Charting Around Asia

The China Syndrome

by John Needham, The Daniel Code Report | June 11, 2009

In the original “China Syndrome” story, a 1979 film, a group of eco activists, led by a feisty female investigative reporter (Jane Fonda) become concerned that a nuclear reactor in US will go critical and melt through its containment barriers to send shots of radioactive material into the ground beneath, and from thence into the ground water table.

The name refers to the idea of the nuclear material burning a hole from the United States to “the other side of the world”, i.e., China. In this instance China is a metaphor, as the opposite side of the globe from the USA is actually the Indian Ocean, but never let the detail stand in the way of a good story.

Today the China Syndrome is on the mind of a number of Governments but for vastly different reasons. In US and Australia in particular, concern is acute that unless China’s growth story is maintained it could be their economies melting down and breaking out of the containment, which is more or less robust depending on which variety of fairy stories you prefer.

US has a linked view of China in the world going forward. US Treasury through in this case the Fed Governor young Tim Geithner, has been pressing the case that China needs to urgently accelerate its domestic consumption to take up the slack caused by slumping consumption in US and elsewhere. Economists, who by definition like to pretend that they understand business cycles, argue that all consumption is a global net and what is lost in the West needs be made up in the East, otherwise slumping gross demand leads to a down turn in economic activity and output, called elsewhere “recession”, but known to your humble scribe as “reality”. For no apparent reason that I can ascertain this is a process to be avoided at all costs. The argument in favor of maintaining the unsupportable, ergo the lunatic 2006 economic momentum is couched in terms of employment, poverty for the East and living standards for the West.

Quite why governments of all ilks insist that building cars, trucks, heavy machinery, airplanes and other machines of destruction and pollution, are the highest and best employment for the masses, hasn’t been spelled out, to me at least, but that is the case everywhere. Personally I think that a global return to an agrarian society would make the world a better place, but as usual, I am in the minority.

For US, the urge to have China diversify its economy, so that more of its production is consumed internally, is a tacit admission that recent levels of consumption are not coming back any time soon to the West. And if China’s growth rates splutter dramatically it will no longer be the funder of last resort (before the people have to pay) for America’s burgeoning deficit financing requirements and Australia’s traditional capital drought. So for US and Australia, any withdrawal by China from the international funding game will have serious consequences. From this scenario, the next step, which is undoubtedly economic heresy, is for domestic savings and the tax base to fund the costs of running USA and Australia Inc.; what used to be known as “living within your means”. Economists now regard this concept as largely a medieval aberration. But it’s certainly a novel thought for most!

Of the Chinese Tiger (or is it Dragon), the notion that a centralist economy still making the transformation from peasant agriculture to global manufacturing giant can be controlled in the way that Western economic modeling suggests is a serious leap of faith. The economic norms in China are not those of the West and a recent study by Tsinghua University shines some light on a few of the structural barriers in China. This from Business Day:

“What's strangling spending in China? Try a 65% flat tax

THE world's most pressing macro-economic question - how to get Chinese households to consume more so Americans and Australians can consume less - may have just been turned on its head by a team of Beijing economists.

Experts from the World Bank, the International Monetary Fund and investment bank UBS all say the reason Chinese consumers are so parsimonious is that they receive a miserly share of national income, while Chinese companies gouge the lion's share for themselves.

Their conclusions rely on Chinese national accounts data that shows employee compensation plummeted from 59 per cent of China's gross domestic product to 47 per cent in the decade to 2007.

"This might well be the mother of all redistributions," said the IMF's former assistant research director, last year.

Bai Chong-en, professor of economics at Tsinghua University, agrees that Chinese households are lacklustre consumers because they are poorer than they should be, given China's formidable GDP growth. He speculates that the problem is not a relative collapse in gross wages but a growing pile of inequitable levies paid to provincial and central governments. "Beijing residents have to pay about 41 per cent of their income into various social security and insurance funds and another 24 per cent to a housing fund," said Professor Bai. "That's effectively a 65 per cent flat tax - and then there's income tax after that - so you don't really have a lot left to consume."

Professor Bai's findings have the potential to challenge an array of government policies. The belief that China has suffered a precipitous decline in employee compensation has percolated to the very top of the Chinese Government. President Hu Jintao promised to "increase the share of personal income in the distribution of national income, and raise that of work remuneration in primary distribution", in his crucial five-yearly work report in 2007.

This comment added momentum to last year's landmark Labor Law. "It means you really don't need big intervention in the labour market, such as the Labor Law," said Professor Bai.

Professor Bai's modelling, based on data from China's 100,000 largest industrial companies, suggests that Government-initiated wage rises may be entirely counter-productive.

"Artificially increasing wages by 1 per cent leads to a 1 per cent drop in employment and so the total increase in wages is about zero." To the extent that employee compensation has declined relative to profits, Professor Bai blames companies exploiting government protection to exercise monopoly pricing power.”

