Saturday, December 18, 2010

China and the world economy

Over the last two centuries there have been many obvious examples of different political economic systems in practice. It all began with the Industrial Revolution that occurred in capitalist countries. Latter, there was the rise of communism and its moral/economic attack on human life. We had the immediate comparison between East and West Germany. For years there has been the obvious comparison between North and South Korea and Cuba and the Cuban refugees just a few miles away in Miami. Now we have the fascinating spectacle of communist China having an apparent capitalist bent. Still, with all of this obvious evidence, there are few people paying attention and noticing the consequences.

But even many of the people watching the Chinese economy are not noticing what is happening, not really. The closet socialists in the U.S. bemoan that America can’t act like the Chinese government and just get things done. We have all of those antiquated laws and protections in place. The Chinese, people are saying, have a better approach to making an economy run well. On the other hand, we have some advocates of capitalism who tout Communist China as a sort of new birth of freedom. Neither of these evaluations are correct. China has opened up options for personal action that the Chinese have never seen. It is a heady feeling, and the Chinese citizen is taking this opening and stretching it as wide as fast as he can. But his feeling is based upon the opportunity and not the reality. The reality is that China is still a communist country. It isn’t free. It still embraces the old prerogatives that communism teaches, plus, the government is attempting to become an economy manager in the manner it perceives the Western governments to be. This is not a good mix for the long-term.

My comments are about the problems that underlie Chinese economy today and the big crisis that is coming. But, if my information is correct…

When China bursts and falls, it will be the capitalist elements that will be blamed. Just watch!

People are very surprised about the success of the Chinese over the last 10 years. They tend to forget that the same Chinese government has killed millions of its citizens. They forget the destruction of the democracy movement just a few years ago. In their minds, China seems to have just come out of nowhere recently.

It is the case that there is a lot of productive energy being used by the Chinese citizen for his own benefit. People living in the right areas are seeing an enormous increase in their standard of living. There is real capital accumulation and utilization. Markets are working. People are finding productive jobs. There is a lot of good happening. The productive aspect of the Chinese economy is not an illusion, unlike the Russian economy which was an illusion during the Soviet era. Yet, there are major problems.

The problems revolve around the fact that the government has not renounced either its own communist nature or the general approach that every other government in the world accepts, namely the twisted Keynesian approach to government controls. This communist government isn’t using the traditional five-year plan, but it is attempting to act as if it can perfectly control the economy by using the “mixed economy” rules that have constantly failed in the West.

It has greater control over the banking system than any Western country does. The banks are either owned outright by the government or controlled sufficiently to make no difference. Consequently, the standards for making loans and evaluating the banks soundness are much poorer than in the West. Estimates are that anywhere from one third to two thirds of all loans made by Chinese banks are not performing, i.e., payments are not being made and the loan will be a loss. That is a percentage far higher than any Western bank has had. You can be sure that the Chinese banks do not have the capital or the reserves to cover those losses. When the weakness of Chinese banks is recognized and begins to affect the economy, the Chinese government will step in and create reserves, i.e., it will inflate the money supply even more than it is already doing now.

The real estate market is in much worse shape than it was in the West. There are reports that the Chinese built an entire city for something more than a million people in the interior. This city stands empty and is, no doubt, beginning to deteriorate. In the real cities, reports are that 60% of the apartments that have been sold are not drawing electricity, i.e., no one is in them. Yet the Chinese are continuing to build at a rapid pace. For those who buy, not having the mortgage system that Western countries have (which is not necessarily a benefit for the West because much of the structure is government created, and thus is not efficient or market driven) the Chinese buyer has a much higher percentage down payment on the property. When the Chinese real estate market fails, the losses are going to be more centered on the productive individual rather than on the banks. Suddenly losing a large part of their new wealth will place a strain on the population of the cities. Things may not remain stable.

At some point, some unforeseen event will stop the continued upward spiral of real estate building and price increases. The last buyer will buy, and all that will be left are sellers, and prices will fall, buildings will go empty, loans will be recognized as losses, banks will either fail or have massive amounts of made-up money shoved into them. Inflation in China could increase dramatically.

What will be the immediate economic consequences? Questions that perhaps cannot be answered in advance include, what will the Chinese do with their hoard of dollars, Euros, and foreign exchange? What will they do with their U.S. Treasury Bonds? There are observers who have been suggesting that China is looking to sell off the U.S. government securities. I haven’t thought so, for no other reason than that the Chinese really don’t want to see the value of those holdings to dive. It made no sense for the Chinese to start selling. But when their economy goes puff!! Who knows what they will do? The degree of collapse cannot be appreciated. There has been no economy of that size, with that many people, so connected to world trade, that has had the size of bubble that China now has. Yaron Brook suggested that their bubble is larger than any seen before. So may be the consequences.

