Subscribe to John Mauldin's
FREE Publication:

Thoughts From the Frontline

Sign up for John’s free weekly letter and join 1 million of his closest friends.

We will never share your email with third parties

Outside the Box

Whither China?

June 18, 2013

All weekend long and this morning as I wake up in Monaco, the number of disparate publications screaming at me about problems in China is just overwhelming. Then I get myself up early to hear a speech by the esteemed British economist Charles Dumas of Lombard Street fame, and I am confronted with even more China. I have been watching China for a long time, expecting a crisis, as I readily admit I simply do not understand a country that has defied so many of the economic laws of gravity for so long. Some kind of return to normal economic paradigms seems almost mandated, but the question has always been when. Have the Chinese discovered some new control mechanism, found some different levers to pull that they should share with the rest of the world, or will we see them revert to something that looks more like whatever it is that passes for "normal" these days? My bet has always been the latter.

That said, I do not expect China to slip silently away. It is here to stay, and it will be bigger and more dynamic in the future, but the transition from an economy driven by investment and massive debt into one more soundly based on domestic consumption will not be easy. Today's Outside the Box will focus on two readings on China that came my way this weekend. The first is from the formidable Lyric Hughes Hale, an expert on Japan and Asia, founder of China Online, who is married to the eminent economist David Hale. I have had the pleasure of meeting with them and find them quite the economic power couple. She gives us a tour of recent work on China. Perhaps, as she asserts, the current Chinese economic model, based on cheap labor and cheap money, has run its course. The challenges that face China are daunting.

Then we turn to a thought-provoking piece of analysis from the Financial Times that underscores Hale's central point. China is grossly inefficient, with severe overcapacity in many industries: "The problem with subsidies everywhere is they tend to support activity not outcomes and they become more of a problem when they're just subsidizing inefficiencies…"

Just a few quotes from some of the other pieces I read in the last 48 hours:

China's shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts, Fitch Ratings has warned. The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead. "The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing." (from Ambrose Evans-Pritchard in the London Telegraph)

And then Stratfor writes:

A cash crunch over the past three weeks has caused rates on loans between banks to spike to the highest levels since mid-2011, drawing attention back to China's financial instability. Rates have since subsided, but conditions exist for them to remain elevated over the next month or beyond. Unlike two years ago, at least one bank has already defaulted on a loan and there are rumors that other defaults have occurred. The emergence of bank defaults poses a serious challenge to the central government's efforts to clamp down on credit growth as part of its broader attempt to reform the country's economy.

And finally, my friend Simon Hunt, who has been deeply involved in China for decades and spends many months each year traveling throughout the country meeting manufacturers, writes:

The credit crisis that we have been warning about has arrived. Debt has reached such peak levels that it can no longer be put under the carpet and rolled over for another day. The economy is having a mini-recovery this month but will weaken again in July.

Not expecting a collapse, Simon does see that serious adjustments are needed and believes they will be enacted:

Nor is there much of a risk that China's credit markets will implode because banks have built up a US$3 trillion war chest which is lodged with the PBOC and because [the] government has assets that can be utilized. The question is how the pain will be shared out throughout the country.

China always has my attention. I believe that Japan is forcing their hand with its own massive quantitative easing. China may have the easiest answer of all the major global trading countries, however. All they have to do is gradually float their currency. As Charles Dumas noted, they have $4 trillion in savings that will look for a home outside of China. A floating currency will weaken the renminbi against major world currencies and help their export businesses. It will also drive US Senators Schumer and Graham nuts, which is a side benefit. A floating currency with no significant QE when the Fed is printing with full abandon will be the strongest argument against the accusation that China is manipulating its currency. Interesting times.

