I live in Chicago, Illinois where I am a managing partner at Netwall Investments LLC, a money management firm (Click here for our past investment record and here for my top 10 highest conviction stock picks).
Recently I was visiting Canada for a family reunion where I have an uncle who has lived in Toronto for a long time (whom I have always suspected to hold some grudge against the US financial markets). Since all my family members know the kind of business I am in, they typically like to strike conversations regarding finance and economics, whether I invite these or not. This uncle of mine thinks that no economy in this world is infallible (perhaps except Canada) and that this scenario was recently seen in the US and Europe. While talking to me, he declared that although America is a super power, it really has a very low threshold for tolerating economic shocks and the recent financial crisis has just proved that. He kept on talking while I kept on listening and then he surprised me by his comment on Chinese holding of American debt.
I have produced this conversation verbatim for your reading pleasure below. (Before you read on, just know that China owns about $1.3 Trillion worth of the US debt).
Uncle: So you think America is back on track now after the financial crisis?
Me: Yes, I think so
Uncle: Did you know that if China were to ask America to pay back all its debt right away, America won't be able to do so
Me: (Surprised) Well, that might be true but China cannot and will not ask for all its debt to be paid back right away
Uncle: Why do you think so?
Me: First, let me ask you a question?
Me: Which is the largest bank in Canada?
Uncle: Well, I think.... Hmm...
Me: Let me tell you. It's RBC (Royal Bank of Canada). Let me also tell you that if all Canadian deposit holders knock on RBC's doors at once to get their money back, RBC will not have enough funds to pay them back immediately. Does this make RBC a weak bank?
Uncle: No, it's a fine bank. But paying back debt is different from asking for your money back from the bank.
Me: In what sense?
Uncle: Government debt is a liability already invested in public projects while deposits are sitting in the bank's vaults
Me: Not true: The commercial banks finance loans with your deposits just the same way as the governments use debt to finance public projects. Your money is not just sitting in a locked vault, believe me. That's why financial institutions are required to have these coverage ratios so that they remain well capitalized when customers need their money back. And if all customers in aggregate will ever demand their money back in unison, the banks would have to turn them back including RBC.
Uncle: I think the dinner is ready...
It might be obvious that I was talking to a not very financially savvy person, but you'll be amazed to know how many otherwise financial savvy individuals believe that someday, all these nations, who are major holders of United States' public debt, will come knocking on our doors and we would have to show them empty pockets. In other words, as soon as foreigners are ready to ditch their dollars, USA will go broke.
Nothing could be further from the truth. This is such a mistaken belief even among the most sophisticated of all that Warren Buffett felt compelled to write an article for Fortune magazine titled "Why Foreigners Can't Ditch Their Dollars" in 2003, which can be read here. For those of you not interested in reading the full text, I will summarize it for you. Basically, Warren Buffett's argument is as follows: Say China wants to sell its US dollars and replace these with Euros, and France agrees to buy those dollars from China. After this transaction is completed, the dollars still remain in foreign hands. Chinese cannot sell these to Americans, because they would get same dollars so there is no point. Hence, Warren Buffett concludes that the only way foreigners can actually "ditch" their dollars is if the US trade deficit turns into a trade surplus, i.e. we start buying more from them than they buy from us. This insight from Warren Buffett is very enlightening and must be understood by everyone and financial professionals in particular.
My goal in this article is to do a fair comparison of China with the United States and see how good we fare. As many of you know that China is being thought of as the next super power, with its economy surpassing that of the US by 2030, we need to self evaluate ourselves fairly and see how we are doing in comparison to the rest of the world and China in particular.
The below graphic is taken from the UK's "The Guardian" newspaper which does an excellent job of comparing USA with China in various industries. It is clear that China is competing neck to neck with the United States in the categories shown.
Source: The Guardian
The United States had the GDP of about $15.7B USD in 2012 while China came second with $8.4B USD and Japan was third with $6B USD (Source: World Bank). China had a trade surplus of $231B at the end of 2012, as compared to the trade deficit of the United States of about $540B at the end of 2012. (Source: US Census Bureau)
The US trade deficit
As you can see above that United States had a trade balance of -$41.8B in September 2013.
Compiled by Netwall Investments LLC
As you can see that with China alone we had a huge trade balance of $315B in 2012. As of September 2013 of this year, this number was $238B.
In aggregate, Petroleum imports drive the trade deficit. In 2012, the U.S. imported $313 billion in petroleum-related products, up from $252 billion in 2010. This was despite higher oil prices, which jumped from an annual average of $74.67/barrel to $101.16/barrel in two years. Petroleum-related products include crude oil, natural gas, fuel oil and other petroleum based products such as kerosene. (Source: U.S. Census, U.S. Oil Imports). Another large contributor to the trade deficit is consumer products, such as drugs, consumer electronics, clothing, household goods, and furniture. In 2012, the U.S. ran a $335 billion deficit in consumer products, importing $516 billion while only exporting $181 billion. This was higher than prior years, despite a relatively weak dollar. Automotive is another category where the U.S. ran a trade deficit in 2012. It imported $298 billion worth of cars, trucks and auto parts, while only exporting $146 billion, running a deficit of $152 billion. (Source: Census Bureau). However the US is a net exporter of services. It exported $630.4 billion in services while importing only $434.6 billion. This caused a trade surplus in services of $195.8 billion. What services does the U.S. export?
