Long on China, Short on the United States

after10

Long on China, Short on the United States
http://mises.org/story/3293

Mises Daily by Tim  Swanson Posted on 1/20/2009 12:00:00 AM        

The year is 1969. Chairman Mao is beginning to construct undergroundescape tunnels throughout Beijing and anticipates a Soviet invasion andbombardment within days. The PRC has just detonated its first hydrogenthermonuclear device in Lop Nur and the countryside is seething in abook-burning cultural revolution. To many foreign observers, the end ofChina is imminent.

The year is 1979. Soft-spoken minister Deng is quickly drawing upagricultural-reform plans to prevent widespread famine and to stymiecivil unrest. Border skirmishes between the PLA and Vietnam turn into ahot war involving tens of infantry divisions. Total foreign investmentamounts to a mere $800,000. To many foreign observers, the end of Chinais imminent.

The year is 1989. Perestroika-minded Gorbachev visits Beijing torepair diplomatic dialogue. International media outlets cover thebilateral event while thousands of students simultaneously occupyTiananmen Square.[1]By the end of the summer, tanks roll through the city and multinationalbusinesses leave once again. To many foreign observers, the end ofChina is imminent.

The year is 1999. President Jiang continues reforms and privatizesthousands of state-owned enterprises putting more than 4 millionChinese temporarily out of work.[2]Currency collapses sweep across East Asia smothering South Korea andThailand. Industry leaders such as Daewoo go bankrupt. The IMF lendstens of billions of dollars to several emerging countries as theirstock markets crash. During this period, China's GDP drops more than2.5% as exports slow. To many foreign observers, the end of China isimminent.

The year is 2009. China's GDP growth slows to an unimaginable 5%.Exports to the developed world nearly stop as demand shrivels into thesingle digits. Half of all toy-exporting factories have closed, sendingtens of thousands back to their family farms. [3] Many foreign owners have quietly left the factories, leaving behind unpaid workers.[4]Mainland stock markets continue to dip as listed firms repair balancesheets and account for losses from overseas investments. To manyforeign observers, the end of China is imminent.

Another decade, another purported crisis in the Middle Kingdom. Thesame exercise can also be done in the reverse, starting with the fiery1960 Nixon-Kennedy debates involving the Taiwanese Strait Crisis or the1948–1949 civil war or even the Japanese invasion and occupation of the1930s. Yet time and again, China somehow manages to survive.

Over the course of more than 5,000 years, it has endured everyimaginable crisis — both man-made and natural — and will undoubtedlysurvive this latest man-made disaster.

However, once again, to many foreign observers, such as Time magazine, the end of China could be imminent.And mainstream pundits such as Nouriel Roubini and überbear Marc Faberforecast a "hard landing" for the world's most populous nation.[5]
Yet the truth of the matter is, no matter how hard or soft China'srecession will be, the West and in particular, the United States, willbe hitting every limestone rock across Mount Everest's northeasternface and then will continue tumbling across the Tibetan plateau. And ifthe next administration plays its cards right, the United States couldvery well end up in the Challenger Deep instead of just the TurpanBasin.

Saving Itself Out of a Recession
Arguably, the worst thing that could happen to China this time around is a growth recession similar to Japan's in the 1990s.[6]No Zimbabwe. No Argentina. No Weimar. No Iceland. No United States. Infact, commentators such as Joseph Salerno and Peter Schiff have notedthat, despite its spendthrift government and zero-interest rates, Japanmanaged to still grow and (relatively) thrive because of its enormousdomestic savings, current account surplus, and robust manufacturingcapacity. [7]
Likewise, the average Chinese citizen not only has little debt but actually saves more than half of his annual income.[8]Student loans, auto loans, and credit-card loans are as plentiful aspurple pandas. Very few municipal or provincial governments are runningdeficits. Oh, and home equity — what is that?

Yet according to the NY Times, this fiscal responsibility is a bad thingand is the root cause of the current crisis. The Asian people saved toomuch money, lent the United States and other Western governments moneyat cheap rates, and therefore created an asset bubble.

