The Cracked China Factor

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Includes: CNY, CYB, FCA, FXI
by: Robert Brusca

Summary

China does not obey the rules.

China does not do what is expected of it.

China has gotten what it has wanted by giving very little in return.

How can that continue?

On the other hand.why would it ever stop?

China has been the most important new force in the global economy over the last thirty years and its influence continues to grow. But China's biggest influence may come from what it doesn't do more than for what it does do. How do you make international investment decisions with Baby Huey on the loose?

China does not obey the rules. China does not do what is expected of it. China has gotten what it has wanted by giving very little in return. How can that continue? On the other hand it has been so successful a strategy why would it ever stop?

And that is no way to run an international economy. A day of reckoning must lie ahead. And that is not just for reasons regarding international relations but because China has gotten here doing some things it simply cannot continue to do, like running up debt hand over fist and exporting relentlessly on the back of an ever-weak yuan.

The Baby Huey factor

As China has developed it has not matured; it has not accommodated its rhetoric to its more senior status. China is still the combative outsider. China still insists it will not obey the ruling authority on its South China Sea claims. It has told the Philippines that it will negotiate with them if the ruling goes against it (…when the ruling goes against it). But what kind of world is this when countries place themselves above the rulings of well-regarded international tribunals? China's acceptance into the WTO and again the yuan's acceptance into the SDR basket have gotten no appeasement from China in any facet of its policymaking as a 'thank you.' China simply takes and does as it likes.

Earlier this year there was stir when it was rumored that China's stock indices would be taken into the MSCI indexes. But, in the end, that did not happen. Getting accepted into one of the foremost international benchmarks would have been a further boost to China and another step in its accreditation as a global player, as a global financial power, and simply as a seamless cog in the international financial system. But it isn't that at all, is it? It really wasn't ready for that step.

Dim Sum or prune Danish?

The yuan is not much closer to being an international investment currency than the Danish krone. China has a legal framework under which no international investor would ever want to have his claims adjudicated. China regularly engages in censorship and does not recognize international trademarking. Piracy is still more commonly conducted in China than anywhere else in the world. This is not a currency or a legal system in which you want to have your day in court. So how can China be a major financial center with such unresolved issues? These issues overhang and threaten China's development. Its reluctance to accept the ruling of any external authority marks China as having a stunted international development despite its size (GDP, population or geography).

One step forward two steps back?

The Permanent Court of Arbitration at The Hague is a highly regarded forum to adjudicate the South China Sea claims. It was set up especially to consider conflicting claims between sovereign states, to create a legal channel to resolve disputes and to reduce the potential for conflict. China's rejection of this course of action puts the world back into a wilder world where might makes right. China's ascension as a world power coupled with its intransigence has made the world less stable, a more dangerous place.

Invest in China: how to do it... maybe not at all

Investing in China is best done with the participation of a connected local. But in a day and age when China is running its own witch hunts against excess and former officials are falling like flies to a revisionist view of their contributions, it is hardly possible to know who might be a good economic Sherpa for Chinese investment. Moreover, that whole process simply lays bare the fact that investing in China is more a political act than an economic act. When you rent-a-Sherpa in China it is not for his knowledge it is for his connections. From the standpoint of modern portfolio theory there is no way to assess the risks and/or returns of investing in China on this model. China has become a game of chance with more uncertainty than risk making investment there more a game of chance.

Modern China is such a stitched together nation of underlying separate groups that China's own hardheaded hardline approach clearly is meant to subdue and suppress diversity. Dissent is strictly controlled and punished. To give the appearance of one-China there is the mandate that everyone will speak Mandarin. China reminds me a lot of Yugoslavia under Tito. Yugoslavia was the most successful of the 'communist bloc economies' under the USSR influence… until it wasn't and it disintegrated. After Tito died and his hardline control ended, the country broke off into its different natural parts. Could that happen in China? Could China fragment?

