China Bubble Redux
I recently posted on what could go wrong in China from a macroeconomic perspective, linking over to DiligenceChina blog. We got some good feedback from readers here, especially the wise comment by Mr. Li, but I want to highlight a new post worth reading on the topic.
The post, written by Vitaliy Katsenelson, VP with Investment Management Associates and a teacher of equity analysis at the University of Colorado, entitled, "The Great Bubble of China?" posits China is "living through one of the greatest historical bubbles."
Katsenelson sees China as a manufacturing country built with high interest debt. He sees China's fall occurring due to factory overcapacity, a rise in the cost of money, and/or a slowing U.S. economy. Kastsenelson even has titles for the books he sees being written after the fall: 'The Chinese Conundrum' or 'The Great Chinese Bubble' or 'Irrational Exuberance 2.' The author's investment advice is to take your money out of commodities and to forget about investing in Chevron (CVX), Exxon Mobil (XOM), or Conoco Phillips (COP). Katsenelson equates the idea that all companies need a China strategy to the idea in the late 90s that all companies needed an internet strategy.
Call me part of the bubble, but I disagree with Katsenelson on all points. China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising and even if they were not, I could see manufacturing tailing off and stabilizing, but I cannot see it crashing. If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Phillippines come to mind), and China has no industries to replace it, labor costs will stop rising. On top of this, China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Phillippines) infrastructure creates real value for manufacturers.
I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China. Secondly, the U.S., though obviously of huge importance to China, is not everything. Thirdly, though I do believe there will be a slowdown at some point (there has to be!), a slowdown is not a crash.
It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?
Comments, as always, are very much welcome.
Comments (8)
Read through and enter the discussion by using the form at the endJoseph Wang - September 9, 2006 8:57 PM
I think I mentioned somewhere is that the remarkable thing is that finance people tend to be China-optimists whereas management people tend to be China pessimists. I'm still not clear why.
Anyway the problem with this analysis is that if the US stops being a source of demand for Chinese products, there are huge untapped domestic markets that can take up these products. China is still a developing country unlike Japan in the 1980's, so these analogies aren't too useful.
China Law Blog - September 9, 2006 11:40 PM
Mr. Wang --
Thanks for checking in. Interesting point you make about the finance versus the management people. I can say that it would be very difficult to find any Westerner impressed by Chinese management of their companies. Maybe that is why.
I agree with you that China is a huge untapped source of demand for Chinese products, but I think the shoes of the U.S. would be too big for the Chinese consumer to come close to filling, at least in the short term. But we also have the EU, the rest of Asia, and even Africa and Eastern Europe to assist.
Paul Denlinger - September 10, 2006 8:25 AM
The Chinese economy is gradually becoming less dependent on the US economy and US consumer by increasing domestic consumer demand; this is a move which is fully supported by the US treasury secretary Harry Paulson. Compared to other exporting nations such as the four dragons of the past, China and India are different in that they have large and growing domestic middle classes which eventually become their engines of growth, replacing exports.
In comparison, the US middle class is getting crushed, and is fragmenting into an upper class, which is dependent on investment income, and a lower middle class which lives from day to day, and can get pushed over the brink by illness for example. Within the past five years, the number of Americans which have been forced into medical bankruptcies has skyrocketed, just to cite one example.
It is ironic that these changes are being pushed by Republican and Democratic policies; the Chinese government would not allow these policies out of fear that they would lead to social unrest. What Americans have allowed to happen, Chinese would likely rise up in rebellion against.
Both China and the US face significant challenges, but the risk is carried by different parts of society. Because of financialization and deregulation of the banking industry in the US, manufacturing is taking a smaller part of the US economy. The US financial sector makes money by moving money around, and contributes 44% of profits in the US, while manufacturing only contributes 10%. This means that the US consumer is ever more important to the health of the US economy as a whole, and many Americans are very sensitive to changes in interest rates.
In contrast, Chinese consumers are much healthier and have significant savings (unlike many Americans, who have negative asset value). The Chinese government is trying to walk a fine line; it needs to stimulate domestic demand and spending, but it does not want Chinese consumers to become victims of predatory banking practices, as has happened in the US.
As for the increase in manufacturing capacity, a great deal of it has to do with the decrease and downsizing in manufacturing capacity in the US.
