Who will save China?

In few months its become apparent that more and more reporters are jumping on the “China is vulnerable after all” bandwagon. I have had this view for some time now, and this post will examine a few reasons why China is as-vulnerable as many other countries in the world. Australia is very vulnerable because we are so reliant on China and commodity prices.

The Chinese Miracle?

The growth of China's economy in the last 15 years is nothing short of a "miracle". Compared to the other miracle economies, the 4 Asian tiger economies up to the 1990s and more recently the Celtic Tiger (Ireland - the roaring tiger of Europe - look where it is today!), China is in a completely new ball park. No country in history has built so much stuff in such a short space of time. World production of materials is mind-boggling. China can do it all, and in turn is de-industrialising higher-cost manufacturing in the western world. Demand for iron ore, coal, copper right down to steel and concrete has exploded. But can China perpetually build more and more steel mills and skyscrapers?

Well, no...

China is vulnerable to economic depression. The common denominator in every country is that all the banks operate under insolvent conditions, its just that the citizens rarely force a bank run to prove this Achilles’ heel. The main point here is, the common base line in every country today is the type of “money” used. The US Dollar, Australian Dollar, Chinese Renminbi and the Zimbabwe Dollar are all fiat currencies. Whilst there are significant differences in value of these currencies (or rather the rate of devaluation/loss of purchasing power), all currencies around today are still “fiat”, that is, money which is declared by Government to be legal tender and without intrinsic value (no gold backing). Through fractional reserve banking ("Money creation") and printing new money into existence the rate of economic growth in any country can be very rapid for a number of years. However, all good parties end in one big hangover. China's hangover is coming (particularly if they do not prepare for post US-Dollar monetary system).

Now that we have apparently coming through the worst of the so called Global Financial Crisis (GFC), every second economist on the street has hailed China as the world’s savour, and indeed in Australia, the Deputy Governor of the Reserve Bank of Australia RBA), Ric Battellino, believes the commodities boom could last for another 15 years – all of course, thanks to emerging economies of China and India.

Whilst I agree that China has helped the world during the GFC, and that we will continue to be in a long-term commodity boom, my reasons are completely different. And here is why:

• Chinese Banks inflated the world out of the 2007-2009 Global Financial Crisis
• The Commodity Boom over the next 10 years will be extremely volatile

Chinese Banks on steroids…

Answers to the future often lie in history. China invented paper money way back in the 10th Century AD. Every single paper-fiat currency created since (except for those existing today) have collapsed to a net worth of zero. Fiat currencies will always come and go because Government's cannot resist the temptation to use inflation to pay for election promises (or to help keep opposition parties out of government..). China, and every other country will not be able to defy economic reality with fiat currency this time around either. Keynesian economics will hopefully follow soon after.

As the following two graphs demonstrate, it’s the major global bank’s that fuelled the sub-prime bubble (in the US) which led to the GFC, and then subsequently it was Chinese stimulus spending and bank lending which helped the world get through the worst of the GFC. China just filled the void to get the world through the first phase of economic depression. This banking bubble is completely unprecedented. There is still many decades of debt still in the system - which is yet to be paid (accounted) for.

Chart 1: Global banking bubble
source: ABC News

Chart 2: Chinese banking bubble... but who will save the Chinese banks!?

The RMB¥ 4 trillion (US$ 586 billion) Chinese economic stimulus plan announced by the Chinese central government was all aimed at getting Chinese companies to build more Chinese goods and buildings. As I will explain a little bit on, China was already building at a very fast and unsustainable rate. This stimulus inevitably brought forward work and is now creating double digit inflation to their economy. Increasing credit always delays and make bubbles worse.

As consumer confidence was low in the US, and China, Japan and Asia were unable to keep exporting products to the US consumer, China took up the slack and increased bank lending dramatically, converting their economy from being strongly export-oriented (to the US) to fuelling domestic demand through stimulus. The Chinese Economic Stimulus Plan was used to offset the sub-prime housing crisis in the US to counter-act it with a Chinese property bubble. In essence, creating a new bubble market to replace a busting bubble market. The end result, I strongly believe, will have dire consequences to China, and Australia and the rest of the world. Like holding out a red flag to a charging bull, China will soon get caught out.

For now the commodity boom will continue, but… the next 10 years will be characterised by extreme volatile periods of double digit annual growth to significant periods of price deflation. Ultimately, gold, silver and soft commodities (food) will be sought after on-mass. People will change their spending habits to have economic security.


Construction, construction, construction!

Construction now makes up 60% of China's GDP. This compares to single digit GDP for China's total exports. China is building and manufacturing absolutely everything for the world, ten times over (or more?)

James Chanos:

No country has ever had done more than 9 years above 33% of GDP (in fixed assets – construction). China is now on its 12th or 13th year.

You gotta be in property! (especially if you are a central government)

In August this year the Financial Review ran an interesting article (lost on page 60) on China's central government trying to cool its property bubble. The article reported that all sorts of random companies were delving into property, from salt companies to railway companies. It goes on...

