China Redux
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: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?"
"China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising... "
"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."
"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."
"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?"
posted by Vitaliy N. Katsenelson, CFA at 9/15/2006 01:50:00 PM
5 Comments:
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.
I am an American living in China. Thanks for the great article.
Thank you
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
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.
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