What 'few' China experts think is likely… might happen anyway

While few China experts think that the current regime will lose its grip, it is that very grip that is vexing. An economy that must be gripped by its leaders to survive will not be very dynamic and will exhibit many economic abnormalities. We saw this in the USSR. Political leaders rarely have real economic vision. Already under this leadership China has launched a demographic time bomb with its one child policy (which it since has abridged). There is a huge male/female imbalance bulge built into the future and it won't simply go away. China has created ecological carnage on its physical property and its people. How much of this do you want to forgive and forget and stop worrying about despite the loud ticking time-bomb that these things represent? These kinds of decisions also represent a habit of operation and of denial. Some habits are hard to break. But China 'experts' can only point to past successes and flexibility. Really? What happens when you lose options, face more problems and can't be flexible and you are resented to boot? How does that play out? My image for China is that of an aging sports hero. Recently, the passage of time has come to damage China instead of improving it.

Life in the too-fast lane

I firmly believe that China has entered into a program of economic development that has been too fast to be sustained and has established some bad precedents to boot. It has been aided by appeasement by the West. China has set up a system that does not respect rules; as it gets larger and as 'playing by the rules' becomes more important for a 'major power' how does it change? I am concerned that China is trying to insinuate itself into the fabric of the international economy without the needed maturity. It has the economic power, the GDP, the population and plenty of transplanted foreign-owned technology. China is also developing its own proprietary technologies. But it has had a problem in constructing its own infrastructure and in making it durable. Its own ways have sometimes proved troublesome. And China now has a huge debt to GDP ratio which means it will not simply be able to continue to throw money at the problems of the future. In fact the approach to the problems of the past is the reason for one of the biggest problems of the future: debt.

China's prospects as a prospectus

An investment prospectus always warns that past performance should not be taken as a guarantee of future returns. China is the poster child for such an expression wrapped in the guise of a sovereign nation. Its political ramblings in the South China Sea (SCS) already speak of a nation in need of an international distraction for its growing domestic problems. China grabbed the SCS properties (1) as a distraction to domestic failures, (2) hoping that there would be undersea mineral rights to be had, and (3) because it wanted to, despite having no solid claim. In short this was quintessential China/Baby Huey. WAAH I want the SCS! Looking ahead…China will no longer be able to simply export itself to stronger growth because the debt problems in the West have put a stop to those games. And it has growing problems at home in terms of demographics, environmental pollution, debt, and a need to reset its economic model. Investing in China is like buying a successful drug company as all its key products come off of patent protection. Future success is not assured.

Sustainable growth is not always fast growth

Increasingly China will have to look to real solutions. By this I mean solutions that require China to have a more balanced economy, a give and take economy like in a real economic system. China must move beyond its past mercantilistic scoop ups of high cost production from abroad that spit out cheaper exports to high income countries. That ship has sailed. China must now sail into uncharted waters.

This time is different…

China will need to develop its own domestic demand and more balance in its economy. That transition will be difficult. China may not be about to fall apart. But its cohesion is going to be more severely tested since its crony-communism model will be harder to sustain when exporting is harder. And when China is not hands down the cheapest place to produce any more that game changes anyway. And without piles of money to throw around the world looks different. I think China and others discount too deeply the extent of the challenges China now faces. Post Great-Recession everything IS different.

The starship China-prise

A higher debt load will constrain what the government can do in the future. China's ratio of debt to GDP already approaches the 300% mark. In short, the easy part is over. China has completed Phase I and has not made many friends in doing that. It has used checkbook diplomacy in Africa. It still lacks natural resources. Still, many look back at China's miracle and from that legacy of achievement gain respect for the future. And I can see that as a great accomplishment. But it was built at a cost…and it is built on an uneconomic base and using unrepeatable actions. China has learned some things it will need to unlearn if it is to be successful in its next phase. That is what investors need to account for when they consider committing funds to China. Like the Starship Enterprise China will have to go where no Chinese government has gone before. Is it up to the challenge?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.