Wednesday, July 09, 2008

China's Challenges: U.S. Meltdown and Peak Oil

Knowledgeable reader Jason C. recently sent in a nuanced query about China which neatly summarizes the many conundrums facing both the Chinese and U.S. leaderships:

In her book China: Fragile Superpower: How China's Internal Politics Could Derail Its Peaceful Rise , Susan L. Shirk (former Deputy Secretary of State) talks about the large amount (hundreds of billions of dollars, and by now nearly a trillion) of US Government debt instruments owned by China which buoy our economy.

She goes on to talk about the geo-political fragility of china and the situation with Taiwan which the US by law (treaty in 1979) must intervene in to protect Taiwan. The result would be economic sanctions and the sell off of debt by the Chinese in retaliation, forcing interest rates higher, gold down, and the rest of the world into global recession.

How does China's large stake in gold affect your statements and hers?

China is one of the largest holders of gold bullion, second only to the SPDR (GLD tracking stock). But arguably much of the GLD holdings are also owned by Chinese interests using shill companies to avoid sovereign scrutiny.

With China's hold on our debt and our gold, what should I be looking out for?

China's own inflation rate (from supply shock as well as ... printing of RMB (yuan notes) to fund infrastructure development, earthquake relief, and purchase of foreign assets (bonds, gold, real estate, companies) is escalating.

How does that color the arguments you have posed to support higher interest rates and higher gold prices?

Thank you, Jason, for an excellent and quite daunting set of questions. Let's begin with five short reports: first, a description of China: Fragile Superpower from

At a time when much writing about China frothily presumes the unstoppable rise of a global titan, it is refreshing that a respected academic and former government official (Shirk was the deputy assistant secretary of state for East Asia during the second Clinton administration) questions the notion that China is going to run the world. "China may be an emerging superpower," she writes, "but it is a fragile one."

Inside China, she argues, the party leadership is hemmed in by threats to its stability: a rapidly aging population, the rise of the Internet, privatization of the economy, a widening gap between urban rich and rural poor, a restive population fed up with corruption, pollution that not only sickens but kills, mounting unemployment in an economy that needs to grow 7 percent annually just to provide jobs for 25 million new people entering the workforce. "All around them," Shirk contends, "the leaders see new social forces unleashed by economic reforms that could subvert the regime." Moreover, Shirk describes a regime -- half Mafia, half corporate board -- so obsessed with staying in power that it is ill-equipped to deal with these challenges.

As for official China inflation: China's inflation rate dipped to a still high 7.7 percent in May, few saw reason to celebrate:
The rise in the consumer price index for May was lower than the 8.5 percent rise in April. Slower growth was widely anticipated thanks to state media reports suggesting the figure would be below 8 percent for the first time in four months.

But restaurant owner Ding Yuyi was unimpressed.
"Yes, I know the May CPI fell below 8 percent, but sorry, I just don't feel it," Ding said, noting he is paying 50 percent more for rice than a year ago, and double last year's prices for many vegetables and other cooking staples.

"I've had to give up cooking some dishes because my customers are very sensitive about prices and I can't make a profit," he said.

Investors dumped stocks on persistent worries over further credit tightening. The benchmark Shanghai Composite Index sank for a seventh straight session, falling 2.2 percent to 2,957.53, a 15-month low.

Food prices, a key component in the consumer price index, climbed 19.9 percent in May from a year earlier, down slightly from a 22.1 percent increase in April. Fresh vegetable prices, which have soared recently, fell 15.7 percent from a year ago, the National Bureau of Statistics said.
"While agriculture seems now to be responding ... there are other price pressures out there that are being severely repressed," Stephen Green, China economist for Standard Chartered Bank in Shanghai, said in a report Thursday.

"There is a lot more bottled up inflation in this economy than meets the eye," Green said.
Chinese retail gasoline and diesel fuel prices were hiked about 11 percent in November but have remained frozen since, despite surging crude oil prices. In January, food processors were ordered to get approval for any price hikes, and fertilizer prices have been frozen to protect farmers.

On Wednesday, authorities said China's producer price index for May -- an indicator of wholesale and raw material prices -- rose to 8.2 percent from April's 8.1 percent, boosted by double-digit increases in prices of oil, coal, steel and other industrial materials.

Next, we turn to China-based correspondent Mike D. for his response to my query about inflation in China as experienced by residents:

It was 7.7% annual in May. My wife feels that is 100% food and other supermarket necessaries since that is what she is most familiar with buying. Meat (pork and beef) are up 80-90% from last year. Cooking oil (Chinese go through it like water!) is up over 100%. Rice is higher in other parts of China, but the price seems to be controlled here at less than 20 cents a pound. As we live in the north, wheat is an important part of the diet and the price of flour is up about 50%. DVD's of recently released (!) movies are still about 75 cents each for professional quality, so we must be thankful for small mercies!

