Feature Article: What Lies Ahead for China?

Methodology

We assume that under normal conditions, the "base case" or "policy" asset allocations employed by our readers are sufficient to achieve their long-term goals within acceptable risk limits. Given this assumption, the main threat our readers' face is a substantial downside loss that breaches these risk limits, and substantially reduces the probability they will achieve their long-term goals. The goal of our Economic Updates is to provide timely warning about dangerous overvaluations that could lead to such losses in one or more asset classes. Our main focus is on what is known as "strategic warning" -- "the what and the why", with a lesser focus on "operational warning" -- "the how". Our objective is not to provide tactical warnings -- "who, when and where" -- that are more commonly known as "trading tips" intended to increase short term returns.

Our economic analysis methodology is based on a technique known as "analysis of competing hypotheses", or "ACH." Human beings normally seek to collect information that supports a hypothesis. However, since a piece of information may be consistent with more than one hypothesis, this method is inefficient. In contrast, ACH focused on disproving hypotheses, and values information on this basis. For example, a piece of evidence that has a very low probability of being observed under a given hypothesis is more valuable than a piece of evidence that is consistent with multiple hypotheses.

Our economic hypotheses take the form of two alternative scenarios. When it becomes apparent that one of them is much more consistent with the accumulated evidence, we generate two new ones. Our two current scenarios are based on alternative behavior patterns often exhibited by complex social systems operating in far from equilibrium conditions. The first is enhanced cooperation and the second is higher levels of conflict. Realization of the cooperative scenario usually results in a higher level of stability and predictability in the system’s operations and gradual movement back towards equilibrium. In contrast, realization of the conflict scenario usually prolongs and often worsens the system's instability. These two scenarios are described in more detail in our previous issues, which (as you go back in time), also describe the scenarios that preceded them.

We further assume that financial market returns reflect the complex interplay between political and economic conditions, which in turn reflect the actions of key groups (i.e., networks), which in turn are comprised of individuals whose behavior is based on an evolving mix of cognitive, informational, emotional and social factors. In our analysis, we use both bottom-up and top down approaches to develop our scenarios and guide our search for information that provides insight about which of them is developing.

The assumptions we make in our analyses, and the conclusions we reach, are inescapably uncertain. We believe it is extremely important for the reader of any estimate or assessment to clearly understand the analyst's confidence in the conclusions he or she presents. How best to accomplish this has been the subject of an increasing amount of research (see, for example, "Communicating Uncertainty in Intelligence Analysis" by Steven Rieber; "Verbal Probability Expressions in National Intelligence Estimates" by Rachel Kesselman, "Verbal Uncertainty Expressions: Literature Review" by Marek Druzdzel, and "What Do Words of Estimative Probability Mean?" by Kristan Wheaton). In our analyses, we are standardizing on the use of a three level verbal scale to express our confidence level in our estimates. "Possible" represents a relatively low level of confidence (e.g., 25% – 33%, or a 1 in 4 to 1 in 3 chance of being right), "likely" a moderate level of confidence (e.g., 50%, or a 1 in 2 chance of being right), and "probable" a high level of confidence (e.g., 67% to 75%, or a 2 in 3 to 3 in 4 chance of being right). We do not use a quantitative scale, because we believe that would give a false sense of accuracy to judgments that are inherently approximate.

The Current Situation

With respect to the situation we face today, we believe three critical issues must be resolved in order for the world economy to return to a period of sustained growth and relatively normal conditions in financial markets -- (1) high levels of household debt across much of the Anglosphere; (2) a deeply weakened world financial system; and (3) unsustainable structural imbalances in the economies of the United States and China, and in these countries’ current account balances. We further believe that the actions of three groups -- middle class Americans, Chinese peasants, and Iranian youth, are linchpins that could have an outsized impact on the future evolution of political and economic events, and, through them, on the way in which the three critical issues we face evolve, and whether we follow a path that looks more like our cooperative or conflict scenario. As our previous monthly financial updates have shown, we believe that the accumulated evidence against the development of the cooperative scenario is much more convincing (to a clear and convincing standard) than the evidence against the development of the conflict scenario (as we seek not to prove, but rather, in the spirit of the scientific method, to disprove our hypotheses).

The essential predicament facing the global economy is by now well known: overleveraged private sectors in the developed world have sharply cut back spending in order to repay their debts. In order to avoid the collapse in GDP that this would otherwise cause, governments have sharply increased their spending and fiscal deficits as a percentage of GDP, which in turn has boosted Debt/GDP ratios that in some cases were already uncomfortably high. This has provoked rising concern with fiscal deficits and sovereign credit risk that has recently come to a head in Greece. However, aggressive though it has been, aggressive debt financed government spending around the world has usually not fully offset private sector retrenchment, resulting in some reductions in the size of global current account deficits and surpluses, particularly those that exist in the United States and China. To offset the contraction caused by a fall in its exports, China has embarked on a stimulus program that has been marked by extraordinary levels of credit growth, which in turn (as has been the case throughout history) has fed what many perceive to be a growing bubble in domestic property markets. Moreover, in order to maintain employment and social/political stability, China has sought to maintain its export markets and export led growth model, either because it is unwilling or unable to increase its level of domestic consumption spending. In sum, while unprecedented fiscal and monetary stimulus around the world has thus far avoided a repeat of the Great Depression, the global economic recovery remains extremely fragile.

