Why China Will Not Surpass the United States as the Next Global Superpower

Many global market observers look to China as the next great bastion of structural economic growth.  With one-fifth of the world's population and an emerging consumer class, many believe that China's rise to economic dominance is inevitable.  While China is currently, and may remain for some time, an engine of global economic growth, there are some fundamental weaknesses underneath the headlines that casual investors either miss or ignore, which could prove detrimental in the years to come.  Furthermore, these cracks in the foundation will, in my humble opinion, limit China's capacity to continue building up their economic house. 

The arguments for Chinese dominance are many.  And most of these arguments are compelling and factual.  The emergence of this economy is truly a structural evolution.  It has been a thirty year process, post Mao, that has included a gradual opening of markets to foreigners along with a slowly eroding anti-capitalist sentiment. 

Here are some main points of the China dominance supporters:

The Chinese Consumer - They are getting wealthier and want more stuff.  A recent study found that there are now more Chinese connected to the Internet than the entire population of the United States.  With this connection to global community (as amazingly censored as it is by the Chinese Government) there comes a realization of status in the world, along with a desire and a vehicle to fulfill these new wants.  The Chinese urban population is growing exponentially and infrastructure build out of urban and suburban centers are growing accordingly.

The Chinese Surplus and Currency Reserve - China has amassed the world's largest currency reserve.  They are our single largest creditor and have a massive arsenal with which to stoke the economic engine should it show any signs of sputtering.  They have also experienced double digit economic growth while running trade surpluses around 10% of GDP per year.  Their sovereign wealth funds total over $1 Trillion in assets and could buy over 10% of the entire US stock market.

Now the problems that lurk beneath these seemingly strong endorsements:

Class Struggles - China's economy is currently still driven by exports...that's what causes the large trade surpluses.  These exports are manufactured by cheap Chinese labor.  This labor is so cheap that many American companies have elected to manufacture goods in China and pay to ship them across the Ocean back to the US for sale in our own domestic stores.  In fact, I read somewhere that Chinese workers earn about one-third the pay that Mexican workers earn and we all know how well they must be paid in Mexico if their workers are risking lives and freedom to come to the US to earn below our minimum wage!  This cheap labor cannot and will not continue indefinitely.  We can see this in recent news stories about the surge in strikes at factories across China, like this one from the BBC.  And even sadder stories, like this one from CNN, of the various Foxconn workers who committed suicide this year.  These add up to a working class that demand better pay and better conditions.  This could prove a difficult transition for a country that depends on being the cost leader for manufacturing.

Bubbles - A bubble in real estate has formed...but its not the worst bubble China has to deal with.  The biggest problem for China is the bubble in U.S. treasuries.  While its no question that the real estate market in China has turned into mass speculation in rapid fashion and could pop at any time, this problem could in theory be contained (its mostly in the luxury segment of the industry) and/or absorbed by government intervention.  The truly big problem for China is its holdings in U.S. treasuries.

How many people have heard some version of the theory that China plans to dump huge portions of their US Treasury holdings thereby causing a run on the Federal Reserve?  This version of the story is backwards.  What happens when China starts to sell some of their reserves?  The value of their remaining holdings drop in value and you find a limited number of buyers.  Your strength becomes weakness as these holdings are only as valuable as the country which issued them.  This massive reserve, which was established to keep the Chinese currency pegged to the dollar, has grown into a $2.4 Trillion anchor.

Now China has tried to address this issue in some ways.  The creation of China Investment Corp. (CIC, a sovereign wealth fund run by the impressive Lou Jiwei) has helped China diversify some of its holdings.  The problem remains however that until they decide to revalue their currency they need to continue to buy US treasuries, and once they stop or even slow the rate of purchases their currency will appreciate markedly, and the competitive advantage that China has enjoyed over the last 30 years will all but disappear.

The conclusion

I don't think China will blow up and turn into economic disaster, but I will say that the only other two times in history that a country ran up surpluses of this magnitude was the United States in the 1920's and Japan in the 1980's.  As I said earlier, cracks in a foundation may not ever cause a collapse, but they can severely limit the amount of building you can safely do on top of it....unfortunately I'm not sure China has figured out fully how to stop.

To sum this whole thing up, (and maybe get some sleep tonight), I'll end with a fundamental truth of markets. Excessive lending can be just as dangerous, and perhaps even more so, than excessive borrowing; even if this lending is out to the most credit worthy of clients (US creditworthiness is a debate for another day).  It is with that thought that I am in full confidence that China cannot surpass the United States in terms of economic power...because Chinese Value is only as good as the American currency its printed on. 

If not Disaster, then What? The Inflation/Deflation Debate Summed Up

I was recently asked about my thoughts on how the economy may look over the short to intermediate term.  More specifically, on whether Inflation or Deflation would be the more likely scenario.  In my last post I mentioned that long-term I did not see either of those scenarios playing out in truly damaging extremes. 

So if we are not heading for economic disaster in the coming years, then what will it look like?  Lets also take this to its logical conclusion and ask, "How then can I make money in the next couple years?"  Now we are talking!