As you know, the price of oil products is controlled and has not changed since November last year. Because of the Sichuan earthquake and the ensuing loss of power plants, I can't see them raising the oil price before the Olympics. Clothing does not appear to have been affected much, but there has always been a huge range in quality and price so it is very hard to judge. As for imported items, there has been no change, perhaps because the CCP has carefully revalued the RMB (5.4% this year) at a slightly faster rate than the CPI.

Here is where, I guess, culture rears its head. The CPI is significantly higher than bank interest, but the Chinese continue to pour their money into the banks. When the Shanghai stock market topped 6,000 last year, there was a brief rush to get in on the easy money and many people put their savings into the market. They got burned badly and the Shanghai index is now back down around 3,000. Once bitten, twice shy. It was pretty clear at the time that the heavy hand of the CCP was behind the crash. I believe that they wanted to keep the banks liquid. Two of the major banks have material balance sheet exposure to the US sub-prime meltdown, not enough to endanger them, but certainly enough to cause some pain.

So, I believe that the CPI figures are reasonably accurate (more accurate than yours in the U.S.!). I don't think it is home-grown but rather imported inflation (the global food shortage and oil prices) and the aim is to keep it manageable while trying to ease the US economy in for a soft landing. If the people scream, the CCP still has many options -- increasing bank interest, accelerating the appreciation of the RMB, tighter price controls, tightening/loosening lending restrictions, etc.

There is no doubt in my mind that the Chinese government, whether you like it or not, is trying to manage the US economy in order to protect the Chinese economy.

Thank you, Mike for a superb summary and incisive conclusion. Next, let's consider what Peak Oil is doing to the entire Asia-U.S. trade model (link courtesy of frequent contributor U. Doran): Oil price shock means China is at risk of blowing up (

Asia's intra-trade model is a Ricardian network where goods are shipped in a criss-cross pattern to exploit comparative advantage. Profit margins are wafer-thin.

Products are sent to China for final assembly, then shipped again to Western markets. The snag is obvious. The cost of a 40ft container from Shanghai to Rotterdam has risen threefold since the price of oil exploded.

"The monumental energy price increases will be a 'game-changer' for Asia," said Stephen Jen, currency chief at Morgan Stanley. The region's trade model is about to be "stress-tested".
Energy subsidies have disguised the damage. China has held down electricity prices, though global coal costs have tripled since early 2007. Loss-making industries are being propped up. This merely delays trouble.

"The true impact of the shock will only be revealed over time, as subsidies are gradually rolled back," he said. Last week, China raised internal rail freight rates by 17pc.
BP 's Statistical Review says China's use of energy per unit of gross domestic product is three times that of the US, five times Japan's, and eight times Britain's.

China's factories "were not built with current energy levels in mind", said Mr Jen. The outcome will be "non-linear". My translation: China is at risk of blowing up.

Come what may, globalisation has passed its high-water mark. The pendulum will now swing back from China to America. The mercantilists will have to reinvent themselves.

Lastly, let's consider a two-part review of American decline: (links courtesy of correspondent Craig M.)

America and China: The Eagle and the Dragon Part one: Freedom fighters (
America and China: The Eagle and the Dragon Part two: Requiem for a dream

But these developments have done little to alleviate the overwhelming impression of Detroit as a city of dereliction, poverty, crime and despair. The city's revival seemed to depend not on luring tourists for a day or two holed up in a casino, but persuading people it was a feasible place to live. As one downtown shopkeeper put it, 'the trouble is the infrastructure and services - garbage disposal, policing, upkeep - is so bad, that nobody in their right mind would want to live here. You call the cops and they probably won't even show up unless it's a murder. It's terrible.' To keep my response to Jason's questions shorter than booklength, here are what I consider the key points:

1. inflation is rising in China for two reasons: global demand for goods and the stupendous increase in money supply Jason described. Without going into detail, money is expanding in China the same way it expands elsewhere: via loans/new debt. Despite lingering bad debt (impaired loans) from the last downturn (2000-2002), the banks in China have created vast sums of new loans. In addition, the trade surplus with the U.S. brings in vast quantities of dollars, and "hot money" has flowed into China (legally and otherwise) to benefit from the appreciation of the RMB (yuan).

As assets like stocks and real estate deflate/fall, then China faces the same problem the U.S. faces: bad debt, great mountains of it, which exceed the value of the assets purchased with debt (condos, municipal sports facilities, etc.)

In other words, inflation isn't going away in China until global demand drops, and easy money/new loans dry up. In other words: recession.

2. Mike D. nailed it: China must manage the U.S. economy for its own benefit. The U.S. has no such challenge; it has benefitted enormously from trade with China in two ways: lower costs for manufactured goods and high corporate profits, which are 14% of U.S. GDP, an all-time high.
The U.S. has little need (and virtually no leverage) to manage the Chinese economy; the cheap goods and the profits flow to the U.S. companies, and if the yuan gets too expensive, or oil keeps rising, then they move production elsewhere.