The past two months have seen a sharp escalation in news coverage about the future of China, with sharp disagreement about whether that country will soon face a collapse of epic proportion with highly unpredictable results for world politics and economics, or whether the leadership of the Chinese Communist Party will be able to muddle through, avoid collapse, and gradually transition the nation to higher levels of private consumption spending and much lower dependence on export and investment led growth. Since this issue is central to investors' portfolio risk management decisions, this month, in place of our usual broad review, this month we will present and evaluate the conflicting evidence regarding the future of China.

Our View of China in 2004

Our starting point -- or our prior view, in Bayesian terms, -- was first described in the in-depth analysis of China that we presented in our March 2004 issue. 

Let's start with the big picture: China's grand strategy, as summed up in the 2002 Report to Congress by the U.S. China Security Review Commission. "It is clear that China anticipates America's decline and is working to shape a world with a weaker United States and stronger competing poles of power where it can play a central role. China's strategy to achieve this objective appears to include biding its time by avoiding confrontation with the United States, and meanwhile gaining access to American investment, technology and know-how…Economic growth is a central pillar of Chinese power. The Chinese government and its industries share an overwhelming and driving goal to increase the power and international standing of China as a nation-state…Chinese policy has been guided since the 1970s by the maxim enunciated by Deng Xiaoping that science and technology from abroad is the prime force of production and central to China's rise from poverty and weakness… They view joining the World Trade Organization as essential to continue rapid growth by accelerating economic reform, attracting higher levels of foreign investment, maintaining and expanding export markets, and playing a more influential role in shaping the rules of the world trading system…China's economic relations with Europe and Japan reflect both an interest in building relations with America's traditional allies and also decreasing China's dependency on the United States for its technology, investment and export markets…Chinese leaders believe that American-style democratic capitalism threatens the Chinese Communist Party's political monopoly, but they also believe they can grow economically and still maintain their power…China has carefully fanned the flames of nationalism and anti-Americanism through the state-controlled media…[This] reflects a larger strategy on the part of the CCP to maintain stability and control as the economy rapidly opens up to the outside world and to American values and culture."

Since the introduction of reforms by Deng Xiaoping in 1978, this grand strategy has, to date, been remarkably successful. But will it continue to be in the future? A number of recent analyses suggest that China may be entering a much more turbulent period. An article in the July/August 2001 issue of Foreign Affairs ("China's Coming Transformation" by Gilboy and Heginbotham) concludes that "the social forces unleashed by economic reform are driving towards a fundamental transformation of Chinese politics…The struggle to maintain the political status quo while pursuing rapid economic growth has resulted in a non-adaptive, brittle state that is unable to cope with an increasingly organized, complex and robust society…Efforts [by the CCP] to resist political change will only squander economic dynamism…and ultimately threaten the system with collapse."

A subsequent article, ("China's Governance Crisis" by Minxin Pei in the September/October 2002 issue of Foreign Affairs) adds more detail to this argument. Pei notes that "China's current crisis results from fundamental contradictions in the reforms it has pursued over the last two decades, the hidden costs of which have begun to surface." These include the increasing problems caused by a weak legal system, declining participation in the CCP (former President Jiang Zemin's attempt to attract intellectuals and entrepreneurs to the party proved unsuccessful), widespread corruption (involving many CCP members) an growing resentment of it, widening income gaps, particularly between urban dwellers and the 800 million people living outside the cities, weakening of the healthcare and educational systems, growing unemployment and widespread underemployment (particularly at state owned enterprises), increasing environmental problems, energy shortages, and a huge volume of non-performing loans (estimated at up to 50% of total assets) to unprofitable (but job creating) state owned enterprises piled up on the books of China's four main state owned banks which dominate the financial system. Regarding the latter, some have estimated that the cost to clean up the state owned banks' books (ahead of full opening to foreign bank competition due in 2006 under the terms of the WTO agreement) amounts to 30% of GDP. Unfortunately, a key tool for alleviating the bad loan problem has recently been put on hold: due to questions about the accuracy of their financial reporting, further public equity offerings by state owned Chinese companies effectively have been suspended by the SEC. Added to the existing 30% public debt/GDP ratio, the contingent liability for cleaning up the Chinese banking system brings the country's public sector liabilities to 60% of GDP, an amount roughly equal to that found in the United States and Eurozone. Whether or not this will constrain the government's ability to address critical problems in the areas of healthcare, education and old age pensions that lead to high domestic saving (and hold back the development of domestic demand) remains to be seen.

