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The Outside View: Is China the New Japan?
Mar 12, 2010

The world is divided on whether China will be the next superpower or is it on the verge of collapse. This is what Mr. Bill Bonner had to say about what the future possibly holds for the Chinese economic story. We have received the approval of Mr. Bill Bonner to carry this article.

There are two views on China. One is that it is an unstoppable powerhouse. The other is that it is about to blow up.

In my opinion, both are probably right. In the long run, China is likely, though not certain, to become the world's dominant economy. There will probably be more rich people in China than anywhere else on the planet.

But history tends to run in fits and starts. Rome was sacked by the Gauls long before Caesar conquered Gaul. And the US suffered through a deep depression before it reached the pinnacle of its power and wealth.

China will have its setbacks, too. And by the look of things, one is coming soon.

I wrote about China in my column in MoneyWeek magazine and in the Daily Reckoning. My point was limited. I was only showing that the 'stimulus' given to the world economy by Chinese growth was largely a fraud...just like America's 'stimulus' program. Proportionately, China's spending - at over $580 billion - is about four times the size of the US.

"Well," you might say, "China can afford it. China has savings. China doesn't need to go into the international debt markets and borrow money. Nor does it need to raise taxes. So, it doesn't risk the kind of pressure...and disaster...that could befall Greece, Britain...and ultimately the US."

You would be right. But, as always, there's more to the story.

Yes, the Chinese save a lot of money. And yes, the government has a huge pile of foreign reserves. But this money is not readily available to be used for its domestic stimulus. This is money China received from foreign buyers in exchange for Chinese-made goods or capital investments into China. It represents a claim on the foreigners' resources and could be used to buy foreign stocks, real estate, commodities, or goods and services.

But to convert it to use in the domestic economy requires that it be exchanged for domestic currency. And who has that kind of Chinese currency on hand? Only China. Foreign exchange reserves result from trade surpluses. By definition, an equal amount of foreign exchange reserves - in yuan - does not exist outside of China. So there is no way to use foreign exchange reserves domestically, except by borrowing the money or creating it out of thin air - more or less in the same manner as the US funds its own stimulus program.

"Well, at least China has no debt," you may say. But even there, the story is a little more complex. Although the government has a huge cash surplus in foreign reserves, local governments are deep in debt. They owe about $1.6 trillion, according to an estimate we found this week. That's more than a third of the country's total GDP.

Plus, China's new bank loans as a precentage of GDP has gone through the rook recently. And such a huge increase in bank lending is bound to lead to trouble.

Credit spree

Such a huge increase in bank lending is bound to lead to trouble
Such a huge increase in bank lending is bound to lead to trouble

Why Central Planning Doesn't Work

Large foreign currency reserves come naturally to export-led economies in their heyday. They make a lot of money by selling products to foreigners. Then, with the money flowing, and a bit of misdirection from the authorities, they tend to over-invest in output capacity. This is what happened to the US in the 1920s and to Japan in the 1980s.

It's the rest of the story that really interests us. Getting right to the heart of the matter, having a lot of cash on hand may make an economy better able to deal with disaster...but it doesn't prevent a disaster from happening anyway.

In the US, as we all know, the Great Crash of 1929 began a long period in which excess capacity and bad investments were gradually and painfully eliminated. There was no net growth in the US during the entire decade of the 1930s. And it was arguably World War II that finally absorbed all the capacity available and squeezed out the mistakes of the 1920s.

By the time the Japanese market crashed in the early 1990s, economists had more fully developed their 'rescue' techniques. The story in Japan was much the same as it is in China today. Japan had invested too heavily in fixed capital. In the boom of the 1980s, Japanese assets had risen to many times what they had been worth in the 1970s. The "cheap Japanese products of the 1970s" had become the quality Japanese automobiles and electronics of the 1980s. In short, Japan went from being a bombed-out loser to the world's most admired economy.

What is also interesting is that the genius of Japan, Inc. was widely attributed to central planning by the MITI, the Japanese industrial board. Analysts and pundits did not seem to notice that MITI gave consistently bad advice - including advising the Japanese auto industry not to enter the US market! Still, American policymakers bemoaned the lack of central planning in the organizations called for more direction from Washington...and business gurus insisted that if we could just be more like the Japanese, we'd be successful too. But the reality is that Japan's success came because its captains of industry had the good sense to largely ignore the central planners and go on with their expansion plans.

