By Patrick Garot – 26 March 2009
The market sure picked up since my March 4 (here) and March 9 posts (here). If you've played along, it is time for you to harvest some rocket gains… but that is not the subject of this article.
Instead I will discuss China. I like James Quinn's diarizing on America's fade-out (here) as brain food, but I just don't see it. The question is leadership. What another nation can lead?
Well, Europe has not come to terms with flailing banks (see Harrison's post here). Japan continues on its real, demographically-driven, low demand fade-out. Oil rich Middle Easterners invest, but don't invent. Korea and Taiwan are small, and hurting on export declines.
Some think that this leaves China (see here) to lead the world into the future. But China can't lead, and won't for decades, if ever.
The Bottom 80%
Consider the USA in 1965. Manufacturing hums along. 160 million folks, most productive and decently educated. A growing service sector, expanding institutions, prosperity. Now add an event whereby the US expands its borders to encompass all of poor Latin America and Africa. Then strip out those regions' natural resources, and you have China today.
China has 1.3 billion people. While 562 million (42%) are listed as "urban", in truth there are 180 million in the metro areas that wow westerners – but a third of those are in slums and shantytowns that most westerners don't see. The chart below gives you estimates of life in China for the bottom 80% -- on a purchasing power parity basis, this 80% average $11.58 per day to fulfill all of their needs.
The truth is that China is two nations. One is booming, fast-moving and sophisticated. The other copes with a poverty equivalent somewhere between today's Laos, Syria, and The Congo – except without the natural resources of those nations, as much of western China is non-arable desert or mountain.
No Domestic Demand
China's bottom 80% earns $4.48 per day in USD: peasantry amounts. After food, shelter and education are paid, less than $2 is left for "desires" that are often priced in dollars – say, an iPod or a netbook manufactured in China.
China's elegant solution since Deng was to mimic early Asian "tigers" with an export-led tide. Thus the bottom 80%'s per-capita income grew from $1.65 per day in the early 1990s, to $4.48 today. Deng's solution worked.
But China can lead? Nations that can lead must be strong inside and out. And Deng's solution hinged on two things: the assent of Western nations to buy stuff made in China, and cheap labor, from attractive currency rates.
A Manipulated Currency
In January 1990, the Yuan was Y4.73 to the dollar. By January 1994, the Yuan was cheaper at Y8.47 per USD. From 1994 all the way to December 2006, the Yuan stayed above 8 to the USD. Since, the Y/USD rate has been managed down -8% in 2007, and -7% in 2008, to Y6.83 today.
China's economic growth has been a Faustian bargain. The BoC manipulated forex so the Yuan stayed eight to the dollar even as the China-US trade imbalance grew tenfold. Exports sucked out dollars from the US. Now China had to offload dollars, so it bought the "safest" dollar-denominated assets like Treasuries and Fannie and Freddie CMBS, to keep this great game – or Ponzi scheme, you could say if you were average Chinese – going.
As Milton Friedman might say: "You get what you get." In Yuan terms, these assets' value has sunk -15% since 2006 just by forex. If our Fed inflates us out of today's crisis, there could be another -15% or more writedown that China will take on US long bond holdings.
Losses on dollar-assets impact China's wealth position, so its economy. "Truth-time" puts forex back to Y4.7 to USD, if not Y3.5. China's instant losses on dollar-assets in that scenario run to 25% of its GDP, or 40% to 45% if Euro-zone writedowns are included. That is, China would get the same wealth haircut the West just got – but China's agony would be worse, with its less developed, less balanced economy.
China has no solution to its self-inflicted "bubble" of manipulated forex. Keep managing the Yuan, hope Western demand returns, then have to pour good money after bad into the West. Or let the Yuan float, take a massive wealth hit, then watch Western firms unbolt every Milacron from every factory floor, as labor unrest takes hold.
The People's Party
A client of mine wintering in Europe is insufferable. When I ask what the vibe is on the streets of Paris, Berlin or Zurich, he says: "They don't know they're in trouble yet, their government hasn't told them."
It's worse in the PRC. The average under-informed Chinese depends on government to direct, manage and assume the risk for everyday life (except healthcare, for which Chinese families must hoard cash).
There is a great misunderstanding of the People's Party. The Party is Populist. It bows to the bottom 80%'s needs above all. But the Party is not monolithic. Current leaders must do what is "good for the people" (the 80%), or more populist figures gradually assume power, and quietly remove the old guard. Deng was such a figure, a master in orchestrating this dance.
Can the Party let banks and state-run firms fail? Many should be failing now: if they marked down their dollar-assets, Shanghai real estate, and loans to 50%-utilized factories, hundreds would fit any definition of "insolvent". But in the Party's China, this cannot happen. If the banks go under, the jobless grow too many, new, more Populist leaders will emerge. And power within the Party is everything in China.
So current Party leaders are in the hind-end spot of following the west, and hoping for our recovery. There's nothing else for them. BoC Governor Zhou's call this week for a new "world reserve currency" to replace the dollar (here) is only a bleat from the Party's future sacrificial lamb.
Law and Education
Anyone who does business in China will tell you contracts mean little, judges reflect the Party, and it is a land of a hundred excuses, lies and slights veiled as misunderstandings. Rule of Law means nil. As much as we in the West seem to invent laws everyday to cope with this crisis, we still adhere to process. And when even process gives out, there remains the ballot box. Not so in the PRC.
China's education system is producing a wealth of technical professionals like engineers, but to look at abstract numbers lacks context. China does not produce the smartest or most creative of these, nor does it produce a large share relative to its 1.3 billion population. In fact, the bottom 80% are under-educated: only 9 years compulsory education is provided. China spends just 2.5% of GDP on education, ranking it 155 out of 182 nations. Contrast this to Argentina's 3.8% or Brazil's 4.0%.
Historical Precedent
In 1989, Sony Chairman Akio Morita published "The Japan That Can Say No" (here), which asserted that the West depended so much on a "smarter" Japan, that all Japanese should shed views of their country as a "poor island nation with few natural resources", and embrace their own "innate superiority".
We saw how that movie played. Trade runs two ways. In Japan's case, its hoard of dollars led to a giant asset bubble and two lost decades. In China's case, its dollar and Euro hoard may find a different path, but the outcome will be the same. Huge overpayments for in-vogue assets of the day (for the Japanese, Columbia Pictures, Rock Center, Pebble Beach; for the Chinese, natural resources firms).
It's called "trade" for a reason. A manipulated currency, a one-way street, comes back to haunt.
China Can't Lead
For each photo of the glitzy Shanghai Bund, imagine six photos of Mexico, Kenya or Cambodia beside it. Such is the PRC that the Chinese know – 14% glitter, 86% hardship or worse.
China has wealth in sheer numbers, but since most folks subside in poverty, this wealth is opportunity, not reality. China and its Party remain reliant on the ability and assent of other nations to raise the tide for its bottom 80%.
While we can expect a rotation that has China trading more to resource-rich Latin America and Africa, China's biggest markets still will be where the numbers are – the US and Western Europe – for decades to come.
China can't lead because it is mostly poor. It can't lead because its snarky forex plan haunts it. It can't lead because of its Party's dynamics. It can't lead because, like Japan before it, it has yet to learn that "trade" isn't run as a scam, but goes two ways.
Which, in the case of a few Chinese engineers I've used, means actually paying for their copies of Office and Autodesk… too much to ask? When that happens, I'll know the Chinese century may be beginning.
