Friday, May 20, 2011

Chancellor & Chanos on China

Excerpts from Edward Chancellor's white paper on China's Red Flags:

Three years ago, Premier Wen described China's economy as "unstable, unbalanced, uncoordinated and unsustainable."

End Game
Forecasting the end game is no easy task since speculative bubbles can run to extremes. It's made more difficult in this case by the fact that China is not a pure market economy. State-owned enterprises can be called upon to prop up markets. Losses may be concealed or shuffled around like a shell game, as has happened in the past. Such measures, however, won't cure China's problems. They only delay the dénouement.

Field of Dreams
China’s real estate market, and indeed its economy and financial system, have been shaped by a belief that past rates of economic growth will continue into the future. This assumption justifies more investment, which spurs the growth, leading to more investment. ...China has become a field of dreams; a build-and-they-will-come economy.

One commentator compares China to the Hollywood thriller, Speed, in which a bus has been planted with a bomb set to detonate if the vehicle slows to below 50 miles per hour. This seems apt. Were China's economy to slow below Beijing's 8% growth target, bad things are liable to happen. 

A recent Barron's article added that fixed-asset investment is a huge part of China's GDP.

He [Chancellor] shakes his head at "this idea that the Chinese authorities are competent to allocate capital at an 8% to 10% rate of growth."

Jim Chanos explained his thinking on China in a recent interview with Charlie Rose. Sixty percent of China's GDP depends on construction. From this Bloomberg article.

Treadmill to Hell
China is "on a treadmill to hell," said Chanos, who said in January the nation is Dubai times a thousand. "They can't afford to get off this heroin of property development. It is the only thing keeping the economic growth numbers growing."

My understanding is that fixed-asset investment is now nearly 70% of China's GDP. That's not a sustainable mix for any economy and it's not like we are talking about a small one.

Bubbles don't usually end without substantial short-to-intermediate term economic disruption. I know of no instance where a bubble this size has not.

The problem is just when it will happen and how severe it will be is impossible to know but the hangover will probably be proportional to the duration of the party.

For investors, the ripple effects of all this will almost certainly be significant even if not directly investing in China.

Be ready to buy more of your favorite businesses if they temporarily go on discount as a result.

Adam

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