All around the nation, giant state-owned oil, chemical, military, telecom and high groups are bidding up prices on sprawling plots of land for big real estate projects unrelated to their core business. ...

By driving up property prices, the state-owned companies are working at cross-purposes to the central government's efforts to keep China's real estate boom from becoming a debt-driven speculative bubble.

Records show 82 per cent of land auctions in Beijing this year were won by big state-owned companies outbidding private developers - from 59 per cent in 2008.

Further:

land prices in Beijing had lept 750 per cent since 2003, and that half of tha gain had come in the past two years. Housing prices have also sky-rocketed, doubling in many cities over the past few years.

And as the prices of new apartments soar - in Shanghai, for instance, they often exceed $US 200,000, while the average disposable income isa bout $US 4,000 a year.

The article also made reference to the status of the state-owned banks. They they:
- had made $US 1.4 trillion in loans, nearly twice as much as the year before
- were making off-balance sheet manoeuvres
- were likely sitting on enormous unreported debt

Lastly, the article argues that different levels of government were behind the push in real estate because it was so "incredibly lucrative". Many municipalities have formed local investment vehicles that borrow from state-owned banks to pay to relocate citizens to build on their land, so the government can then auction off the new properties for profit.

Does this all sound like Sub Prime Mortgages on steroids times by a factor of 10?

Housing Affordability in China

One clear clue (regarding the rising real estate prices in China) is that the average price-to-income ratio in Beijing has reached 27:1, five times the world average, according to data from the Bureau of Statistics of the Beijing Municipality. In addition, the average price-to-rent ratio neared 500:1 in the city, far above the international alarm threshold of 300:1, which sends out a clear signal that the foundation of the real estate boom is losing stability.

Steel production up 6 fold in 10 years

To further put this into perspective, all this construction material had to come from somewhere. Of course, in Australia we know about the China boom and our record iron ore and coking coal sales have led to our highest terms of trade since the early 1950s.

Australia has helped fuel the great Chinese construction bubble. In 1999, the Chinese steel industry produced some 124 million tonnes of crude steel. This was a similar size to Japan and the United States. For comparison, in the same year Australia produced about 8 million tonnes. The following two charts illustrate the magnitude of China's construction mania.

Chart 3: China produced 16% of total world steel in 1999
source: World Steel Assoc. (public data)

Chart 4: 10 years later China now produces more than 46% of total world steel output
source: World Steel Assoc. (public data)

China’s steel production has gone up almost 6 fold in the last decade. To put this in perspective Australia’s steel production is now about 1% of China’s (or 0.5% of world) total annual steel production. ie. China produces Australia’s total annual steel production in just 5 days! China is now making more steel than what the entire world produced in around 1990.

To analyse this from another perspective, there are more stories in the media in recent years of ghost cities and empty mega malls springing up in parts of China.

Video: Fuelling the next housing crisis – this time in China

China also has the world’s largest shopping mall, the New South China Mall (based on leasable area) remains 99% vacant since opening in 2005. (video now unavailable)


Centrally planned economies do not work

Centrally planned economies have never worked over the longer term. I am not debating the nitty gritty of what the difference between communism vs. capitalism is, at the end of the day, the more intervention by Government’s and, particularly, central banks, the more mis-allocation of labour and capital there will be. The end result is massive overcapacity and ultimately price suppression (monopolistic behaviour on other countries). China is an extreme case at point, where the central government right down to municipal governments have had competing interests to increase employment at all costs. The municipal/provincial governments have also been competing for trophy industries, they all want to be the biggest and best at manufacturing, particularly steel and automobile industries. Exponential growth in credit, employment, and government intervention in markets eventually comes to an abrupt halt.

Far from what many economic commentators in Australia preach day in day out, that China is Australia’s economic savour amongst the global uncertainty in Europe and the US. To the contrary, I believe our over-reliance on China will ultimately bring harsh repercussions for Australia. On one side, China and the US will kill off the commodity boom. The biggest mining boom in history, inevitably will end in the biggest mining bust. The expansion plans of BHP Billiton, Rio Tinto, Fortescue Metals (among others) will result in major overcapacity, and empty ports. A huge call, perhaps crazy in today's climate, but this endless expansion will not keep going. Many of the major projects will be mothballed. Marginal projects will once again be marginal and left on ice for easy money to come around again.

James Chanos sums up the current situation rather nicely. James is best known for seeing the problems of Enron and shorting its stock up until its collapse. He recently warned that China's hyper-stimulated economy is headed for a crash, led by its housing bubble.

Its become very apparent... that China has embraced capitalism to keep the socialist elites entrenched, while more lately in the West we have embraced socialism to keep the capitalist elites entrenched. It’s a little bit of the opposite side of the same coin.

** Note ** I am soon to launch a new website at www.scottreeve.com, which will incorporate this blog and other areas of interest ~ Cheers, Scott

The mother-of-all bounces

Last November I posted on the mother-of-all-crashes Through a couple of graphs I detailed why the Australian and US sharemarkets were falling at a faster rate than the great sharemarket crashes of 1929. After the post, the Aussie market drifted sideways for a few months before falling even lower to below 3100 (March 09), for a total peak to trough fall of 55 per cent.

