china collapse mar 11 2010 volume 2 3

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VOLUME 2.3 MARCH 11, 2010

China Collapse:

Are the Bears Out to Lunch?

China has weathered the global financial crisis extremely well. Exports rose 45.7% in February

from a year ago and GDP growth near 10% through 2010 is likely (Charts 1 & 2). In contrast to most

developed nations, the Chinese financial system has shown few signs of strain during the downturn.

Non‐performing loans (NPLs) are at record low levels and capital ratios at publicly listed banks have

been beefed up with rights offerings of around 250 billion rmb over the last few months. Despite these

signs of strength, there is a rising chorus of sceptics who argue that the recovery is hollow and that the

miraculous growth rates China has achieved over the last 15 years will soon be over.

Of course, these arguments have been made many times during China’s transformation. At its

most basic level, the bear argument is derived from the fact that China has had what is probably the

biggest, longest economic boom in history. The logic applied is that the bigger the boom, the bigger the

bust. Here are the key arguments supporting the bear case:

Imbalances between China and its debtors have grown relentlessly, which will eventually crack the

undervalued rmb and force a limit to U.S. indebtedness.

Excessive dependence on exports combined with a failure to adequately develop domestic

consumption leaves China vulnerable to external shocks.

Overinvestment has led to significant overcapacity; corporate profits are threatened and the banking

sector is vulnerable to a sharp increase in non‐performing loans, particularly after the credit boom

and government stimulus in 2009.

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Excess liquidity and volatile capital inflows are leading to frothy asset markets particularly in stocks

and real estate.

Inflation is on the rise and the risk of monetary tightening is growing.

Finally, shady accounting and political interference undermines confidence in official statistics and is

probably hiding some nasty surprises.

Chart 1 Chart 2

The bear story has a lot of adherents and it is based on assumptions that all the above points

have some validity. A reckoning may well come to pass at some future point but it won’t be soon. Over

the time horizon of most investors, it has a low enough probability of occurrence that people should not

pay much attention to it. Here’s why.

China’s U.S. $2.2 trillion build‐up of reserves and the flipside—American overindulgence and

excessive debt accumulation—are both clearly unsustainable, yet there are few signs of strain between

China and its debtors besides political noise. Despite the financial crisis and the dramatic slowdown in

trade between the U.S. and China, the currency peg is intact and the dollar continues to defy its sceptics.

China’s stimulus has been successful in bridging the export slowdown with little damage to public


finances (unlike in the West) (Chart 3). Protectionist sentiment will definitely mount in the U.S. and

other developed nations, as they are desperate to rekindle domestic manufacturing industries, reign in

current account deficits and (most importantly in an election year) to find a scapegoat for high domestic

unemployment. The rmb will be the principal target, but Chinese policymakers will be reluctant to

restrain the export sector when they consider the global outlook to be so uncertain.

Chart 3

Whether the rmb is allowed to appreciate any time soon is a difficult question. Some

economists in China argue that the appreciation of the yen was a key factor in the Japanese crash and

recession. So they resist the appreciation of their own currency to avoid a similar fate. Obviously, this

argument confuses cause and effect. The Japanese currency spiked upwards in the mid to late 1980’s as

a consequence of years of imbalances that resulted from artificially cheap exchange rates. Modest and

carefully managed currency appreciation could have helped cool the Japanese bubble, but only if it was

implemented before the economy and financial system became dangerously overextended. Given a

(flawed) intellectual foundation to resist currency appreciation and an overemphasis on the short‐term

need to maintain growth and high employment at all costs, the timing of the rmb trade is a hard call to

make, but any significant move is not likely to be soon.

Regarding excess credit expansion, Chinese policymakers would probably agree that they


overdid it in 2009 and that the recovery was quicker and more robust than expected. Money supply

expanded at a 30% annual rate (Chart 4). Unlike in the U.S. where the Fed’s open market activities did

not result in appreciable credit expansion, in China bank lending increased by an equivalent 30% in 2009

(Chart 5). Political interference in the banking system has its benefits. Exports are increasing at a 45%

rate from a year ago and house price increases are accelerating. Chart 6 shows an 8% increase but some

estimates are considerably higher. The authorities have moved to reign in bank lending. Consequently,

Chinese equity markets sold off by about 12% in January, which we view as a healthy correction rather

than a trend reversal.