For Australia, the China Syndrome is more direct and pressing. Australia’s decade long mining boom which has almost single handedly kept Australia out of recession, has been extended by China’s extraordinary buying power in minerals and energy as it seeks to stockpile gargantuan supplies of Iron Ore. From Alan Kohler of Business Spectator in Sydney:

There seems to be a colossal iron ore arbitrage going on in China. According to a Reuters report a few days ago, and then another yesterday from ANZ’s head of commodity research, Mark Pervan, there are currently 80 bulk ships waiting off China to unload iron ore. That’s 10 per cent of the global Capesize vessel fleet. A huge spike in demand for iron ore from China has, in turn, pushed the Baltic Dry bulk shipping rates index up 200 per cent since early April. The Baltic Dry index is a composite of four indices, of which the Capesize index has seen the biggest rise – up 315 per cent.

This in the midst of a global recession. The iron ore shipments are simply not supported by any underlying increase in demand for steel. Steel production in China was relatively strong in May – an annual rate of 544 million tonnes, compared to 500 million in 2008 – but steel inventories are also rising rapidly. Exports are still falling, albeit at a slower rate, and underlying steel demand is weak. In fact the iron ore unloaded in China this year is being stockpiled, mostly at or near the ports. Those facilities are now full.

While the stockpile overhang clears, the shipping rates are likely to crash again. Those who have been seeing the rally in the Baltic Dry index as a leading “green shoot” are likely to be disappointed – indeed the index has fallen 15 per cent in the past four days.

Morgan Stanley’s Asia chairman, Stephen Roach, has just put out a note entitled Asian Relapse, in which he suggests that China is vulnerable to relapse in 2009 as the government stimulus fades and is not replaced by a US-led snapback in external demand. The iron ore arbitrageurs may have made the coming relapse a little more severe.

The background to this historic jump in Ore shipments is being played out against the drama of Rio Tinto’s on-again-off-again elopement and then dénouement of China’s state owned miner Chinalco. Those who follow the activities of miners will recall that Rio saddled itself with $38 Billion in debt as its directors had a rush of blood to their heads in July 2007, and like investment bankers everywhere, assumed that the good times would roll for ever, and that Newton’s Laws of Gravity had been miraculously repealed. With that thought uppermost, Rio embarked on the purchase of Canadian Aluminium producer Alcan right at the top of the commodities market and has been in trouble ever since. Stress caused by BHP abandoning an all script offer for Rio and falling commodity markets pushed Rio into the embrace of the only suitor still standing, China’s Chinalco.

Rio first courted and then with a little market recovery, rejected a complex funding and partial acquisition bid from Chinalco worth $19.5 Billion. This deal would have given China a seat at the big Iron Ore table where 3 companies, Vale, Rio and BHP control world pricing. Rio, now appears to have fallen for the devil it knows rather than the one that is new, and has fallen into bed with its eternal rival BHP, in a neatly structured deal to meld their Pilbara, Western Australia, Iron Ore projects.

Australia is counting on its big miners to stave off collapsing consumer demand. To the extent that China can continue to devour the present level of imports of basic materials, the “China will save us” mantra continues to have traction. Indeed Australia remains as proof that the “global” recession is not global at all, as it not only remains recession free, but shares its bounty with the people as the housing boom continues unabated. Across the Tasman in tiny New Zealand, the most common expression is “what recession” as technical recession, evidenced only by the collapse of a few high flying property entrepreneurs, whose ambition outstripped their ability, has failed to impact housing prices and activity, or the ordinary man’s leisure lifestyle of booze and sport. And now ski season is upon them with reports that pre-season ski pass sales have outstripped all records. As New Zealand, closely followed by Australia has the most expensive ski passes in the world, for really very ordinary facilities, all we can say is “what recession indeed!”

So for both our countries, much depends on China staying strong and avoiding the cost to it, of the consumer pullback that is evident elsewhere, as punters come to grips with the fact that saving must again be part of their life plan as it was for previous generations and Western households are going to reduce their leverage either willingly or otherwise. Today’s Wall Street Journal from the stable of Aussie Rupert Murdoch has this cautionary tale on what is likely happening in China:

The cost of China's stimulus program is turning out to be much larger than official figures indicate, raising the stakes for the government's attempt to restart high growth through massive borrowing. The spending spree has helped steady China's economy while other major nations remained mired in the global downturn. It is one of the largest stimulus programs adopted by any government in the world -- yet China plans to hold its budget deficit to just 3% of gross domestic product this year. That's about where the U.S. hopes its deficit can end up in a few years after it scales back its stimulus spending.

In fact, China's formal budget is paying for only about a quarter of the two-year, four trillion yuan ($585 billion) investment program. Stimulus projects typically get fast approval and a partial financial contribution from the central government, with local authorities left to come up with the majority of the funds. But they don't have much money, as China's tax system channels most revenue to Beijing. The result over the past few months has been an explosion in local-government debt -- liabilities that have the indirect support of Beijing but don't appear on its books.

