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China SyndromesJohn Mauldin
This week I have been struck by a wide variety of articles on China. Is it a boom getting ready to change the face of the global economic landscape, or is it a bubble looking for a pin? The answer may be a little bit of both, and as with everything Chinese, at least seen from our shores, can be confusing. Plus, we deal with the issue surrounding the revaluation of the renminbi. The London Financial Times gives us this bold headline (in 72 point type): "The Chinese boom is bound to end in tears. But it might not end for another 10 or 20 years yet, with bumps along the way." Stephen Roach of Morgan Stanley writes this week that China is on schedule for a slowdown. "After five days in Beijing, I am convinced that a slowdown in the Chinese economy is at hand. China's leadership is clearly worried about the risks of overheating. And those worries will likely translate into actions that should result in a meaningful deceleration of Chinese GDP growth over the course of 2004. For world financial markets and global commodity markets that are expecting the China boom to continue, a likely soft landing could come as quite a surprise. For China's trading partners who are counting on open-ended support from the Chinese demand dynamic, a slowdown could comes as a rude awakening." Steve Sjuggerud writes in the Daily Reckoning, telling us "pao mo" (Chinese for bubble): "China in 2004 really is like the NASDAQ in 1999. The waiters and the windsurfers [small investors who are buying anything Chinese] are expecting astronomical returns. But they - and most investors - don't have a clue about what it is they're buying... and they'll likely end up disappointed." But Andy Carpenter of The China Club shows big returns on his recommended Chinese stocks for his readers and tells us to buy more. Who's right? China Syndromes There are any number of ways to spin recent Chinese growth and the prospects for growth in the future. There is no doubt that China is the source for the recent rise in commodity prices of all types. Last year, China consumed 40% of the world's cement, 7% of the world's total consumption of crude oil (surpassing Japan as the #1 importer of oil), 31% of global coal, 30% of iron ore, 27% of steel products, and 25% of aluminum. The pressure on scrap metal prices, copper, tin and zinc are clear. This is from an economy that is much less than 10% of the world's GDP. Early this month, a report hit my desk pointing out the huge problems in shipping being created by the hunger of China for materials to build its growth. At Beilun port near Shanghai, one of China's major iron ore import terminals, ships must wait for up to a month to berth and offload. China is expected to import 180 million tons of iron ore this year, up about 21% from last year. They need it for its steel, construction and auto industries. But it is not just in China that long shipping lines are developing. At ports in India, ships must wait for as long as 30 days to pick up iron ore on the way to China. In the Reuters report, industry experts estimate that as much as 25% of the world's bulk shipping capacity is now tied up in port waiting lines. This can be expensive, as leases on these ships run $100,000 per day. This bottleneck in shipping is making already high prices for commodities, grains and soybeans even worse. According to a Cazenove report, last year China accounted for 70% of the global increase in seaborne dry bulk trade. Container freight rates rose about 30% last year and are expected to rise another 10% this year. The Baltic Dry Index, a benchmark for freight rates of dry cargoes such as ores and grains, jumped more than 170% last year. Want to build some ships to take off the strain? It will be 2008 before you can get delivery and forget about a firm quote, as who knows what the price of steel and energy will be? As fast as China is building infrastructure, they are still behind the curve. There is only 60% of the needed rail network capacity for moving coal from the port areas into the interior. Last year, China grew officially at 9.1%. Private estimates are closer to 12%. Such growth is unsustainable, if for no other reason than infrastructure cannot keep up with the growth demand. China at 4.4% of world GDP overtook Britain at the end of 2003 calendar year, and will pass France by the end of 2004 or early 2005. Sometime on or around 2010, it will overtake Germany; and between 2015-2020 it is expected to overtake Japan to become the world's second largest economy. All other things being equal, China would need to grow its GDP at 3 % per year faster than the USA for some 65 years to catch the world's number one. An improving exchange rate against the $US would, of course, shorten this period. (Source: www.Onlineopinion.com.au) you can count on an improving exchange rate over the next few decades. Water, Water Everywhere... The Financial Times had this to say about the increasingly chronic shortages of water, which is the life blood for an economy. " 'China faces a serious problem of water shortages. This has become one of the important factors restraining economic development this year,' said Wang Jirong, a senior official at the State Environmental Protection Administration (Sepa)...The water shortage reduces industrial production by $28 billion a year, officials said. [Note from John - back of the napkin numbers suggest the Chinese economy is roughly $2 trillion, so that