Chart 4 Chart 5

Chart 6 Chart 7


There continues to be no risk of generalized price inflation in China. There was a brief period of

deflation in the last quarter of 2009, and the annualized rate of change on the CPI and PPI is currently

reading 2% and 5% respectively (Chart 7). However, it is important to note that prices are still well below

the peak levels of 2007. Continued productivity gains resulting from robust fixed asset investment and

abundant labour (there is a virtually inexhaustible supply of workers migrating from rural areas) will

ensure that any bottlenecks are fleeting and localized. The most likely scenario is that the era of Chinese

disinflation is likely over, to be replaced with a period of mild inflation.

The question of how much slack there actually is in the Chinese economy is subject to debate.

There are certainly examples of key state‐sponsored enterprises, particularly in heavy industries that

operate with significant overcapacity, but this is hardly a contrast to most developed nations who all

have their pet industries that fall under the protective wing of the state—think GM or U.S. Steel. While

the expansion of lending such as that in 2009 is often said to aggravate overcapacity, the bulk of the

additional lending was directed to infrastructure projects which are badly needed throughout most of

China, and many of these were conducted by various levels of government, rather than the corporate

sector.

Corporate profits would ultimately suffer if indeed there was widespread overcapacity in the Chinese

economy. The downturn in profits seen in 2009 is not remarkable compared to Western corporations

(Chart 8) and will likely rebound sharply when the numbers from the 2nd half of 2009 come in.


Chart 8

One concern for investors is whether the sharp increase in state‐directed lending in 2009 will

lead to a potentially destabilizing jump in non‐performing loans. Non‐performing loans peaked at

around 20% a few years after the 1997 Asian Crisis. In 1999 and 2000 the government transferred rmb

1,400 billion of non‐performing loans to a “bad bank” in exchange for 10 year bonds paying 2.25%, in an

amount equivalent to the face value of the NPLs. The recovery rates on these loans were initially

reported around 20‐30%, but there have been no figures reported in the last few years. Due to the

bailout (which has yet to be fully resolved) official NPLs at listed banks are reported to be in the 2‐3%

range. NPLs would have to go up a long way to be a concern, and even then, the capacity of the state to

bailout the banks again, if necessary, is huge.

Although hypocritical for Westerners to lecture the Chinese on financial discipline and

transparency in the wake of the 2008 financial debacle, the fact is that Chinese banks have been sorely

lacking on these two fronts. Accustomed to being made whole through state backing, it remains to be

seen what influence shareholder scrutiny resulting from public listing will have on Chinese banks. The

Chinese financial system is currently undergoing a gradual metamorphosis—emphasis on gradual. Full

transparency and independence from political interference are a long way off, and there may be some

nasty surprises as the state control wanes and investors are finally able to have a peek inside the


kimono, so to speak. This may be reason enough to avoid investing directly in any listed Chinese banks,

but there is little cause for concern over any systemic risk to the Chinese economy from bad loans.

Asset prices are another cause of concern. The Shanghai stock exchange (SSE) index has risen

sharply since late 2008, driven significantly by foreign investment (Chart 9). The B shares index is up

177% since October 2008. The SSE A Shares are now trading at a P/E of 28 (Chart 10), which is

significantly lower than the longer term average of 37 (and well below the Japanese 1989 peak of 70).

Even if GDP growth slows to 7‐8%, current valuations are fair.

Chart 9 Chart 10

Specific measures to cool the housing market are a contrast to the repressive approach applied

in previous cycles. Rather, policymakers are discouraging speculative investment while freeing up land

for development and stepping up affordable housing construction. Despite the excessive expansion of

credit last year, it looks like policymakers are showing good timing and judgement in manoeuvring the

Chinese economy for a soft landing.

