Volume 2.3 China Collapse Mar 11 2010

8/14/2019 Volume 2.3 China Collapse Mar 11 2010

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BOECKHINVESTMENTSINC.,17501002SHERBROOKESTREETWEST,MONTREAL,QUEBEC.H3A3L6TEL.5149040551,[email protected]

VOLUME 2.3

MARCH11,2010

ChinaCollapse:AretheBearsOuttoLunch?

Chinahasweatheredtheglobalfinancialcrisisextremelywell. Exportsrose45.7%inFebruary

fromayearagoandGDPgrowthnear10%through2010islikely(Charts1&2).Incontrasttomost

developednations,theChinesefinancialsystemhasshownfewsignsofstrainduringthedownturn.

Nonperformingloans(NPLs)areatrecordlowlevelsandcapitalratiosatpubliclylistedbankshave

beenbeefedupwithrightsofferingsofaround250billionrmboverthelastfewmonths. Despitethese

signsofstrength,thereisarisingchorusofscepticswhoarguethattherecoveryishollowandthatthe

miraculousgrowthratesChinahasachievedoverthelast15yearswillsoonbeover.

Ofcourse,theseargumentshavebeenmademanytimesduringChinastransformation. Atits

mostbasiclevel,thebearargumentisderivedfromthefactthatChinahashadwhatisprobablythe

biggest,longest

economic

boom

in

history.

The

logic

applied

is

that

the

bigger

the

boom,

the

bigger

the

bust.Herearethekeyargumentssupportingthebearcase:

ImbalancesbetweenChinaanditsdebtorshavegrownrelentlessly,whichwilleventuallycracktheundervaluedrmbandforcealimittoU.S.indebtedness.

ExcessivedependenceonexportscombinedwithafailuretoadequatelydevelopdomesticconsumptionleavesChinavulnerabletoexternalshocks.

Overinvestmenthasledtosignificantovercapacity;corporateprofitsarethreatenedandthebankingsectorisvulnerabletoasharpincreaseinnonperformingloans,particularlyafterthecreditboom

andgovernmentstimulusin2009.


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Excessliquidityandvolatilecapitalinflowsareleadingtofrothyassetmarketsparticularlyinstocksandrealestate.

Inflationisontheriseandtheriskofmonetarytighteningisgrowing. Finally,shadyaccountingandpoliticalinterferenceunderminesconfidenceinofficialstatisticsandis

probablyhidingsomenastysurprises.

Chart1 Chart2

Thebearstoryhasalotofadherentsanditisbasedonassumptionsthatalltheabovepoints

havesomevalidity. Areckoningmaywellcometopassatsomefuturepointbutitwontbesoon.Over

thetimehorizonofmostinvestors,ithasalowenoughprobabilityofoccurrencethatpeopleshouldnot

paymuchattentiontoit.Hereswhy.

ChinasU.S.$2.2trillionbuildupofreservesandtheflipsideAmericanoverindulgenceand

excessivedebtaccumulationarebothclearlyunsustainable,yettherearefewsignsofstrainbetween

Chinaanditsdebtorsbesidespoliticalnoise.Despitethefinancialcrisisandthedramaticslowdownin

tradebetweentheU.S.andChina,thecurrencypegisintactandthedollarcontinuestodefyitssceptics.

Chinasstimulushasbeensuccessfulinbridgingtheexportslowdownwithlittledamagetopublic


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finances(unlikeintheWest)(Chart3). ProtectionistsentimentwilldefinitelymountintheU.S.and

otherdevelopednations,astheyaredesperatetorekindledomesticmanufacturingindustries,reignin

currentaccount

deficits

and

(most

importantly

in

an

election

year)

to

find

ascapegoat

for

high

domestic

unemployment. Thermbwillbetheprincipaltarget,butChinesepolicymakerswillbereluctantto

restraintheexportsectorwhentheyconsidertheglobaloutlooktobesouncertain.

Chart3

Whetherthermbisallowedtoappreciateanytimesoonisadifficultquestion.Some

economistsinChinaarguethattheappreciationoftheyenwasakeyfactorintheJapanesecrashand

recession.Sotheyresisttheappreciationoftheirowncurrencytoavoidasimilarfate. Obviously,this

argumentconfusescauseandeffect. TheJapanesecurrencyspikedupwardsinthemidtolate1980sas

aconsequenceofyearsofimbalancesthatresultedfromartificiallycheapexchangerates. Modestand

carefullymanagedcurrencyappreciationcouldhavehelpedcooltheJapanesebubble,butonlyifitwas

implementedbeforetheeconomyandfinancialsystembecamedangerouslyoverextended. Givena

(flawed)intellectualfoundationtoresistcurrencyappreciationandanoveremphasisontheshortterm

needtomaintaingrowthandhighemploymentatallcosts,thetimingofthermbtradeisahardcallto

make,butanysignificantmoveisnotlikelytobesoon.

