Friday, September 15, 2006

China Redux

Sep 15, 2006 - Minyanville.com
Some interesting feedback... I wrote an article in July 2005 titled “China Speed -- Running Into the Great Wall”, making a case that Chinese economic slowdown will send that great country into a severe recession. Last month I updated that article adding some minor twists. I found an interesting counter point to my article on this website that I thought I should share with readers:

The post, written by Vitaliy Katsenelson, VP with Investment Management Associates and a teacher of equity analysis at the University of Colorado, entitled, "The Great Bubble of China?" posts China is "living through one of the greatest historical bubbles." Katsenelson sees China as a manufacturing country built with high interest debt. He sees China's fall occurring due to factory overcapacity, a rise in the cost of money, and/or a slowing U.S. economy.

Katsenelson even has titles for the books he sees being written after the fall: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2.” The author's investment advice is to take your money out of commodities and to forget about investing in Chevron (CVX), Exxon Mobil (XOM), or Conoco Phillips (COP). Katsenelson equates the idea that all companies need a China strategy to the idea in the late 90s that all companies needed an internet strategy.

Call me part of the bubble, but I disagree with Katsenelson on all points. China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising and even if they were not, I could see manufacturing tailing off and stabilizing, but I cannot see it crashing. If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising. On top of this, China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.

I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China. Secondly, the U.S., though obviously of huge importance to China, is not everything. Thirdly, though I do believe there will be a slowdown at some point (there has to be!), a slowdown is not a crash. It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

I was glad to see interest in the article and it got me thinking more about the discussion. Let me try to reply to every point made:

"China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising... "
I actually agree with this statement, at least in part. China is likely to transform to a broader economy over the years, but it will take time. And with manufacturing making up such a large sector of the economy, it will take awhile (decades) before the services sector will be able to make meaningful contributions to the economy.
"I could see manufacturing tailing off and stabilizing, but I cannot see it crashing."
The operational and financial leverages are likely to prevent a normal slowdown, as revenues fall the costs will not fall as fast (by definition of leverage) and thus profitability will suffer.
"If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising."
Business Week had a small article last year making the case that China saw some double digit wages in inflation, but I think this is not true for the whole economy, but more common in specific industries. If the Chinese economy implodes, I don’t think the wages will be rising, the implosion will be deflationary for China and the rest of the world. I agree that if labor costs in China become high enough, companies will start looking for a cheaper alternative.
"China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers."
I agree.
"I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China."
This comes back to my point of leverage - China has plenty of that. A U.S. slowdown will decrease incremental demand and depending on the amount of the U.S. slowdown it may be enough to decrease incremental demand to send many Chinese producers into red. Also, something I did not mention in the article is the bad loans are a real issue in China, a number I saw was 40% of GDP. Once the economy slows down they’ll come to the surface.
"It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"
As I mentioned in my article “But, as with any bubble timing, the pop is very difficult, Bears are usually too early to call it and Bulls are usually too late to see it.” I really have no idea when it will take place. The Chinese government plays a very large and important role in China's economy, thus it may postpone the crash by intervening. But the longer it intervenes the great the decline will be. I have no idea when it will happen, but I am aware of the risk and thus we structure our firms portfolios accordingly, trying to minimize our exposure to a slow down in the Chinese economy.

6 Comments:

Blogger ChinaLawBlog said...

You make a lot of good points and your analysis is sound.

I would have much preferred if your analysis were not so good so that I might step in and "enlighten" everyone as to how things really are. But, when you get right down to it, I think all of our disagreements are of degree, not kind.

I do not see it taking as long as you do for China to diversify. I do not see China becoming a software outsourcing center within 5 years, but I do see its economy becoming much more consumer and service oriented in that time.

I also think you are right to point out the bad loans as I see that as a potential weak spot, but I think your numbers on that are too high. I have heard, for what it is worth, that only around 8% of the loans are considered, "bad." Of course, who really knows?

Anyway, you obviously know your stuff and it has been interesting discussing this with you so I am going to do another post on this on my blog.

Thanks.

9/15/2006 02:15:00 PM  
Blogger Vitaliy N. Katsenelson, CFA said...

