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July 17, 2004

The China Productivity Miracle
by John Mauldin

This week we look at China with a few thoughts that are not part of the conventional wisdom, and throw in a comment or two on global money growth, employment problems in the third quarter, and a comment on the presidential race.

NY Times: Serious Summer Reading

Last Sunday morning,I was sitting in my living room talking with the host of a radio show called the Smart Investor in Phoenix, and he asked if I had seen the Sunday New York Times, as they had recommended Bull's Eye Investing as "serious summer reading." After lunch, I went to the local Barnes and Noble, bought a NY Times and sure enough, there in the Business Section, was a picture of my book and a very kind review.

All in all, they recommended five books, four for beach time entertainment, and Bull's Eye Investing, "...our nod toward the fact that some people like to better themselves during the summer."

Mark Lemmons writes on Amazon: "Rarely does a book on the topic of investing and the economy qualify as "can't put it down" material, but this one does - I finished it in a short weekend...Mauldin makes a compelling case for caution as a small investor, but also identifies strategies and analytical approaches that provide the reader with a path forward even in what he calls the 'Muddle Through Economy.' In the end, Mauldin's concise recipe for moving forward as an investor is nothing less than gourmet fare."

You can get your "serious summer reading" at www.amazon.com/bullseye.

Sock It To Me, Baby

I read with dismay this morning the following item in Dennis Gartman's daily letter:

"Why the US has to try to meddle in international trade as often as it does via trade protection is really quite beyond us here at TGL, but it does. Now the US wants to impose limits on the number of socks that China can export to the US, joining bras, knit fabrics and such that were protected late last year. The textile industry here in the US, long given to tariffs and trade protection, is striking again while it thinks it has an audience asking the government to protect it from Chinese imports.

"The importation of socks into the US is a relatively (no it's a very) small industry, averaging less than $50 million/month. This is not steel; this is not autos; this is not grain... this is but $50 million/month that US companies cannot compete with. If consumers want these cheaper socks and if China's exporters can send them abroad and compete with US producers, then so be it: let the socks walk! But to constantly protect indigenous US businesses from competition is anti-capitalist at the very core. Somewhere, this has just gotta stop. Sadly, in an election year is probably won't."

If the Chinese are stealing our jobs, a brand new study by the Conference Board begs the question, "Who is stealing the jobs from the Chinese?" (As we will see, the Chinese actually lost 9 times more textile jobs than the US.)

Released last week, the study shows that between 1995 and 2002 China lost 7 times more manufacturing jobs than the US. In the off chance you have not seen the latest edition of Asian Labour News, I will quote:

"China is losing more manufacturing jobs than the United States. For the entire economy between 1995 and 2002, China lost 15 million manufacturing jobs, compared with 2 million in the U.S., The Conference Board reports in a study released today. "As its manufacturing productivity accelerates, China is losing jobs in manufacturing - many more than the United States is - and gaining them in services, a pattern that has been playing out in the developed world for many years," concludes The Conference Board study.

"According to Robert H. McGuckin, Director of Economic Research at The Conference Board and co-author of the study: "Increased unemployment has also accompanied the restructuring of the industrial sector, but per capita income has risen over the period."

The new report from The Conference Board, the global research and business membership network, is the result of a joint research project with The National Bureau of Statistics of China. The study is based on data for the 51,000 large and medium sized firms in China's manufacturing, mining and the utilities industries. While the study focuses on the larger firms, according to McGuckin, "the same patterns are observed among smaller firms."

"China is rapidly losing manufacturing jobs in the same industries where the U.S. and other major countries have seen jobs disappear, such as textiles. Matthew Spiegelman, Economist at The Conference Board and co-author of the study, notes: "The U.S. lost 202,000 textile jobs between 1995 and 2002, a tremendous decline by any measure. But China lost far more jobs in this sector--1.8 million. All told, 26 of China's 38 major industries registered job losses between 1995 and 2002."

China's Productivity Miracle

China's industrial labor productivity growth exploded at a 17% annual rate between 1995 and 2002. As in the more developed countries, this rise in productivity comes from improved technologies and the reallocation of resources from lower to higher value activities.