Regardingexcesscreditexpansion,Chinesepolicymakerswouldprobablyagreethatthey


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overdiditin2009andthattherecoverywasquickerandmorerobustthanexpected. Moneysupply

expandedata30%annualrate(Chart4).UnlikeintheU.S.wheretheFedsopenmarketactivitiesdid

notresult

in

appreciable

credit

expansion,

in

China

bank

lending

increased

by

an

equivalent

30%

in

2009

(Chart5). Politicalinterferenceinthebankingsystemhasitsbenefits. Exportsareincreasingata45%

ratefromayearagoandhousepriceincreasesareaccelerating.Chart6showsan8%increasebutsome

estimatesareconsiderablyhigher. Theauthoritieshavemovedtoreigninbanklending. Consequently,

Chineseequitymarketssoldoffbyabout12%inJanuary,whichweviewasahealthycorrectionrather

thanatrendreversal.

Chart4 Chart5

Chart6 Chart7


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TherecontinuestobenoriskofgeneralizedpriceinflationinChina. Therewasabriefperiodof

deflationinthelastquarterof2009,andtheannualizedrateofchangeontheCPIandPPIiscurrently

reading2%

and

5%

respectively

(Chart

7).

However,

it

is

important

to

note

that

prices

are

still

well

below

thepeaklevelsof2007.Continuedproductivitygainsresultingfromrobustfixedassetinvestmentand

abundantlabour(thereisavirtuallyinexhaustiblesupplyofworkersmigratingfromruralareas)will

ensurethatanybottlenecksarefleetingandlocalized.ThemostlikelyscenarioisthattheeraofChinese

disinflationislikelyover,tobereplacedwithaperiodofmildinflation.

The

question

of

how

much

slack

there

actually

is

in

the

Chinese

economy

is

subject

to

debate.

Therearecertainlyexamplesofkeystatesponsoredenterprises,particularlyinheavyindustriesthat

operatewithsignificantovercapacity,butthisishardlyacontrasttomostdevelopednationswhoall

havetheirpetindustriesthatfallundertheprotectivewingofthestatethinkGMorU.S.Steel. While

theexpansionoflendingsuchasthatin2009isoftensaidtoaggravateovercapacity,thebulkofthe

additionallendingwasdirectedtoinfrastructureprojectswhicharebadlyneededthroughoutmostof

China,and

many

of

these

were

conducted

by

various

levels

of

government,

rather

than

the

corporate

sector.

CorporateprofitswouldultimatelysufferifindeedtherewaswidespreadovercapacityintheChinese

economy. Thedownturninprofitsseenin2009isnotremarkablecomparedtoWesterncorporations

(Chart8)andwilllikelyreboundsharplywhenthenumbersfromthe2ndhalfof2009comein.


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Chart8

Oneconcernforinvestorsiswhetherthesharpincreaseinstatedirectedlendingin2009will

leadto

apotentially

destabilizing

jump

in

non

performing

loans.

Non

performing

loans

peaked

at

around20%afewyearsafterthe1997AsianCrisis. In1999and2000thegovernmenttransferredrmb

1,400billionofnonperformingloanstoabadbankinexchangefor10yearbondspaying2.25%,inan

amountequivalenttothefacevalueoftheNPLs. Therecoveryratesontheseloanswereinitially

reportedaround2030%,buttherehavebeennofiguresreportedinthelastfewyears. Duetothe

bailout(whichhasyettobefullyresolved)officialNPLsatlistedbanksarereportedtobeinthe23%

range. NPLswouldhavetogoupalongwaytobeaconcern,andeventhen,thecapacityofthestateto

bailoutthebanksagain,ifnecessary,ishuge.

AlthoughhypocriticalforWesternerstolecturetheChineseonfinancialdisciplineand

transparencyinthewakeofthe2008financialdebacle,thefactisthatChinesebankshavebeensorely

lackingonthesetwofronts. Accustomedtobeingmadewholethroughstatebacking,itremainstobe

seenwhat

influence

shareholder

scrutiny

resulting

from

public

listing

will

have

on

Chinese

banks.

