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China Bluff Exposed, Regime Overthrown
China's communist regime continued to print money, lending it to everybody that wanted and didn't want it. The giant housing, infrastructure, and manufacturing bubble came to a violent crash when the debts where not paid and inflation forced the authorities to tighten despite massive unemployment. The combination of high inflation and high unemployment in the urban centers took the people to the streets. The Chinese citizens refused to accept state intervention in the economy and their personal life demanding more personal and economic freedom resulting in prolonged civil unrest which almost reached a full scaled civil war. The collapse of the Chinese regime and economy resulted in a colossal bust for commodity prices, albeit temporarily, and caused a severe recession in Australia, Brazil, Russia, Argentina, and the Gulf States.
Despite China's Collapse Commodity Prices Turn Up Again
Just a year after China's colossal bust commodity prices resumed their up trend. General scarcity combined with large physical deficits and money printing worldwide caused commodity prices to go up despite a weak world economy. Investors and eventfully the public started to seriously question the legitimacy of fiat currencies around the world.
New Economic Term Developed, A Yo-Yo Depression
Throughout first 15 years of the 21st century investors and economists where debating heavily upon the economic environment. Is it deflation, inflation, stagflation or hyperinflation? Eventually, a new term emerged- Yo-Yo depression which describes an economic environment in which the economy moves violently every year or so from inflation to deflation.
In How to profit from the coming collapse of China we explained that China is facing a severe financial crisis due to three main reasons:
Well, in the last few days the notion that China might face a slowdown gained momentum (or god forbid a "R" or even a "D") which took down global markets, along with continued headwinds fro Europe.
What are the implications of a Chinese depression?
The major driver behind increasing minerals and energy commodity prices since early 2009 has been demand in China, where consumption has grown and offset falling demand in major developed economies such as the United States, the European Union and Japan. Demand for commodities within China has been underpinned by the government’s economic stimulus package, which is targeted to infrastructure developments such as roads, railways and electricity networks. The stimulus package has also buoyed consumer sentiment which has supported demand for consumer durables such as automobiles and electrical goods. For many commodities, stock building has provided additional support for imports.
The increase in China’s minerals and energy demand since early 2009 has been accompanied by significant increases in imports of some commodities such as iron ore, thermal and metallurgical coal and copper. This rise in imports has in turn provided support for production in exporting countries such as Australia and Brazil.
So obviously, a crisis in China means a fall in commodity prices and a move towards very low inflation rates worldwide or even outright deflation. That will probably mark the peak of the deflationary pressures confronting the globes.
China's inflation is keeping oil prices uncomfortably high
China's money and credit supply is growing at an annual rate of 30%. Credit growth of 30% in China is equivalent to a 10% growth rate in the United States (Since China's economy is a 1/3 of the size of the U.S economy).
China's money supply (M2) is about the size of the equivalent number in the U.S(north of 8 trillion U.S$) So, the affect of the 30% growth rate in China's money supply is affecting the world's economy as if the United States M2 was growing at the same rate.
The Federal Reserve has stopped Q.E for that preciase reason- if it resumes Q.E it will face and oil price spike that will take oil above 100 per barrel. It is waiting for a market crash that will cause a collapse of oil price.
However, since China is inflating in such a rapid pace, oil prices are lagging the stock market and the EUR/USD. Although the dollar is up 20% versus the Euro oil has only fallen 10% from it's peak in early 2010.
A crisis in China will enable Bernanke to really print money
Bernanke is a student of the Great Depression and he thinks the solution is to print money (Quantitative Easing) in order to prevent a debt deflation spiral. However, he is face with a double whammy -- on one hand money supply is contracting along with credit and on the other hand the price of oil remains stubbornly high.
The decision by the Fed to end Q.E at March 31st 2010 has marked the peak of the global reflationary cycle that started when Q.E was announced at March 2009. So we have seen since then a strong dollar and weakness in risk assets.
It should be obvious to anyone that the Fed will not just sit by the sideline and watch the world economic system- it will try to inflate. But, in the meantime it is waiting for the price of oil to fall so it will not be trapped in a situation similar to what it faced in July 2008, when oil reached 145$ a barrel in the midst of a massive credit contraction.
So once the demand for commodities falls we will see Q.E return with a vengeance.
China's crisis will end the global wage arbitrage
First in manufacturing, now in services, the global labour arbitrage has been unrelenting in pushing US pay rates down to international norms. But the real wage compression in the US has not been uniform across the income spectrum. In large part, that has occurred because increasingly broad segments of the American labour market are now exposed to a uniquely powerful competitive force - the IT-enabled arbitrage.
Courtesy of the hyper-speed of sharply accelerating Internet penetration, the global labour arbitrage has pushed into areas that historically have been unaccustomed to wage competition. In earlier research I found that the disconnect between compensation and productivity growth during the current economic expansion has been much greater in services than in manufacturing. This once non-tradable segment of the US economy is now feeling the increasingly powerful forces of the global labour arbitrage for the first time ever.
The global wage arbitrage has tied the hands of the Federal Reserve. When it tried to inflate, the money went to commodity prices but not to wage increases in the United States. As a result, the attempt to reinflate in 2008 only resulted in stronger inflation, since the ability of the American household to repay his debt was diminished -- not only was his wage stagnating but on top of that he had to pay much more for petrol.
Wages in China are rising at a rapid pace of 30% and more. This is closing the global wage arbitrage at a very rapid pace. China simply can't play the cheap currency game anymore -- the printed money has finally found it's way to wages.
The bulls my argue that this phenomena is good development since it will help rebalance the global economy. However, what they fail to understand is the simple fact that business owners in China can't handle 30% wage increases since there is too much over capacity and since the Yuan has already strengthened 20% versus the euro.
After the Chinese growth story will halt the will be able to resume Q.E, and more importantly it will start to affect American wages, since manufacturing will need to return to the United States.
Investment implications
• The Chinese hot stocks like Baidu (NASDAQ:BIDU) and New Oriental Education and Technology Group (NYSE:EDU) are the last defense of China bulls. They are traded in the NYSE, and it seems that western investors have yet to waken to the fact that China is going to crash. (Investors in the A share market have been selling since August 2009, when the Chinese market topped) .
• All commodity producers are extremely vulnerable in the short to medium term (names like Rio Tinto (RTP) and Potash (NYSE:POT)).
• Oil producing countries are going to suffer (RSX could be a good short).
• An investor has to be ready to "shift" his investments from deflationary oriented assets (Dollars, Swiss Francs, T-bills etc.) to inflationary oriented assets once Q.E 2.0 starts.
• Gold is the only asset that will perform well both in inflation and deflation and for that reason it should be the constant part in one's portfolio. During deflationary periods it should serve as a hedge for short positions, and during inflationary periods it should be part of an "inflation basket."
Disclosure: Short EWA, China, Israel, Europe, and long Gold
Source: China's Coming Depression and the Peak Of Deflation