Byron Wien of Blackstone Advisory Services is bullish on China. This might not be particularly newsworthy in and of itself, but some of his arguments are definitely worthwhile and should be explored.
The basic thrust of Wien’s position is that the Chinese government can react much more quickly than Western nations to economic issues and has thus been able to fix its problems much more easily than the United States. Wien points to China’s success over the past few decades as evidence to support his conclusion.
In 2008 and ‘09, the US was in full blown panic mode and Congress and the Presidents (Bush and eventually Obama) were not on the same page in devising a solution; the end result was slow and disjointed policy. Meanwhile, China took aggressive action to stimulate the economy and made strategic metal purchases at discounted prices, which quickly put its economy back on track. Many would say that the results speak for themselves.
While I do believe there is some merit in Mr. Wien’s position, I find myself much more skeptical of the situation. Major economic movements generally take some time to develop and nations can be on the wrong course for decades, before collectively coming to a realization that it was in fact, the "wrong course."
Case in point --- the US housing bubble was about two decades in the making and involved a confluence of factors, such as heavy governmental subsidies, deregulation of the banking industry, structured finance run amok, a continual low interest rate environment, and prevalent belief amongst the American masses that real estate prices would never fall. The Japanese Asset Bubble provides even more food for thought, as Japan was able to produce strong growth for nearly 3 decades, before falling into a two decade long funk.
China and Infrastructure
Where I think Mr. Wien hits upon something is in regards to infrastructural projects. Wien argues that China is able to do things much more quickly than the US. The US is often paralyzed by a slow-moving political process. While we could debate the merits of the American governmental model versus the PRC, it’s not really necessary in this case once you realize that the US transportation systems, for all practical purposes, is not really a “free market.”
Right now, highways are very heavily subsidized by general taxes, with a 30% shortfall estimated in trust funds across the nation; with the state governments specifically having about a 40% shortfall. Meanwhile, the decisions as to what projects get built and which ones never see the light of day comes down heavily to political favor. Taking this into account, it’s easy to argue that there are major market distortions present in the US transportation system and we often end up with grossly inefficient results. The PRC’s more streamlined and less blatantly political process may very well be more efficient.
Supply, Demand, and the Dollar Peg
However, where China has major issues has been its attempts to manipulate basic supply and demand for their exporters. This has been particularly evident in their currency policies, which have been designed to weaken the Yuan and strengthen the Dollar; which acts as an effective subsidy to China’s exporting companies and a tariff against American companies.
The basic problem with this set-up is that ignores the actual needs of the Chinese market. If Chinese consumers need more scarves and jackets but cannot afford them, there is a misallocation of resources. On the other end, US consumers might not need quite as many scarves and jackets, but they receive them at much more favorable prices due to the currency peg in China. This artificially stimulates demand; but that demand is not necessarily sustainable, which can result in significant overcapacity. So in theory, the currency peg should eventually create market distortions that result in oversupply to external economies and undersupply to its own.
China is beginning to face the latter problem. While inflation has been virtually non-existent in the US in the past year, China’s inflation rate has pushed upwards to around 4.5%. Food prices have been particularly hard hit, as the average price of a basket of 18 vegetables jumped 62% year-over-year in November. In response, the PRC has proposed food price controls. Unfortunately, these controls will likely led to even greater supply shortages, as producers now have less incentive to supply the Chinese market.
The logic behind the rising inflation problem should be obvious: by artificially suppressing the price of the Yuan to boost exports, China has squeezed its own consumers severely. Not only has this manifested itself via higher food prices, but it’s also become evident in the rapidly rising real estate prices. In spite of proactive steps towards controlling the bubbly real estate market, the PRC has not had much success yet. It will likely take a significant monetary clampdown to put the brakes on everything; yet, this will almost inevitably result in an economic downturn.
There are some convoluted dynamics involved with the real estate market. Real estate prices are artificially high due to the Yuan undervalued, yet, people continue to buy real estate and other hard assets because they believe these assets will retain value, while the purchasing power of their currency is weakened. It’s difficult to blame the consumers here. They are making the “right” decision on a microeconomic level. If the value of their currency is evaporating, then it makes sense to own more hard assets that will retain value.
The only problem is that consumers have more difficulty seeing the bigger macro picture. Once consumers get squeezed to the limit, real estate prices will not be able to continue their thrust upwards; leading to the bursting of a real estate “bubble.”
The position of Chinese exporters is also being undermined by this inflation. China’s Dollar peg has acted as an invisible wage squeeze on average workers. As these consumers can afford to purchase less, they eventually demand more to compensate for their declining real wages. Unfortunately, this cuts into the already razor-thin margins of Chinese exporters. With higher labor costs, these exporters become less competitive, and voila!: suddenly we have a large amount of overcapacity.
So while I believe there is some truth in Mr. Wien's argument, particularly when we are talking about infrastructural investments, he’s ignoring the larger distortions that have been unsustainably driving China's GDP growth over the past decade.
I cannot claim to see the future or know how the PRC will handle any impending crisis, but for now, there should be significant skepticism about the Chinese “economic miracle” and it would stand to reason that due to the heavy distortions involved, things could go south very rapidly in the next few years.
Impact on the Markets
What does this all mean to investors? It’s difficult to predict how many Chinese companies will hold up during a significant downturn, because so much is dependent upon the Chinese government’s own perception of events. At the very least, however, many of the manufacturers that are already on the verge of hitting red could finally be pushed out of existence. Companies that are heavily dependent upon Chinese demand could suffer, as well.
The one sector I would particularly keep a close eye on is metals. China has been driving a large chunk of the growth in global commodity demand. If this demand is undermined, metal miners could be affected significantly. In particular, I’m skeptical of companies involved with silver. The problem with silver miners is that they are already priced fairly aggressively based on projections of increasing prices. Yet, if demand is undercut by a Chinese downturn, this could put a lot of pressure on silver prices. Given the fact that extraction costs for many miners are significantly below spot prices, it stands to reason that margins have a good deal of room to shrink.
Not all is gloom and doom, as there will undoubtedly be some Chinese companies that hold up well and many of these companies are selling at discount valuations already. For now, however, I would prefer to focus on finding undervalued US and Latin American companies.
Disclosure: Author holds small short positions and puts on various silver and copper related stocks. These positions are intended to hedge more bullish bets elsewhere.