Of course, nothing fails like success. Count on people to overdo it...whatever "it" is. If they are running a hugely successful export economy, they will over-expand export the point where a correction is unavoidable. If they are running a consumer-led, credit-fed economy, such as the US or Britain, count on them to consume too the point where consumers get so deep in debt they have no alternative but to cut back.

So here we are, 2010, and we have in front of us the world's most successful export economy - China. It is a centrally planned economy, though no one is too sure who does the planning or how much planning they do. It has enormous output capacity...probably far beyond what is profitable...and huge reserves of foreign currencies.

It is also the great hope for the rest of the world's economies. Growth in China - at double-digit rates, no less - is supposed to be the engine that pulls the entire world economy out of a recession.

If it were true that China is a solid, growing economy .and that it alone could keep the entire world economy expanding we might think differently about our Family Wealth Portfolio allocations. It would be stupid (as Jim Rogers says) not to have an investment position in China. It might also be wise to expand our exposure to emerging markets generally. If China grows, Brazil grows, too, since Brazil is an exporter of raw materials and food, to China.

On the other hand, if we thought China was going to blow up...or even slow down significantly..we should be very cautious. If the US in the 1920s or Japan in the 1980s provide any guidance, they tell us that the decline could be deep...and it could last for a long time. That would be bad for equities almost everywhere...and bad for commodities, too.

I'm going to draw this point out a bit...just to show how a setback in China would affect far more than just China itself.

Brazil...Australia...And the World...

Brazil's trade with China is not only a contributing factor to Brazil's recent economic success - it is the whole thing. The volume of this trade has increased 1,100% over the last nine years. This has turned Brazil into the world's tenth largest economy...and by far the most powerful economy in Latin America.

But China is not only holding up the Brazilian economy. China is also Australia's top trading partner - buying huge amounts of mineral and energy products, principally iron ore and coal - and the biggest buyer of raw marterials in the world - absorbing 30% of the planet's aluminum, 40% of its copper and 47% of its steel.

Any significant problem in China would lead to an immediate "risk off" move by investors everywhere. Suddenly, all those speculations that depended on recovery and growth would look much less attractive. And the dollar carry traders would rush for the exit - eagerly turning in their yuan and reals for the safety of good ol' dollars.

The rising dollar would make it easier for the US to fund its deficits...but make it harder for US industries to get out of the slump. A higher dollar increases the real cost of the US minimum wage, for example. Higher labor costs make it harder for the US to compete...and less attractive for companies to hire people. A big setback in China would not start a great de-leveraging, it would just allow the one that began in 2007 to fully express itself. The US economy would relapse into recession - one that would quickly come to resemble the depression we've been talking about.

You could also expect a selloff on Wall Street, tout de suite... with the US stock market finally sinking down to its ultimate low - probably under 5,000 on the Dow...perhaps under 3,000.

In short, the world economy - including the US economy - is propped up by the expectation of Chinese growth; and it wouldn't take much to kick out the prop.

Here is a graphic prepared by trader Michael Hampton and sent to us by one of our London-based analysts, Dominic Frisby.

Depression bound

My guess is that a slump or crash in China fits into the ninth box. But it leads to an increase in the dollar, not a decrease.

This will be an important detail to traders, but not to us. If the dollar goes up, so does the REAL cost of borrowing. Debtors then are caught in a "desperate squeeze," which requires more mediation from the fiscal and monetary authorities. Both routes - higher real rates or higher nominal rates - end up at the same destination: a greater depression and a destruction of government's credit.

What about the Stimulus?

Let's return to Japan... After the "Crash of '87" Japan feared a decline in demand in the US for Japanese-made goods. The Japanese responded to this challenge in a way very similar to China's response to the crisis of 2007-09: by increasing its capital investment. This was precisely the wrong thing to do in both cases. Both Japan and China have/had too much capacity already.

Then, in Japan, came the beginning of the on-again, off-again depression that has dogged the country ever since. All the elements that should have led (according to standard economic theory) to an economic renaissance were in place. The yen was kept low. Interest rates were extremely low (practically zero). The national government ran huge fiscal stimulus programs. The export sector continued to make money - showing large surpluses (around 4% of GDP) during the entire period. And the household savings rate declined from 10% down to 2% - an enormous shift that should have signaled a big increase in consumer spending.