First of all I can best sum up the inflation/deflation debate by saying that deflation is by far the more worrying concern for our economy as a whole.  If prices start going down and consumers decide to hold on to their cash for longer and longer periods of time, we will see unemployment shoot up over 20% as economic activity in this country grinds to a halt.  A deflationary spiral is like a black hole in that once you cross the event horizon, the gravitational pull is too strong and you get sucked in.  With a Federal Reserve and Treasury that are keenly aware of the ramifications of crossing the deflationary event horizon, there will be massive action to try and artificially inflate the dollar before we fall into that trap.  I think it is safe to rule out deflation as an economic prospect for the next couple years.

That all being said, there are deflationary pressures.  Again, I mentioned in my last post that wages are the biggest contributing factor to inflation.  Well, I dont hear too many stories of people getting huge raises these days.  This is a big deflationary pressure on prices as people are making less money and getting more and more cost conscious.  The price increases (or lack of decreases at least) that we have seen and will continue to see, are greatly just a factor of government intervention in the form of extended unemployment benefits and stimulus spending.

So as unexciting as it is to hear, I believe we will continue in this malaise of modest-if-existing-at-all rises in the price level.  The government does have the ability, the firepower, and the motivation to keep this economy from entering a deflationary spiral, and as long as the market has confidence in that claim, we will be able to eke out some modest levels of economic activity. 

However the inflation will not shoot up anytime in the near future, at least not until we get some very meaningful reduction in the unemployment rate.  This could take another two to three years, as we are currently only generating enough jobs to almost account for the increase in the labor force (college and high school grads, returning mothers, etc...)  This does not help us pick away at the over 8 million unemployed people in the country.  This could be greatly helped by the current administration if they were able to get some meaningful job creating legislation passed to grease the skids, (tax breaks for small and mid-size companies that hire new people...etc)

So with a very boring slow growth economy for the next few years, or a "New Normal" as Mohammed El-Erian of PIMCO calls it, how do we make any money?  Well we could hold cash at the bank and earn 0.02% on it.  We could try and lock it up for longer term in search of a better yield and maybe get a one-year CD for .85%.  We could buy a 10 year treasury Note for 2.59%.  The good news is with this is that with Inflation being nothing right now we can chalk these figures up as pretty close to Real return (nominal minus rate of inflation), but there has to be some better investments out there.

Well in this sort of scenario we can actually take advantage of the fear mongers and beat them at their own game.  By shorting stocks and bonds and publicly espousing doom and carnage in the business press, the Dr. Dooms of the world have actually created a pretty attractive risk yield in certatin markets, which more rational investors can take advantage of and get paid on.  One area that is particularly lambasted and getting some signs of market pricing fear are muni-bonds.  Right now a municipal bond fund will pay a much better yield than any laddered CD or Money Market, and I believe that fears of defaults coming from major municipalities is very overdone.  That being said, there are some areas I may want to avoid, like Michigan and Arizona where there are some deeper strucural problems that were unveiled by this last downturn.

I am also a fan of the "bet on blue chips" right now.  With our largest corporations holding incredibly large cash balances, they are not out in the capital markets trying to invest in growth, so they are more and more electing to just pay their shareholders cash.  The dividend yields on some of these companies are well over 3 and 4%.  That doesnt mean that there wont be a significant amount of principal volatility, where the value of your shares go up and down violently.  There is still a very fragile market psyche and a lot of headline risk that can move market prices.  But if you invest in solid companies that are paying you cash consistently and reliably then its called "getting paid to wait" for this dyslexic market to figure itself out.

BY FAR, the best investment that you can make right now is education and training on yourself.  In an increasingly competitive job market, where there is not a lot of extra room on many payrolls it is imperitive for people to continually enhance their resumes and bios.  Even those with jobs right now have to realize that there are a dozen people who would line up to take that job from you for less money.  And increasingly these people standing in line are educated and sharp.  Therefore, take some evening classes, buy a book, get some professional licenses, or numerous other options.  While you might make a 3% yield on some great dividend paying stock, you could also get a 20% pay increase with certain credible skill sets added on to your resume (or at least hopefully avoid a 100% pay decrease).

Please let me know your thoughts on questions.  It is getting late and some of this stuff may not translate as well from my brain to the screen as I would hope.

Is this the start of a Lost Decade, or a prelude to post WWI Germany

The hottest topic on financial news networks these days is the question "To which brand of economic collapse do you subscribe?" This is where academic economists and market pundits come on TV to point to similarities to the United States' current environment to that of various other economic horror stories through-out history. And while this type of radical apocalyptic story-telling can make great television, it does not jive with a logical reality.

I will not waste the time of my tiny "but ultra-cool" readership by going into a diatribe about academics vs. markets, or try to give a history lesson. I do want to try and ease any fear invoked by these sensationalists on TV by saying DONT PANIC, because we are not headed for either deflationary Lost Decade status of zero growth and sky rocketing debt loads, nor are we heading for days where a loaf of bread will cost $3.2 Billion.

