Sunday 14 August 2011

The Coming Hard Landing of China.

China is a success story told many times over. It’s economic miracle has been the stuff of folklore. There are investors out there who think that China will keep growing forever. The commodity speculators love China. Be it oil price or copper, any spike in price in any commodity is attributed to the insatiable demand from China. But behind the obvious, there is another story. For those who are willing to question the fairy tale story, it is time to short China.

Let us start by looking at the socio-economic model of China. The communist party of China has ruled the country with iron hand for over from 1949. The political elite of China want to avoid any social unrest and upheaval at any cost. They have an unenviable task.  They have to provide enough work, food and shelter to the millions of ordinary Chinese. Being a command economy means there is no free market. The local purchasing power is insignificant compared to the western world. In order to create work and alleviate poverty, the leadership decided to take the route of growth by export.

Today China is the manufacturing powerhouse of the world and the single biggest factor in the growth has been low labour cost. Companies from all over the world shifted their production base to China to take advantage of the cheap labour. With the result, western civilization lost jobs. But most of the wages that a Chinese worker gets is at a level that is just sufficient for survival. Millions of rural poor migrate to bigger coastal cities in search of work and live in deplorable conditions. The worst part of the deal is that the companies that produce goods for the world do so at a very low level of margin, average 4% to remain competitive. And now every country is trying to grow out of poverty through export. Irony is, not every country can be net exporter, and someone has to be net importer as well. And consumers in western civilization do not have the capacity anymore.

China imports all the raw materials from other countries, iron ore from Australia, energy from Middle East, and machinery from Germany and produce goods to export. When the world demand for the cheap Chinese goods plummet, as it will with the slowdown of the global economy, what will happen to the export oriented growth model?

After 2008, China decided to kick start its economy through construction. And they found it is the easiest way to keep people employed while projecting a growth of GDP. But creating assets which does not give income does not actually create sustainable growth. When, not if, the world economy slows down in the coming months and years, the available capital to continue such useless construction projects will come to a halt. Already millions of homes and cities are lying vacant across China. As if the sub-prime housing crisis is being played all over again in China, but in a much greater scale.

Over the last 40 years, there has been a growing middle class in China who are well educated and are demanding. Since the currency is pegged to US dollar, the QE in the USA is exporting inflation to China in the form of higher food cost. And unlike in America, food cost constitutes over 40% of the average household expenditure in China. So inflation is rising in China and China is now battling hard to control the price rise. This is causing huge social unrest and the Communist Party is uneasy about it. As a result, we are seeing a slow rise in the value of Chinese Yuan vis-à-vis US$. But this cuts both ways. While a rising Yuan will help reduce the cost of imported foods, it will reduce the profit margin of the exports and make them uncompetitive. More so in today’s weak demand situation where the exporters do not have the leverage of negotiating higher prices.

There are talks about the huge Chinese holding of US debt and the threat they possess to US Economy. Actually it is the other way round. China has no option but to invest in US treasury and if they don’t, they would not be able to keep their currency down and be totally uncompetitive. If they want to sell the massive holding of the US Treasury bonds, they would push the prices down and lose money.  So again, China is caught in a no win situation there. With the money fleeing Europe, there is no shortage of demand of US Treasury, at least for now. So US do not need China, as much as China needs US.

The demographics are another factor to be worried about China. With one child policy strictly followed by the party for so long, the average age of the population is growing and the country is graying. Moreover, because Chinese parents prefer boys to girls, there have been systemic abortions of girl featus on a large scale for a very long period of time. With the result, the ratio of man and woman has been totally skewed. In some places there is one woman for every two men and poor migrant workers cannot get wife for the love of their life.

Central command always fails. The asset allocation in central command economy is not based on efficient use but what the party leaders think best. And few people cannot decide what is best for millions. Corruption is rampant and so are the red gift bags. Even the death penalty does not deter the local authorities much. The end result is something other than desired.

The bubble is about to burst along with the global debt deleveraging and the popping  sound will be heard loud, far and wide for many years to come.

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