- Intellectual property, as measured by royalties and license fees ($120.8 billion).
- Travel-related services ($116.1 billion).
- Financial services ($270.2 billion).
Income classes in American society:
In my opinion, American society can be broadly categorized into 3 classes:
- The top 5-10% (extreme affluence)
- The middle class 80-85%
- The bottom 5-10% (poverty)
Now you might disagree with the above ratios depending on how you define these terms but these three categorizations are sufficient for the purpose of this discussion.
You would notice that in the most prosperous countries of the world (think USA, Canada, Japan, Germany, UK etc), you have the happiest middle class. Obviously "happy" is a relative term and in this context we will define happiness as being a state in which you don't feel like taking it out into the streets. Below is the normal distribution curve based on the above three categories.
Wealth distribution in the US
Since one standard deviation captures 68% of data samples, it is safe to say that the above is a reasonable representation of the middle class. Now poverty does not exactly begin from -2 and affluence not exactly from +2, but these definitely get concentrated as you move towards the tail ends.
Distribution of wealth in America:
Let me warn you ahead of time that I am going to discuss unjust distribution of wealth in China, thus I feel obligated to discuss the same scenario in the US for a fair comparison.
According to "Mother Jones" two thirds of the total wealth is controlled by the super-rich in the US. Here are the stats from Mother Jones.
- The richest 10% controls 2/3 of Americans' net worth
- Top 1% control 34.6%
- Top 1-10% control 38.5%
- Bottom 90% control 26.9%
So who are these bottom 26.9%? These are widely categorized as people who are middle class including the poor (extreme tail). So why does it not cause social unrest in the United States? I think I have an answer:
The main reason it does not cause unrest in our nation is because the bottom 26.9% have a reasonable life style. Again "reasonable" is a relative term but behavioral psychologists claim that as long as food, shelter & clothing needs of a human are well met, at least social disorder would not ensue. These middle class Americans typically shop at the same grocery stores as the super-rich (there might be expensive clothing and jewelry stores that cater to the super-rich but I have never seen such a grocery store). If you are thinking Whole Foods (WFM), the person on a Food Stamp card can also shop at Whole Foods. So the point here is that even the poor are not being denied access to food, clothing and shelter and while true they sometimes resent the super-rich, they will not likely cause social unrest even if the fact remains that top 10% Americans have the greatest amounts of wealth.
Source: UC Berkeley
Euro Vs. Dollar:
I remember a conversation around year 2000 with a medical doctor friend of mine, who had completed an MBA and was always interested in talking about world economics. As you might know that the Euro was introduced in 1999, so one day we engaged in a conversation where he argued that the Euro would completely overtake the US dollar as the world's number one reserve currency. I completely disagreed with him by pointing out that the Euro was a creation of many nations with different socioeconomic environments and an upheaval in one economy would cause a ripple effect in others. Remember this conversation was taking place well before the recent economic crisis in Europe. I told him that the United States is one unified country and even though there are 50 states, it is still one country. This is very powerful as the pain is felt throughout the nation even if one part of the nation suffers. Take hurricane Katrina for example, when it hit New Orleans in 2005, fellow Americans in California were eager to give shelter to those affected in New Orleans, some 2000 miles away. We speak the same language, have the same education system and have uniform norms more or less.
Contrast this with Europe and say there is a natural disaster in Greece, how much people do you think will feel emotional pain in Germany (apart from the fact if some family member of someone in Germany is affected in Greece). Similarly, when Germany was recently bailing out Greece from its financial woes, the German parliament was revolting why Chancellor Merkel is scapegoating German people for Greek's troubles. So the takeaway here is that although Euro will remain strong if European countries do well but I have reservations in believing that it will ever become a single reserve currency overtaking the US dollar. I might be wrong but time will tell.
Can Renminbi replace US dollar as world's reserve currency?
China wants Renminbi to be the reserve currency of the world. China's fears were especially echoed during the recent debt crisis in the US during which it warned against a debt default. In its efforts to move away from the US dollar, China has recently signed a currency trading agreement with Australia. There has been a recent SA article in which author (Russ Winter) describes how much both China and Russia want to move away from the US dollar. This article also points to Chinese signing an agreement with the UK and Brazil to use Renminbi as the reserve currency. As a matter of fact many claim that Yuan has already passed the Euro as the reserve currency of the world. (Source)
China's socioeconomic environment:
The Union of Soviet Socialist Republics (USSR) formally ceased to exist on 26 December 1991. The main reason was the social unrest due to ambitious people becoming tired of the communist government's monopoly on everything. So the social unrest is a powerful force especially when people decide to take it out on the streets. I am not saying that there is social unrest in People's Republic of China but the gap between the haves and the have-nots is widening and the government controls everything. Sometimes the Chinese government tries to portray itself alongside the ranks of first world countries but it actually remains a second world country. Investopedia defines the first world country as follows:
"A country characterized by political stability, democracy, rule of law, a capitalist economy, economic stability and a high standard of living."