My speech at GAIM will be tomorrow, and then I will take a few days to explore the south of France before heading off to Cyprus. I will speak at a venue that is being arranged on Wednesday in Nicosia, and the event will be open to the public. I will announce the time and place in this weekend's letter. And then it's on to Croatia and a long weekend with David McWilliams and his family on some idyllic little island in the middle of nowhere. Sounds divine. I hope you are enjoying your summer, wherever you may be.

Your needing more gym time analyst,

John Mauldin, Editor
Outside the Box

Stay Ahead of the Latest Tech News and Investing Trends...

Click here to sign up for Patrick Cox’s free daily tech news digest.

Each day, you get the three tech news stories with the biggest potential impact.


China’s Innovation Hurdle

By Lyric Hughes Hale

At a meeting in Chicago, the China-United States Exchange Foundation released a report, "U.S.-China Relations in the Next Ten Years." Chicago Mayor Rahm Emanuel opened the meeting, chaired by CH Tung, the former Hong Kong chief executive, as well as Henry Paulson, the former U.S. treasury secretary. The mood was celebratory, especially after the overnight announcement that the presidents of both countries…

Discuss This

4 comments

We welcome your comments. Please comply with our Community Rules.

Comments

Ronald Nimmo

June 22, 2013, 3:29 a.m.

“China may have the easiest answer of all the major global trading countries, however. All they have to do is gradually float their currency.”

I thought that China’s currency was expected to rise as soon as it was allowed to trade freely on the foreign exchange markets. It was universally believed that the government of China was artificially keeping it too low by pegging it to the dollar. Now John is telling us that the exact opposite is true. How did this dynamic suddenly change direction by 180 degrees?

Iminty@gmail.com

June 18, 2013, 7:36 p.m.

Thanks for the refreshing break from the US/EU/Japan!

Is chinese overcapacity a strategy to diversify from US debt holding that is set to devalue with QE?

won’t the overcapacity be used up when the monetary expansion around the world drives growth and inflation?

What other options does China have to get value out of it’s US debt holdings before they devalue?

While this may not be efficient in terms of our standard NPV methodology of investing in long term assets, is it not just the break away from the time value of money models due to the currency skirmishes and wars we are soon tomsee ?

Will M

June 18, 2013, 4:28 p.m.

I don’t buy the argument that the Chinese currency will devalue - they have over a trade surplus of over 2.0% with the US.  In order for trade to noramlize which it must, the USD must depreciate relative to the RMV.  Japan at its worse was at 1.2% - the yen was at 260 then and is now at 100.  If China isn’t a currency manipulator, they why not float it - according to these guys, it would be in their benefit.  My money is the other way. 

Really?
A floating currency will weaken the renminbi against major world currencies and help their export businesses. It will also drive US Senators Schumer and Graham nuts, which is a side benefit. A floating currency with no significant QE when the Fed is printing with full abandon will be the strongest argument against the accusation that China is manipulating its currency. Interesting times.

tragle@marlboro.edu

June 18, 2013, 11:06 a.m.

I was a consultant to the UNDP in Beijing, based at Peking University, from 1989-91.  While there I met an American machine tool engineer who visited two or three times a year to service American made machines.  I asked how good were the workers at handling highly sophisticated machinery.  He replied, “They can use them all right, once they are taught, and if a machine breaks down and I have shown them previously how to repair it, they could make any repair.  If not, they pushed it to the wall and waited for me.”  He then made a perceptive comment: “Give an American child a mechanical toy, and if it breaks down, he is likely to take it apart to see what makes it work.  He may break a few in the process, but he learns a lot.  Give a Chinese child a mechanical toy, and if he breaks it he would never dream of taking it apart.  It has to do with the educational system.”  This fit exactly what we had observed at the universities.  The students were very, very intelligent, but they simply repeated what they were taught.  I once told my students that i felt like a dog eating its own vomit when they merely repeated back to me what I had said.  I once even brought my wife to a seminar class in order to argue with me over the text.  Eventually the graduate students caught on; she became the class “den mother”.  I suspect the educational system must change from the bottom up for innovation to become general.