Last but not least, a number of commentators have recently pointed to the mounting signs that the money supply growth caused by China's recycling of U.S. dollar export receipts is beginning to have noticeable negative effects on the economy, including, for example, overinvestment in productive capacity, potential asset bubbles in the property market, and greater number of non-performing loans state owned banks.

To be sure, the current leadership of the CCP is trying to address these issues. President Hu Jintao and Prime Minister Wen Jiabao have launched a widespread anti-corruption program, and tried to reposition the CCP as a more populist organization fighting for the country's still very, very large number of "have nots." At the same time, they have explicitly set lower growth goals for the economy, and taken steps to limit the impact of dollar recycling (e.g., mandating slower bank credit growth, and allowing more overseas investment of export proceeds by companies). The critical uncertainty is whether these actions will be able to limit the building pressures for fundamental political change. If it does not, their only alternative means of holding the state together (and maintaining the CCP in power) would logically require an appeal to nationalism, which in turn would seem to require a more bellicose China (e.g., a serious, and economically debilitating crisis involving Taiwan). The pressures on the political system "already in the pipeline" seem likely to become more intense due to mounting economic problems."

Evidence Against the Cooperative Scenario Developing

Let us now turn to the evidence that has been presented in various articles over the past two months or so against the hypothesis that the cooperative scenario is developing in China -- i.e., against the proposition that a smooth transition to growth driven by private consumption is underway, that will result in minimal domestic disruption along the way as well as minimal conflict with the United States.

In "China’s Red Flags", GMO's Edward Chancellor first reviews ten characteristics of "speculative manias and financial crises" throughout history, and then applies them to the current situation in China. The following table briefly summarizes his analysis (though we urge you to download and read the full piece):

Historical Indicator	Application to China Today
"Great investment debacles generally start out with a compelling story."	"Forecasts for urbanization and economic growth make for a compelling Wall Street pitch...Yet like the projections for internet growth back in the late 1990s, there's a possibility that these forecasts may be exaggerated."
"A blind faith in the competence of the authorities is another typical feature of a classic mania."	"In the Communist Party of China We Trust." Belief that the CCP will be able to take steps to avoid a significant slowdown in growth, or a deep crisis.
"A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria."	China's fixed investment/GDP ratio, at 58%, is unprecedented. Yet there is growing evidence that this money has not been well spent, with substantial overcapacity in many industry sectors. The efficiency of investment (change in investment divided by change in GDP) has been declining for more than 10 years.
"Great booms are inevitably accompanied by a surge in corruption."	Widespread evidence of endemic corruption in China.
"Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation."	"Low interest rates are part of Beijing’s policy to promote investment and subsidize state owned enterprises (SOEs)...Last year the money supply grew by nearly 30% while interest rates were maintained well below the economy's nominal growth rate."
"Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts."	"An undervalued exchange rate has boosted exports and kept interest rates low."
"Crises generally follow a period of rampant credit growth."	"In response to the global financial crisis and the collapse of export orders, Beijing ordered its banks to go out and lend. Last year new bank lending increased by a sum equivalent to 29% of GDP."
"Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won't let bad things happen to the financial system."	"The major Chinese banks are controlled by the state. They have a history of poor lending decisions...Policy driven lending to China's SOEs has landed China's banks in trouble before."
"A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious. Investments financed with borrowed money don't generate enough income to repay the loan (what Minsky called Ponzi Finance). As a result, the financial system becomes increasingly vulnerable to what would normally be considered insignificant events, such as a small rise in interest rates or a decline in asset prices."	"The trouble is, land sales to property developers account for some half of local government revenue. So if the real estate market tanks, then the local authorities may have trouble fulfilling their implicit obligation to make good on the infrastructure loans they have indirectly backed... No one can gauge the robustness of the credit system since Chinese banks appear particularly reluctant to report problem loans."
"Dodgy loans are generally secured against collateral, most commonly real estate. Thus, a combination of strong credit growth and rapidly rising property prices are a reliable leading indicator of very painful busts."	"Given low rates on cash and the wild volatility of stocks, property appears a much more attractive bet to Chinese savers...Boosting the housing market was a key element in Beijing's stimulus package...Residential completions in Beijing have grown faster than the population...Much of this excess supply is being purchased by property market investors. A recent survey found nearly a fifth of all recently sold properties were kept vacant...Real estate prices have become very stretched relative to income...Housing has become a national obsession...The commercial property market looks similarly overblown."

Chancellor sums up his argument thus: "In the past, whenever an economy has exhibited the ten red flags listed in this paper, there has been an unpleasant outcome...Three years ago Premier Wen described China's economy as 'unstable, unbalanced, uncoordinated, and unsustainable.' The Great Recession hasn't cured these imbalances. Rather, China's ensuing investment and credit booms exacerbated them."

Another widely read and influential research report is "China's Investment Boom: The Great Leap Into the Unknown" by Pivot Capital Management. It is also worth quoting at some length (again, we urge you to read the whole piece). "The Chinese economic "miracle", referring to the past 30 years of growth at an average real rate of 10% can be broadly split into three periods. In the 1980s, the first stage was unleashed by modest reforms of Deng Xiapoing such as liberalization of prices in the agricultural sector. After a brief pause coinciding with the Tiananmen events, the second stage concentrated on rationalization of labor that saw a proliferation of light industries at the expense of agriculture and State Owned Enterprises (SOEs). The third stage has been focused on expansion of heavy industries and infrastructure.

