Tuesday, October 21, 2008

A 1,000 Foot High Tsunami
October 21, 2008

A topic of much debate is how the recession in the U.S. and Europe will impact China. One camp sees strong domestic growth, investment and government spending as cushioning the inevitable fall in exports; another camp sees thorny structural problems being unmasked by global recession.

Longtime correspondent and frequent contributor Cheryl A. sent in this story China's Growth Slows to 9%, Below Expectations, which linked to this piece in the Far East Economic Review: The Great Crash of China.

The Economist checked in with this update Growth slows in China, as the global economic slump takes its toll (Oct. 20 2008).

Earlier this year, The Economist ran a piece which supports the "decoupling" camp's belief that domestic spending is larger than statistics give it credit for: An old Chinese myth Contrary to popular wisdom, China's rapid growth is not hugely dependent on exports (Jan. 08).
In a recent entry The Coming Destruction of U.S. Bonds (October 3, 2008) I quoted from Henry Paulson's essay in Foreign Affairs, The Right Way to Engage China, as we can probably assume Paulson has access to reasonably accurate data:

One of the most notable indications of China's imbalanced growth is its large current account surplus, which last year amounted to over 11 percent of the country's GDP. This reflects the fact that China spends much less than it produces and earns and that it has a high rate of national saving. Chinese household consumption was only 35 percent of GDP in 2007, down from roughly 50 percent 30 years ago, when Beijing started market reforms. (Household consumption is roughly 70 percent of GDP in the United States and 60 percent in India.)

On the other hand, household savings are high, as individual Chinese try to compensate for the country's thin social safety net, limited options to finance major expenditures such as education, and few investment options other than bank deposits. Demographics will only exacerbate these trends: as China's population ages, the traditional source of support in retirement -- children -- will become increasingly scarce.

(If you'd like some context for China's long-term structural challenges, please read my 2005 report, China: An Interim Report: Its Economy, Ecology and Future .)

Let's stipulate a few points before we begin any analysis:

1. Statistics on China are not entirely reliable for a number of reasons. (Cheryl A. sent along a comment made by Marc Faber in an interview with Bloomberg dated Oct. 20. 2008, along the lines that one thing China learned from the U.S. is how to doctor economic data. He doesn't believe the 9% growth number and says China will be lucky to have an annual growth of 5%.)
2. There is a long lead time in exports, hence any impact of the Western meltdown is still ahead.
3. "reports from the ground" in China provide nuance and context which is missing from statistic-only analysis/opinion.

With those points in mind, here is a report filed a week ago from a good friend of ours, a Chinese native who has traveled widely in the West and has split her time between China and the U.S. for many years. Our friend did not grow up in an elite but worked her way up like everyone else via education and hard work:

"No matter whom we talked to these days, the topics were all related to the financial and economic situation in the U.S. They seem to follow what's going on in the U.S. very closely. They believe that the many complicated products recently developed by those banks, and the U.S. government not doing a good job in monitoring those banks caused the financial problems in the U.S.

According to the newspaper and internet messages here, almost all ordinary Chinese people object to putting more money in the U.S. to help rescue the mess there. I don't think the Chinese government is eager to help out either. However, they all realize that the slow economy in the U.S. is going to affect China's export business, and hence the factories and other related sectors. On the other hand, they also believe that the Chinese products which have been sold in the U.S. are mostly daily necessities of ordinary American people, not luxury products that you can live without in a slow economy. So they think the weak buying power of American people will affect European products more than Chinese products.

The economy here seems fine, although my friends as well as my father did complain about the weak stock market. But you don't feel the panic here at all, people still have their stable jobs and incomes, and even those who have lots of money tied up in the stock market have large deposits in the bank. Most people we talked to own at least one or two apartments (some houses), and are all paid off. So they hardly have any expense, except food, clothing and gas.

I won't say people here are taking pleasure in other people's misfortune in this regard. But you do have a feeling that America/Americans' image is significantly declining."

Put this all together and I think a 1,000 foot high tsunami is heading for the shores of both China and the U.S.

Let's start with the wave heading for the U.S. Given our correspondent's report (as well as many other online reports), we can anticipate a rising political pressure within China to spend its surpluses on domestic development.

The enormous need for infrastructure and additional education in China's vast rural interior is beautifully illustrated by this remarkable 1999 film Not One Less .

If the Chinese central government shifts its export-created surpluses to domestic spending, the big loser will be U.S. bonds and debt. Here is my oft-published chart of the U.S. bond yield and the staggering rise in Chinese ownership of U.S. debt:

What this chart illustrates is that the only reason interest rates haven't skyrocketed along with rising U.S. debt is that China and other non-U.S. players with hundreds of billions of trade-surplus dollars have been soaking up that debt (bonds) with their dollars.