This compares with an average annual growth of 4% in the US, which most observers find to be an off the chart performance. 27 of the 38 industries in China saw annual average productivity growth of over 10%. Steel production saw a job loss of 557,000 jobs, but actual production has soared.

A large part of this "productivity miracle" is simply the government selling large, bloated industries and the new owners down-sizing the employee rolls, yet producing more. Even with private manufacturing industry in China adding 9 million new jobs, there was a net loss of 4 million manufacturing jobs in China in the period.

Chinese labor is now producing 3 times as much as it did a mere 9 years ago. Let's think about that for a moment. It is not just the lower wages in China that helped produce the boom of the last 10 years. It is that they are becoming more efficient. That is one reason why US import prices are stable (or falling[!] as they did last month) even as the dollar is down 20% over the last few years. Those who export to the US are simply making products cheaper. (See more on this below.)

The always astute Caroline Baum, writing for Bloomberg last year, quoted a study that showed that 22 million manufacturing jobs were lost globally between 1995 and 2002, even as manufacturing output soared 30%.

"The angst over the fate of U.S. production workers, whose numbers peaked in 1979, is not unlike the epitaph for farm workers in the early 20th century, says Steve Wieting, senior economist at Citigroup Inc. 'Real manufacturing output has risen 77 percent even though the number of manufacturing workers has fallen 22 percent since the 1979 peak,' Wieting says.

"Similarly, real farm output rose 96 percent since 1979 with 31 percent fewer agricultural workers. Because output equals income, 'something was earned with the gains in manufacturing and farm output during the last 25 years of falling employment in these industries,' Wieting says. A rising supply of food and consumer goods caused prices to rise more slowly than per-capita income, giving consumers more income to spend on other things -- on services that didn't previously exist." (Bloomberg)

Even though manufacturing and farm employment fell by 22% and 33%, respectively, since 1979 total US employment managed to grow 41%.

And then, in what may be one of the best lines I have read in quite awhile, Wieting says, "Our studies suggest that hunter-gatherer societies offer full employment for all, simply providing the basic necessities of food and shelter," Wieting say.

"Of course," Baum concludes, "with all of their resources devoted to providing food and shelter, they have little 'income' left to consume anything else -- made in China or otherwise."

What those who want trade protection really want is protection from change. They want local consumers to pay something extra (over what they would pay for an import) for whatever it is they produce so they can continue in their lifestyle.

Instead of favoring this or that group in an effort to shore up voters for this fall, we should focus on helping people adapt to a changing world. It is unseemly that a country which supposedly espouses free trade should stoop to such nonsense as putting limits on Chinese bras and socks. The Chinese know the political game, and have shown admirable restraint, but this simply undermines whatever free trade leadership we have.

Let us make no mistake, the growing global marketplace has made the world a much better place. Not every boat has risen evenly, but far more enjoy a better life because of a growing world market.

This global marketplace is under enough pressure from trade imbalances, debt, currency manipulation and such without imposing the additional pressures of trade restrictions and other bureaucratic nonsense.

Is China Slowing Down?

Many observers suggest that the Chinese government is tapping on the brakes, trying to slow the economy down. They are raising bank reserve requirements and slowing down the rate of loan growth. Can they simply slow the economy down, or will they overshoot and cause a recession?

Stephen Roach of Morgan Stanley posed the question most succinctly:

"And, of course, the debate over the China slowdown rages - not whether it will occur but whether the coming landing will be soft or hard. The latest indications on China's industrial output growth - a further deceleration to a 16.2% year over year gain in June - paint a picture of a Chinese economy that is only in the early stage of either type of landing."

Maybe, and maybe not. Greg Weldon (Weldon's Money Monitor) takes up the debate and truly offers some new thoughts on the debate.

First, he writes this week:

"We note that 24 of the 31 Chinese Provinces reported shortages of electricity, with the government calling the shortfall in supply 'acute', within the coastal manufacturing municipalities. Subsequently, Beijing announced that 6,000 factories will be closed for one-week each, in 'observance' of ... 'high temperature holidays'. Indeed, city hotels have been 'restricted' to keeping thermostats no higher than 26-degrees Celsius, and asked staff to take to the stairs, so as to avoid ... 'power hungry elevators.' Industrial Production might be slowing ... BECAUSE of lop-sided demand for electricity.