What all three stages had in common was a central role of investments as a driver of economic growth. Indeed, China has emulated the path of other countries that have rapidly developed in the second half of the 20th century driven by high investment to GDP ratios. However, both in its duration and intensity, China's capital spending boom is now outstripping previous great transformation periods (e.g. postwar Germany and Japan or South Korea in the 1980-90s). The gradual increase in China's investment ratio that started in 1998 has now reached unprecedented levels. As a result, capital spending has become the dominant growth driver. The experience of the Asian tigers, as well as the post-war reconstruction periods of Germany and Japan, provides highly relevant benchmarks for analyzing China's multi-decade growth process and current situation. The eventual reversion of investment ratios in those countries tells a cautionary tale on its own, however, what makes the situation even more alarming, is the rapidly decreasing efficiency of China's investments.

In the third decade of expansion, the Incremental Capital Output Ratio (ICOR, defined as the ratio of Gross Fixed Capital Formation to GDP divided by real GDP growth. The lower the ratio, the more efficient capital spending is at generating growth.) in China has markedly deteriorated compared to the previous two decades as well as to other high-growth countries in their pre-peak investment stages. In 2009 China's ICOR will be more than 2 times higher than the 80s and 90s average. The falling marginal returns on investment are symptomatic of the increasingly speculative nature of China's capital spending boom, where a self-feeding process of credit growth and investments in manufacturing, infrastructure and real estate is currently under way...[However], the effectiveness of domestic credit in generating growth is collapsing. In the period from 2000 to 2008, it took on average $1.5 of credit to generate $1 of GDP growth in China. This compares very favorably with the peak $4 of credit for $1 of GDP in USA in 2008. However in H1 2009 in China this ratio was already at around $7 to $1. Credit might be going into the luxury property and stock markets, but the trickle down to the real economy is very poor.... The decreasing efficiency of investments will ultimately lead to a pullback in capital expenditures....

To sum up, China is already at a very advanced stage of industrialization even when measured on a per capita basis, so   room for further capacity expansion is limited. Urbanization is a driver that is vastly overstated, as China is much more urbanized than is reflected in statistics, so there is no "explosive" pent-up demand for residential construction and all that it entails. China's infrastructure is also relatively well developed and the expansion in the areas that still have room to grow was fast-forwarded by the stimulus implying that capex growth rates will already peak out this year. Sectoral analysis of investment in China confirms our initial conclusion that effectiveness of capex at boosting growth is diminishing and so investment will cease to be the dominant driver of future China's growth…"

"As the dust settles, we believe China will enter a phase of permanently reduced capital spending activity, whereby consumption will become the upper boundary of growth... In the best-case scenario emphasized by China bulls, private consumption will smoothly overtake investment as the growth engine so that there is no pullback in the overall growth rates. Here, we will start with a very simple fact that   private consumption in China accounts for about a third of GDP. After a bumper year for credit and investment activity, it is going to be hard for investment to continue growing at an annual real rate of 30%. Even if we assume optimistic real annual investment growth rates of 10% for 2010 and 0% for 2011, leaving the trade balance where it is now, private consumption would have to grow at an average real rate of 20-30% for the next two years for overall GDP real growth levels to hit the magic 10%.

On a conceptual level, consumption is one of the most stable components of any country's national accounts. Even in post-war US, real private consumption growth very rarely exceeded 10%, with the highest rolling 10-year average close to 5% (1952-1962). Likewise, in a war devastated, un-urbanized and demographically booming Japan, real annual consumption growth peaked at 12% in 1961. The average for the 1970s was a tamer 6%. Pundits calling for 20-30% growth rates in Chinese private consumption should dust their economic textbooks...Between 1997 and 2007, China’s average real annual consumption growth rate averaged 8.2%... This means that private consumption would have to grow at anywhere between 3 to 4 times faster than in the past decade to compensate for the imminent [decline] in investment...It is hard to overemphasize what this shift to a consumption driven economy means for China's overall growth rate. On a simple mathematical level, it means that average real consumption growth rates are going to be capped at 7% to 8%, so that the overall economy grows at 5% to 6% per year for the foreseeable future, and probably slowing down even more later on... In a soft landing scenario, China is likely to shift to a lower growth trajectory for the next decade. In a hard landing scenario, which is entirely feasible, there would be an abrupt decline in capital spending exacerbated by a banking crisis...Considering China's role as a trailblazer and locomotive for current global recovery efforts, any sign of a Chinese slowdown would have significant global consequences. Not only would it challenge the notion of emerging markets leading the world economy out of its slump, but it would also raise doubts over the sustainability and effectiveness of various stimulus efforts underway in other countries."

