commissioner.org
| Source | Jim Devine |
| Date | 06/07/28/15:24 |
| Jubak's Journal 7/28/2006
Why China's train wreck will hit us [the U.S.], too As China's runaway economy heads for disaster, here's what investors can expect to see. By Jim Jubak THE ROAD FROM DEVELOPING to developed economy is lined with wrecks and filled with potholes. During the 19th century, as the U.S. economy moved from global insignificance to global dominance, the United States hit major holes in the road in 1819, 1837, 1857, 1873, 1884 and 1893 -- each a major financial panic with its own combination of bank failures, stock market crashes, economic depressions and monetary contractions. In my last column, "China's economy is out of control," I argued that China is about to hit one of these inevitable potholes. I put the date at sometime in 2009, about a dozen years after China faced its last battle with economic panic during the Asian currency crisis of 1997-1998. In that column, I sketched out my reasons for fearing that China's economy, which grew by 11.3% in the second quarter of 2006, is growing too fast. In today's column, I'll try to lay out what would happen if, indeed, China's economy is now headed toward what I called a "train wreck." ... A major economic break Please be clear about one thing: I'm not predicting the end of the Chinese economic miracle. Even if I'm right about China suffering a major economic break in 2009, I don't think that will end, by any means, the country's extraordinary drive toward global economic power. Economic train wrecks of the sort I describe here are the normal growing pains of any rapidly developing economy. [thus, his earlier "pot hole" would be more appropriate. Or if we're talking about "growing pains," it would be "acne."] However, history argues that it's unreasonable to expect that China will make the transition from undeveloped to developing to developed economy without the periodic wrecks that characterize the history of all of the world's current developed economies -- including the United States. The Chinese economy with its still-changing mix of Communist top-down command and capitalist bottom-up [sic] market economies is, of course, very different from the Wild West capitalism of the 19th century in the United States. Still, I think that history can help pinpoint five trouble spots in any breakdown in Chinese growth. 1. A collapse in profits and price of speculative companies. Of course, the price of speculative financial assets such as land or art will collapse if China's economy hits a major pothole. So will the profits and prices of productive industrial assets in those industries that have seen the greatest influx of speculative investment capital. In the panics of 1873, 1884 and 1893 in the United States, railroads -- the major speculative industrial investment of the time -- collapsed as business depressions that cut rail traffic caused a rapid contraction of freight prices. Overbuilding financed with foreign hot money had pushed rail capacity far ahead of demand. In the panic of 1873, nearly one-fifth of all railroad mileage in the United States was sold in bankruptcy proceedings and 89 of the country's 364 railroads failed. From 1873 to 1875, 18,000 businesses failed in the United States. As you might expect, overseas investors, a major source of speculative capital invested in the railroads, took a bath. I'd expect the same pressures to come down hard on those Chinese industrial sectors in which big influxes of foreign and domestic capital have created dramatic overcapacity. Industries that are marginally profitable now, such as textiles, would run quickly to red ink. Already unprofitable sectors, such as iron and steel, would become even less profitable. And the dreamed-of profits in hot new industrial sectors, such as autos, would simply vanish. Overseas investors would take a bath. 2. The walking dead will haunt the economy. Nineteenth-century U.S. capitalism was exceedingly efficient at cutting its losses -- companies went bankrupt and assets were liquidated with extraordinary speed. That's not true of the Chinese economy. China's current government has made it abundantly clear that it's willing to sacrifice just about anything -- profits, the environment, public health, judicial due process -- to preserve jobs. [aren't they forced to do so by the rise in working-class discontent?] If in an economy growing at 11% the government isn't willing to shut down unprofitable companies, I think there's no chance that Beijing will let unprofitable companies shut down and throw hundreds of thousands of Chinese out of work in a bad economy. One of the advantages of a top-down command economy is that the officials in Beijing can change the rules of accounting, force lenders to make unprofitable loans, and prevent financial markets from marking down the prices of troubled companies. I'd expect that China would follow a policy modeled on its approach to troubled banks after the 1997 crisis: Give companies plenty of time and plenty of money to fix their problems rather than forcing them out of business. 3. We lose money on every sale but make it up on volume. In the 19th century, the major constant -- despite individual booms and busts -- was falling prices of commodities. The boom of 1897 finally ended 33 years of falling prices of things such as wheat and copper that had been driven by a huge global expansion of production capacity. An economic downturn in China is likely to export deflation, too. But the biggest deflationary effect will be in manufactured goods. Think it's tough to compete with China on the price of manufactured goods now? Wait for a downturn, when companies are told to keep workers employed and busy producing even if the finished product is just piling up in warehouses. 