Wednesday, July 9, 2008

China Watch: Problems in economy

I do not consider myself an expert on Chinese economics, although I am advanced in the study of that country. Unfortunately, however, when one studies a nation or region, what many people expect from you seems to be the ability to prophecize events and conditions in that region. They say, "Oh, you study China. Great, what will happen there next?" or "Do you think their economy will continue to improve?"

I cannot do this for China, at least not with much accuracy, and I cannot do it for the United States either.

But in my opinion, the Chinese economy will continue to grow for a bit and then slow down. At that point the Chinese economy will continue to be important in the world, but much of its current activity will shift southward to Indonesia and Vietnam.

This assumes, of course, that catastrophe such as civil war or economic collapse does not occur. Then again, although I think such things are possible, I don't think they are going to happen.

I think a parallel could be drawn between China now and Japan and its economic boom in the 1980s.

By the way, for more of my views on the Chinese economy and current conditions see my other blog at ,

Peter Huston

If China slips on oil, it will learn that distance is tyranny

July 9, 2008

China's days as the world's manufacturing base may be numbered, writes David Hirst.

AS MUCH of the financial world comes to realise the extent of our economic woes and the possibility of catastrophic consequences, reports on the scope of the crisis are coming at bewildering speed, killing any hopes of sharemarket rises daily.

On Monday, the Dow, buoyed by falling oil prices in the morning, was buffeted and continued to take water when Freddie Mac and Fannie Mae began to founder. Those two organisations, if one can use that word loosely, are the bears' best friends, and a mention of them is enough to send the indices into troubled waters.

But along with the publicised Bank of International Settlements reports, and apparently unreported outside of Europe, is an extremely dire study (on which the BIS reports may be partly based) that finds that banking losses have skyrocketed to $US1.6 trillion ($A1.7 trillion), with total debt risk of $US26.6 trillion, which has stunned European financial authorities.

And perhaps more frightening is a report published by the London Telegraph on Monday that China oil prices threaten the "blowing-up" of the Chinese economy and the demise of the Chinese economic model, as distance from markets threatens to impose a harsh tyranny. "The great oil shock of 2008 is bad enough for us," writes the Telegraph, citing some very solid sources. "It poses a mortal threat to the whole economic strategy of emerging Asia."

China's economic model is, like most economic models, based on oil prices far below what they are today. Even the ships that transport the basic goods to be assembled in China and then freighted around the world are built assuming cheap oil. And its super-mass production relies on very slim profit margins. And, before we take heart in the hope of cheaper oil, China's banks, controlled as they are by the Communist Party, are not exactly models to follow, except for those elements in the US Government that seem to be uncovering new and exciting ways to nationalise or socialise that country's banking system. Freddie Mac and Fannie Mae are likely starters for formalising such, but more of that when we have digested the problems to Australia's north.

On Monday, a US website posted a translation of a German newspaper report from Marco Zanchi, a noted European writer and editor of Finanz und Wirtschaft of Zurich, commenting that his "dire" predictions for world markets had "echoes of Japan written all over it, with the spectre of zombie banks slowing the US for years" unless its mess was cleared away.

The report, titled "The large financial crisis has just begun", opens with the statement: "Those that assume the misery is coming to an end are wrong. When it comes to write-downs, losses and raising fresh capital, the crisis has only just begun for banks. Losses are expected to reach $1.6 trillion, only a fraction of which have been uncovered."

"But that is not everything," the study continues. "While banks give their word of honour that no further capital is needed, the paper by Bridgewater Associates says: 'We have big doubts that financial institutions will be able to obtain enough new capital in order to cover the losses. This will worsen the credit crunch."'

The suggestion that China may soon be dead in the water is so unthinkable that it should be unprintable. Especially in Australia. For Australia has de-coupled in its mind from the US and found a new great and powerful friend. Along with news of the huge strains Vietnam is experiencing — I believe no sharemarket in history has, like Vietnam, fallen every day for a solid month — the news out of China might result in a blow to the lucky country's glass jaw.

The Telegraph report follows a weekend Reuters story, "Asia's exporters suffering as global demand weakens", which quotes a Deutsche Bank estimate that 20% of China's low-end exporters will go belly-up this year.

China's official inflation rate is 7.7% but it has started rolling back domestic subsidies for fuel — and fertiliser, the price of which has increased about 300% recently. The Chinese Government has realised a bit late that its energy inefficiency puts it at a competitive disadvantage; ending the subsidies is seen as necessary to force businesses to become more efficient energy users. This will be a painful process.

Likewise, the cost of a 40-foot container from Shanghai to Rotterdam has tripled since the price of oil exploded. China's industries have been built on cheap transport over the past decade. A report cited by the Telegraph from Stephen Jen, currency chief at Morgan Stanley, states that "at a stroke, the trade model looks obsolete. Asia's intra-trade model is a Ricardian network where goods are shipped in a criss-cross pattern to exploit comparative advantage. Profit margins are wafer-thin. Products are sent to China for final assembly, then shipped again to Western markets. The snag is obvious …

"Energy subsidies have disguised the damage. China has held down electricity prices, though global coal costs have tripled since early 2007. Loss-making industries are being propped up. This merely delays trouble. The true impact of the shock will only be revealed over time, as subsidies are gradually rolled back."

Last week, China raised internal rail freight rates by 17%.

BP's Statistical Review says China's use of energy per unit of gross domestic product is three times that of the US, five times Japan's, and eight times Britain's.

China's factories "were not built with current energy levels in mind", says Jen. The outcome, he suggests, will be "non-linear". Translation: "China is at risk of blowing up."

The Asian outsourcing game is over, says CIBC World Markets. "It's not just about labour costs any more: distance costs money," says chief economist Jeff Rubin.

Although many governments might envy the stability of Communist Party rule of 60 years next year, it masks potential social instability, a condition common with many of the most successful but newer economies. China is being crunched by the triple effects of commodity costs, 20% wage inflation, and sagging import demand in the US, Canada, Britain, Spain, Italy and France. And critics warn that Beijing has repeated the errors of Tokyo in the 1980s by over-investing in marginal plant. A Communist Party banking system has let rip with cheap credit — steeply negative real interest rates — to buy time for the regime.

Whether or not this is fair, it is clear Beijing's mercantilist policy of holding down the yuan to boost exports has hit the buffers.

Of course, oil prices may fall. But broader international economic issues are coming into play.

The research paper published in Europe is "hot" in professional circles not only because of its content, but also because of the originator: Bridgewater Associates is the second-largest hedge fund in the world. The people behind it are brilliant, first among them Ray Dalio, who founded the company more than 30 years ago. And Bridgewater's macro-analyses have special weight with central banks as some of them are Bridgewater customers.

What is at risk for the banks? To identify the dimensions of the crisis for financial institutions, Bridgewater has calculated the expected losses on a wide range of risky credit-based US assets. Then, one would need to know basically who had how much on the books. The total value of these risky loans comes to $US26.6 trillion. The losses on these assets would then sum to $US1.6 trillion, if all of the assets were valued at market prices, writes Dalio.

David Hirst is a journalist, documentary maker, financial consultant and investor. His column, Planet Wall Street, is syndicated by News Bites, a Melbourne-based sharemarket and business news publisher.

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