A number of other recent analyses have focused more narrowly on the argument that the "mother of all property bubbles" is building in China. James Chanos concluded that "China is on a treadmill to hell...The nation is Dubai times a thousand...that can't afford to get off the heroin of property development, as it is the only thing keeping the economic growth numbers growing ("China on Treadmill to Hell Amid Bubble", Bloomberg.com, 8April10). Takatoshi Ito, a professor of economics at Tokyo University, concluded that "China's property bubble is worse than it looks...[as] official data may be significantly underestimating real price increases." Moreover, "What is happening in China now is familiar to any Japanese who lived through the bubble in the second half of the 1980s and its subsequent burst" ("China's Property Bubble", voxeu.org 15April10, and "China's Property Bubble is Worse than It Looks" Financial Times 16Mar10). Finally, Andy Xie, formerly Morgan Stanley's Asia economist, and a man whose opinions we have found to be quite insightful over the years, has also been widely quoted about the growing Chinese property bubble. In the 23March10 issue of Caixin, Xie questioned whether China’s attempts to slowly deflate the growing bubble would meet with success: "We have seen this movie before. Beijing launched property tightening measures several times in the past but then relaxed them as soon as the market felt the bite. The bottom line is that local governments, and Beijing through them, depend very much on property for fiscal revenues. The market does not believe the government will cut off the hand that feeds it...The [current property bubble] will continue until Beijing proves its credibility. And it can only prove its credibility by maintaining a tight market policy until local governments and developers run out of money. After that, everyone will have to play by new rules." At the present time, however, "local governments are readying for another round of property inflation. They have been using bank loans to resettle residents [from land they want to sell to developers to generate fiscal revenue] and resettlement costs have skyrocketed since those being moved need enough compensation to buy properties at today's high prices...Such resettlements played an important role in supporting demand for property...Resettlement compensation...is probably the most important government action supporting today's economy...But it comes with major negatives. Local governments borrow to pay resettlement packages, using land as collateral for the loans. Resettled residents use the cash they receive from the local government as down payments for housing. In this way, government debt becomes equity supporting household mortgage debt; there is no real equity in the financing chain. This gives local governments a strong interest in further inflating property prices." Xie also believes that cultural factors are at work "China was a rural economy not so long ago. The most important asset was always land. 'Be a government official and become rich' is a millennium old Chinese saying. It didn't explain where the money went. It always went into agricultural land." Xie also notes that a substantial portion of money derived from China's endemic corruption is now also flowing into the domestic property market, further fueling the boom ("I'll Tell You When the Chinese Bubble is About to Burst" Bloomberg.com, 25April10). In summary, Xie concludes that "China’s property market is a massive bubble."

Other authors have taken a closer look at the flip side of the property bubble: the massive amount of potentially bad debt that has built up in China, whether it has been fully acknowledged, and who will bear the cost when the bad loans are eventually written off and/or worked out. In "Is China Actually Bankrupt?", Jim Jubak shows how IMF public sector Debt/GDP data for China fails to include some very critical categories, including local government debt, debts incurred by investment companies sponsored by local governments, debts that resulted form the 1999 resolution of China's last non-performing loan crisis, and loans from state owned banks to state owned enterprises. Taken together, Jubak estimates that China's true public sector Debt/GDP ratio is closer to 100% than the much lower estimates that are usually reported. Victor Shih, from Northwestern University, focuses on one aspect of the problem (which appears to be the most important): direct and indirect borrowings by local government entities. He estimates the total amount to be $1.7 trillion at the end of 2009 (about 33% of GDP), which Shih forecasts will double by the end of 2011. Shih also estimates at least 25% of direct and indirect loans to local governments and government sponsored entities will eventually go bad ("China’s 8,000 Credit Risks", The Wall Street Journal, 8Feb10, and "Victor Shih Sees Bank Bailout Redux", China Real Time Blog, WSJ.com, 17Mar10).

Michael Pettis, of China Financial Markets recently wrote an excellent overview of "Who Will Pay for China's Bad Loans?" (6April10). Pettis notes that, while a surge in non-performing loans (NPLs) doesn't automatically result in a banking collapse, they do, always and inevitably, extract a cost from the economy. The key question is how this cost is allocated. Looking back at the 1999 NPL crisis in China, Pettis notes, "China paid a very high prices for its [last] banking crisis. This cost didn't come in the form of a banking collapse, but rather in the form of a collapse in consumption growth, as households were forced to pay for the enormous clean up bill." Pettis concludes that "there were three sets of tools that Beijing used to manage the sharp increase in bad loans that threatened the banking system a decade ago...The first involved reducing the accumulation rate of NPLs by keeping the interest rate charged to borrowers low...Households paid for this in the form of very low returns on their savings (and, with few alternative investment opportunities, they had no choice but to accept the cost)...The second was infusing the banks with additional equity, both directly and via the creation of Asset Management Companies to purchase NPLs at face value.