would mean water problems cost them over 1% of potential growth, no small amount of rice. Back to the article.] "Water tables are falling. Rivers run black with effluent. Cities are slowly sinking into their foundations and acid rain falls across almost a third of China's land area. The chronic degradation of China's environment is not new. But official alarm is growing in step with the costs that such degradation extract from the economy, raising implications for international commodity prices and Beijing's plans for political reform. "Jirong said that because of the overuse of groundwater, the ground in cities such as Shanghai, Hangzhou, Suzhou and Wuxi was sinking under the weight of its buildings. In Shanghai, the authorities have had to limit the construction of tall and heavy buildings in some areas because of subsidence. "China is short of 30bn to 40bn cubic metres of water a year, equivalent to the capacity of the 175 meters (575 feet) deep Three Gorges reservoir when full. The shortage reduces industrial production by Rmb230bn ($28bn, E23bn, L15bn) a year, officials said. "In Shandong, a large agricultural province, a drought so far this year is exacerbating a situation in which water is so short that the Yellow River, called 'China's sorrow' for the ferocious floods that it once unleashed, now runs dry before it meets the sea almost every year. "Water shortages have led to declining grain production, and higher grain prices. Further declines are expected this year. Lester Brown, director of the Washington-based Earth Policy Institute, has warned that higher food prices may become a permanent part of the economic landscape as Chinese grain production has fallen by about 70m tonnes - or Canada's total production - since 1998." On a side note addressing China's need for commodities and grains, Stratfor.com reports that China and Brazil are entering into a trade pact, which will help China insure source for raw materials and grains. But their analysis also gives us insight into Chinese thinking. "Building a strong 'strategic partnership' with China is a pillar of Brazilian President Luiz Inacio 'Lula' da Silva's foreign policy. Beijing and Brasilia likely have different perceptions of the geopolitical importance of their growing partnership. Brazil perceives Beijing as a key player in a global multipolar network of regional powers aligned against U.S. hegemony. However, China sees itself someday displacing the United States as the world's foremost superpower -- and Brazil is just another piece on Beijing's geopolitical chessboard. "...China views itself as an emerging superpower on a fast track to surpass the United States someday -- not as a leader of the downtrodden. This means Beijing will leverage its strategic relationship with Brazil and other major commodity exporters to further its superpower ambitions, which in coming decades will require huge imports of agricultural and other basic commodities." Let's look at just a few of the problems facing the leadership of China. 60% of the GDP is still in the hands of inefficient state-owned companies. "Huang Xiaoxiang, vice-governor of Sichuan province, says that more than 500 state-owned enterprises in his province are being put up for acquisition or merger this year. Shao Qiwei of Yunnan says that in his province the proportion of industry in non-state hands is expected to rise to 50% in 2005, up from 30% today." (Financial Times) These companies require large loans to prop them up, but going too fast in shutting down inefficient firms could create employment problems. As noted above, China needs to expand its infrastructure to deal with the growth which requires capital and materials. More and more people are streaming in from the country looking for jobs, although this may slow down as new railroad lines into the interior allow companies to set up in the lower wage areas of interior China. The Chinese government, from the very top, has made it clear they intend to slow down the growth, which if allowed to continue at the current pace would certainly end up in a big bust. If inflation begins to emerge, the Chinese government would be forced to raise rates, which would likely increase the pressure to the upside on the Renminbi. They have to worry about a slowdown in US demand which is the main engine for the global economy. A slowdown would certainly hurt domestic growth, as they do not yet have a strong enough internal consumer base. "Ma Kai, Chairman of the National Development and Reform Commission. Chairman Ma worried that China was close to a critical point when bottlenecks in materials consumption could begin to constrain economic growth. Ma Kai was unequivocal over his concerns about the risks such trends posed to the sustainability of Chinese economic growth. In his words, 'If such an illogical mode of economic growth is maintained, it will be difficult to keep economic growth at 7%.' In China, that's as direct a message as you'll ever see." (Morgan Stanley) Pao Mo Shifting focus for a moment, let's look at what my friend Dr. Steve Sjuggerud has to say about the Chinese stock market. "Just take a look at what has happened in previous 'China manias.' We don't have a decent history of stocks in China to draw from, but the next best thing is Hong Kong. Over the last 20 years, every time the P/E ratio of the Hang Seng Index (Hong Kong's version of the Dow) reached 20, Hong Kong stocks lost between a third and half of their value. "It happened in late 1987, and