business acumen and entrepreneurship of the Chinese diaspora throughout the world over the last two centuries is legendary. Why would we not think the same cultural forces would be at work inside China, waiting to be unleashed?
We’ve spent the last two letters acknowledging the rather severe problems China faces. There is no question that one of the greatest real estate bubbles of the last two centuries has developed in China and that it is massively leveraged. Capitalism is generally messy, and the Chinese have created a dragon-sized monster of a mess. The corruption I mentioned in my opening appears to be somewhat rampant, distorting the use of capital in ways that produce uneconomic results. Many of the state-owned enterprises (SOEs) are hopeless basket cases and should be allowed to die, their assets sold off to new owners who can hopefully figure out how to put them to better use.
The banking system has often allocated capital according to political rather than economic ends, and it doesn’t take an economic rocket scientist to figure out what the results will be. There are trillions of dollars of bad loans in the Chinese system. It is quite easy to look at these problems and forecast a rather stark ending.
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When I look at Japan or France (or the US prior to the subprime crisis), I have no problem making a firm forecast, either positive or negative, because I feel I have some understanding of the problems and can diagram a decision tree and ponder the results of possible decisions. As I have noted numerous times, Japan is faced with the rather stark choice of either Disaster A or Disaster B. I can see no decisions they can make that do not end up in economic turmoil. Ditto for France. I am hopeful that the US will use the small amount of time it has left to make the right decisions on entitlements and the budget. I can still see a possible path that could lead to things turning out well.
However, when I look at China, the decision tree is not only huge, it has questionable roots in the data. There are some branches, some paths to the future, that could turn out to be semi-benign. But in China, as in the US, I can easily see choices that will create domestic turmoil and macroeconomic chaos around the world. In both countries, big, hard decisions must be made, but it is not clear that we or they will make them.
In China, Xi and Li, if they stick to their announced program (and it appears so far that they intend to), promise to become the most important and most revolutionary leaders since Deng Xiaoping. What they are attempting to do is no less difficult than the task Deng was faced with in 1978. The problems are just different in character.
No country in the history of the world that I’m aware of has been able to allow a massively leveraged bubble to pop without creating economic turmoil. But then I can’t remember when a country with resources as vast as China’s has tried to proactively manage a bubble. Can a centrally controlled economy (which has never really worked in the long run) pull this off? Can China switch to a consumer-demand-driven, decentralized system without major disruptions?.
The Chinese do have some considerable advantages that should not be readily dismissed. For one they have a highly educated population. The government of the country consumes a smaller proportion of GDP (if you factor out SOEs), relatively speaking, than the governments of any of the developed-world countries do; taxes are relatively low; and the Chinese people are significant savers, far more so than their Western counterparts, which gives them a large capital base for expansion. They also hold a few trillion dollars in foreign capital (which I expect them to use). And rather than spending their income trying to drive consumption, they are spending on infrastructure that is there to be used by their established businesses and entrepreneurs (in contrast to the Keynesian-fueled US deficits, for which we have little to show!).
Further, their consumer market is nowhere close to being optimized. There is massive room for growth in the consumption of all types of products and services, which of course makes China ripe for a burst of entrepreneurial growth to counterbalance the significant deleveraging that will be forced upon them as they try to slowly let the air out of their debt bubble.
Xi and Li seem determined to deal with the corruption that is endemic to much political and business activity in China and to redirect the focus of economic activity from land sales and real estate construction to the production of goods and services. If the absolute rule of law cannot be established, the difficulty of attaining these goals will be significantly increased. Further, they have to allow nonviable businesses and banks to go bankrupt in an orderly fashion without threatening the overall system. That is not an easy task. But the Chinese leadership appears to be taking on the tasks, including labor reforms, that will be required if they are to navigate the treacherous waters in which they find themselves.
And the Chinese must do this as all the major central banks of the world are creating a significant imbalance by holding interest rates far below the Wicksellian “natural rate” and creating all sorts of potential bubbles and malinvestments, while driving currencies to unnatural valuations. China’s biggest problem may be outside its borders as a world devolves into a major currency war and the protectionism that typically follows. As if they don’t have enough to worry about with their own internal bubbles.
To be sure, I can’t see a path that will result in 7.5% annual growth for the next 10 years. That train has left the station. But is there the possibility of more “normal” growth, with the occasional business-cycle recession? If they can continue to unleash the power and drive of their private sector and not continue to prop up failing state-owned enterprises, pumping money into investments that have no final positive economic result, those measures will go a long way to solving the quandary they are in.