"There is no such thing as a free stimulus package. There is a huge amount of unreported government debt, and we're adding to it now clearly," said an economist for Standard Chartered in Shanghai. A government audit of stimulus projects in May found local governments had put up only 48% of their matching funds. Some local governments were so badly off they used stimulus money from Beijing to retire some of their older debts, the auditor said. That means local governments generally have to borrow the money for any new projects. As they are largely barred from taking on debt directly, the borrowing is happening through government-backed companies. There aren't solid figures on how many loans from state banks went to such firms. But in the first quarter, new loans for infrastructure projects -- usually run by companies with government ties -- totaled 894.8 billion yuan, equivalent to 22% of the national stimulus package.

Like other economies with big stimulus plans, China is making the bet that the burden of the debt it takes on now will be lightened by faster economic growth in the future. It's a bet that has worked for China before, and many still feel confident. "If the economy grows, tax revenues will increase, and then paying the debts back is not a big problem. My own judgment is that the scale of these debts is controllable," says Liu Shangxi, deputy director of the Research Institute for Fiscal Science, the finance ministry's think tank. Yet, even before this year's splurge, local-government debt was already sizable. The institute estimates off-budget local government debts at about four trillion yuan -- by coincidence, the same amount as the stimulus plan, and equivalent to 16.5% of gross domestic product.

As the central government is ultimately liable for those hidden debts, China's total state debt is closer to 35% of GDP than the 18% shown by official figures. So China's government finances aren't quite as sterling as they first appear, though its position is still better than highly indebted nations such as Japan, Italy or the U.S. The problem is that the preponderance of off-budget financing makes it almost impossible to know how much worse things are.

So there is the big bet. Either China holds itself together while the demand for its goods in the West is reduced dramatically as reality bites, or we have an inverse China Syndrome where a slowdown in China’s economic dynamism results in a meltdown in Western economies particularly in Australia and US but for entirely different reasons. One needs funding the other, trade.

Despite having avoided recession so far, Australia’s share market as represented by the SPI 200, the major index of the Australian Stock Exchange has exhibited all the signs of a cardiac attack in sympathy with US and European markets. The Government too has acted as if Armageddon has arrived, firing all its guns including guaranteeing retail bank deposits and wholesale bank borrowings plus the usual gifts to insolvent auto manufacturers, notably General Motors Holden, the Australian subsidiary of GM and the manufacturer of the top end of the US Pontiac range.

Note how the Danielcode black line which you have seen in many other markets forestalled the SPI’s plunge into the abyss.

The chart below is China’s Shanghai Composite index which bears an uncanny resemblance to the SPI. In spite of market jokes about this index, it is relatively stronger than the Australian market.

So sweep those cobwebs out of your fiscal bomb shelters, and ensure they are well stocked with all the necessities of life and a few fun items as well. They may be coming into use much sooner than we thought!

The idea that China can replace dwindling Western consumer spending with a miraculous change in the spending and indeed social habits of its own citizens, virtually overnight, is of course preposterous, but the absurd is now called “economic policy” and accepted almost universally. Of course this policy comes from the same crowd who were supposed to be regulating big global banks and assuring us that the subprime crisis was contained.

I didn’t believe them then, and I certainly don’t now. But its all part of the vast pageant of life and at the least a constant source of amusement!

The final chart is a quarterly view of Japan’s spavined Nikkei index. It should be a constant reminder of what happens when banks are officially allowed, nay encouraged, to conceal bad debts. Unable to withstand the political pain of remedial action, governments take the default setting of zero interest rates and the stupidly named “quantitative easing” where further debt is created in thin air to address a problem of already excessive debt. Markets eventually get wise.

Next week in “Charting around Asia” we will focus on government and Reserve Bank antics Down Under as Australian and New Zealand’s Dairy farmers are primed to be offered by their masters, as a sacrificial token to the bankers and the still insatiable maw of their great housing bubble which continues unabated.

It’s a dastardly tale of spin, cynicism and collusion. It’s happening now and nobody knows!

John 1:10 He was in the world, and the world was made by him, and the world knew him not.

CAUTION-The Daniel numbers on these charts are from historic sequences that may not be current at the time of publication. They are appended for historic interest only. Do NOT use these numbers to trade markets. Current Daniel sequence numbers for most currency crosses are available to subscribers at the Danielcode website.

John Needham is a Sydney Lawyer and Financial Consultant. He publishes The Danielcode Report and writes occasionally on other markets. He lives with his family in Australia and New Zealand.

“The fox knows many things, but the hedgehog knows one big thing. A Hedgehog Concept is not a goal, intention or strategy to be the best. It is an understanding of what you can be best at. The distinction is absolutely crucial”. ~ Isaiah Berlin, The Hedgehog and the Fox

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John Needham | The Danielcode Report | Taupo, New Zealand | Email | Website

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