the index fell from around 4,000 to around 2,000 - a 50% fall. It happened in January of 1994, and the index fell from around 12,000 to around 8,000 - a 33% fall. It happened during the dot-com boom in 2000, and the market fell from around 16,000 to around 9,000, nearly a 50% fall. "Can you believe that it's happened again already? Yes, last month, the P/E of the Hong Kong stock market rose above 20. Time to sell. China in 2004 really is like the Nasdaq in 1999. The waiters and the windsurfers are expecting astronomical returns. But they - and most investors - don't have a clue about what it is they're buying... and they'll likely end up disappointed. You may have lost money in the Nasdaq bust of 2000. Don't get burned a second time." Up to a point, Steve has a point. But I disagree that China is like NASDAQ in 1999. A P/E of 20 is not a NASDAQ P/E of 100 or more, where it actually was at the top. Using conservative accounting, it may well have been double or triple that. China may well correct, as do all markets. If the Chinese government does slow the economy down, it should also have a damping effect on their markets, at least for a time. But China still has a lot of boom left in it. Yes, there will be "bumps" as the Financial Times noted, but there is going to be a lot of opportunity in that country, especially for those that do their homework and find value in the emerging companies. Investors who blindly buy any stock with a Chinese connection are likely to end up sadder but wiser, and Steve is right to urge caution. This is a country that could double its GDP and double again in the next 20 years. Japan certainly had its run, although there were bumps. My side bet with Steve, if he will take it, is that we have yet to see the top of a Chinese bubble, which will take decades to develop. It may well be the most spectacular of all bubbles, because the confidence that is bred from the powerhouse growth they will experience will feed the emotional references that will make investors think there will e no end to the growth, which is the root of all bubbles. Along the way, there will be recessions and a few odd crises, and some serious corrections. Why should China be any different than any other market? As James Kynge writes in the Financial times, "Eventually, either an ill wind or a surfeit of domestic success will cause China's stellar phase of growth to abate or crumble - just as it has in every emerging economy in history. When that day comes, the fall-out may be spectacular. But as things stand, the vigor of Asia's emerging powerhouse appears strong enough to carry it forward for some time." On a side note, if the Chinese government is indeed successful in slowing down their economy, it will have a major impact on their neighbors, who are becoming dependent upon increased Chinese demand for their own growth. This is a whole story in itself. For more on this topic, I commend to you the excellent research by Stephen Roach and Andy Xie of Morgan Stanley [Mar 24 and Mar 26]. This is one of the reasons to take to heart the warning of Richard Russell when he says that it looks like the markets around the world are forming tops, just as the US market seems to be doing. Whither the Chinese Renminbi? I am often asked when I think that the Chinese government will allow the Renminbi to float, and how far down the dollar will fall when it does? There is little doubt that a floating Renminbi will trigger all sorts of changing economic trends, but depending upon when and how the float is begun, it may not be the disaster for the dollar that many expect. There are a lot of forces at work, and it is not at all clear that the immediate effect will be a dramatic revision of the dollar. Let's review the situation. First, I do not think the Chinese government will allow the Renminbi to float until they have shored up their banking problems, which are huge. Just the four largest banks are sitting on piles of debt that equal from 10% to 30% of their total loans. In the US, more than 1% of bad loans in a bank's portfolio would start to be noticed. A floating currency might trigger banking problems which could trigger currency flight which might not mean a lower dollar. Plus, while China had a huge trade surplus with the US last year, they had a net deficit overall, as they are buying large amounts of materials and consumer items especially from Asia. The government is taking steps to infuse capital into these banks in a fairly clear effort to open some of them up for foreign purchase. Further, what happens when Chinese citizens are allowed to own foreign currency? Is it possible they might want to diversify? The immediate reaction might be that the dollar and/or other foreign currencies go UP against the Renminbi. Second, there are a reported 20,000,000 people coming from the country and moving into the Chinese cities every year. Think about that. They must build the equivalent of multiple Chicago's every year, plus throw in a Houston or two, just to house them. The economy must find them work even as the government is trying to shut down, modernize or privatize old and inefficient state-owned companies, which are the source of much of the above mentioned bad loans. Then throw into the equation that there are about 100,000,000 workers employed at state owned companies. Gary Shilling tells me that about 30% of those workers are simply filling space. If these businesses were privatized, where would these workers go? My back of the napkin figuring suggests that would be the equivalent of a 7-10% rise in US unemployment if they were to privatize these dinosaurs this year. Do you think there might be a little unrest here in the good ole US of A? Would there be a politician left standing come the next election? And we should note that the Chinese save about 40% of what they earn. This they deposit in their banks which in turn loan it to the state owned businesses which are losing money. A most curious model from a capitalist perspective, but one which is somewhat understandable given their circumstances. Remember Tiananmen Square? The Chinese government does. They are doing everything they can to grow their way out of their problems. 