LOST DECADE:
Starting in 1989 Japans rapid growth of the previous 20 years ground to a halt. Interest rates were dropped to zero, Banks were nationalized, the stock market over the next ten years fell 82%. So what caused Japan to fall into this trap? Their growth was fueled by debt and when that growth ran out, the engine stalled. Once the economic fire goes out, its very hard to start up again. Without prospects for future growth, citizens hide cash in their matresses knowing that everyday they wait to buy, they can buy more. At that point it becomes a self-fulfilling prophecy.

First of all the coup-de-grace that no one talks about is that Japan has zero population growth and with that an aging population that is getting less productive as time goes on. The US however is still making babies and babies cost a lot of money! This in turn creates a natural source for economic activity. More people equals more demand for food, energy, diapers, and hand sanitizer, and thus more people put to work to serve that demand.

Also, while we do have high levels of debt in the US, we still have room to raise it higher. In other words the treasury still has some dry tinder to throw in the furnance in order to stoke a self-sustaining blaze that will get the economic engine turning. The other problem comes when too much dry powder is thrown in and the blaze becomes uncontrollable. This brings us to the next doomsday scenario....

POST WWI GERMANY:
At the height of the crisis in 1923 the price of a kilo of butter at the general store rose over the course of a few months from $26,000 Marks to $6,000,000,000,000 Marks!! Yeah thats trillion. Thats more than all the German Marks that were in circualtion just ten years prior!

Now believe me, I can understand the arguments that this country could experience higher inflation down the road. But to suggest we could see anything similar to the images of people taking wheel barrows of money through the streets to buy eggs is non-sense. The people who own the 1-800-buygoldnow companies may promote this kind of scenario but even on a more muted basis, hyper-inflation of that kind is not on this country's horizon.

There are two quick reasons why we wont experience hyper-inflation. First, the dollar is still considered the reserve currency of the world. This means that there is an international demand to hold dollars. Inflation is described as too many dollars chasing too few goods, but when you have people chasing those dollars then the risk that there are too many out there is significantly lowered. Second, the biggest component of inflation is wage growth. With unemployment at 9.5%, there are over 8 million jobs that need to be created before we have to worry about labor demand rising meaningfully.

In conclusion lets consider a quote from uber-philospher Bertrand Russell
"The whole problem with the world is that fools and fanatics are so certain of themselves, while wiser people are so full of doubt" The next time you see a table pounding, doom-sayer on television, my advice is to be skeptical.

Why Dont We See Solar Powered Cars?

There are a lot of very uneducated people in the media who do an extreme disservice to the country when they talk about the evils of oil and gas companies in regards to alternative clean energy. For example I heard a political talk radio host say "There is no reason, other than corporate greed, that we shouldn't all be driving solar powered cars by now". This is a completely asinine comment for someone to make.

So, Why don't we see solar-powered cars?

Quite simply, the most advanced solar panels can generate the equivalent of one horsepower of energy per square yard. That means in order to capture enough energy to power my old tin can Kia Rio at 110 horsepower would require 110 square yards of solar panels! In fact a leading high-tech solar company was able to add solar panels to the new Prius and generate 240 watts in full sunlight. This was the equivalent of adding 9.5 miles of range to the electric motor on a bright summer day, and adds a total of .3212 horsepower. While not nothing, this does not appear to be something that will be able to power the car independent of other sources.

Don't get me wrong, I think solar and wind energy are incredibly important, and I would like to see this country and the world, reach the loftiest-while-still-realistic forecast of 20% of total energy consumption. But like Bill Gates said, solar and wind power are not credible sources of power generation, its more like energy farming. What he is saying is that its not feasible to cover the entire planet with solar panels and wind turbines, which is what it would take to reach energy demand. Therefore we need another solution.

What about Algae? Unfortunately there we also have a problem with economics and scale. A small clean energy company says they found a way to generate bio-fuels from algae at around the equivalent of $80 to $90 dollars a barrell. With oil trading at $83 or so at the time of this writing that seems pretty competitive, however, in order to get a 10% share of the gas use in the US they would need to be able to apply that 80-90 dollars of cost on an algae pond the size of New Jersey! (insert own NJ joke here) While even a 2% share would be a meaningful cut into demand, the technology has not been proven on a larger scale. A well-known Venture Capitalist out in San Jose has said that he has been approached by many different algae companies and that he hasn't seen one viable business model involved with the technology. We may still have a ways to go here.

Ethanol has been known to be corrosive on engines and is not viable without subsidy. Hydrogen has finally come to terms with the physics of converting hydrogen gas into a more stable fuel ready substance. You expend more energy in the process than it eventually creates. And unfortunately we have not been able to figure out a way to contain a fusion reactor and the millions of degrees it generates just yet.

The most promising alternative clean energy power generator I have seen is the slow-burn nuclear reactor, which would use current stores of nuclear waste and burn it like a candle. The most optimistic forecast on this technology being developed and rolled out is 20 years.

So the next time some media talking head goes on about "greedy board members blocking alternative energy progress" lets remember that capitalism is what has made our current progress in clean energy possible. Intelligent and hard working entrepreneurs are getting closer and closer to finding viable sources of energy. Investment tips in this arena would be to find a small cap clean energy company with a promising new technology that will eventually get bought out by one of the big boys to reach scale. If you find one, let me know. I'm still looking.

Keith