Seven Troubling Trends

Seven Troubling Trends

Table of Contents

Preface: Then and Now

Introduction: China’s Lost Chances and its “Unthinkable” Future

China’s Amazing Growth Story

China’s Elite Are Worried- Should You Be?

Storm Clouds are Gathering

The Seven Domino Trends Confronting China’s Leadership

Domino Trend #1: Investment Returns Are Falling While Economy Slows

Domino Trend #2: Property Bubble is Popping

Domino Trend #3: Wages and Cost Soaring=Low Margin Exports & Manufacturing are Losing Edge

Domino Trend #4: China Calculus of European & American Multinationals Changing Fast

Domino Trend #5: China’s Primitive & Complicated Financial System is Leaking Oil

Domino Trend #6: Hopes of Consumer Boom Are Fading

Domino Trend #7: Endemic High Level Corruption is SparkingMass Protests

The Endgame: China’s Bicycle Economy Running into a Storm of Slower Growth and Rising Corruption and Protests

Risk Management & Recommendations

China in Charts

Preface: Then and Now

More than two years ago, I wrote the first draft of the “China Skeptic” report which provided an overview of seven troubling trends in China that I thought could lead to the collapse of the Chinese communist regime.

I remember sending the draft to a very respected and influential publisher. His first words to me when we later met were:

“Carl, you make a very compelling case here but no one will believe that China could collapse.”

That was then. Now as I look back three years later, the seven troubling trends outlined in the “China Skeptic” have deepened beyond even my expectations.

China auto sales fell 3.4% on a year over year basis through June. Electricity production fell 2.0%, merchandise exports 8.3% and retail sales 10.5% year-over-year through July.

Industrial activity is weakening. In February, industrial production growth came in at just 6.8% year-over-year according to March report from China’s Bureau of Statistics. This is down from a February 2007 pre-global recession growth rate of 18.5%.

In the U.S., factories are running at roughly 80% of their capacity, while in China, it stands at 70% according to a Federal Reserve report from March 18, 2015.

Capital continues to flow out of China at a rate of $35 billion per week as the elite look for escape hatches.

Debt, both consumer and government, quadrupled since 2007 to reach $28 trillion. Last month, McKinsey & Company released a report on global debt levels and noted China’s debt-to-GDP ratio stands at 282%, higher than America or Germany. These debt calculations not only include government balances, but also those of households and non-financial corporations.

Property prices continue to struggle. The latest home prices report for China’s largest cities shows that 61 out of the 70 major city centers experienced price declines. The housing market in China makes up about 25% of the economy.

The pace of foreign direct investment into China is declining as foreign multinationals pull back and Chinese economic growth slows. In fact, direct investment by corporations in China in 2014 was less than that invested in Southeast Asia.

The much-anticipated Chinese consumer economic boom has not materialized. In the first quarter of 2015, new auto sales in China actually declined year over year.

China continues to pursue a confrontational foreign policy with its neighbors, even going to the extent of building artificial islands with military capabilities in international waters.

The real estate and stock markets continue to be volatile and manipulated. The latest sharp pullback in the Shanghai index – 30% in three weeks have rattled investors and the Chinese mandarins alike.

The Chinese government has responded in typical fashion; banning short sales and shutting down trading in more than half of stocks trading on the exchange. China’s own government tried to force prices higher by purchasing shares in large companies.

While I have gone back to each section and made updates to each section of this report, I have decided to stand behind my early thesis.

I encourage you to read on and decide for yourself about the future.

“This could be the early stage of a very serious situation,”

Larry Summers, former US Treasury Secretary

Be Very Afraid of The China Bubble

Time Magazine

Introduction:

China’s Lost Chances and its “Unthinkable” Future

I remember the meeting of the Asian Development Bank’s board of directors in the spring of 1992 very well. Representing the U.S. during a review of a Chinese finance sector loan, I asked what I thought was a straightforward question; “Wasn’t it time for China to begin privatizing state-owned banks and companies?”

After a pregnant pause, the attack from the other board members began. “Why was America always so impatient?”….. “These things have to be done slowly and carefully”, and “The Chinese will develop a privatization plan that suits their needs and culture”.

Well, here we are twenty years later and China remains a semi-market state capitalism model.

One half of Chinese work for the Chinese government or for state-owned or controlled companies. One quarter of state-owned companies are unprofitable and state-owned companies grab 90% of bank lending. The top five state-owned banks control 80% of total bank lending.

China has had so many lost chances.

China had the choice to set itself on a path to sustainable growth but instead chose a strategy of overdependence on investment and exports.

