Friday, March 28, 2014

A Guide to Investing in China

Big Trouble in Big China . . . Here’s What You’ll Need to Know by Market Authority

A few weeks ago, we discussed the QE and Abenomics programs in Japan, and the impact on the US market.

We now shift our attention to new developments in China, and the impact these events may have on the financial markets.

First, some economic history. Mao Zedong (founding father of the People’s Republic of China) established the communist party in 1949. Mao is the most well-known figure in modern Chinese history. He “ruled” China from 1945-1976.

Second to Mao, but more important to China’s current economic powerhouse status, is Deng Xiaoping, in office from 1981-1989. Deng inherited an economy plagued with issues from the Communist Revolution and enacted reforms to establish a socialist market economy.

Deng’s economic reforms had three main objectives:

1. Opening up China to global trade.

2. Attracting foreign investment.

3. A limited-amount of “private” competition. (I use the term “private” gingerly here because the government still owns a majority stake in almost all industries.)

Now why is all the Chinese-made crap we buy at Walmart so cheap?

Under Deng, China also engaged in monetary mercantilism to become the world’s largest producer of marketable goods.

How was this done? The Chinese central bank, the People’s Bank of China (PBOC), has long engaged in a campaign of artificially suppressing the price of their currency, the Yuan. This was through aggressively purchasing $’s to keep the Yuan weak and their goods more attractive, thus boosting exports.

This might sound confusing, so let me explain. Let’s say China and Germany both produce widgets at a cost of $10. If China weakens their currency by 10%, then the $ cost to buy a widget from China is now 10% cheaper or $9.

If you’re titled with a widget buying job for Walmart in the US, do you buy the widget for $10 from Germany or the $9 widget from China?

The answer should be obvious.

Now, as China sells more widgets and their economy strengthens - the value of the currency should also rise. However, the PBOC has undertaken measures (buying $’s) to keep the Yuan from rising, and the artificial weakness allows China to sell and produce more widgets than anywhere else in the world.

And let’s take a look at how this has played out for China’s economy. Look at the extreme rise in China’s economy since the early 80s.

This spike in economic output began creating jobs at a rate that humans have never witnessed. It’s estimated that 10mm rural farmers migrate to cities each year. It’s also estimated that China creates a city the size of Houston every month!

Here’s what happened to Shanghai in the past 20 years.

This dramatic landscape change happened to just about every city in China in the past 20 years - Beijing, Tianjin, Guanhzhou, Shenzhen, Chongqing, Chengdu all now rival any major city in the US.

This building binge has led to an unquenchable thirst for natural resources. China has single-handedly inflated the price of all natural resources.

Here are some of their global investments.

Next up, we’ll look at how China remained relatively unscathed through the 2008 financial crisis.

Now we've learned about the social demographic time bomb that the Chinese government faces. That is, the need to find jobs for 10mm rural farmers that migrate to cities each year. The Chinese government is well aware that a recession will lead to social unrest and political upheaval. Their concerns are reflected in the dramatic government response to the 2008 crisis.

When the 2008 financial crisis shook the very foundations of capitalism in the US, Treasury Secretary Hank Paulson famously referred to the US response as using a “bazooka.” By these qualifications, the Chinese response was a nuclear warhead.

Think of the economy as your narcoleptic uncle Danny who falls asleep on the couch after Thanksgiving dinner. How do you wake this guy up and get him out of your house? You can give him a little bit of coffee to get him going again, in the hope that he stays awake and heads home. Or you can spike his latte with an amphetamine, which will wake him up, but may lead to some further complications when he hasn’t slept for 2 days.

China went with the amphetamine. While the 2009 US stimulus package amounted to a measly 1.5% of GDP (that’s a tall latte at Starbucks), the Chinese pushed through a stimulus package that amounted to 20% of GDP (that’s a whole bottle of NoDoz).

The Chinese government effectively told the banks to open the lending spigots.

This spike in bank lending led to a revival of GDP growth.

After a spike back to the 20 year average in 2009-2011, the Uncle Danny’s amphetamines are wearing off and China GDP growth has begun to taper off.

The banks, delirious from the amphetamines, made all sorts of spurious loans in 2009. Spurious loans that helped build the infamous “ghost cities.” Here are a few examples…

Now that the Chinese economy is slowing, the loans extended (under the influence of NoDoz) are showing signs of debt service stress. Builders who borrowed money to build simply can’t find tenants to pay rent.

As we saw in 2008, the first wave of property defaults quickly morphed into a contagion. In the US, smashing your sinks and toilets with a sledgehammer and ripping the electrical out of your foreclosed house became a national past time. Thankfully, for Chinese builders, most of these properties going into default don’t have tenants.

Next week, we’ll look at the first wave of defaults about to occur and how the Chinese government will likely respond.