China, the Wild Card — Seven Notes

1) Is China really growing or not?  Wait, is that a stupid question, or what?  Of course China is growing, and pulling the global economy out of the ditch as well.  Read this report from Time.  Uh, maybe not.  What if it is all a lending bubble?

What seems to be happening is that the powers that be in China are encouraging banks to lend aggressively.  Firms in China aren’t finding a lot of opportunities in export markets, so they build up inventories “that they know they will need eventually.”  Financial counterparties and individuals speculate on financial assets like real estate and stocks as they find cheap financing available.  (Example)

That’s my view of China at present.  I think those that are arguing for a resurgence in China at present are missing the similarities to the late 1980s with Japan where large amounts of productive capacity were built up with no markets large enough to sell the incremental production to.

I could be wrong, but this is leading me to lighten up on cyclicals.  Maybe some utilities…

2) With all of the noise of those looking for a replacement for the US Dollar as the world’s global reserve currency, I have two questions:

  • Are the surplus nations looking to reduce their surpluses, and thus suck in fewer foreign assets?
  • Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time?  Surplus nations need a safe place to invest.

3) In the meantime, the US tries to assure trading partners that their purchasing power is safe.  We remember the laughable assertion of Tim Geithner trying to assure the Chinese that they did not have to worry about devaluation of the dollar.  Well, now he is saying the same things to the Saudis.  At least with the Saudis, we are doing their bidding in the Middle East, by bottling up Iran,  so perhaps he does not have to worry so much there.

4) Back to point 2.  Are the current account surplus nations willing to consume from the rest of the world and flip around to deficit conditions, letting their currencies appreciate, and killing their politically powerful export industries?  That’s what it will take to replace the US Dollar.  I don’t care who is arguing against the US as a reserve currency.  The reserve currency must by nature offer high quality securities on net to the surplus nations to invest in.  It must run current account deficits on average.

That’s why China can’t be the world’s reserve currency.  China isn’t willing to stop export promotion, or encourage domestic consumption.  India and Russia may kvetch as much as they like, but both are in the same boat as China, but to a lesser degree.

Oddly, the best policy for most of the complainers would be to allow/encourage imports, and stop export promotion.  Freed from these distortions, the global economy would start to normalize.  Cross-border capital flows would decline because exports would not need to be balanced out.

5) The US has no interest in selling Yuan-denominated debt yet.  China eagerly buys Treasuries today.

6)  Does the one child policy fuel excess savings in China?  Maybe, but I doubt it is a big factor.  Dowries are unlikely to eclipse the actions of the central bank and government.

7) A final note from Andy Xie — there is a lot of momentum in China, but little underlying change in the fundamentals.


My summary is this:  To the degree that the recent upturn is driven by expectations that China pull the global economy out of the ditch, the move is mistaken.  As my friend Cody Willard asked me three years ago, what happens if Chinese growth proves to be a sham?  Can you trust their statistics?

My answer was that I wasn’t certain, but that things would get more clear if that were the case — and I think things are clearer now.  My policy implication is to move assets out of export-driven sectors, and those driven by China demand.  Utilities, here I come. ;)


  • Bo says:

    This is very true. There is a big financial bubble(real estate and stocks) in China as well as a big capacity bubble. In a sense today’s China is more like US in the 1920s right before the great depression where you have huge over capacity with little or no social safety net. However I think near term it is actually very positive for the equity and commodity markets as facing a challenge the authority will always choose to defer the hard choices which means they will keep flooding the market with cheap money. Ultimately it will collapse but I am not seeing it in the charts yet.

  • steve says:

    wrote on China yesterday, their economy our problem. take a look

  • Paul in Kansas City says:

    Thought provoking. I like the pipelines.

  • Dan says:

    Just to be clear, Andy Xie left Morgan Stanley several years ago.

  • Harper Capital says:

    …Wasn’t Andy Xie fired for being a little too honest about certain Asian leaders? Asian leaders who happen to control who get to underwrite debt offerings and Investment banking contracts?

    Gotta love an honest analyst. HCP.

  • matt says:

    What if the U.S. current account deficit goes near zero?

  • Saloner says:

    My compliments on an excellent post Mr.Merkel. There have been very few recent articles that lay the perspective out as well as this one.
    Very well done indeed.

  • darren says:

    should you follow the link to the actual article from Andy (two links in) here’s the end quote from it…

    “If you are a speculator and confident you can get out before it crashes, this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you lost money during your last three market entries, stay away from this one – as far as you can.”

    David, I’m generally impressed with your perspective, but this feels like it needs a broader source of inputs. I like the utils too, but not based on this.

  • darren — I’ll have more on utilities — this isn’t the reason to buy them. Later tonight, I’ll have a sector analysis post up.

    matt — as it gets closer to zero, there should be upward pressure on interest rates, because of the lack of subsidy to the current account deficit, and an economy where the export sector is doing pretty well. Oh, and the US dollar should be lower.