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China: The Teetering Dragon

|Includes:iShares China Large-Cap ETF (FXI), HAO, TAO

 China is an industrial bull posting huge growth statistics with astonishing consistency.  China appears to be the new Japan, which in the American mind circa 1984 was going to take over the world, making everything we use and owning almost everything.  The bull case for China is uttered in the hushed tones of quiet earnestness more frequently than the Lord’s Prayer on Sundays.   We need not recite it here.  But what of the bear case?  I believe there are frequently overlooked material risks to China Inc. that make Chinese related equities vulnerable to a steep fall.

To understand the key to the China bear case, it is necessary to understand the key driver of China’s success.  China’s growth over the last 20 years has been predicated on a pact with the U.S.  In this pact, the U.S. agreed to export manufacturing jobs in exchange for the cheaper goods and credit offered by China.  China, in turn, was able to grow materially, but had to accept U.S. debt as payment and the whims of U.S. monetary policy though links with the U.S. Dollar.  In other words, the Chinese growth miracle has been predicated on imbalances with the U.S.  Likewise, U.S. living standards have been predicated on increasing indebtedness to the Chinese. 

This obviously begs the question of:  how can China continue to post extremely strong growth statistics if its largest customer is no longer willing to borrow to increase purchases?  The answer is that growth cannot continue unless either the U.S. consumer resumes over-consuming or China replaces lost sales and growth with another customer or internal demand.  This is highly unlikely. 

Many will argue that China will replace lost U.S. demand with internal demand and cite the stimulus package as a success of doing this.  This is incorrect.  It is extremely difficult to alter the incentives and power-bases associated with an economy built on exports – just ask Japan.  If at all possible, it will take years to re-direct the economy.  With respect to the stimulus, it’s likely that much of it has been wasted and has gone to foster asset bubbles.  A material portion of the forced lending that has taken place over the last 6-9 months has likely gone to unproductive assets.  On a corporate level, loans are going to increase capacity just when the world is suffering from excess capacity and the country’s largest customer is cutting back on purchases.  Additionally, if one looks at real estate, it is easy to conclude that loose monetary policy has fostered bubbles.

As indicated here,, China is building entire cities in which no one wants to live.  China also continues to build office buildings despite 50% vacancy rates in some key areas like Shanghai, as indicated here

The continued investment in corporate assets and real estate despite declining demand and over-supply is evidence of excess and loose financial policies and will likely result in mountains of bad debt.  These are likely just two symptoms of what is likely to be a severely compromised economic system.

Given valuations, rampant speculation, mis-allocation of capital, the probability of rising levels of bad debt, the probability of either an internal or dollar liquidity event and I have to conclude that China offers much more risk than reward at this point in the cycle.  I don’t know what will cause the Teetering Dragon to fall – it could be one material event or a cascade of smaller events. But when the party does end, I’m sure it will be swift and severe.

Stocks: FXI, TAO, HAO