This increasingly popular line of reasoning was reiterated in a recent episode of Dialogueon CCTV in which two American professors, Michael Pettis of PekingUniversity and John Attanasio of SMU, noted that in 1998, Americansbegan spending and shopping like never before. Pettis suggested thatAmericans were funded in part by Asian countries, which, havingexperienced a calamitous financial crisis in 1997–98, sought to parktheir savings in safe havens (e.g., US Treasury bonds). As a result,this immense savings distorted the marketplace and caused the ensuingbubble.[9]

Rewriting the Narrative
In the current frenetic marketplace, it has become all too clearthat methodology is still important to effectively analyze the healthof relative economies. As noted above, numerous outlets, including CNN and Bloomberg, have had front-page articles highlighting the purportedly faltering economies of Asia, in particular China.
Several of the articles have noted that in places like Guangdongprovince — the world's manufacturing basin — factories are closing bythe hundreds and in the process laying off thousands of low-skilledemployees. Bloomberg recently notedthat in the past 11 months, more than ten million workers have losttheir jobs. China's once perpetually smoldering steel mills have cutback on ore orders from Australia, and even bottom-dollar scrap metalfrom Japan goes unsold to the dieting Chinese.
The commentators are also quick to note that declining exports —measured in the form of lower cargo tonnage — illustrate a deleterioustrend that will only increase as Western consumption continues to dryup.

To make matters worse, the commercial-construction bubble haspopped, with property sales dropping precipitously, as much as 40% inlarge coastal cities like Shanghai and Shenzhen, and even 55% inBeijing.
And if things couldn't be any more dreadful, China's two main stockindices have each lost nearly two-thirds of their value since theypeaked a year ago.
Clearly China is in for a world of hurt, and the first solution isto implement a universal car-ownership scheme, build hundreds ofaircraft carriers, and reduce interest rates to zero across the board.

Thus, in a Keynesian framework, the Chinese save too much, spend toolittle, and are destined for low economic growth. Furthermore, in aKeynesian world, entrepreneurs going bankrupt are a sign that marketsare failing.
Maybe not.

Grossly Distorted Plans
Let's assume that GDP is an accurate measure of growth.[10]

Let's also assume that analyst Marc Faber is correct that China has been fudging its GDP numbers and didn't grow at 9% in the third quarter.

Instead, let's assume that China's growth rate over the past yearhas been 0%. What does the future hold? Can it grow or is it bound forthe abyss?

Looking at the fundamentals from a Keynesian perspective, theChinese should stop saving immediately and spend everything they haveon bridges that dead-end into Himalayan mountains. Construct an armadaof unsound merchant vessels. Erect colossal monuments that consume vastresources and spur economic activity.

However, from the point of view that savings in capital investment is the true catalyst for wealth creation, China is head and shoulders above its Western counterparts.
For starters, Chinese residents typically did not get involved inexotic financial derivatives or purchase Humvee's on credit. Chinesebanks, however bloated and inefficient the West tries to paint them,required 20–30% down payments on houses, and two-thirds of all loansare funded by deposits (as opposed to capital markets in the debtorWest).

Furthermore:

•      Household debt in China amounts to roughly 13% of GDP, as opposed to 100% in America.[11]
•      Asshown by the IPO of China Railway, the government remains committed toprivatizing state-owned firms. This at a time when many Westerngovernments are nationalizing entire industries.
•      China continues to implement land reforms.[12]This includes granting land-use rights to peasants, empowering them tolease or transfer land to others — a first in a region that onceresembled the collective farms of the Soviet states.
•      Chinahas begun legalizing short selling and margin trading. In contrast,this past year the West restricted their use or selectively banned themoutright in a self-serving manner.
•      China is opening capital markets through QFII and QDII,lowering real-estate taxes and abolishing others like the stamp tax onhome purchases. In addition, Yuan convertibility and capital controlsare being relaxed across the region.[13]
•      Chinahas finally restructured and privatized all of the big national banks.The Agricultural Bank of China (the third largest) recently had itsumbilical cord cut and now must sink or swim on its own. This is theopposite of the direction being taken in the West.
•      Similarly, while the housing bubble deflates, China's political class is not (yet) attempting to prop up the real-estate sector en masse.The Fed and US Treasury are doing everything they can to prevent pricedeflation by purchasing hundreds of billions in mortgage-backedsecurities.[14]

Surely the Chinese are doing something wrong. These shortsighted liberalizations will end in utter ruin, right?[15]

Why Save When You Can Spend?
Senior members of Congress, along with Fed chairman Ben Bernanke,are promoting a new stimulus package, and the White House is looking atalternative ways to get the United States to spend itself out of arecession. Economists Nouriel Roubini and Paul Krugman have eachpromoted $600–$850 billion spending plans, and President-elect Obamahas suggested that deficits won't matter under his administration.

