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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
*AllchartdatafromIHS/GlobalInsights,andmaynotbereproducedwithoutwrittenconsent.
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ChartsStockMarkets
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Commodities
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ExchangeRates
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InterestRates