In both cases, the capital infusion was financed by government borrowing, which at artificially low rates reduced the income paid to lenders -- in this case, banks which bought the bonds, and the household depositors which received lower deposit rates...The third and most important tool involved the central bank mandating a wide spread between bank lending and the deposit rate, which increased bank profitability...With all these transfers from the household sector to the banks, amounting to at least 5% of GDP every year, households were forced to clean up the Chinese banking system. Beijing's strategy to clean up the banks was very successful, and certainly prevented the banking crisis that everyone expected [ten years ago]." However there was a significant cost to the economy, in the form of artificially depressed household incomes and consumption spending, which made China more dependent on investment and exports to maintain GDP growth and employment. As Pettis notes, "added to the other major transfers from the household sector (the undervalued exchange rate and slow wage growth relative to productivity growth)...it is not surprising that during the period of the bank bailout, household income in China, already a relatively low share of GDP, declined to alarming levels." Moreover, by artificially holding down lending rates, this approach to resolving the NPL problem also caused firms' cost of capital to be artificially low, leading to inefficient investment, the results of which we have recently seen in China's worsening Incremental Capital to Output Ratio. Pettis concludes, "This, then, is the real risk of another bout of rising non-performing loans in China...If the world can no longer absorb rising trade deficits, and especially if over the next few years trade tensions, increase, China must reduce its excessive reliance on exports and investments to fuel its continued growth. The only healthy way it can do so is if household consumption rises as a share of GDP because of surging consumption...But since growth in household consumption has always been constrained in China by the growth of household income, it may be unreasonable to expect a surge in consumption when households are also required to [once again] clean up another sharp increase in non-performing loans in the banking system...As part of the trade dispute that China is facing with the rest of the world, this should give some indication of how little room China has for adjustment. Anyone who is too impatient with the glacial pace of Chinese adjustment must recognize how difficult it will be for China to quickly reorient its economy towards household consumption. The risk is that China, like Japan in the 1990s, will rebalance towards a higher share of consumption in GDP not through a surge in consumption, but rather through a sharp contraction in investment and exports and overall GDP growth, as households struggle to pay for consequences of the lending boom."

Evidence Against the Development of the Conflict Scenario

Let us now turn to the economic evidence against the conflict scenario -- that is, evidence that, in contrast to the above, suggests that a cooperative transition -- both within China and within the global economy -- is possible. Perhaps the most important is a recent study from the IMF, "Determinants of China's Private Consumption: An International Perspective" by Guo and N'Diaye. The authors begin by reviewing the arguments that have been put forth that the high levels of savings in China somehow result from unique cultural circumstances (some of which we have covered in previous issues, such as how the one child policy resulted in an oversupply of males and therefore raised the amount of savings that must be accumulated to attract a spouse). The authors then review comparative economic data for China and other countries that have passed through similar development stages. They conclude that this analysis shows there is nothing special about the low level of consumption [and the high level of savings] in China. "Around one third of the fall in private consumption from 2000 to 2007 can be directly attributed to a fall in household income, while the remaining two thirds is due to other factors that may affect directly or indirectly household income and the household savings rate...The challenge is to explain why variables that drive higher consumption elsewhere are so low today in China, including a low level of service sector employment, the low level of financial sector development, and the low level of real interest rates...Efforts to further raise household income, the share of employment in the services sector, and to liberalize interest rates and create alternative savings instruments are likely to have the biggest impact on consumption." In a second IMF paper, "Public Expenditures on Social Programs and Household Consumption in China", Baldacci, Callegari, et al, conclude that "a sustained 1% of GDP in public expenditures, distributed equally across education, health and pensions, would result in a permanent increase in the household consumption ratio of 1.25% of GDP." Finally, a number of commentators have suggested that a rise in the Chinese exchange rate relative to the U.S. Dollar might also result in higher Chinese household consumption spending on imported goods.

However, rebuttals to these papers are not hard to find. Regarding the first IMF paper, one need look no further than Pettis' work to find reasons why neither an increase in household income nor liberalization of interest rates are likely to happen, given the nation's approaching need to work out yet another non-performing loan crisis. With respect to higher government spending on social programs driving higher consumption spending, one would imagine that the leaders of a country facing a slowdown in GDP growth, a substantial non-performing loan problem, quite possibly a dangerous rise in unemployment, and with one of the world’s fastest aging populations (the legacy of the one child policy), as well as a very inefficient tax system, might think long and hard before creating new government healthcare and pensions liabilities. Moreover, in a nation that has a long tradition of upheaval, and shifting power between the central and local government, how much trust would Chinese households actually place in such new government entitlement programs, even if they were enacted?

