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[Note: This article first appeared on Minyanville.] Last month I updated an article I had written on China in which I made the case that a Chinese economic slowdown will send that country into a severe recession. I have since found an interesting counterpoint to my article that I would like to share with readers.

The author, Dan Harris of the China Law Blog, makes the following points:

[Katsenelson] posts [that] China is "living through one of the greatest historical bubbles." [He] sees China as a manufacturing country built with high interest debt. He sees China's fall occurring due to factory overcapacity, a rise in the cost of money, and/or a slowing U.S. economy.

...The author's investment advice is to take your money out of commodities and to forget about investing in Chevron (CVX), Exxon Mobil (XOM), or Conoco Phillips (COP). Katsenelson equates the idea that all companies need a China strategy to the idea in the late 90s that all companies needed an Internet strategy.

Call me part of the bubble, but I disagree with Katsenelson on all points. China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising and even if they were not, I could see manufacturing tailing off and stabilizing, but I cannot see it crashing. If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising. On top of this, China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.

I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China. Secondly, the U.S., though obviously of huge importance to China, is not everything. Thirdly, though I do believe there will be a slowdown at some point (there has to be!), a slowdown is not a crash. It is interesting to note that in this post from June, 2005, Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

I was glad to see interest in the article and it got me thinking more about the discussion. Let me try to reply to every point made.

China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising...

I actually agree with this statement, at least in part. China is likely to transform to a broader economy over the years. But it will take time. And with manufacturing making up such a large sector of the economy, it will be decades before the services sector will be able to make meaningful contributions to the economy.

I could see manufacturing tailing off and stabilizing, but I cannot see it crashing.

The operational and financial leverages are likely to prevent a normal slowdown. As revenues fall, costs will fall more slowly and profitability will suffer.

If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising.

Business Week had a small article last year making the case that China saw some double-digit wages in inflation. I do not believe this is true for the whole economy but rather for specific industries. If the Chinese economy implodes, I don’t think wages will be rising. The implosion will be deflationary for China and the rest of the world. I agree that if labor costs in China become high enough, companies will start looking for a cheaper alternative.

China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.

I agree.

I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China.

This comes back to my point about leverage. China has plenty of that. A U.S. slowdown could decrease incremental demand enough to send many Chinese producers into the red. Also, something I did not mention in the article is that bad loans are a real issue in China. A number I saw was 40% of GDP. Once the economy slows down, they’ll come to the surface.

It is interesting to note that in [his] post from June, 2005...Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?

As I said in my article, "...as with any bubble timing, the pop is very difficult. Bears are usually too early to call it and Bulls are usually too late to see it.” I really have no idea when it will take place. The Chinese government plays a very large and important role in China's economy, and it may postpone the crash by intervening. But the longer it intervenes, the greater the decline will be. I have no idea when it will happen, but I am aware of the risk. We therefore structure our firm's portfolios accordingly, trying to minimize our exposure to a slowdown in the Chinese economy.

Source: Feedback on the Chinese Bubble -- A Point-by-Point Refutation