7-10% annual growth rates means they double their economy every 7-10 years. Such growth will create a lot of new jobs and absorb a lot of workers. Can it overheat their economy and cause problems? Can they sell enough "stuff" to be able to buy all the material they need to grow at such a pace? What happens if the US, their #1 trading partner and source of cash flow, goes into recession? This is a very complicated situation for the Chinese leadership. Rocking the boat by taking risky gambles in not in their genetic structure. They will eventually float, as they know they need to do so. But they will do so slowly and at their own pace. Central banking is something that is new to them. The stories of central banks around the world making small decisions that caused large problems are numerous. We have several examples from US history. In a conversation I had with Shilling today, he told me something of which I was unaware. The Chinese Central Bank does not have the ability to do open market operations like the Fed. The primary way they can cool off their economy is to increase reserve requirements, which they did last year. But Shilling believes the Fed gave up on that tool years ago as ineffective. Long-term I think the dollar still has problems, as long-time readers know. But it is not clear that the dollar will immediately fall against the Renminbi if the Renminbi were allowed to float today and Chinese citizens could buy dollars. There are too many unknowns. I can conceive a situation where the dollar rises against the renminbi and falls against other Asian currencies. What if China falls into recession? Might not the price of their products become even cheaper, as is normally the case in recessions? Asking the Chinese to risk a recession and turmoil today to solve our political problems could be very short-sighted. The argument from American manufacturers is that they want the Renminbi to rise so that they can more effectively compete. What they could just as well say, although it is less politic, is that they want American consumers to pay more for the products we import, thus creating inflation and lowering American lifestyles. Calling for the Chinese to float the Renminbi is one of the cases which could prove the old line, "Be careful for what you wish, for you might get it." Then again, if the Chinese continue to grow as they have, it is likely they will indeed resolve some of their problems to the extent that when they do float their currency, it will indeed rise. Timing is everything. Book Quotes, Houston, and San Diego Next week, we will look at the excellent research by James Montier on echo bubbles, why they develop, how then end and what it means for the US markets. It makes for interesting reading. In the world of investment analysts, Peter Bernstein is at the top. I refer to him as the Pope. He is held in the highest regard by all who know him. Anything he writes is worth reading twice. His last book, Against the Gods - The Remarkable Story of Risk, is one of my all-time must-read, you-gotta-get-it recommendations. My publisher (Wiley and Sons) also published that book, and they sent him a manuscript of my book to read. I was sincerely touched to read the following on his website last weekend:
"This book has more wisdom per page than any reader has the right to ask for. John Mauldin knows the score and tells the reader how to join him in keeping count." (Peter Bernstein). On a book marketing note, we will soon be working with Barnes and Noble (BN.com) and Amazon.com to make the book available to you for at major discount in a few weeks, to launch the book, although I note it is already 30% off at Amazon. I also note the release date at Amazon says April 15, and it will ship to bookstores then. It should be in your local bookstore the last week or so of April. I am off to Houston tomorrow to speak to TEXPERS, an organization of public pension plans in Texas on the subject of how to choose hedge funds. It will be nice to have my bride with me. Then on to San Diego on Monday to speak at MAR's First Annual Conference on Dynamic Asset Allocation. Finally, I will be in Las Vegas speaking at The Money Show from May 11-13. This is a massive event. They expect over 10,000 attendees, and you can register for free. The response to last week's letter was quite large and very diverse. It is any time I approach anything remotely political. The split in public opinion, especially between the US and Europe, is so evident. I may comment upon it at some point, as sometimes it is a bit disconcerting. But we plow on. Your 'hoping to visit China someday soon' analyst,
Copyright ©2004 John Mauldin. All Rights Reserved. John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. This information
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