"Consider it this way --- Five years ago, the (then) State Development and Planning Agency put forth a five-year plan for the build out of the country's electricity-grid ... envisioning what was, at the time, a RAPID pace of industrial output expansion, forecast at +7% yr-yr over the five year period.

"Oooops, 15% growth ... in a single year ... THREE TIMES the annual growth in demand for electricity that was EXPECTED from the industrial sector. Additionally, we observe that the Steel, Cement, Chemical, and Non-Ferrous Metals industries, together in tandem, account for 29% of the nation's demand for electricity.

"THUS, from the perspective of trying to optimize a pace of expansion that is consistent with a sustainable ability to 'fuel' itself with power ... a slowing in the GROWTH rate of cement and steel, to a STILL DOUBLE-DIGIT pace of expansion ... is NOT a 'bad' thing. So, myth number one is shattered ... Industrial Production is NOT going into ANY landing, soft NOR hard."

Many suggest that a slowing China will see exports decrease, but that has not been the case. But the reality is that exports are soaring, up 48% year over year in May alone.

Finally, I have been writing for years that Chinese leaders face a huge problem. As China sheds its bloated government owned business, it must find jobs for those who will become unemployed. Managing expectations, especially those of the unemployed who see many people around them beginning to see better times, is important. How big a job does the Chinese government have?

Again, we quote from Weldon:

• Chinese Unemployment Rate ... 23%
• Number of People Unemployed in China, 169 million ... EQUAL to the ENTIRE US LABOR FORCE
• Chinese Agriculture employs HALF of the working population, versus less than 3% in the US and 4% in Europe.

"Indeed, the government cannot be TOO UPSET that Industrial Production continues to grow by more than 15% year-over-year, and that Exports have topped $50 billion monthly, expanding at a MIND-NUMBING year-over-year rate near 50% !!!

"The Central Bank may desire less raw material price inflation, and may try and complete the high-wire act in terms of managing capacity constraints in the power-sector ... BUT ... JUST LIKE THE US FED ... they do NOT mind ... a more rapid trend rate of economic growth."

The main problem for China is not necessarily internal to China. China needs to grow its exports and internal demand so that it can create more jobs. It is the global trade imbalance - the undue dependence upon the US - that threatens the global expansion.

If the primary engine of global growth, the US economy and specifically the US consumer, begins to slow, then Chinese export growth will slow. Perhaps it will even recede, if the recession in the US is severe enough. It is that simple.

China has all sorts of problems. Too little water. Not enough power. Pollution levels that are simply alarming. License plates are actually auctioned off in Shanghai in an attempt to control traffic congestions and air pollution. We could create a list that goes on for pages. They are slowly solving many of these problems.

But the opportunities also abound as well. China will not be able to avoid the business cycle forever. Sooner or later they will have a recession, just as we will in the US. In fact, my thought is they, and much of the rest of the world, will in fact have that recession because of a slowdown in the US. For now, the Chinese government is doing what they can to create a dynamic manufacturing machine which creates new employment, which will create internal demand and doing so in a way that is creating a true future economic powerhouse.

Do not look for the Chinese to raise their interest rates or float the yuan anytime soon. They are on a fast-moving treadmill, with the very real need to create jobs at home more important than their need for a floating currency, which much of the world really wants to see happen. Just as the by-word for the Fed raising interest rates is "measured," so any action by China will also be "measured."

Global Productivity and Prices

The dollar has dropped 20% on a trade weighted basis over the past few years, and you would expect import prices to rise. They have not, to any appreciable degree. Because the world (not just China) is producing more and more for less and less, prices are falling as fast as the dollar is dropping.

This is allowing the global trade imbalance, and especially the US trade deficit, to continue without the normal check of rising prices. It is making a troublesome situation (the US trade deficit) more of a problem. The fall of the dollar has produced no real pain in the US, as the "stuff" we buy from abroad is still relatively as cheap as a few years ago, especially the high tech toys (the exception being some European products). But it has made the dollars held in reserve by foreign banks drop, and there is real pain in their balance sheets.

Global productivity is not going to stop, either in China, the US or anywhere else. It is a fact of life. But the trade imbalances cannot continue. By definition, if a trend cannot continue, it will eventually reverse. Just like a stock market bubble, the longer a trend continues, the more out of balance the situation, the worse the eventual reversal.