This can be seen as manipulation for the benefit of oil exporters and Asian exporters equally anxious to prop up American consumers with low interest rates, or as intervention to keep their currencies lower than the dollar, or as a combination of manipulation/intervention and "safe haven" parking of stupendous hordes of dollars.

Regardless of the perspective, one thing is clear: as soon as that foreign buying declines, U.S. interest rates will start rising.

Rising rates as the U.S. attempts to borrow-and-spend its way out of a deep recession via stupendous deficits of $1 trillion or more a year is a 1,000 foot high tsunami which will wash over housing (rising mortgage rates) and government spending (more money will be diverted to paying interest on old and new debt).

Some readers have suggested that domestic savings will start pouring into Treasuries as Chinese investment in T-bills recedes (you know how the tide seems to ebb just before the tsunami hits), and I agree some domestic savings will flow into "safe" T-bills. But the question is: will enough flow in to keep rates low?

There are three big problems with this scenario:

1. domestic savings rates are still very low, and it is quite a stretch to anticipate the U.S. saving $1 trillion a year and putting it all in T-bills.
2. the yields on T-bills are so low now that they are only appealing in times of panic/crisis; as soon as that fades, investors will seek better returns just as they always have.
3. As recession guts U.S. household incomes, then people may find they have less to save even as they slash household spending.
Ironically, the biggest incentive to more domestic purchase of T-bills would be a much higher yield--a condition I think we're going to get regardless of what the Fed does with the Fed Funds rate.

I think the 1,000 foot high tsunami heading for China is made of many smaller waves coming together:

1. The idea that investment in steel mills, shopping malls and commercial real estate will continue unabated during a deep recession/depression in the U.S. and Europe is suspect. China now faces over-capacity in virtually every industry, domestic and export alike. As I have noted here many times, over-capacity in domestic TV production has been an issue since early 2000; now the same over-capacity can be found in autos, steel, cell phones, etc.

Stories of nearly empty giant shopping malls are filtering in; a gigantic over-building of commercial and retail space in China has taken place and those bubbles are about to burst.
2. Retail sales rose 22% nominally, but inflation accounts for some of that rise; and with exports having a long built-in lead time, the effects on household income from a declining export sector have yet to be fully realised.

Add in the inevitable collapse of real estate overdevelopment and construction, and you get a significant drag on retail sales.

3. Complacency is the enemy of good judgment. If there is a single word to describe the fall of the U.S. financial empire and economy, it would be a tough battle between hubris and complacency. Our friend's report suggests complacency is running very high in China now; the successes of the Olympics and the space flight and the demise of the U.S. financial house of cards are clearly creating a rosy glow of confidence/complacency that the effects on China will be minimal.

That sets up brittle expectations which are vulnerable to shattering. Our friend's report reveals a faith that the U.S. consumer will still be buying Chinese exports regardless of recession; while this is undoubtedly true to some degree, it is also true that the U.S. is literally awash with too much of everything. Once people start opening up their millions of storage lockers and selling the contents for a few cents on the dollar, the demand for "new" will be considerably less.

4. China has its own lending/debt bubble. It's difficult to sort out how much easy money is sloshing around China looking for a home, but it is certainly in the hundreds of billions of dollars--much of which has now been mal-invested in empty malls, factories making stuff nobody's buying, municipal sports complexes which generate no revenues, etc.

Will China weather a global recession? Of course; Chinese people are used to hardship, many families have large savings and as our friend noted, most households have little or no debt. Those are huge advantages in any economy. But at least to this observer, an "impossible" drop from +10% GDP growth to -1% GDP decline is already baked in by the upcoming collapse of exports and direct foreign investment and the consequences of mal-investing much of the past decade's surpluses in projects with little or no positive return (empty malls, sports complexes, etc.).
There will be plenty of Chinese ghost towns, too, just as there are so many overbuilt, mal-investment ghost towns in the U.S. The tsunami is traveling from the center toward both East and West, and the consequences will last for quite some time.

Bonus "it's a small world" story:
I haven't mentioned that Obama and I graduated from the same private prep school in Honolulu. I don't think this alumni connection taints my analytic skepticism too greatly, but I do have a soft spot for Obama's Hawaii connections, which I believe are more profound than most Mainlanders can understand.

I recently discovered some of my old Lanai High School teammates scrimmaged with Obama after-hours on the Punahou basketball courts; here is my report, graciously posted on Ian Lind's widely read and highly respected Ka'a'awa-based blog ilind.net--The Obama-Lanai Connection.

Put this in the "Dis stay one small-kine world" file.... And for your listening
pleasure/amusement: Patriot Express (in disguise) sings Sarah Palin, Queen of the Red party. The lyrics helpfully pop up for your reading pleasure.

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