Finally, two other recent analyses conclude that the impact on employment of an appreciation of the Chinese Renminbi versus the U.S. Dollar is quite likely to be negative, at least in the short run. Chapter four of the April 2010 IMF World Economic Outlook is titled, "Getting the Balance Right: Transitioning Out of Sustained Current Account Surpluses." It is clearly aimed at finding ways to reduce a critical global imbalance: China's high current account surplus and the United States' current account deficit. While it attempts to provide encouragement for a substantial appreciation of the CNY versus the USD, this goal is undermined by some of its findings, particularly that negative growth and employment effects are more likely to follow exchange rate appreciation in a surplus country when it has a larger surplus and a faster rate of GDP growth. These conclusions are echoed in another recent IMF analysis, "Employment Effects of Growth Rebalancing in China", also by Guo and N'Diaye. They find that "while rebalancing China's growth toward a domestic-demand led economy would likely raise aggregate employment in the long run, there could be employment losses in the short run as the economy moves away from the tradable sector to the non-tradable sector. Yet when maintaining employment growth is seen by the leaders of the Chinese Communist Party as critical to social peace and their own continued legitimacy, it is close to impossible to see them blithely acceding to demands for a substantial revaluation of the CNY versus the USD. In sum, it is one thing for Chinese Premier Wen Jiabao to promise a boost in employment, household consumption, consumer credit, and service industry growth, as he did at the end of the recent National People's Congress. But it is quite another thing to actually deliver on those promises.

Conclusions

So where does this leave us?

This review has not changed our previous conclusion, that the evidence against the cooperative scenario developing is far more compelling than the evidence against the conflict scenario developing. We believe that there will probably be a serious economic downturn in China at some point over the next three years. While the CCP leadership would like to delay that crisis until after 2012, events outside of China -- such as the enactment of trade sanctions by a U.S. government frustrated by continuing high unemployment -- may trigger it before then. However, that still leaves us with three issues: (1) the timing of what seems to be the inevitable crisis; (2) the way it will play out; and (3) the implication of these developments for asset allocation.

What Happens Next?

With respect to timing, we can only repeat an observation we have made many times over the past 14 years: One of the hallmarks of a complex adaptive system is that, as its level of internal and external tension rises, and its stability declines, so too will its creative efforts to adapt and prevent a move into the chaotic region of operation. We saw this process play out in the run-up to the crisis of 2007; so too, we believe we are seeing it play out again today, both in China and in the global economy and financial markets as a whole. One example of this is the decision on the part of Chinese and U.S. leaders to pull back from the rapidly intensifying conflict that was developing in the run-up to the scheduled April release date for the semi-annual U.S. report on which nation's have been deliberately manipulating their exchange rates, to the detriment of the U.S. economy. At a time when the U.S. faces the highest unemployment levels since the Great Depression, this was surely not a decision taken lightly by the Obama Administration (e.g., a recent Rasmussen poll found that 25% of Americans now believe China is the biggest threat to the United States, trailing only Iran at 30%). Yet as this review has shown, the Chinese leadership also faces serious problems and constraints, and the central governments of both nations undoubtedly are unwilling to push the system into the chaotic region if this step can be avoided, or until they believe that taking this step would be to their advantage. In sum, one of the hallmarks of a complex adaptive system is its ability to absorb rising tensions without tipping over into the chaotic region for a much longer period of time than most people initially believe is possible. We don't believe that China will be an exception to this rule -- in particular, we believe that with a major leadership transition on the horizon in 2012, every effort will be made by the CCP to maintain stability at least until a new generation of leaders are in place.

That leadership contest is now aggressively underway, and may offer us important insights as to how events in China could develop over the next five years. Some have described the 2012 leadership transition as a contest between two factions: the so-called "Princelings" (offspring of party elders, especially those who were close to Mao) and the so-called "Communist Youth League" (CYL) faction, who generally come from humbler backgrounds, and which provided the current leadership team of President Hu Jintao and Premier Wen Jiabao. The two most visible Princelings vying for 2012 leadership positons are Vice President Xi Jinping, and Chongqing Party Secretary Bo Xilai.

In broad terms, the CYL faction seems relatively more focused on finding a way to prolong the current system, including such measures as aggressive bank lending, resistance to substantial appreciation of the CNY versus the USD, and berating the United States for failing to adjust its own economy. More darkly, the CYL leadership has not hesitated to run roughshod over property and contract law in order to benefit Chinese companies (the recent controversy over forced disclosure of technology secrets as a condition of Western companies selling to the Chinese government being only the latest incident), has presided over a very substantial increase in military and domestic security spending, and has stoked the fires of Chinese nationalism, in a variety of ways, from the Olympics to the rhetoric of various government officials (the Commerce Ministry being the most vociferous). In our view, they are the faction whose behavior is most likely to lead to our conflict scenario, when the current Chinese bubble inevitably pops.