The Nations Online categorize China and Russia as the 2nd world countries as shown in the graphic below.
China's ranking (Source: The Nations Online)
My point of presenting this information is that second and third world countries typically have larger gaps between the haves and the have-nots and thus are more susceptible to the social unrest than first world countries. And this gap can sometimes become a powerful catalyst for a social revolt as it did happen in USSR in the 90s.
China's wealth gap is widening:
Chinese Family Panel is a research program from leading Chinese universities, who surveyed more than 14,960 households and 57,000 people in 5 provincial level areas. The survey found that in 2012, the households in the top 5% income bracket earned 23% of all China's household income. The household in the lowest 5% accounted for just 0.1 % of total income. Average annual income for a family in 2012 was 13,000 Renminbi, or about $2,100. When broken down by geography, the survey results showed that the average amount in Shanghai, a huge coastal city, was just over 29,000 Renminbi, or $4,700, while the average in Gansu Province, far from the coast in northwest China, was 11,400 Renminbi, or just under $2,000. Average family income in urban areas was about $2,600, while it was $1,600 in rural areas. Also figures show that rural incomes are less than one-third those in cities, with the top 10 percent of urban Chinese earning about 23 times that of the poorest 10 percent. Compare this to the average income of bottom 80% of Americans, which is $29,000 as shown in the above paragraphs. Thus on average, it is about 1400% more for an average American than for an average Chinese.
The research from National Economic Research Institute shows that China's wealth gap may be worse than official statistics indicate. The incomes of better-off families are understated, says Wang Xiaolu, an economist at the independent National Economic Research Institute in Beijing. Undisclosed income, which Wang says could add up to $1.4 trillion annually, ranges from kickbacks to businesses or government to perks such as subsidized housing offered by state-run companies. If so, the wealthiest 10 percent of the population earned 65 times that of poorest 10 percent, not the 23 times shown by the government data.
According to the Forbes magazine in 2013:
"In fact, according to a recent online poll conducted by the Chinese language, China Youth Daily (CYD), the vast majority of Chinese believe income disparities will hinder China's development in the next 10 years. Seventy-five percent of the 11,300 respondents to the poll said the wealth gap was the biggest problem for China's economy long term, followed by the abuse of power (59.4 percent), entrenched interest groups (52.8 percent), ecological and environmental degradation (52.6 percent) and infringements on the rights of disadvantaged groups (50.3 percent)."
The bottom 80% of Chinese has only 7% of the country's wealth. If we look at the income levels across the country on the Chinese map, annual per capita income is only concentrated in very few regions (blue areas) and a large part of the county remains below mean.
Source: The Atlantic
Watch this video on Bloomberg TV named, "Why China's Wealth Gap May Spark Social Unrest."
One study finds that China's Gini coefficient was, as of 2010, an alarmingly high 0.61. That would be up substantially from the CIA's 2009 estimate of 0.48 and the World Bank's 2005 number, 0.43. The Gini coefficient, though imperfect, is a widely cited tool for measuring the disparity between a country's rich and poor. The higher a country's number, the more unequal are its people.
Comparing this new measurement with past Gini studies suggests that China may now be one of the most economically unequal countries on Earth, and the most unequal outside of sub-Saharan Africa. Compared to World Bank data, China ranks as the world's fifth most unequal, tied with Botswana. It performs a little better alongside CIA data, which would rank China as the world's seventh most unequal, between Haiti and the Central African Republic. These comparisons are imperfect, since the Chinese university study may not have used the same measurements as the World Bank or CIA studies, but it sure is a way of demonstrating the severity of China's growing class problem. Below is the income distribution obtained from China Household Finance Survey.
Although China has made great strides towards improving its stature in the world, it becoming a super-power remains a far cry. China is very different from the US. Most people in the US don't understand how that country really works. The government mostly controls everything and the entrepreneurial spirit that exists in the US is not as prevalent in China as many people mistakenly believe. Corruption and bribery are simply incomprehensible for Americans but remain a common problem for China to get a handle on. China is highly dependent on the US as it remains the largest exporter to the US with a total trade volume of US $484.68B as of last year. Similarly the US is also dependent on China for the export figure of US $110.5B in 2012.
Recently another Hedge Fund manager and a fellow SA author Whitney Tilson, has shared his views on China and its economy by actually paying a visit to this country. He admits that Chinese remain very hard working people and makes various other interesting observations about the Chinese economy. Mr. Tilson has done a fair analysis in his article with the following conclusion:
"While I'm long-term bullish on China, I'm also long-term bullish on America."
I think I agree with the above thought. China has made great progress in the last few decades and I am sure that both China and the US would continue a path to prosperity without stepping on each other's toes.
In the end I must say, "Viva USA!"