I took the bad debt $900 billion figure from Ernst & Young report assuming Chinese GDP is at $2.2 trillion we get bad debt at about 40% of GDP. Who knows if that figure is right or not, but either way it is high.

9/15/2006 02:30:00 PM  
Anonymous Bill Lindeman said...

I am an American living in China. Thanks for the great article.

9/16/2006 07:18:00 AM  
Anonymous Vitaliy Katsenelson said...

Thank you

9/16/2006 08:24:00 AM  
Anonymous Skip Reith said...

Interesting article, and I agree that China could easily implode. Some of the factors keeping the implosion from happening:

1. The Chinese government continues to interfere with the economy, tying to keep it strong
2. US interest rates are high, keeping the dollar high, allowing Chinese imports to be low priced
3. Vietnam, Philippines, both Koreas, Japan, and other Pacific Rim countries are all feeling the competitive byte of China, and are all responding
4. The Chinese government attempts to keep the Yuan weak, again allowing the Chinese product to remain at a low price so they can continue to do exportation

Managed economies do not have the flexibility of open markets, and modern economies need to be nibble in order to compete long term. While China is doing better than Russia at managing the economy, Russia is a warning of what can happen with a managed economy.

The US economy is showing signs of a recession. If that happens, and interest rates decline, the dollar will weaken significantly. This will reduce the economic advantage China has versus the US, affecting the Chinese ability to competitively sell into the US market. Those countries with a significant trade surplus with the US (such as China) will feel the effect of a low dollar much more than those with a small surplus.

While China has a labor cost advantage versus the developed nations of the US and Europe, they are actually at a cost disadvantage versus Vietnam and North Korea. If anything happens to Kim Jong-il, then North Korea could become a major economic factor versus China.

The Chinese Government purchases huge amounts of dollars and Euros in order to keep the Yuan relatively weak versus these currencies. I will point out that during the ‘70s and ‘80s Japan tried the same tactic and it did not turn out so good for them either.

So, these factors, combined with the bad debt you mentioned, a weak (but at least growing) economic and physical infrastructure, and a more economically and politically aware population all will contribute to the ultimate popping of the Chinese bubble. And, the problem with a managed economy is that the managers will not see the pin that will pop the bubble. They may protect that bubble from many sources (for example, diversification away from manufacturing), but no bureaucracy will know all of the sources of problems (or all of the potential solutions).

The bottom line is the burst will come, just like it came to Japan, Russia, Europe, the USA, the Pacific Rim, South America, and everywhere else. The more managed the economy, the bigger the burst, and China is a seriously managed economy. So, the pop will come, and it will come hard.

Now, the question is one of timing. Because of the economic control and significant economic momentum, the Chinese economy still has some life in it. I would be surprised if the pop happened in less than five years, but I would also be surprised if they lasted more than ten years. Japan’s economy should have burst somewhere around 1981 – 1982, but they managed to hold on for many years before the burst came. The kind of burst we will see with China is like the one that happened to Japan and Russia – the collapse of an economy that is controlled to a more or less extent by the government (or government like oligarchy). These types of collapses tend to take a while to unravel, versus bubble popping in an open market, then tends to happen quickly.

However, the original premise of the article is that the coming collapse of the Chinese economy makes investing in commodity-based companies (like Exxon, Chevron, or Southern Copper) risky. A collapsing Chinese economy would kill the commodity markets, and these companies’ stock would all suffer. However, given the likely fact that the collapse is several years in the future, and that not only is China doing significant infrastructure improvement, but so is Vietnam, India, and others, commodity prices will remain strong for a while yet. While we see a softening of commodities now, the commodities will rebound and test (if not break) the highs of earlier this year. When they do, the stocks of these companies will all rebound significantly, and also test and break their highs.

Skip

9/17/2006 06:36:00 AM  
Anonymous Edward1 said...

Vitaliy, your forthright discussion with someone who takes ussue with you is a testament to your strength in analysis and research. In contrast, President Bush's tactic of calling critics "unpatriotic", instead of just trying to refute their arguments on the merits of those arguments (or lack of merits), testifies to his weakness.

9/29/2006 09:28:00 AM  

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