Now, a year on from that post, we have witnessed, perhaps, the mother-of-all (dead cat?) bounces, in an 8 month period from mid-March 2009 to mid-October 2009, the All Ords has rebounded some 56 per cent from the trough (see chart below).

Chart 1: All Ords - crash and bounce
The rise or fall of the All Ords is largely attributed to the big 4 Australian Banks and BHP. The big four banks account for 21.47% of the All Ords, while BHP accounts for 10.15%. If you compare the chart below (Financials Index) with chart 1, they are a mirror image of each other.

Chart 2: The Big 4 banks led the All Ords crash, and now the recovery. Notice the % fall and % rise similar proportions to Chart 1 (XAO)
No other area in the Australian economy has done as well as the Big 4 Australian Banks. They now have combined market capitalisations which exceed the pre-GFC crash. Through help of the Government, they have increased their monopolistic position in lending. For reasons unknown, the Australian Government and ACCC allowed Westpac to buy St George Bank (no. 5 bank), and Commonwealth Bank to buy BankWest. In early September 2009, the Australian Prudential Regulation Authority figures reported that the big four lenders captured almost 100 percent of the $7 billion in new mortgages written in July 2009, squeezing the small lenders out of the mortgage market. Before last year's funding freeze in global markets, the big four banks' share of new mortgages was running at about 60 per cent. Some day soon, just like in the US, we will be having the “too big to fail” debate in Australia. The Australian banks are sitting on the mother-of-all housing bubbles, which is staying upright for now due to unprecedented net migration and government stimulus intervention (see further below). Give it a couple of years, the Great Australian Housing Ponzi Scheme will eventually run out of buyers.

Like the Aussie market, most world markets have bounced, including the Dow Jones (US). As the following chart demonstrates the length and magnitude of this bear market bounce is unprecedented when compared to the Great Depression bear market rallies.

Chart 3: Depression-era bear market rallies (Dow Jones)
source: Chart of the Day

The three charts above give us a clue about the state of the world economy (and I would argue, the state of the US-centric monetary system). Extreme volatility is in full swing.

USD-AUD Exchange Rate

No better example of extreme volatility in the system is the USD-AUD exchange rate.

Chart 4: In 16 months the AUD has gone from almost parity with the USD, crashing 39%, and now rebounding 56% from the lows at 60 cents
So what has changed?

Nothing, nothing has changed. The fundamentals are still broken. The US is still trading insolvent and an aging population will ensure most Western Countries will pursue a path of monetisation (going into more debt) to pay for the welfare state. What has changed is two things:

Inflation and Timing

During the GFC we were constantly told of deflation (decreasing prices). However, during this time I argued that inflation was and will remain our greatest concern. In the middle of the GFC (June 08), Australia's money supply growth was at 23 percent (annualised), the highest rate since the mid 1970s. I ask.. is it any wonder that it appears Australia is such a buoyant economy right now? We inflated our way through the GFC. Another angle is that we populated our way through the GFC (see chart below). If you add more citizens to the economy, there is greater demand on food, housing and general consumption. Add Government "free" handouts, and the warm fuzzy experience we feel aobut our "resilient" economy was all-but inevitable. To the contrary, I believe this is making a bad situation worse, at least for the long run. The artificial wealth effect continues.

Chart 5: Inflate and populate out of financial crisis! Australia net migration since 1860. You would think there was a gold rush on...source: ABC News, Alan Kohler, 23 Sept 2009

The other difference at play here is timing. During the GFC, the All Ords, Dow Jones and even world trade (click to see charts) were declining at a faster rate than what they did during the 1929 crash. The rate of fall was just unsustainable. It's the law of the markets... or like bouncing a tennis ball. If you bounce it hard on the ground, its going to bounce back to some extend. In market terms, this is called a dead cat bounce (however some stocks fall and just don't bounce...). Timing is everything. For instance BHP was almost $50 per share prior to the GFC crash, than fell to $21 seven months later. Same company, and arguably the fundamentals of BHP were stronger than ever. The difference is market mood. Perceptions of value change over time.

Dow-Gold Ratio still falling

One of the key indicators I keep an eye on is the gold-dow ratio. When we price the world sharemarkets against gold, the downward trend is still well intact. Historically the Dow-Gold Ratio goes to below 1 when gold becomes very expensive relative to the sharemarket (Dow). There is still a long way to go... Gold is very cheap at US$1,100 oz!

Chart 6: What bounce?
source: Chart of the Day

Money can be made in all market conditions. Volatility in the markets in the last two years is telling us something is happening. Short-term it may appear that everything is back to normal. This couldn't be further from the truth. Measuring the share market and housing markets (and other debt-based markets) in terms of a tangible good (ie. gold) tells a very clear non-volatile storey. The long-term fundamentals have not changed, but arguably getting worse year by year, as Government and banks continue to fuel the fire with more fuel (inflation).

Cheers
Scott

(feel free to comment!)