4. Who will eat the bad loans? In 1873, Jay Cooke & Co., which had acted as a de facto Treasury to sell the bonds that financed the Union in the Civil War, failed, overextended by its efforts to finance the Northern Pacific Railroad. In the ensuing panic, banks simply refused to pay out gold. Security prices collapsed and the New York Stock Exchange closed for 10 days. Don't expect anything like that kind of very visible financial collapse in China. First, as the Asian currency crisis of 1997 demonstrated, the Chinese government is very good at giving the country's big banks the time and the accounting latitude to fix their bad-loan problems. Second, the Beijing government has prepared for a rise in bad loans as a result of an economic downturn by selling off stakes in the country's biggest banks to overseas investors. The government has guaranteed that some of the world's deepest financial pockets will be available to bail out China's banks in the next crisis. 5. A different kind of labor unrest. Strikes that turned into pitched battles between unskilled or semi-skilled workers on one side and thugs hired by company management (or U.S. troops called out to put down the "unrest") on the other accompanied the U.S. economic panics of the 19th century. The Beijing government's biggest challenge in any downturn will come from younger, relatively privileged and well-educated graduates of China's universities and technical institutes. [really?? -- couldn't the problem be _both_ the working class and the stratum that Jubak focuses on?] According to a recent McKinsey & Co. study, even the current booming economy is leaving large numbers of this group disappointed. For example, China produces an impressive 600,000 university-trained engineers annually. But thanks to an educational system that stresses rote and memorization, McKinsey calculates that only about one-third of those engineers have the skill level demanded of an engineer by a global economy. That's great for the qualified one-third: Their salaries have soared. But it's bad news for the two-thirds who aren't able to find jobs that match their expectations. An underemployed and dissatisfied class of university graduates is far more of a threat to the government of a developing country than unrest among the peasants. Assessing the fallout So what does all this mean for us investors? First, the good news: In the short term, if the Beijing government really has lost control of the economy, the lead-up to any train wreck will be a further acceleration of economic growth. That growth will be increasingly inefficient, wasteful and speculative, but it will also be faster. The final straw could well be the massive surge in government spending in the run-up to the 2008 Beijing Olympics. As a result, the Chinese economy is likely to consume even more of the global supply of commodities as it speeds out of control. Look for prices of iron, copper, nickel, coking coal and other raw materials to continue to climb into 2007, at least. You certainly don't want to be holding shares of commodity producers if the Chinese economy does stumble, but the acceleration that will ultimately produce the wreck is likely to push stocks of these companies higher. For you, as a short-term investor, that means buying mining stocks and commodity producers for the next 12 to 18 months, making sure you revisit your picks before the end of 2007. Now, the bad news: Because the Chinese economy remains a top-down command economy -- and not a market economy -- any economic downturn in China is likely to be relatively mild but also extremely drawn out. Because Chinese companies won't go bankrupt, because Chinese banks won't fail, and because hundreds of thousands of Chinese workers won't be thrown out of work, China's economy won't experience anything like the chaos that characterized the panics of the 19th-century United States. But the danger is that without some version of these destructive mechanisms, after the train wreck arrives in 2009 (by my best estimate), the Chinese economy could wind up stuck in a lower gear for a long time. (Think Japan.) A lower gear might be just 7% GDP growth by the official numbers, but that still represents just breakeven in China's race to find jobs for all the new workers its population throws up each year. And 7% growth would be a huge four percentage points less demand growth for the global economy.That's enough of a decline in demand to send shock waves through national economies that are depending on high commodity prices to provide the cash to meet the aspirations of their own populations for jobs and more consumer goods. Unfortunately, many of the national economies that will get squeezed hardest by any slowdown in China belong to politically unstable regimes; Russia, Iran, Saudi Arabia and Venezuela come to mind immediately. A slowdown in China means increased unrest in those already troubled areas and yet a further step up in volatility for an already volatile world. (And if you think that sounds like a reason beyond 2008 to own gold and other assets -- such as inflation-protected U.S. Treasurys -- that appreciate with volatility, you'd be right.) |
Copyright (c) 1998, Joongpil Cho