As Worth pointed out above, 3% growth for China would require significant realignment of expectations in markets around the world. That outcome would be frustrating for those directly involved but not a disaster for the world as a whole.As I said at the conference, the world needs the Chinese to succeed. The world needs a functioning, growing China that is a responsible member of the global community and a force for stability.
If the Chinese get this wrong, we will face one of the most significant macroeconomic upheavals of our lifetimes. If they get it right, they could continue to be a key factor for global GDP growth.
Every night when we go to bed and say our prayers, we investors should mutter something along these lines: “Now I lay me down to sleep [insert personal requests], and please, God, bless the leaders of China and give them the wisdom to not screw it up.”
This letter is already longish, so there is no time to do more than acknowledge the very real and important geopolitical dance that is taking place in the South China Sea. Many of my friends, when they come back from China or Japan or both, express deep concern that things could spiral out of control. Both countries seem intent on proving something that quite frankly many of us in the rest of the world simply cannot get our heads around. Not to mention the involvement of Vietnam, the Philippines, Taiwan, and Korea, all of which feel they have rights in those waters. And there doesn’t seem to be anyone who can make them all play nice in the sandbox.
There was a time in the history of this letter when we paid a lot of attention to the US subprime crisis or to the problems in Europe or those of Japan. There are still significant negative forces in those regions and elsewhere around the world. But now we must begin to pay close attention to China. How the Chinese navigate their problems will have significant impact on our economies, our businesses, and our investments. For the macroeconomic world at large, there are a LOT of balls in the air. Unlike in 2006, when everything was just fine, there are now plenty of topics available for future letters. Shoot me a note with your suggestions. I do pay attention.
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For the last seven days I have been pleasantly surrounded by the Tuscan countryside. The weather’s been perfect, and the conversations in the evening have been both enthusiastic and enlightening. I can’t tell you how much I’ve enjoyed spending the last six days with George Gilder. Not only is he a fount of intellectual insights, he is a never-ending source of great stories. I have to rank him right up there with the all-time great raconteurs I have met over the years.
George has been working on his latest book, on a new economic theory of money with a healthy dose of bitcoin thrown in. And I don’t want to give away too much, but let’s just say that there was an interview with the mystical, if possibly mythical, demiurge Satoshi Nakamoto held late at night in the grotto here in the villa in Trequanda. The world will just have to wait for George’s book to arrive to learn the details.
It’s getting close to time to hit the send button, as we leave in an hour to go to Florence (Firenze) to see the sights and in particular for me to once again see Michelangelo’s statue of David. I’ll again be spending the coming week close to “home” here in Trequanda, thinking about, outlining, and writing portions of my next book.
Then next Saturday I will leave for Rome, where I will spend four days with my good friend Christian Menegatti of Roubini Global Economics, meeting with bankers and policymakers to try to get a handle on Italy in particular and Europe in general. And maybe we’ll take a few side trips to see some of the marvelous historical sites.
Then it’s back to Dallas, where I will more or less stay for a month before heading out to Nantucket and New York City for a week, and then of course it will be time for our annual fishing trip out in the Maine boondocks, sometimes called the annual meeting of the Shadow Fed, organized by David Kotok of Cumberland Advisors.
One of the great benefits of being here in Tuscany is the local food. In addition to some fabulous restaurants, we have been able to find local chefs who will come in and make meals from scratch. Every night is a feast, but a healthy one.
One of the great revelations is that the gardener for the villa here, Ivo, a 70-something spry little elf, is a fabulous cook. Yesterday he came in the early afternoon to begin his preparations, bringing with him only fresh ingredients straight out of his garden. I have always said that one of the great joys of life is a perfect tomato, and Ivo may be the ultimate source of that joy. He literally spent hours hand rolling the spaghetti pasta, and I’m not quite certain what he did to the chicken, but it had the table in awe. It is such a delight to watch him singing old Italian songs (he does a mean Dean Martin) and literally dancing around the kitchen. This is a man who knows how to enjoy life. I really don’t think he is worried about whether there is a bubble in Chinese debt – if he is worried about anything at all. We should all try to figure out how to be more like Ivo.
They are telling me the cars are ready to roll, so that means it’s time to take my leave. Have a great week. Next week Ivo promises lasagna. I hope you can have a few great meals of your own.
Your thinking I need to visit China analyst,
© Mauldin Economics