But the problem is, even if they can muster the political votes and citizens' approval, their plans cannot work.

In order to finance the last $168 billion stimulus package inFebruary 2008, Congress actually had to borrow money from abroad.That's right: the package did not come from the vaults of the Treasury,but rather from foreign savers from Japan, China, Russia, and theMiddle East. Politicians took out a loan that has to be repaid bytaxpayers — with interest.

Upon receiving their rebate checks in the mail, many Americansdutifully spent the money as told — shopping at places such as Walmart.Walmart in turn sent a large portion of the monies back to the originalmanufacturers in places like China. And the Chinese in turn used themoney to buy more US Treasury debt.
Without the Chinese, the United States would not have had any kindof temporary stimulus. Without the Chinese, the United States would notbe able to finance its large deficit.

And without a healthy China, the United States cannot hope to finance yet another round of faux stimulation.
In fact, blinded by Keynesianism, rather than thanking the Chinese for building and financing the faux American dream, some have chastised themfor saving too much, claiming that it was their high savings rate thathad to be invested somewhere that created the artificial credit bubblein the first place.
This fully ignores the role the central bank played in artificialinterest rates and the part various federal housing agencies played indistorting the marketplace. It also fails to acknowledge the rolesavings has in economic growth.[16]

In the event that a new stimulus plan is sped through Congress,unless it includes cuts to federal spending or tax increases,foreigners will once again fund it.
At least until foreigners get tired of the same rinse cycle and refocus their funds outside of the United States.

Emerging on Top
As noted above, in the past year at least 67,000 factories across China have closed down and hundreds of thousands of migrant workers have moved back to family farms. [17]While this phenomenon may be painful in the short run, the Chinese areat least allowing bankruptcy to clear out ineffective business models.[18]
In the United States, failure is no longer an option. In fact, more than $8.5 trillion dollars are being used to prop up catatonic firms such as Citi, Fannie Mae, Freddie Mac, and AIG.

As a result, in the long run, China as a whole will be able to adaptto market conditions and prosper because sick companies will have beenexpelled from the marketplace and capital will be reallocated to themost efficient participants. Conversely, because the West has given upon bankruptcy and the freedom to fail, they will continue to flounderas they prop up poorly managed firms.

Furthermore, the Chinese not only have relatively high householdsavings and relatively low corporate debt ratios, but the governmentcontinues to privatize state-run firms and allow them to go bankrupt. [19]

Thus the only unknown factor for the future is just how much damagethe Fed will do to the US currency, potentially driving away foreignholders of dollars.
If history is any guide, while China may be faced with uncertaintyonce again in 2019, it is backstopped by a nearly $2 trillion foreignreserve and solid financial ground. The same cannot be said for theUnited States. Perhaps foreign observers should take note.

Tim Swanson is a graduate of Texas A&M University and currently lives in mainland China. Send him mail. See his article archives. You can subscribe to future articles by this author via this RSS feed. Comment on the blog.

