A Gradual Transition!
BIG PICTURE - A gradual transfer of wealth and power is currently underway. Thanks to globalisation and economic reforms, the great wealth divide between the industrialized nations and the "emerging" economies is contracting. Over the coming decades, I anticipate this process to accelerate. In other words, I believe the future will bring rising consumption and a higher standard of living in today's impoverished countries (China, India, Brazil and other "third world" countries), whereas we are likely to witness the reverse in the US and parts of Western Europe.
Over the past decades, the US has been the engine of global growth; however its dominance will be challenged in the not too distant future. If my assessment is correct, China will replace the US as the world's single most important economy. Before you dismiss my claim as a far-fetched fantasy, I want you to consider that China has the biggest population in the world, the largest foreign exchange reserves (over US$1 trillion), a booming economy, an extremely high savings rate and expanding surpluses. Moreover, its currency is extremely undervalued and China (despite extremely low per-capita consumption levels) has already surpassed the US as the biggest consumer nation.
Sceptics who doubt China's role in the global economy should take note of the fact that Europe already imports more from China than it does from the US. To top it all, the US is the largest debtor nation the world has ever seen, its debt to GDP ratio is over 400% (Figure 1), it has a negative personal savings rate, its currency is overvalued and its society is heavily dependent on consuming cheap, imported goods.
Figure 1: US - heavily in debt!
Source: Grandfather Economic Report
To be fair, thanks to the Federal Reserve's expansionary monetary policies over the past 5 years, US asset-prices have risen considerably; also known as the "wealth effect". At the end of last year, the market capitalisation of the US stock market rose to a record-high of US$20.6 trillion, matching the value of household real-estate, which also rose to a record-high at the same time. On the surface, this may seem like brilliant news, however you must realise that this "wealth illusion" achieved by an ocean of money and record-high indebtedness is only a consequence of inflation. Moreover, history shows that although asset-prices can come down rather abruptly, debt must always be repaid. So, I remain cautious of this engineered American "prosperity".
Today, China has become the manufacturer to the whole world and (at least for now) it continues to sell its merchandise in exchange for US Dollars. Now, some people may consider this an act of stupidity given the state of the world's reserve currency. However, in my view, by keeping this game going, the Chinese are simply "buying time". Quite simply, they are happy to accept payments in US Dollars because this allows them to strengthen their economy further. In my opinion, the Chinese are extremely smart when it comes to business and they know only too well that they must get rid of their huge US Dollar reserves which they have accumulated over the recent years. In fact, this process may have already begun. Recently, China announced that it plans to diversify between US$200-300 billion of its foreign exchange reserves and is considering an investment in "strategic assets crucial for its development". This development is negative for the US Dollar and will help underpin the prices of natural resources.
Lately, the US has accused China of following unfair trade practices. According to the American establishment, China is guilty of artificially suppressing its currency; allegedly, a key factor behind its balance of trade problem. I find this rhetoric totally absurd on three levels.
Firstly, over the past few years, China's imports have grown immensely. Whilst it has imported a lot of natural resources from Latin America, Africa and Asia to feed its economy, it has not bought much from the US. This is not because communist China has a hidden agenda against the "land of the free", but it has everything to do with the fact that the US is not very competitive.
Secondly, if China was not keeping a lid on its currency and supporting the US Dollar by investing in US Treasuries, long-term interest-rates in the US would be significantly higher and this in turn would seriously hurt the housing boom. Finally, if China let its currency rise against the US Dollar as being demanded by the US establishment, imported Chinese goods would become extremely expensive for the average American, thereby hurting US consumption and its economy. So, Americans should in fact be grateful to the Chinese for helping fund their deficits and overall consumption!
As sure as night follows the day, at some point in the future when China feels that its economy is strong enough, it will stop accepting US Dollars in exchange for the goods it exports to the US. When that happens, you can be sure that the US Dollar will sink against the Chinese Yuan and the American economy will slip into a serious recession. This is one of the reasons why I continue to avoid US financial assets.
Whether you like it or not, China will provide economic leadership over the coming decades and investors should have a position in this exciting market. At the moment, the Chinese authorities are busy raising interest-rates and the bank's minimum reserve requirement in order to curtail the rampant speculation in Chinese stocks and real-estate. Despite the tightening efforts of its authorities, the Chinese economy continues to power ahead. In February, Chinese exports were up a phenomenal 52% when compared to a year ago, retail sales grew by 14.7% and industrial production surged by roughly 19%.
It is interesting to note that Chinese money-supply and bank-credit continue to expand at roughly 17% per annum, which is positive for asset-prices. Nobody knows if and when Chinese stocks will correct, but if we do get a meaningful correction, I suggest that long-term investors deploy a portion of their capital to this impressive economy.
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