Many observers claim China can "de-couple" from the U.S. and grow its economy by selling its stupendous manufacturing output to its domestic consumers. As I noted yesterday, this is based on flawed assumptions of the size of China's domestic economy:

Those who believe China can "decouple" from the U.S. fail to weigh the reality that about 75% of the Chinese economy is export-based, in comparison to about 20% for exporting nations like the U.S. and Japan.

Furthermore, China's GDP is grossly overstated by the usual purchasing power parity (PPP) methodology, as noted by Harold Brown of the Center for Strategic Studies in the March/April 2008 issue of Foreign Affairs:

"Per capita GDP at PPP is a good measure of affluence, that is, the of the individual standard of living. Butt he appropriate measure of the potential influence of a national economy on the rest of the world is the national GDP at exchange rates.

Even if China's remarkably high growth rate does not falter, a continued 6% gap between the U.S. and China's GDP growth would still leave the Chinese economy in 2020 at about one-third the size of the U.S. economy. "

In other words, China is extraordinarily vulnerable to a reduction in exports.

So how does China manage the U.S. economy? One, peg the yuan to the dollar (adjusted in careful, gradual increments), and Two, buy U.S. Treasuries to keep U.S. interest rates low to provide more fuel for U.S. consumers.

Given all of the above, we have to ask: wouldn't it be economic suicide for China to dump its Treasuries, and thus political suicide for its leadership? The populace might well cheer the conquering of Taiwan for a week or two, and then as their livelihoods vanish, their euphoria and pride would soon turn to anger--an anger which would eventually turn toward the government which engineered their impoverishment.

3. Peak Oil is real, and it isn't going away. Yes, solar and other alternative energies may well replace much of the energy we currently obtain from oil, but that transition--taking solar and wind energy from less than 1% of global energy to 50% or more--will take a long time. In the meantime, global trade will become increasingly expensive and increasingly unprofitable. There is little China can do to bring oil down as supply falls (depletion) and demand rises (100 million scooters in India, etc.)

I have written before that I expect one last "head-fake" of oil prices dropping as the global recession deepens, but falling supply will soon catch up with lower demand, and prices will leap beyond what most pundits think possible (try $1,000 a barrel).

4. Rising expectations are even more dangerous than inflation. I have long maintained that rising expectations are the key psychological driver behind widespread social turmoil. As Peak Oil guts the trade model China depends on for its wealth creation, and the purchasing power and wealth of its citizenry falls, China's leadership will face growing domestic unrest.

Yes, it could distract the populace with a war for Taiwan; but as I said above, the financial cost to China would be essentially suicidal. (Note that Taiwanese investors own much of China's industrial base, and they may not consider the invasion just another ho-hum blip on the trading screen.)

Then there's the possibility--never easy to parse ahead of time--that the invasion might escalate into a limited nuclear war. As covered here before, the more concentrated a nation's essential infrastructure is (think Three Gorges Dam), the greater the damage a few nukes can wreak.
The U.S. has been engaged in a nearly permanant state of war for decades; would China's leaders really think the most warlike nation on the planet would turn away from conflict? Based on what evidence?

I would summarize the dilemma China's leadership faces in this way: has the U.S. economy and the global trade/energy nexus slipped beyond its control? I would say yes. The U.S. is entering a long, deep and profound recession which will slash domestic consumption of Chinese-made goods. At the same time, the inexorable rise in oil prices has gutted the profitability of the Asian trade model for everything but high-value goods (solar panels, semiconductors, etc.)

My premise about interest rates is based on these observable trends. As China's exports to the U.S. shrink, so too will its supply of surplus dollars, and thus its ability to keep buying hundreds of billions of additional U.S. Treasuries. With that key prop removed, then rates in the U.S. will have to rise, as the demand on the pool of available global cash made by staggering Federal deficits will exceed the supply of those willing to recklessly gamble on the dollar and the U.S. economy for a lousy 3.5% return for decades to come.

Gold is another issue. Let's just say that gold tends to be horded and valued in times of insecurity and turmoil, and if you see insecurity ahead, then you will be unlikely to sell your gold to get renminbi or dollars or quatloos. Does China have enough gold and the political will to base its currency on gold? That's a speculation for another day.

Here are several other China-related stories of note:

China's Export Machine Threatened by Rising Costs Orders Drop, Shops Idle in Sweater City; Losing Wal-Mart

inflation menace threatens asia decoupling

Victim or Victor? China's Olympic Odyssey Resurgent nationalists are counting on a torrent of gold medals to erase centuries of humiliation. Will the Beijing Games complete a restoration of Chinese greatness or arrogance?

The Cleveland of Asia: A Journey Through China’s Rust Belt

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