In contrast, the Princelings seem to be taking a different route, preparing to use a resurgence in Maoist teachings and beliefs to manage the challenges to CCP legitimacy that will inevitably accompany the bursting of the bubble. Bo Xilai epitomizes this approach, with his aggressive anti-corruption campaign in Chongqing and his populist focus on economic development that benefits the masses rather than just the elites. In this regard, Bo Xilai seems to be using an archetypical religious script, that features a creation story (the Long March, Mao's pulling down of the "three big mountains" of feudalism, bureaucracy, and imperialism, etc.), a fall (the rise of uneven economic development) and redemption (presumably, via a return to fundamental Maoist precepts). This is likely to have a powerful impact, as people traditionally turn more to religious belief (and clearly I am stretching the meaning of that term here) for solace during periods of deep turmoil. Put differently, the Princelings seem to be preparing for one of the periods of intensified inward focus during a period of turmoil that have characterized Chinese history -- call it tradition with Maoist elements. Whether the rest of the world will find this approach more cooperative and less confrontational remains to be seen. Indeed, it seems uncertain -- at best, a 50/50 bet -- whether neo-Maoism will be able to contain the social and political forces that will be unleashed by the combination of dashed expectations, nationalism, and a surplus of young males. Moreover, the rest of the world is not a passive, reactive player in this game, as shown by rising demands in the United States for trade sanctions and tariffs on China (in the absence of exchange rate changes) in order to reverse perceived job losses. Events in China may well be significantly affected by developments abroad.

Finally, we highlight another aspect of the ongoing leadership transition in China. In an excellent recent paper, ("A Global Model for Forecasting Political Instability"), Goldstone, Bates, et all present a four factor model that appears, at least in retrospect, to have an excellent track record in forecasting the onset of serious episodes of political instability between 1955 and 2003. Three of the variables are straightforward: the level of infant mortality, the extent of instability and conflict in neighboring countries, and the extent of state led discrimination against domestic groups. The fourth, however, has the most explanatory power: the authors call it "Regime Type", which they characterize by "patterns in the process of recruiting political leaders and competition between political participants." The type of regime that has the highest association with political instability is what the authors call "Partial Democracy with Factionalism", which is characterized by a leadership selection process based on a mix of birth status and limited use of elections, and political competition that is dominated by factional groups. China increasingly seems to fit this description, which provides an early warning indicator that rough waters lie ahead.

Implications for Asset Allocation

Finally, what are the asset allocation implications for our updated assessment of possible future developments in China?  The following table summarizes our views on this question:

Asset Class	Comments
Real Return Bonds	Lower global economic growth and higher uncertainty should hold down real return bond yields
Fixed Income	Reluctance of China to change export oriented model and/or significantly revalue CNY/USD XR will exert deflationary pressures. However, this should be followed by stronger measures to reflate. Careful attention to valuation will be critical. So too will credit risk management, including sovereigns, for which credit risk is now an issue. We agree with PIMCO that high quality corporate risks could play a role in a portfolio, along with CAD and AUD. Norway and Sweden may also prove attractive, providing investors view them as relatively more stable than other nations. Appeal of USD Govts will depend on the extent to which the economy's response to the crises that lie ahead is characterized by superior flexibility and innovation, and resolution of municipal debt, social security, and health care financing challenges.
Commercial Property	In certain regions where property is a traditional refuge in periods of deep uncertainty (e.g., EUR and CHF), it should do well. Elsewhere, it will generally suffer from economic stagnation, while retaining some appeal as an inflation hedge. A bright spot may be industrial property, to the extent that turmoil in China and/or XR changes results in return of production to Europe and North America.
Commodities	Falling growth in China will trigger a sharp downward shock. Recovery will depend on perceived attractiveness as an inflation hedge.
Timber	Will remain attractive as a long-term inflation hedge and diversifying asset class for portfolios.
Developed Market Equities	Continued high uncertainty will limit investment and growth; Growth expectations implicit in current prices are unlikely to be realized; Returns will likely be below long-term averages.
Emerging Market Equities	Without strong Chinese growth, very likely that current valuations will be viewed as too high, with falling prices resulting.
Volatility	Likely to rise from current levels, which seemed to be depressed either by ignorance of the scale of the challenges that lie ahead, or excessive optimism about the world economy's ability to meet them without substantial disruption and uncertainty.
Gold	Along with rising concerns about high public sector debt levels, rising instability in China and failure to achieve investor's current growth expectations for that country will increase uncertainty, fear and gold prices.
Uncorrelated Alpha Strategies	Conditions will be ripe for skilled global macro managers to deliver high returns. Not so for Equity Long/Short, which will be hurt by its traditional net long position. As always, Equity Market Neutral will come down to superior manager skill, and disciplined hedging of market exposure. Arbitrage strategies could suffer as historical relationships fail to work in a period of fundamental economic change and high uncertainty. Currency strategies like carry trades will also likely suffer due to high uncertainty and unpredictable changes in the global economy.

 

| Product and Strategy Notes: State Street's Filed -US ETF "IBND", Claymore's "WFVK"; Investing in Bond Indexes; New Paper - Sharing Longevity Risk - A Must Read | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Global Asset Class Valuation Updates Detail through March 31, 2010 | Table: Market Implied Regime Expectations and Three Year Return Forecast | This Month's Letters to the Editor: How Can a Retail Investor Access Volatility? Clarification of "Return Momentum" | Table: Fundamental Asset Class Valuation and Recent Return Momentum | April 2010 Issue: Key Points | Investor Herding Risk Analysis | Feature Article: What Lies Ahead for China? |