In a globalized world, it makes no sense to analyze any national economy on its own, especially economies as large as the US and Chinese economies. Analysis of any economy on its own fails to take into account the very complex matrix of relationships and dependencies which govern the world now.
David Li - September 10, 2006 9:37 AM
If we look at the bubble as the investment frenzy and investors end up losing their shirts, China is definitely going to be one of those bubble, much like the railroad bubble in the US at the turn of twentieth century and the Internet/Telecom bubble in the turn of this century. Investors lost a lot but contribute to build up an infrastructure that enable the later transformation of the economy. Once the bubble bust, the assets were written off but they have already been layout. Railroad transform the American West and connecting the states to create a true American economy. The Internet/Telecom bust layout the fiber channels around the world which enable the outsourcing and off-shore and create a true global economy. Thomas Freeman's "The World is Flat" really takes about the transformation of the Internet/Telecom big bang. Well, bubble bust for the American investors but big bang for India, China and Russia.
So, what if China is a bubble? Currently, 21 of the 25 major industries in China are controlled by foreigner companies. China may have produced 70% of the shoes for the world but they are marketed under the names Nike and other global brand. Wal-Mart buys 10% of the Chinese output and has it global procurement center set up in Shenzhen China. The auto industries in China are VW, GM, Toyota and other global brands. 90% of Desktop and 70% of notebooks are made in China but they are AMD/Intel inside. The major investments come from the suppliers to these big global supply chain. Unlike Japan's exporting to US under the names like Toyota and Sony, China's exporting to America are through Wal-Mart. The poorer American become, the more demand for Chinese goods.
So, what's will an foreign investment bubble done for China? We may start to feel this in auto industry by the end of the decade. Fueled by the optimistic outlook of Chinese car growth, GM, VW and others have invest heavily in China through partnership with companies like Shanghai Auto. The auto market in China doesn't grow as expected so what do GM or VW do? Exporting the made in China cars to global market while their governments are bailing them out at home. Things get worse? Their Chinese partners funded by the Chinese government free money start to acquire their assets in fire sale price. The same goes for other foreign investment everywhere in China: foreign put in the money, market doesn't perform as well, the Western MBA educated management cost lose, the Chinese local enterprise gets assets in fire sales price...
Bubble isn't always the bad for everyone. One man's bubble is another man's big bang.
China Law Blog - September 10, 2006 1:59 PM
Paul --
Thanks for checking in. I agree with you generally on the big picture, but I think you overdramatize the differences between the US and China. I do not think it is fair to tout the Chinese middle class and act like the US middle class is disappearing. Yes, I agree the US middle class is shrinking, but it is still here. In thriving cities like Seattle (where I am) and Portland (where you are) the middle class is definitely getting squeezed. But there are still huge swaths of the country (Peoria, if you will) that are still overwhelming middle class. China, on the other hand, still has approximately 900 million people who have yet to make it into the middle class.
I do like your point about how it is getting increasingly difficult to view an economy, even ones as large as the US and China, in isolation.
China Law Blog - September 10, 2006 2:01 PM
David --
Thanks for checking in. I like your point about how even if China is a bubble, what is happening now will, in the long term, still be a good thing. I also have trouble viewing China as a bubble when there are still so many people in the country who have yet to even really be touched by the Chinese miracle.
Brendon Carr - September 10, 2006 8:09 PM
Dan, I can't dispute that China's legal infrastructure may be, surprisingly, better than Vietnam's or Indonesia (a well-known judidical hellhole)'s. But having worked with Malaysian companies and Malaysian lawyers, I would dispute the characterization that Malaysia is behind the curve with China. Malaysia (and Singapore) inherited the English common law in 1948 and now has a well-developed (and accessible) jurisprudence and legal profession. Company and commercial law, in particular, is so very familiar to us English-speakers who dominate world commerce that I would count the Malaysian and Singaporean legal systems as their competitive bulwark against the rise of China.
China Law Blog - September 10, 2006 8:50 PM
Brendan --
Thanks for checking in.
I agree with you on Malaysia. I wrote too quickly and I stand corrected. I have deleted the part on Malaysia legal from the body of the post. Thanks for catching this.