Yet even these positive trends were not enough to reverse the deep deflationary bias of the Japanese economy. It wiped out, according to one estimate of stock and real estate losses, an amount of wealth equal to three times GDP. In the US, that would be a loss of about $40 trillion. In China, it would be a loss of about $10 trillion.

What lesson do I draw from this experience?
First, an economy that is so heavily dependent on exports is extremely vulnerable to two things: a decline in demand from its major customers and over-expansion of its own output capacity. China seems to have run into both problems.

Second, such an economy finds it very difficult to turn itself around. This might be true of all economies, for all I know. In the US - an economy powered by consumer credit - a slowdown is met by policymakers with increases in consumer credit! In China (and Japan before it) - an economy powered by exports -- a slowdown in exports is met with an increase in capital investment, which increases export capacity.

Third, in all cases central planning makes the situation worse. Central planners respond to existing economic interests, not those of the future (which don't exist yet). They try to prop up existing banks and large enterprises. In the process, they starve the as-yet-unborn startups of capital and market opportunities.

Fourth, huge amounts of money are lost as the inevitable deflation/depression/slump runs its course.

Is a crisis in China coming?

Of course, I don't know. No one does.

But, as Marc Faber says, even if there is no sharp crisis...there is bound to be a more moderate one. According to Faber there is "a 99% possibility that China will slow down considerably and I would say there is a 30% chance that it will crash."

Recent data suggest that the rebound may have run its course. "China's PMI (purchasing managers' index) numbers for February were released yesterday and received surprisingly little media attention," writes Prieur du Plessis.

"The rate of expansion of China's manufacturing sector that accounts for more than 50% of the economy has moderated sharply, with the overall PMI falling to 52. Just on its own (excluding the non-manufacturing sector) it seems as if China's year-on-year economic growth in the second quarter could slow to 10% and even less.


"The following graph provides the same information, but over the longer term.

Hongkong manufacturing sector

"The manufacturing industry has started to shed excess inventories as stocks of major inputs indicate contraction. This does not bode well for metal prices in at least the short term.

Chinas manufacturing industry

"New orders are still expanding but at a significantly reduced pace. However, new export orders fell sharply from 53,2 to 50,3, indicating only marginal expansion. New orders and new export orders lead the Economist Metals Index by approximately one month. The drop in especially new export orders does not augur well for metal prices and downside pressure can be expected.

Chinas manufacturing export Industry

"The roll-over in new export orders is particularly evident and the question is whether this could indicate a trend change.

Chinas manufacturing export Industry

"The drop in both new orders and stocks of major inputs perhaps explains the weakness in the Baltic Dry Index. Imports of raw materials such as ores and metals have probably dropped significantly."

Chinas manufacturing sector

Baltic dry index

Baltic dry index

Of course, the charts are inconclusive. And so is the history of Japan's depression. China's situation is different enough so that it may not follow Japan's footsteps. Still, what impresses me is the risk: It is huge.

It doesn't take much imagination to see that China could easily blow up. It takes even less to imagine that it will slow down. Either way, the negative effect on the US and other economies will be inescapable.

All of which is enough to convince me that we should stay on our toes for the next few months...and be ready to get out of our emerging markets positions at any time.

Editor's Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis. He is also the author, along with Lila Rajiva, of Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics.

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4 Responses to "The Outside View: Is China the New Japan?"

Mukta V

Mar 25, 2010

Very well written and shows that economics is a very challenging function. For long there was debate about China marching ahead of India but looks like the bubble will pull it down. We in India are yet to develop education system where our fast growing economy will get well trained employees. So we have productive agegroup but unskilled labor!!!

It again reminds me of a staement made (by whom? I think Galbrith) 'Looking at India I believe god exists.' All other nations strided in their progress due to government stimulus we went without!!!!

Rather we excelled where the government did not interfere!!!
Mera Bharat Mahan!!!


Tanu Bhargava

Mar 23, 2010

Very well written, and logical.



Mar 22, 2010

very interesting and well written article. provided clear and logical insight into a trouble in the making. hope to hear more updates regarding the same.



Mar 18, 2010


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