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November 26, 2004

China at a Crossroads
by David Chapman

Over the past twenty five years the Chinese economy has been nothing short of miraculous averaging roughly 9% per year. In the process China has become one of the prime economic engines of the entire world. During this period the Chinese economy went from a totally command economy to one that maintains many of the elements of a command economy but through reforms has opened up more than anyone ever thought it would.

Despite economic reforms China is still ruled by one party and dissidents are still subject to arrest. But with numerous economic reforms and freedom has come the demand for more personal reforms, freedom and democracy. The current system has taken on more the characteristics of fascism (marriage of state and capitalism) then it is the old communist model.

But growth and those who benefit from the growth has been very uneven. The main benefactors have been the coastal provinces and urban populations. China has seen spectacular urban growth over the past decade but the population is still largely rural. And it is the rural population that still makes up about 60% of the population that has not as yet benefited from the growth. The result has been that unemployment remains quite high particularly in the rural inland provinces and there remains from the old days numerous inefficient state industries.

Still as The Economist points out the growth is starting to make some inroads into the inland provinces (China's growth spreads inland - The Economist, November 20-26, 2004). Growing unrest in a number of the inland provinces keeps pressure on the central government to ensure that economic growth becomes more evenly divided. We are reminded that Chinese revolutions (Communist, Boxer) were largely economic in nature due to huge inequality.

But one thing that has been amazing with the incredible Chinese growth of the past quarter century is that no major economic slowdown has occurred. The longer it goes on of course the higher the risk. We are all reminded that over that same quarter century of spectacular Chinese growth we have had the Japanese property and stock market bust (1990-1995), the Asian financial crisis (1997-1998), and the Internet/Tech bust (2000-2002). So to say it can not happen is pure wishful thinking.

Since 2001 the Chinese have embarked on a huge spate of construction projects (including the 2008 Olympics) many of them quite speculative, financed by money from the Chinese banks where risk assessment seems to be merely a word in the dictionary. Chinese banks, according to The Economist, are just conduits to throw money into government projects and state-owned companies, with little regard for risk or profits. According to a recent article in Asia Times (Crash landing coming for China - Jack Crooks, November 12, 2004) the Chinese banking system is virtually insolvent. At the end of 2003 outstanding loans to GDP was 145%, the highest ratio in the world. Bad debts at 40% are also the highest in the world. Crooks describes Chinese bankers, particularly at local branches, as being unable to tell a good loan from a bad loan. Pay is dependent on asset growth not whether you make a profit or not.

This speculative bubble is an accident waiting to happen and belatedly the Chinese have begun to realize that something has to be done about it. Ergo the recent increase in interest rates for the first time in almost a decade and a tightening of administrative controls. It may be that all of this is too little too late and an economy that is becoming an accident in waiting may hasten its way there. China's economy is very dependent upon increasing amounts of capital to finance the manufacturing, construction and infrastructure and without this feed the economy will stall. The service sector is the smallest of any major economy and consumption is also the lowest of any major economy. Household debt has grown very rapidly in the coastal provinces but remains very low in the inland provinces.

China, like Japan before it, has become a major exporting country. And its major exporting partner has been the United States. It is a very circular relationship. Again as Crooks drew so neatly in his November 12 article China as global manufacturer ships its low priced goods for the US consumer and the US Dollars that come back to China makes them then a capital supplier wherein they help finance the huge and growing US deficits in trade and budget by buying US Treasuries thus subsidizing the US consumer by allowing the Fed to maintain low interest rates. Growing consumer demand then fuels the final bit of the circle by spurring further investment in China.

On paper it looks great. Trouble is that is has also fueled the debt bubble in the US and spurred the investment bubble in China. China is financing the debt bubble (along with Japan who together make up the primary purchasers of US debt) while the reinvestment back through the shaky Chinese banking system that knows no bounds in what constitutes a solid investment is when you look at it closer two bubbles that are accidents waiting to happen.

The Chinese have fixed the Yuan to the US Dollar. So the Chinese have not suffered the deterioration in their US$ reserve and investment portfolios the way the Europeans, Japanese and even Canada have. But pressure is mounting on the Chinese from the US to allow their currency to revalue higher against the US$. The Chinese are resisting and if they do it, and they probably will, they will do it in their own good time. The hiking of rates and tightening of administrative controls are probably a first step. The second step may well be to widen the trading band for the Yuan from the current miniscule 0.3% to a 3-5% range (Asia Times - China readies to pull the peg - November 20, 2004).

Everyone is caught in a catch 22 with the falling US$. A falling US$ makes the exporting countries currencies more expensive thereby putting pressure on their exports and then they in turn want to stem that flow by buying more US Treasuries to continue to finance the US debt bubble. As the US$ goes down the value of their US debt holdings falls also increasing pressure on them to dump them but that in turn will just mean that the US$ falls even faster. Japan, according to recent statistics has slowed their purchases of US debt but they are still the largest purchaser. China is trying to diversify away from US debt by converting into Yuan and or looking for purchases in other currencies or investments in other countries. China also wants to increase its official gold holdings which would is as well another way of diversifying its reserves.

In some ways a stronger Chinese currency would be positive for them as it reduces the cost of the commodities that they use. Remember with a fixed Yuan to the US$ the price of oil and an whole host of other commodities is rising as well. But in the other catch 22 if the Chinese economy was to slow and the demand for these commodities fell then there could be a commodity price crash as well. How to lower the US$ and raise the value of the Yuan without causing a global economic crash? That is the question. And may we add that in the case of the US, no one ever devalued their way to prosperity.

And as if that isn't enough China with its huge growth has now become the world's second largest user of oil and the demand should just keep growing as more and more people buy cars as a result of growing incomes. That makes oil a strategic commodity for China and they are making it clear it is. With the US also long declaring that oil is a strategic commodity and the fact that two thirds of the world's oil reserves lie in the dangerous mid-East another economic clash could be lying in the wings. Recently China secured a huge $70 to $100 billion deal with Iran for oil. Given all the rhetoric and saber rattling between Iran and the US over Iran's nuclear weapon ambitions, any solution to that just got more complicated. The military solution to the problem may have hit a brick wall. Ditto for a military solution to the nuclear weapon ambitions of North Korea, where that is just too close to China for comfort.

China is at a cross roads. And if China is at a cross roads so to is the rest of the world because if China's attempts to try and bring itself down with a gentle landing and it fails turning into a crash landing then it will impact the rest of the world as well. But the Chinese economy is young and with 1.2 billion people the growth possibilities are huge. So even if China were to have a crash landing it would be cleansing and they should emerge from it stronger. But we are not so sure how a debt laden country such as the US will emerge from a Chinese crash landing. That could be a completely different story.

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2008 David Chapman

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