China had the choice of balancing growth with protecting the environment but instead chose growth at all costs.

China had the choice of using trade surpluses to provide a safety net so that rural Chinese could avoid saving 30% of their household incomes but instead chose to let reserves grow to $3 trillion.

China had the choice to put in place basic institutions such as an independent judiciary, a transparent process to transfer power, a free press and bankruptcy laws to support growth but instead avoided any reforms that might weaken the authority of party leaders.

China had the choice to, like Singapore, take a hard line on political corruption but instead looked the other way as business and politics became one and the same.

China had the choice to open its markets and become a champion of free trade but instead chose a policy of state mercantilism welcoming foreign capital and know-how but protecting access to markets.

I could go on but the point is that all these choices by China have important consequences. The Chinese like to portray themselves as patient strategic thinkers looking ahead centuries as others look at years but the facts dispute this view.

To be blunt, China is now unfortunately set on a path to deep disappointment, great uncertainty and perhaps upheaval.

This is the inconvenient truth about China that you will likely find unthinkable.

You have likely seen hundreds of newspaper headlines about the scary euro debt crisis and predictions of a coming American debt and dollar crisis. And article after article about how the China juggernaut will eclipse America and rule the world or at least dominate Asia.

Meanwhile, I have long been a China skeptic.

While giving the Chinese people enormous credit for their shared success, I question further progress without significant economic and political reform.

And while I have been deeply involved in Asian financial markets for thirty years, the first key to my understanding of China’s dim future is that I am not a China expert.

My introduction to Asia was through Japan in the 1980s where I was a student at Sophia and Keio University and then worked as an investment banker. This was a time that everyone, and I mean everyone, thought that Japan would dominate the world economy forever.

David Halberstam included in his book The Next Century the following passage from a speech he gave in early 1989 before the fifty governors of the United States:

“If there were any purely economic model for the future, it was the Japanese.”

Later that year, Japan’s stock market hit its peak and then both stock and property markets fell apart. The Japanese stock market is trading today at only 1/3 its peak and its GDP is back where it was in 1996.

I saw the flaws in Japan’s investment and export economic model, its property bubble, and its old boy banking system. This prompted me to move out of the market before its bubble economy fell apart at the seams.

The great majority of investors and the financial media elite missed the signs of the Japan bubble becauseit was unthinkable.

But it happened.

Remember the high-flying Asian Tigers of Southeast Asia? I was also fortunate to avoid the 1997 Asian financial crisis when currencies crashed and Southeast Asian markets like Thailand and Indonesia collapsed 65% as debt levels spun out of control. Capital flew out of these countries at a speed that seemed unthinkable to investors.

But it happened.

In 2010, the “Warren Buffet of London”, Anthony Bolton, was lured out of retirement by Fidelity to launch a China special situations fund from Hong Kong. Over his 27-year history of managing money in the UK, Bolton had delivered to his investors an impressive compounded annual return of 19.5%.

Bolton came to conquer China with strategy to capture the country’s rising middle class by focusing on smaller consumer-oriented companies. Given his stock-picking reputation and China’s double-digit economic growth, it was unthinkable to investors that his new fund would be anything but a success.

But after three years of investing, Bolton’s Fidelity China Special Situation Fund’s net asset value is down 17%.

The financial media and corporate elite are completely missing the coming China crisis because it seems unthinkable.

This is why more “experts” are not putting together all the signs that China is encountering considerable turbulence.

It's part ignorance, part politics but maybe it’s just that China may well be sliding into a crisis too unbelievable to even think about.

These financial and political challenges in China will have a far greater impact than what happened in Japan or Southeast Asia. This is because China is far larger and far poorer.

After all, it was Japan’s huge stockpile of savings that allowed it to survive a zero growth economy for two decades. Japan’s culture also kept it together as it weathered tough economic times.

In addition, the increasing complexity of the Chinese economy makes it more vulnerable to shocks. One crack at the wrong time and place can lead to an earthquake of radical change.

This is how Joshua Cooper Ramo puts it in his book “The Age of the Unthinkable”:

“Change in complex systems, whether they are ecosystems or stock markets, often takes place not in smooth progression but as sequence of fast catastrophic events.”

The second key to my seeing the China red flags is that while I have lived and traveled throughout Asia during my career – for the past decade I have lived in independent-thinking Colorado.

This is a long way from Wall Street, Boston and Washington not to mention London, Hong Kong, Sydney, Tokyo, and Singapore where everybody thinks the same and China is viewed as an unstoppable juggernaut.