The

Chinesefinancialsystemiscurrentlyundergoingagradualmetamorphosisemphasisongradual. Full

transparencyandindependencefrompoliticalinterferencearealongwayoff,andtheremaybesome

nastysurprisesasthestatecontrolwanesandinvestorsarefinallyabletohaveapeekinsidethe


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kimono,sotospeak. ThismaybereasonenoughtoavoidinvestingdirectlyinanylistedChinesebanks,

butthereislittlecauseforconcernoveranysystemicrisktotheChineseeconomyfrombadloans.

Assetpricesareanothercauseofconcern.TheShanghaistockexchange(SSE)indexhasrisen

sharplysincelate2008,drivensignificantlybyforeigninvestment(Chart9).TheBsharesindexisup

177%sinceOctober2008. TheSSEASharesarenowtradingataP/Eof28(Chart10),whichis

significantlylowerthanthelongertermaverageof37(andwellbelowtheJapanese1989peakof70).

EvenifGDPgrowthslowsto78%,currentvaluationsarefair.

Chart9 Chart10

Specificmeasurestocoolthehousingmarketareacontrasttotherepressiveapproachapplied

inpreviouscycles.Rather,policymakersarediscouragingspeculativeinvestmentwhilefreeingupland

fordevelopmentandsteppingupaffordablehousingconstruction. Despitetheexcessiveexpansionof

creditlastyear,itlookslikepolicymakersareshowinggoodtimingandjudgementinmanoeuvringthe

Chineseeconomyforasoftlanding.

ThelongertermoutlookforChinaiscertainlyacauseforconcern,butseriousproblemsare

likelybeyondthetimehorizonofmostinvestors. Chinahasconsiderableroomtomanoeuvretodelaya

reckoning:amplereserves,robustgrowthandlowinflation. Mostimportantly,thefinancialbalance


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betweenChinaandtheU.S.isintactandwillcontinuefortheforeseeablefuture. WebelievetheU.S.

economysgrowthwillslowbutstaypositive,providingareasonablelevelofdemandforChinese

exports.Meanwhile,

Chinas

exports

are

becoming

increasingly

diverse

as

the

bulk

of

new

trading

is

withemergingAsia,LatinAmericaandAfrica(Chart11).

Chart11

Chinacontinuestoprovideexcellentinvestmentopportunities.Thebestcasescenariowouldbe

if

there

was

a

bit

of

a

shakeout

over

the

next

few

months

as

monetary

policy

was

normalized.

Tighter

monetarypolicyandperhapslimitedrmbappreciationwouldhelptakesomeofthefrothoutthe

marketsandestablishtheconditionsforalastingbullmarketinChina. Looktobuyonweaknessover

thenextfewquarters.

InvestmentConclusionsWeremainpositiveonriskassetsequities,commoditiesandcorporatebondsfortheshort

term,atimeframeofroughlysixtotwelvemonths.Thebasicbackdropcontinuestobeoneofplentiful

liquidity,verylowinterestrates,gradualhealinginthefinancialsystem,virtuallynonexistentinflation,


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banklending,moneysupplyandthepersistenttendencyofbankstobuildexcessreservesmeansthat

theFedcontinues,asthesayinggoes,topushonastring(Charts1215).Thereisnoshorttermthreatof

Fedmonetary

ease

translating

into

rising

price

inflation.

Moreover,

key

asset

markets

such

as

commercialandresidentialproperty,equitiesandcommoditiesdonotindicatebubblesthatneedtobe

restrained.TheS&P500islittlechangedfromfourmonthsagoandisstillalmost25%belowthepeak10

yearsago.Thehousingrecoveryhasfalteredandcommercialpropertyisstilldecliningonanational

averagebasis.

Chart12 Chart13

Chart14 Chart15


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Insum,welookforacontinuedpositiveenvironmentforstocksandcorporatebondspreads,

althoughthegreatbulkofspreadnarrowinghasoccurred.WelookforrelativestabilityinU.S.Treasury

yieldswith

atendency

for

rates

to

drift

up.

Treasuries

may

be

asafe

place

to

hold

liquidity

but

total

returnswillbepoor.Fundamentally,theU.S.dollarisaweakcurrency.Itsmainattributeisthatit

doesntsmellasbadastheeuroandtheyenand,aswehavesaidmanytimes,noone,apartfromhedgefunds,hasanyinterestinadollarcrisis.

Staylongrisk,stayworriedanddontforgettokeepyourfocusonlongtermwealth

preservation.

Enjoy

the

better

times

because

they

wont

last.

Tony&RobBoeckh

March11,2010

www.BoeckhInvestmentLetter.com

[email protected]

*AllchartdatafromIHS/GlobalInsights,andmaynotbereproducedwithoutwrittenconsent.


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ChartsStockMarkets


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Commodities


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ExchangeRates


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Volume 2.3 China Collapse Mar 11 2010