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14 Reasons To Be a Bear in a China Shop

There is a lot of lopsidedly-bullish analysis on China in the mainstream press and in the "blogosphere". Less so today than two years ago, but still enough to suggest that China's problems are not generally understood. To do our bit to counter-balance the aforementioned bullish analysis, here is a list of 14 reasons to be a China bear:

1) We regularly read that China's economy is growing at 8%/year or 9%/year or some other impressive-sounding rate. These are simply numbers that China's government concocts for public consumption; they don't reflect what's really happening. It's possible that right now China's economy is not growing at all and it's certain that a significant part of the growth of the past several years is a monetary illusion rather than something sustainable.

2) China is now paying the price for its government's attempts to grow the economy through currency devaluation.

In a recent commentary we explained why currency devaluation generally makes an economy less, not more, competitive. The gist is that a sustained reduction in a currency's foreign exchange value must be linked to a sustained reduction in that currency's domestic purchasing power, meaning that any trade advantage achieved through lowering the exchange rate will be offset by higher local prices.

This applies where a currency's exchange rate is 'free floating', but China pegs its currency to the US$. Moreover, about 8 years ago the Chinese government reduced the Yuan's fixed foreign exchange rate to a level that massively under-valued the Yuan relative to the US$. This gave China a trade advantage, but it also meant that the Yuan supply had to be inflated relatively quickly to offset the upward pressure on the exchange rate stemming from the artificially low peg. This seemed to work well for many years, but eventually the monetary inflation brought about a large reduction in the purchasing power of the Yuan. The Yuan's reduced purchasing power combined with baby-step increases in the pegged exchange rate has eliminated the Yuan's under-valuation against the US$. More importantly, the whole process has left China in a position where investment bubbles wrought by the monetary inflation are bursting at the same time as the cost of living is rising at an uncomfortably fast pace.

3) Due to China's $1T-$2T "shadow banking system" (informal lending that happens outside the banking system), there is a lot more debt-related leverage in China's economy than indicated by official figures.

4) The Chinese manufacturing sector's most important customer (the euro-zone) is in recession and its second most important customer (the US) is either in recession or soon will be.

5) Over the past decade China has experienced unprecedented mal-investment in property and infrastructure. There are now millions of vacant apartments, huge shopping centres with almost no tenants, many empty commercial buildings, spectacular airport terminals with almost no traffic, and magnificent roads and bridges in the middle of nowhere.

6) In general, China's provincial governments are in similar financial situations to the government of Greece.

7) China's obvious "inflation" problem (its rapidly rising cost of living) is limiting the government's ability to use more monetary stimulus to 'kick the can down the road'.

8) The cost of labour in China has been in a steep upward trend (in response to many years of fast money-supply growth), which means that China is becoming a relatively expensive place for a foreign company to locate a factory.

9) China's policymakers exhibit the same short-term approach as their Western counterparts. For example, the massive stimulus of 2008-2009 succeeded to the extent that it made things look better in the short term, but it has ultimately left the economy in a much weaker state.

10) China's major banks are insolvent and are totally reliant on life support provided by the central government. This life support is bound to continue, which will add to the inflation problem.

11) Corruption. The PBOC (China's central bank) estimated last year that $120B had been stolen by government officials and sent outside China since 1990. The actual figure sent outside China is likely to be much higher, and then there's all the corruption that doesn't lead to money being sent out of the country. All governments are corrupt, but China's government, being more powerful than most, is more corrupt than most.

12) The financial protection being given to State-Owned Enterprises (SOEs) is starving the private sector of capital. Due to the widespread perception that insolvent SOEs will be bailed out, investors are favouring the bonds of inefficient state-run operations with very weak balance sheets over the bonds of private companies that have far superior prospects and performance. This crowding-out of private-sector credit by state-backed credit is evident in many countries, but the problem is more extreme in China. According to the chief executive of brokerage CLSA in Singapore, as quoted in the article posted HERE: "You've got basically 10 times the amount of credit going to the state sector [in China] as to the private sector to produce the same amount of output."

13) Wealth accumulation in China is being seriously hindered by capital controls that make it difficult to get money into the country and even more difficult to get it out (unless you are well connected).

14) China is no longer a communist country, but it still has a command economy. The government has complete control over the banking system, which results in the total monetary value of bank loans made during any year bearing no resemblance to the total monetary value of prudent lending opportunities. The government also exerts considerable control over the prices of important commodities, the entire construction industry, the amounts of exports and imports, the movement of people between provinces, and the number of children per family (the famous "one-child policy"). This leads to great inefficiency, but it also means that China's government has more ability than most governments to maintain an illusion of real progress in the face of major underlying weakness.

The good news for those who are looking for an opportunity to exit investments that rely on strong economic growth in China is that despite the "inflation" problem, the Communist Party's power transition scheduled for late this year could result in policies that postpone a collapse until next year.


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