The irony is that I have lived and worked in all these places.

So recognizing what is happening in China required me to challenge conventional wisdom and my background in a dramatic way.

This is story well worth following because any significant changes in the trajectory of China’s economy or political system will shake the foundation of the world economy and have a big impact on global financial and trading markets. The key is to recognize and monitor seven important trends that will shape China’s future. In many cases, these trends touch and overlap each other like dominoes.

But they do not have to fall.

There is time to make the required changes though I am skeptical that China has the unselfish leadership and political will to make these changes.

And even in the wake of a worst-case scenario for China, like in any financial crisis, there will be many big losers and few big winners.

If you want to be one of the winners, you need to understand what is happening and get your portfolio ready for the financial earthquake before it happens.

Before I begin to explain why the China story is taking a bad turn, I have to warn you.

The data backing these seven China trends affecting a country that many believe is the engine of global growth is disturbing. It is also very much related how China’s leadership responded to the financial crisis of 2008-2009.

I know what you are probably thinking. You've got to be kidding me – the China locomotive running off the tracks?

Yes, this is a very big story that you need to stay on top of.

Before we discuss these troubling seven trends, we need to begin with what fueled China’s incredible growth story over the past three decades.

This is because the drivers of China’s success have become the seeds of its current troubles.

The Amazing Chinese Growth Story

China has had 30 years of tremendous growth.

Just think, when China began to open up to the world in 1978, exports for the full year were equal to one day of exports in 2010

In 1980, China’s economy was the size of the Netherlands, in 2013, it added an amount equal to the size of the Dutch economy.

In 1990, China’s economy was the same size as Taiwan – now it is more than 10X bigger

China’s success is not magic – it has been built on a tested and straightforward formula:

1) Rapid manufacturing export growth fueled by cheap labor, cheap land and foreign investment

2) Huge investments in infrastructure, property and factories driven by cheap capital and foreign investment.

Hundreds of millions of Chinese have been pulled out of poverty and some have been able to accumulate great wealth. This is a great success story. Unfortunately, the recipefor China’s success to date is also the source of its current troubles.

China’s Elite Are Worried – Should You Be?

You would think that with all this economic progress and momentum, wealthy Chinese would be brimming with confidence regarding their country’s future.

The Financial Times, in an article “Chinese doubt the road ahead”, cites a Chinese banker with close ties to a number of wealthy and powerful political families:

“There is a sense that we are approaching an inevitable breaking point, when the pressures in society will boil over and consume the rulers.”

“Almost all the elements are in place for an uprising like we saw in 1989. Corruption is worse today that it was then, people feel they can’t get ahead without political connections, the wealth gap is much bigger and growing, and there has been virtually no political reform at all. The only missing ingredient now is a domestic economic crisis.”

The signs of a nervous elite are clearly out there.

A survey co-sponsored by the Bank of China showed that 60% of those with $1.6 million or more of personal wealth have begun the process of emigrating or considering starting the process. My banker friends say that Chinese companies raising capital offshore are keeping it there – as far away from Chinese authorities as possible.

A study by Bain & Co. shows that these emigration numbers are “rising dramatically”. The wealthy Chinese are snapping up offshore real estate and other investments to protect their wealth. In the Financial Times, Hung Huang, a publishing and fashion mogul says: “You can feel the anxiety of the ultra-wealthy and even of the political elite. They feel there’s no security for their wealth or possessions, and that their assets could be taken away at any time.”

China is burning through foreign reserves at a blistering pace to stabilize the yuan and offset capital flight estimated at $35bn a week. This is automatically tightening monetary policy, squeezing liquidity, and risks holding back the very recovery in China needed to quell doubts.

The Recent Devaluation of the Yuan by China’s Central Bank

The decision in late August 2015 to modestly devalue and loosen the tie between the yuan and the greenback was probably done for a blend of three reasons according to renowned China expert Michael Pettis.

“Improve trade. While China’s current account surplus has been very high, this is mainly because imports have done worse than exports. Both have fared poorly. The numbers were especially bad in July, when imports were down 8.1% year on year while exports were down 8.3%. Because of its peg to the appreciating dollar, the renminbi has been very strong on a trade-weighted basis. The new currency regime may be aimed at reversing this.

Qualify for SDR. There may have been concern that the large and persistent gap between the fix and actual trading in both the onshore and the offshore markets would prevent the RMB from qualifying for inclusion in the SDR basket. What is more, by including a RMB pegged to the dollar, the already overly dominant weight of the dollar in the SDR would be substantially increased, something the IMF clearly does not want.