Over the next few months, we are going to look at this situation quite closely.

Global Liquidity Falls

I know that much of this week's letter has been quotes, but some weeks I find that other people say what needs to be said. And that is the set-up for the piece we are going to look at next. I could ominously and simply say that global liquidity fell for the first time since December of 2001, and leave it at that. Or I could quote Ian Douglas of UBS in London in their Fixed Income Strategy Daily letter and let him give you more insight. I think the following is important, and I suggest you digest it. Under the heading that "The global liquidity cycle turns. Medium-term risk to asset prices" we read:

"Something was reported last week that hasn't been seen since Dec 2001. Global liquidity fell. Before you eject this mail into the filing system known as the recycle bin, let me try and highlight the importance of what has happened.

"The IMF publishes a monthly data series global FX reserves (ex-Gold). As the name suggests, this is a summation of the FX reserves of the world's central banks and is published as a dollar value. It can alternatively be thought of as global M1. It should come as no surprise to readers of this publication that FX reserves have been growing strongly through to the first quarter of this year. In the 12 months to Mar 04, global reserves grew by a staggering $791bn (equivalent to around 7.5% US GDP), a 30.3% year over year increase. The charts below illustrate the growth - in both levels and percentage terms.

"The global economy has obviously strengthened significantly over this period, but at nothing like the pace required to absorb this liquidity explosion. Global nominal GDP growth looks to have been running somewhere around the 5% mark over the same period. When global activity is weaker than the pace of global liquidity creation (or monetary growth) a situation of 'excess liquidity' develops - the scale of which is broadly determined by the GDP growth / monetary growth gap.

"This excess needs a home. If real economic activity is not strong enough to absorb the cash it tends to find its way into asset prices and periods of high levels of liquidity growth are typically associated with asset price inflation. In its most obvious guise, this is the inflation of short-dated US security prices which would surely be at higher yields had the central banks of Asia not been on the bid.

"But the asset price inflation has been and usually is a wider phenomenon than just bidding up short dated risk free asset prices. What also typically characterises periods of high excess liquidity is a fall in risk aversion (the cheaper the money the lower the relative cost of risk) and therefore a strong performance from risks assets. The year long rebound in global equity prices and strong performance of low grade credit and emerging markets need to be seen in this context. (So should strong house price growth in most parts of the world, old master painting prices making new highs, strong fine wine prices, and doubtless many other examples). Note also that previous spikes in liquidity growth have been similarly associated (eg the equity bull market of the 85-87 period).

"The figures released by the IMF are somewhat dated - being for April - but fit with other more timely indications such as the Japanese reserve growth figures we commented upon yesterday. In the year to April the average monthly growth was $65bn, with April's contraction of $8.3bn being the first fall in twenty seven months. If we are right that the rate of reserve accumulation will continue to fade this suggests it will not just be Treasury prices that are vulnerable. It may be prudent to unload some risk more generally - and drink that Bordeaux before the prices start to fall."

Employment Numbers and Uphill Battles

Finally, a little update on the US employment numbers. A few weeks ago I wrote that last year, the employment numbers started to include an estimate for the birth and death of new businesses. There is a time lag between the time these businesses are created (or die) and when the Bureau of Labor Statistics finds out about them. So they have created some fairly elaborate models for estimating the numbers of new businesses. While this does attempt to show more realism in the actual final number, it also throws some subjectivity into the numbers.

As they note on their site (www.bls.gov), "The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend. BLS will continue researching alternative model-based techniques for the net birth/death component; it is likely to remain as the most problematic part of the estimation process."

Last month, 182,000 jobs were in that category across the entire spectrum of the employment markets. They estimate over 700,000 new businesses have been created in the last four months alone, or more than double the amount created in the preceding 10 months. Were those 182,000 real, or were they the creation of a government agency desperate to show employment growth?

As they note, this model will understate growth at the beginning of recoveries and mask problems at the beginning of downturns. But there is nothing in any of the rest of the economic data which suggests a major change in patterns, so I give some credence to the possibility that 195,000 jobs were created by new businesses. My friend and astute analyst Bill King argues differently, that we are late in the recovery cycle and the jobs are not there. In the US, most new jobs are created by small businesses, and in recoveries, it is normal for lots of new small businesses to be created.

