated. Who else in the world was discussing a credit crunch and an environment when banks weren't going to lend as the stock market was making new highs? The modern world hadn't even heard of a credit crunch or thought an environment could exist where banks would not lend. That is, until it happened. Now even the local talk at the barbershop revolves around these topics. Who else was talking about impending doom in China as its economy roared forward with great growth? So........ It is not inconceivable that China's industrial output could drop by 50-70% as we hit the economic impacts of this cycle. Don't blink. You read that right. And, no I didn't make that number up. What did we write on here long ago? Well, it's funny you ask. We wrote that the U.S. outsourced much of the supply chain shocks associated with severe economic calamities. Guess where they were outsourced? Uh, China? The potential impact of China's industrial contraction could lead to a 30-50% drop in its GDP. And, how will you decipher reality if the communists are really manipulating data? Because you will see other outcomes we talked about when world leaders were dancing with glee - nationalism, extreme social unrest or the potential for revolution in China. The two most obvious outcomes to economic calamity are successful revolution with some unknown future state or failed revolution with a return to a hard line communist government in China and a repudiation of their experiment with capitalism.
Now we come to a more interesting topic, as if a potential collapse in China isn't interesting enough. How will the communists attempt to channel any social unrest for fear of losing power? Or even losing their heads? (Literally) Funny you would ask another interesting question. Of course, it is very conceivable they will stoke nationalism while blaming their economic ills on fabricated enemies outside of their borders. Rising nationalism across the globe is also a topic we have discussed in anticipation of this cycle's outcomes. Who might be a prime candidate for blame? Why, of course, that would be the good ole U.S. of A.
Should we see an economic environment anything remotely comparable to what we have been anticipating, it would be plausible that the Yuan would become a worthless currency much to the chagrin of every prognosticator who could grab a microphone to tell us it was or is undervalued. These voices have been everywhere. Not a single voice anywhere has said the Yuan is overvalued. And, what does that do for the global economy? Well, if social stability holds in China and trade continues relatively uninterrupted, a massive bout of deflation coming out of China. It matters not whether China sees inflation or deflation in its own economy. The global impact will be the same. A flood of worthless products on the international markets. Worthless, that is, if the Yuan breaks its dollar peg. And, it likely will because Chinese authorities will very likely devalue their currency be it consciously or through self-fulfilling policy. More of that race to the bottom of the barrel we wrote about. Don't you just love a good race?
Guess what will likely become the hottest commodity in the active Chinese black market in coming years? Counterfeit Nike shoes? Counterfeit Sony Playstations? Counterfeit Viagra pills? How about genuine American dollars as restive Chinese spurn the currency of the communists?
And, what political, economic and social ramifications arise where devalued goods flood out of China? The effects on global volatility of this environment are potentially recursive and its end state is completely unpredictable. If social and even political instability develops around the globe, what happens to the massive investments in emerging markets and China made by international firms and global financial concerns? Well, we've talked about this one as well. No one loved the Nazis more than good European and American capitalists. That is, until global volatility developed. So, might I ask a simple question? How does one quantify intrinsic value and risk of investments with so much global volatility? How does one quantify the risk associated with international firms that may not only lose sales in emerging markets but may lose their entire investments in a worst case outcome? As an example, were China to take a hard line approach and close off foreign investment? Or even nationalize existing foreign investment? No one can accurately quantify risk in this environment.
You might consider the historical context for this type of volatility. That would be an environment where seeds of conflict are planted. I am not stating there will be global conflict. We could see nothing or we could see regional conflicts around the globe as corrupt states attempt to maintain their powers over the sovereign or we could see something much worse. The seeds of volatility have been sewn and now we have no other choice than to reap the harvest.
While every bull and bear was telling us to invest in China, we were warning of the tremendous risks again and again. Bulls loved China for the never ending growth associated with the world's largest population. Pax Globalia. The Asian Century. Bears loved China because they viewed it as a safe haven from the U.S. dollar and from the inevitable collapse of the U.S. Perfect examples are Rogers and Schiff, two well known bears that love the China story. They have been wrong on every investment call since this bear market started. Well, except for gold. So far.
Eerily, everything we have talked about is still coming together quite nicely. The greatest risks in the world have yet to reveal themselves. Grab something to hold on to. The world is very likely to hit a serious bout of turbulence for some time to come.
Now is a good time to end with a remark we made on here as the global stock markets were making their all-time highs. A time when the intelligentsia was telling us how bright the future was. In fact, never brighter according to Treasury Secretary Paulson as an example. "As I have said time and again this is the biggest bubble the world has ever seen. What truly worries me is that the size of the bubble has grown so much incrementally larger over the last seventeen months alone that it now threatens a chance of intermediate term recovery. What might have been a manageable outcome seventeen months ago has now become a global nuclear bomb. The world will literally shudder and shake when this cycle ends." Even the handful of prescient U.S. economists who anticipated a slow down were focused on the housing problem. We accurately wrote and still hold the truth-based perspective that neither housing nor the consumer can cause a recession let alone what we are witnessing today. I guess the economics community didn't attend class the day this fact was discussed. And, for that, this crisis has been and will continue to be underestimated.