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September 13, 2006

Concerns About the China Factor
by Davide Accomazzo

For those of us who like to focus on global economic numbers as they are released, statistics relating to the Chinese economy have of late been attention-grabbing.

On August 30th China's National Bureau of Statistics revised upward the country's 2005 gross domestic product (GDP) growth to 10.2 percent reflecting faster expansion than first reported. For the second quarter 2006 China's GDP grew 11.3 percent over the year earlier, while industrial output clocked in at a record 19.5 percent rate in June. At the same time investment and exports have catapulted China's economy to the world's fourth largest in the 28 years since free-market reforms began.

It is worthy to note that the China boom is hurtling along at its fastest pace since 1994 when its economy was one-fourth its current size.

The situation in China reflects a global economic landscape that has undergone a seismic shift in the last decade, and is echoed by the fact that the combined economies of China and India are now greater than the United States. According to the Bank of Nova Scotia emerging and newly industrialized Asian nations, excluding Japan, now account for 30 percent of the world's economic growth when GDP is adjusted to reflect purchasing power parity. Meanwhile, the countries that make up the G7 (Canada, France, Germany, Italy, Japan, Britain and the United States) currently represent 41 percent of global GDP, down 6 percent from a decade ago.

Asia's ascendance as an economic superpower has been augmented by robust regional dynamics. Trade within the Asian region centered around China is now nearly twice as large as the trade that takes place within the NAFTA zone. As a result of the boom, infrastructure projects in the area are undergoing a massive expansion, and the furious pace has spurred a migration of people from the country to cities and led to rapidly rising income levels, which has in turn boosted consumer spending.

The problem is that this level of growth in China is not sustainable as it leads to rampant inflation, inefficiencies in capital allocation, margin compression and increased banking instability. The Chinese government recognizes this and has embarked on a series of steps to try and rebalance the economy. These steps include an increase in the banks' reserve requirements, a cut in tax rebates from exports, tighter controls on land development and a range of other "administrative measures." However, while there are signs these actions are starting to have some impact, most are far from optimal.

Administrative measures are blunt instruments that create distortions elsewhere in the economy. They are also hard to enforce. It is reported that the majority of recent land transactions in some provinces are illegal because local governments have defied Beijing's directives to restrain property investment. By the time orders do get implemented, there is a risk that it will be too little too late. In the meantime the interest-rate hike which took effect on August 19 has not had the same impact as the one in October 2004. Unless the People's Bank of China initiates more rate hikes, monetary policy is set to remain over-stimulative for the time-being.

In their defense, China's central bank's caution to use monetary policy may partly be because the effectiveness of such tools in China's economy is limited. But that point reveals a central issue -- that China is NOT YET a mature free market country, and in fact has a primitive financial system which is still centralized and steered by politicians who act primarily to benefit their political interests first.

Given decisions to date China's policymakers are more concerned with denting growth. China needs GDP growth north of 7% a year just to stay even with its massive population and new job seekers. Reducing unemployment and underemployment requires even faster growth. In fact just recently "an official" at China's National Bureau of Statistics stated that high-speed economic growth will not solve the country's unemployment problem. While attributing the phenomenon to numerous factors, including the migration of rural labor forces to urban areas, structural adjustments to the economy, the impact of reforms and the bankruptcy of some state-owned enterprises, this same official expressed confidence about the employment situation, saying the Communist Party of China and the government is very focused on the issue and has made job creation a priority.

At the same time, the government is alarmed by runaway real estate prices because unaffordable housing has become a major political flashpoint for the majority of urban Chinese.

This poses a real conundrum for the Chinese government. As long as China is fueled by cheap money, slowing down one sector through "administrative measures" only means that the money will flow into other sectors and create an asset bubble somewhere else. In any case, Beijing is for now reluctant to effectively tackle the growing domestic imbalances in its economy by implementing "modern" fiscal and monetary policies.

With that in mind we can attempt, by looking at the interests of the political elite, to make an educated guess as to the timing of when China may be forced to face the ramifications of its extreme growth.