The jobs numbers are all guesstimates anyway, and it is the longer term trend and direction which should concern us, and not the month to month numbers. And lately, the trend has finally been good.

However, that was then, and this is now, as my kids often point out. Last July, the BLS seasonally adjusted the numbers down 83,000 jobs, so one assumes they will adjust things down this year. For the entire 3rd quarter last year, the increase in new jobs from the birth-death cycle was marginal, a mere 74,000.

Let's look at a few quick facts. The economy must grow at 3% just to keep employment steady in the face of rising productivity and population growth. The economy slowed to 3.8% in the first quarter of this year and seems to be slowing the second quarter. Consumer sales are slowing somewhat. Mortgage applications and refinancing are down. As many observers note, this is the first summer in three years without rebate checks and other tax stimulus. Further, the re-fi boom has gone away.

I am in San Diego today, so can only quickly look at the CPI release, but the earnings numbers were ugly. Real wages were down 0.8% in June, and down what looks like 1.4% for the last four months. Average weekly earnings were down as well, because of a drop in the number of hours worked.

Nothing is falling off the table, just slowly, ever so slowly, coming down from the heady economic pace induced by all sorts of stimulus of last year.

This does not bode well for third quarter employment numbers. The economy in theory has to create 83,000 jobs in July just to "stay even" statistically in the seasonally adjusted headline number that everyone is going to focus on. Given the above quote from Douglas, (decreased liquidity), the "anxiety" over another Fed raise in August (if they don't raise rates, what message will that send?) and the summer blahs, I might not want to be long the market indexes in August. Just a thought.

And, yes, I know that the above combined with the democratic convention it does not bode well for the Bush campaign. Today, looking at battleground state polls, Bush would win the electoral vote and be re-elected. But the elections are not in July. They are in November. If the seasonally adjusted employment numbers are weak, which is what the media looks at, voter sentiment in swing states could change. For a number of states, it will not take much. I still think Bush (or maybe better to say, Karl Rove) pulls it out, but that may be just me rooting for the home team.

San Diego, Surf and the Zoo

As you read this, I am in San Diego meeting with my Jon Sundt and his team at Altegris Investments. They are celebrating their annual summer employee party tonight. I am also here with my youngest (ten year old) son, where he has decided that surfing is a cool thing.

For those interested, I work closely with Altegris to offer accredited investors access to hedge funds and alternative investments. For those who are interested and who qualify, I write a free letter on hedge funds and private offerings called the Accredited Investor E-letter. (I should note to current clients that I have not written one in a while, but am going to start once again after I get back from vacation in a few weeks.)

You must be an accredited investor (broadly defined as a net worth of $1,000,000 or $200,000 annual income - see details at the website.) You can go to www.accreditedinvestor.ws to subscribe to the letter and see complete details of what we actually do, including the risks in hedge funds. (In this regard, I am a registered representative of Millennium Wave Securities, an NASD member firm.)

My daughter Tiffani is back from her six-month long sabbatical and once again working in the firm. Already it is beginning to relieve the pile of projects that were on my desk. She is with me in San Diego. Saturday the three of us get to do one of my favorite things in the whole world - visit the zoo, and not just any zoo but the best in the world. With a vacation starting in another week life is starting to look better and better. Enjoy your weekend, as I am certainly going to enjoy mine.

Your seeing something besides bulls and bears analyst,

John Mauldin
Frontlinethoughts.com

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended by Mauldin may pay a portion of their fees to Altegris Investments who will share 1/3 of those fees with MWS and thus to Mauldin. For more information please see "How does it work" at www.accreditedinvestor.ws. This website and any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement or inducement to invest with any CTA, fund or program mentioned. Before seeking any advisors services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Please read the information under the tab "Hedge Funds: Risks" for further risks associated with hedge funds.

If you would like to reproduce any of John Mauldin's E-Letters you must include the source of your quote and an email address (John@FrontlineThoughts.com) Please write to info@FrontlineThoughts.com and inform us of any reproductions. Please include where and when the copy will be reproduced.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

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