Notes[1] For an alternative explanation regarding Tiananmen Square in 1989, be sure to read "China and the New Cold War" by Justin Raimondo.
[2] Depending on the study, it is estimated that between 1994 and 2001 up to 65 million Chinese government workers were removed from "iron rice bowl" positions. For more, be sure to peruse the "Grasping the large and letting the small go" policy. This is tangentially covered in "The Peaceful Rise of China."
[3] See "Chinese toy firms forced to close" from the BBC.
[4] See "China's bosses are abandoning ship" in the LA Times.
[5] One sinophobic analyst, Paul Krugman, has remained relatively silent regarding China's short-term future, while in the past he has railed against their economic investments. For instance, three years ago he complained that China wanted to purchase oil giant Unocal and believed the federal government should block the sale (which it effectively did). See Alex Tabarrok's thorough debunking of Krugman's sensationalism. Furthermore, this past year Krugman lamented about increased prices of imported goods from China — that American's would have to pay more for China's "inflation." This wholly ignores the large amounts of inflation the Federal Reserve produces each year and exports to other countries that maintain dollar pegs. Not that any central bank should exist, but his lamentations are entirely one-sided and hypocritical.
[6] It is almost impossible for China to end up like Japan. For starters, Japan's government racked up large amounts of debt equal to 180% of GDP. China's external debt is roughly $350 billion or about 10% of nominal GDP. Furthermore, the Bank of Japan lowered and kept interest rates at zero for years. While the People's Bank of China has indeed lowered rates, the main one-year lending rate is still above 5%. Plus, while the average savings rate in Japan has dipped to 8–10%, the Chinese savings rate remains solidly above 50%. See also "China's economic problems are short term."
[7] Joseph Salerno discusses the Japanese experience in a recent podcast. The reader is invited to view copious video interviews with Peter Schiff and Jim Rogers, both of whom discuss Japan in the 1990s. See also The Concise Encyclopedia of Economics entry on Japan by Benjamin Powell.
[8] Between the years 1978 and 1996, the average Chinese savings rate was 37%. This has increased steadily, hitting 52% in 2006, where it currently remains. In 2005, the US savings rate dipped below 1%. According to the New York Times, the average American only has $392 in savings and thousands of dollars in credit-card debt. The average US household also owes $117,951 on items such as a home mortgage, car, and student loans. See also "Growth-Financial Intermediation Nexus in China" from the IMF.
[9] By irrationally blaming the hand that feeds them, these academics are making sure that no one from China ever again saves or invests money in US-based monetary instruments because China does not have to invest in the United States to grow. Furthermore, neither the US government nor its federally controlled housing agencies had to spend that money. In fact, the government could have paid off its obligations and maintained a balanced budget. Instead, it spent it all and continued borrowing. And it is pure balderdash to insinuate that the flood of Asian savings somehow coerced the Committee on Ways and Means to appropriate billions in extra liabilities. No one in Asia pointed a gun at Larry Summers, Paul O'Neall, Dennis Hastert, Bill Thomas, or anyone and told them to spend the money. And as incredible as it sounds, current US policy makers and many academics will soon find out what the alternative is: no Asian money means no deficit spending. It also means no one is going to buy mortgage-backed securities or bonds backed by credit-card debt or auto loans or college loans.
[10] The main problem with emphasizing GDP is that it only measures aggregate movements of money and cannot measure whether the consumption is efficient or productive. Hence, one of the problems with any stimulus plan is that many policy makers simply look at steps to increase GDP in the short run and ignore the long-run implications — the unseen consequences of policies. For example, building pyramids could indeed boost GDP; however, there is very little economic utility gained from building pyramids. See also "What is up with GDP" by Frank Shostak.
[11] See "Reflating the dragon" and "Domino or dynamo" both from The Economist.
[12] Not only has China privatized land ownership, but they have also signed seven free-trade agreements (FTAs) and continue looking for ways to liberalize trade barriers (e.g., Peru). While I have criticized FTAs in the past, the current political class in the United States has all but given up on implementing them or discussing their philosophical merits (e.g., Columbia, South Korea).
[13] See "China sets out to make Yuan an international currency" in the Times of India.
[14] The Fed alone plans to purchase up to $500 billion in MBS through June 2009. It recently began fulfilling outlays during the week of January 5, buying $10.2 billion in such assets.
[15] To be evenhanded, I should note that Chinese policy makers are set to bail out local airlines, relax bank lending standards, and have promised to expand the monetary base by 17% this year (up from 14.6% in 2008). They have also removed quasi-market-driven gasoline pricing and replaced it with a percentage tax. Yet despite these artificial interventions, the underlying fundamentals of both Chinese consumers and corporations (high savings, low debt) should still prevent China from collectively facing the same negative conditions that the UK, Japan, the EU, or the US will in the coming years.
[16] Both Bob Murphy and Robert Higgs have recently noted that the Fed has created an inflationary storm that will unravel in the coming years. Holders of US Treasuries will lose value and would therefore have an incentive to dump the assets. See the "Bailout Reader."
[17] Bloomberg recently noted that up to 20 million Chinese workers may lose their jobs through this year. In a country in which roughly 60% of the population still live and work on rural farms, it is arguably plausible that those temporarily made redundant will be quickly absorbed back into agriculture life — just as those who lost jobs in the late 1990s were.
[18] For a contrarian look at the three decades of China's reforms, be sure to read "Private Ownership: The real source of China's Economic Miracle" by Yasheng Huang.
[19] See "China's economic fundamentals 'in good shape'" by Xinhua News.

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