The longer‐term outlook for China is certainly a cause for concern, but serious problems are

likely beyond the time horizon of most investors. China has considerable room to manoeuvre to delay a

reckoning: ample reserves, robust growth and low inflation. Most importantly, the financial balance


between China and the U.S. is intact and will continue for the foreseeable future. We believe the U.S.

economy’s growth will slow but stay positive, providing a reasonable level of demand for Chinese

exports. Meanwhile, China’s exports are becoming increasingly diverse as the bulk of new trading is

with emerging Asia, Latin America and Africa (Chart 11).

Chart 11

China continues to provide excellent investment opportunities. The best case scenario would be

if there was a bit of a shakeout over the next few months as monetary policy was normalized. Tighter

monetary policy and perhaps limited rmb appreciation would help take some of the froth out the

markets and establish the conditions for a lasting bull market in China. Look to buy on weakness over

the next few quarters.

Investment Conclusions

We remain positive on risk assets—equities, commodities and corporate bonds—for the short

term, a time frame of roughly six to twelve months. The basic backdrop continues to be one of plentiful

liquidity, very low interest rates, gradual healing in the financial system, virtually non‐existent inflation,


recovering economies and a stable dollar. So long as these conditions remain in place, investors will

continue to be pressured into seeking higher returns. But, as we emphasize in every issue, this is not a

stable long‐lasting equilibrium. The massive worldwide reflation is an experiment and it did save the

world from a total financial collapse. As Ben Bernanke, the Federal Reserve chairman, said almost

exactly one year ago in referring to the 2008‐2009 financial crisis, “I felt we were pretty close to a

financial meltdown”.

However, the reflation has had positive results so far but this in no way implies that the U.S. and

world economies will be made whole again. It remains to be seen how much private debt—the

proximate cause of the crisis—will be reduced and to what extent escalating public‐sector deficits can

be brought under control in a timely way. If governments do not put in place credible programs to

control public‐sector debt ratios, the markets will do it for them and it won’t be pretty as the plight of

Greece has so well demonstrated.

The recent sovereign debt crisis and its incipient global spread have been contained for the time

being but it won’t go away. Recent talk of creating a European Monetary Fund (EMF), an ego driven

“solution” to the debt problems of the PIGS (Portugal, Ireland, Greece, and Spain) is dangerously flawed

and cannot work in the manner of the International Monetary Fund (IMF) which is apolitical and

credible.

For the near term, we expect the U.S. and global recovery to slow but stay positive. The Fed will

be in no hurry to tighten policy for a number of reasons: the financial fragility of the system, non‐

existent inflation, continued very high unemployment in the U.S. (close to 10% and 16% counting

discouraged workers) and structural unemployment at 40% of total unemployed. The firmness of the

U.S. dollar in the exchange markets, financial constipation in the U.S. banking system as indicated by


bank lending, money supply and the persistent tendency of banks to build excess reserves means that

the Fed continues, as the saying goes, to push on a string (Charts 12‐15). There is no short‐term threat of

Fed monetary ease translating into rising price inflation. Moreover, key asset markets such as

commercial and residential property, equities and commodities do not indicate bubbles that need to be

restrained. The S&P 500 is little changed from four months ago and is still almost 25% below the peak 10

years ago. The housing recovery has faltered and commercial property is still declining on a national

average basis.

Chart 12 Chart 13

Chart 14 Chart 15


In sum, we look for a continued positive environment for stocks and corporate bond spreads,

although the great bulk of spread narrowing has occurred. We look for relative stability in U.S. Treasury

yields with a tendency for rates to drift up. Treasuries may be a safe place to hold liquidity but total

returns will be poor. Fundamentally, the U.S. dollar is a weak currency. Its main attribute is that it

doesn’t smell as bad as the euro and the yen and, as we have said many times, no one, apart from hedge

funds, has any interest in a dollar crisis.

Stay long risk, stay worried and don’t forget to keep your focus on long‐term wealth

preservation. Enjoy the better times because they won’t last.

Tony & Rob Boeckh March 11, 2010 www.BoeckhInvestmentLetter.com [email protected]

*All chart data from IHS/Global Insights, and may not be reproduced without written consent.


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