Expect Chinese Pullback to Affect Emerging Markets

As I have written before, China is a relationship based system. The market is based on government pronouncements. The stimulus was caused by a wall of money from banks, which was misallocated, because it was assigned by the government through the banks to state owned businesses and local governments. Some went into the stock market and real estate markets. A lot was used to stockpile commodities. That is where Brazil comes in.

Brazil has had a higher percentage of exports of commodities to China and it has recently boosted its trade. Since we are far from high growth, the demand for commodities over the past few months has been driven by China. As China pulls back, so will the demand for Brazilian commodities.

Without the American consumer, the demand for consumption of Chinese goods will fall off and China will experience slower growth. Also look for massive dumping. And the complaints to the WTO are not coming from the US. The big filers are places like India and even Latin America.

I point out that all of my pronouncements have been correct. Look also for growing toxic assets within the Brazilian banking system. I have predicted this for months and the dominoes continue to fall. First Russia, then the Gulf, now Nigeria. The next will be China and Brazil. I can't confirm it. I do know they are there. It is typical of a state dominated financial sector. In Russia the state owned Sberbank has just been hit by a $180 mm embezzlement scheme. In China it was $780 million for I believe CCB.

During booms all banks make bad decisions. As Buffett says, you get to see who is naked when the tide goes out. Brazil has been exceptionally lucky that the Chinese stimulus package kept commodities afloat while all other economies where collapsing. But as the Chinese economy deteriorates so will the economy of Brazil and with it bank loans.

It has to do with information. Information has value. It is disclosed only for money or because of a legal disincentive. The conflict of interest between the state as enforcer of the legal disincentive and the owner of the bank will be decided in favor of the bank. So the state will cover it up as long as possible. There aren't any stress tests that I know of. Trust me. They are there.

The Chinese have put a $1.2 trillion loan band aid on the problem but it won't stop the hemorrhaging because American buyers are not going to pick up the demand and the Chinese cannot change their legal environment fast enough to increase their own demand from 35%. So the growth in the US will be slow but steady, while the economies of many emerging markets (EMs) in East Asia and commodities producers (ex India) will flounder.

Eventually the US market will recover as capital is reallocated to more efficient firms. Without an efficient legal system in EMs that cannot happen. The banks will never get rid of their toxic assets. Toxic assets a can only go if there is a way to collect collateral through foreclosure or bankruptcy. These do not exist in many EMs.

Comments

[Ricard:]

Convincing argument.

Regarding the below quote, I would wonder whether or not it was actually mis-allocated, or simply a state-sponsored 'investment' in cheap commodities, before more China-fueled speculative frenzies price them beyond what China may deem reasonable.

If your argument is that funds were 'mis-allocated' because they did not fuel domestic consumption...I'd actually say that fueling domestic consumption is not necessarily a desirable outcome (just look at our economy...), unless that consumption is matched by an equally robust rise in the industrial base. That may indeed be the case in China, but I'd imagine that stimulus or no stimulus, the vast majority of its population is still too poor to afford basic consumer goods.

"The stimulus was caused by a wall of money from banks, which was misallocated, because it was assigned by the government through the banks to state owned businesses and local governments. Some went into the stock market and real estate markets. A lot was used to stockpile commodities."

Aug 20 01:14 AM

[prairiedog555:]

Do you believe that when "the tide goes out" the dollar will move higher as it did at the start of the stock market decline?

Aug 20 09:06 AM

[ManInTheMirror:]

Great article William!!

Do you know if Hedge Funds have to report their earnings at the end of October each year? I was wondering because I was looking at the rapid market decline from last year (2008) and the question of "could last year's sell off, a market decline of about 25% in two months, have been influenced by Hedge Funds"? If so, do you think we could see another rapid decline in September and October of 2009, just like we saw in September and October of 2008? In other words, do you think Hedge Funds have the incentive to "take their profits" and sell out of Emerging Markets, so they can show their investors how much money they recovered after "The Great Recession"?

Moving on, what are your thoughts on FXP? (See link below) From what I understand, it gets "(200%) the inverse (opposite) of the daily performance of the FTSE/Xinhua China 25 Index" (Google Finance).

<www.google.com/finance...;

Another question, what do you think of this: "to paraphrase Michael Pettis' article on Seeking Alpha, because of China's high debt, which Michael Pettis estimates is 35% to 50% of GDP in China their citizens must keep high savings, so the banks and stay liquid while debt fails (i.e. non-performing loans, toxic assets). Meaning, China can't create it's own internal demand to fill the void of decreased US demand due to its high debt. Thus, increased US savings should be harmful to China because it would mean less consumption of products manufactured in China."?

(seekingalpha.com/artic...)

Aug 21 09:27 AM

[ManInTheMirror:]

Sorry about that broken link, here is the one to FXP:

www.google.com/finance...

Aug 21 11:57 AM