In two years China will host the largest international event: the 2008 Olympics. This will be the perfect showcase for the new China, a country which knows well that for the first time in its modern history it has an opportunity to position itself as a global economic and political superpower. As it stands the idea that American hegemony is overstretched and fatigued represents thinking advocated/ believed by many, Russia's economy under its "oily curtain" is too reliant on the vagaries of international commodities markets, India remains the acknowledged tortoise in the economic race between the two Asian giants, while "old" Europe - too busy figuring out the meaning of life - shuffles from one crisis of confidence to another.

So until 2008, notwithstanding any uncontrollable economic tsunami occurring, China will continue to aggressively build up its infrastructure and secure more raw materials and energy supplies at any cost whatsoever. This factor has already been evident in the magnitude of increased demand many commodity markets have already experienced. If China follows this script then Chinese economic growth and supply-side demand will be prolonged for at least the next two years. Therefore, as a general trading framework, we should look to take advantage of any short term technical weakness in commodities, keeping in mind the summer of 2008.

What about after the 2008 Olympics? I think China (and the world) will have to come face-to-face with its enormous portfolio of non-performing loans which will cripple China's banking system. The ramifications are potentially scary when one thinks about the fact that China is the second biggest holder of U.S. Treasuries and together with Japan accounts for more than half of world reserve accumulation between 2002 and 2005. In fact, the United States now needs to attract about $2.5 billion a day to fund the trade gap and keep the value of the dollar steady.

The build up of reserves and a growing trade deficit with China has given U.S. politicians fodder to demand change. The U.S. has been pushing China to let its currency trade more in line with market forces. Fed Chairman Ben Bernanke also chimed in saying "I don't think that we can continue to finance the current account deficit at 6 percent or 7 percent of GDP indefinitely, and it's desirable for us to bring down that ratio over a period of time."

Yet others argue that the squeals in Washington at the yawning U.S. trade deficit with China are overblown. The basis for the viewpoint is that the wide difference between both sides' data is overstated. After ironing out data discrepancies, Oxford Economics found that China's share has hovered at about a fifth of the total U.S. merchandise deficit since 1995. By most measures, the U.S. is still the top manufacturing nation producing almost a quarter of global output, the same as in 1994. If U.S. manufacturing is stronger than many Americans believe, China poses a weaker challenge than is often supposed as its output is still less than half that of the U.S. and many of its industries are suffering a severe profits squeeze. According to the Institute for International Economics and the Center for Strategic and International Studies, on average two-thirds of the value of Chinese products is imported. Further many big-ticket Chinese exports are of things no longer made in the U.S. or that have never been made here. Therefore a large renminbi revaluation would merely shift Chinese production to lower-cost locations elsewhere.

When push comes to shove recent tumults such as the Lebanon-Israeli war, which instigated a reflexive "flight-to-quality" into U.S. Treasuries, regularly reminds us that for the time-being the greenback's status is still "the" world currency reserve. And when all is said and done, those who would fear China imposing a new economic world order should think back to when the same was said of Japan.

However things evolve economically and/or politically, the Chinese proverb "may you live in interesting times" seems appropriate at this juncture in our world's history.

Davide Accomazzo
Cervino Capital Management LLC

DAVIDE ACCOMAZZO has been trading professionally since 1996. From 1996 through 1997 he was employed as a Euro-convertible bond/international equities sales trader for Jefferies Group, Inc.. In 1998 he left to trade his own capital and in 1999 started Kensington Offshore Ltd. In 2001 he launched Kensington Capital Management LLC, a CTA that focused on trading options on futures and currency futures. Mr. Accomazzo was recruited by UBS Wealth Management USA in 2004 to manage the portfolios of high net worth investors. In 2005, Mr. Accomazzo co-founded Cervino Capital Management LLC, www.cervinocapital.com, as Managing Director, Head of Trading.

The analysis and opinions expressed in this commentary are those of Davide Accomazzo as of the date of this issue, and are subject to change. Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. This material does not constitute a solicitation to invest in any program of Cervino Capital Management LLC. Investment involves risk. Investing in foreign markets involves currency and political risks. The risk of loss in trading commodities can be substantial.

Please mail questions and comments to info@cervinocapital.com. Your email address will be kept strictly confidential and will not be used for any other purposes.

Copyright © 2006-2008 Cervino Capital Management LLC. All rights reserved.

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