We can easily see that one immediate consequence for the rest of the world will be a hit on the commodity markets and those countries that are depending upon the Chinese, e.g., Brazil. These countries will see an immediate fall in revenue. Commodity prices will fall, hard.

For ourselves, the consequences will also first connected to the commodities. The price decline will include gold. The number of buyers will decline and the sellers, especially the Chinese sellers will expand. At least during the crisis and for a while afterward, gold prices will be lower. Other commodities will also decline, especially those that the Chinese have been big buyers, e.g. oil. (See what happened in 2008.) The upward pressure on prices for goods in the U.S. that are tied to commodities will be reduced. Consumer prices could even decline.

What will happen after that is hard for me to predict. The Chinese economy is not as closely tied to other countries as ours is. Their banking system, for example, is pretty isolated, from what I can see. Would companies producing for export be forced into closing? Would their exports suffer? Imports would suffer. To the extent that the gap between imports and exports widened, there could be problems. To the extent that the wealthier countries depend upon exporting to China there would be adverse consequences. We will have to see how all of that plays out.

We have no clue what precisely Chinese government would do, except that they are wedded to the belief in the power of the government. To the extent that they see their citizens’ reactions to be threats to communist power, they could unleash the military again. They could try Western style mixed economy solutions, and expand and lengthen any possible recovery. It is unlikely that they would somehow learn that the governmental actions in the economy do not produce prosperity.

No doubt, in the West, government after government will step forward to save the day. At this point, with interest rates on short-term money at near zero, it is laughable that any might think that their theories are going to have any beneficial results. But, our great leaders are also wedded to their theories. Remember, their theories are not based upon any real evidence, but make believe. That they haven’t worked in the past will not hinder their efforts. The Western world might still be in “recovery” when China blows, which means our “recovery” will dip. Our economy will certainly suffer.

The stock market in the U.S. will definitely decline. Since the financial center may not be hit as badly as before, the decline in equities might not be as large, but it will not stand up to this bad news. I am firmly in the camp that considers the market’s recent rise to be pushed by inflation, i.e., government created money. Riding U.S. stocks is a very risky endeavor today. I don’t see a fundamental justification for stocks to have risen. New pressure from China will undercut the equity market.

Frankly, only commodities seem to me to offer any opportunity for increasing wealth today or even just protecting what you have (besides owing a successful business that can deal with economic shocks). I don’t mean riding commodity prices upward. I mean being able to take advantage of the up and down volatility of the prices of commodities.

When China does blow, as people have done in the last sixty years, there will be a flight into the dollar (another reason why commodity prices will drop for those of us in the U.S.). As badly as the dollar is managed, it will look better than any option (other than gold, maybe). Eventually, the damage done to the U.S. economy will be apparent and the dollar will lose strength. Still, when considering the alternatives, no other currency will look stronger. We are now seeing the weakness of the Euro. Bailing out a couple of Euro zone countries with new loans only broadens those who must suffer under the debt burden. Analysts do their calculations and bemoan the apparent fact that there is no way out for an economy with so much debt. Opening up their economy so that it can actually be productive never enters into their consideration.

When is China going to implode? Sooner or later? China is now experiencing some problems with price inflation. For years, as part of the creation of all of that real estate, the Chinese have been expanding bank credit and thus the money supply. They thought that everything was okay until prices began to rise during their “recovery” from the mortgage-backed securities crisis. In response to the crisis, the Chinese government did its stimulus gimmick, spent a lot of money it didn’t have, patted themselves on the back for the apparent recovery of their economy, and now consumer prices are rising. Surprise! Now the Chinese government has to act again. Since interest rates are still very low, they are having to increase the reserve requirement, i.e., banks there, just as they must under our Federal Reserve System, must keep a percentage of their deposits in accounts at the central bank. The higher the reserve percentage, the lower percentage of loans a bank can have outstanding. The Chinese central bank has now increased that percentage for the third time in the last few months. Further, officials in China have placed price controls on certain items, which as anyone knows, does not work. So we are now seeing some significant cracks in the Chinese economy. I don’t know if these cracks are sufficient to cause the bust, but they are at least the beginning. We can look forward to Bernanke like statements about how there is no problem, how the problem is small, then that the problem is only in one sector, and then how the Chinese government saved the world from another evil consequence of capitalism. Plan on it.

What we can do is to start telling people ahead of time what they can expect to see, especially the “capitalism did it” excuse. Maybe fewer people will believe it this time.