Chinese "train-wreck"?
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

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

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

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

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

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.)

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