Why will China collapse?
China’s old growth model is dead
Rather than focusing on production for domestic markets, countries were advised to focus on production for export. This shift away from import-substitution toward the export-led growth was driven significantly by the economic troubles that emerged in the 1970s. At that time many developing countries, who had prospered under regimes of import-substitution, began to experience slower growth and accelerated inflation.
The problem is that the export-led growth model suffers from a fallacy of composition whereby it assumes that all countries can grow by relying on demand growth in other countries. When the model is applied globally in a demand-constrained world, there is a danger of a beggar-thy-neighbor outcome in which all try to grow on the backs of demand expansion in other countries, and the result is global excess supply and deflation.
This appetite for cheap Chinese exports, which had at one point seemed insatiable, means that the West has come to owe China over $2 trillion. China has become the world's biggest creditor, but creditor nations running persistent trade surpluses have two historical examples: the US economy in the Twenties and the Japanese economy in the Eighties.
In both of the previous examples a failure to allow exchange rates to adjust to the new reality created a large speculative pool of credit that, in turn, led to overvalued domestic assets and, eventually, an economic crisis. When economic activity worldwide is growing at a healthy clip, China’s higher share of exports to GDP is welcome. When the opposite holds true, China is the one that suffers the most.
China's growth has been based largely on one-time changes in behavior that cannot be repeated. Over the past generations the percentage of people employed has almost tripled; it cannot triple again.
China is in a Price/Wage spiral
China and other countries have tried to implement policies to boost domestic consumption as advanced nations are unlikely to absorb the region’s excess production, but just can't boost demand and imports by 80% in one year, since (a) it is artificial, and (b) it leads to very high inflation.
Well, China has been printing a lot of money for a long time in order to keep the yuan low, which befitted their export sector. As a result of their policy they accumulated massive foreign exchange reserves and had giant trade surpluses. Since China includes over one billion people and since most of them were farmers up until the 1990's, the money printing didn't cause wages to rise dramatically. (Money flows to places where supply is tight, and China had abundant labor.)
So the money went in to commodity, real estate, and stock prices in China. But now something totally different is happening. China's trade surplus is gone, food prices are rising and wages too. This, combined with weak exports and a weak euro, is killing Chinese corporations' margins and contributing to a classic wage and price spiral.
Since China produces simple products and since China has focused on quantity and not on quality there is no significant productivity growth to offset the money printing. Once the movement to the cities was exhausted (there is no demand for more Chinese peasants producing more Nike shoes…).
China has a giant housing bubble that is financed by a ponzi scheme
As China’s economy weakened in late 2008, private lenders began demanding money back from distressed private companies. Loans from state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel bank lending into cash for individuals and businesses that were in the lending business. This money has flowed into asset markets, especially real estate. Prices have risen at a record pace in a year where the export sector is very weak.
Local governmental officials, whom the government demands to produce double digit GDP growth numbers give real estate developers permits to build housing projects in return for bribes. They also get bribes in return for allowing the shark loan companies to operate under their jurisdiction. Some of them are active partners in loan shark businesses. For example, a party secretary of legal affairs who controls the public security bureau, which is a court and prosecutor division of government in Yongkang City, in Zhe Jiang province tried to run abroad using a passport in 2009 after he found out he can’t repay 60 million yuan. Every scheme has a ringleader whose job is to collect money from all the participants in the ponzi scheme. When some of these ponzi schemes blow up, the party leaders always get bailed out first, and some even ask local business owners to lend them money, and then bail out their own personal fund. After that the ringleader turns himself in and gets protection from the local government.
Most of the funds that are collected in this classic ponzi finance go to local land purchases and real estate development. Part of the funds are used in order to pay back the rolling loan. The short term interest rate in this black market is very high and ranges between 20%-150% annual rate. The sources of the ponzi funds are diverse, as ordinary citizens, banks with corrupted bank officials, and state enterprises play the game.
How to profit from the collapse
1. Short commodity producers. China is the biggest consumer of industrial commodities, except for oil. Prices are determined at the margin and when China falls commodity prices will plunge. Companies like Rio Tinto (RTP), Potash (POT
), Alcoa (AA
) are classic shorts in that case.
2. Buy long out of the money put options on the Yuan ETF (CNY
). Investors worldwide are making large bets that the Yuan will revalue and gain value versus the U.S. dollar. Ironically, this intensifies the potential of a Yuan crash, since the presence of so much speculative funds is going to overweight China’s foreign exchange reserves. If China decides to let the yuan float, it may go up initially but once foreign investors take the money out of the country once the revaluation has been done, the flow of capital will drain China's holding of FX reserves since it will need to sell them in order to prevent a Yuan collapse, and to save the banks (See: The Next Black Swan- A Yuan Devaluation
3. Short Australia ETF (EWA
). Australia has a giant housing bubble of its own. The index is 50% financial and the rest is commodity producers. When China falls the commodity producers will suffer, as will the Australian economy. Combine that with the collapse of its own housing bubble and the index could lose a lot. Plus, remember that in such case the Australian dollar will fall sharply, so if you short the ETF you will make a profit out of currency appreciation.
4. Short the Russian ETF (RSX
). Same story as Australia; once the price of oil falls Russia’s economy will not be worth much.
5. Short the Japan ETF (EWJ
). I know it has been falling for 20 years now, but once China falls all the export growth that Japan did have in the last year will disappear (hint: it didn’t come from the U.S. consumer). That could finally trigger the fiscal crisis everyone has been waiting for. Short the ETF. In that way even if Japan decides to hyper-inflate you will still make money since the ETF is in dollars.
6. Short Canadian banks. Like Australia, Canada too has a housing bubble. With a slump in oil they will make a great short (and so will the currency).
7. Buy the dollar. With a crisis in Europe and China the dollar will be the least bad game in town.
8. Buy gold. In times of uncertainty it is always a good idea to buy some gold. If you trust GLD
you can buy it, and if you want physical you can buy PHYS
Disclosure: Long Gold, Long the Dollar and Short everything else