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China Speed Part Deux

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Some interesting feedback...

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I wrote an article in July 2005 titled "China Speed -- Running Into the Great Wall", making a case that Chinese economic slowdown will send that great country into a severe recession. Last month I updated that article adding some minor twists. I found an interesting counter point to my article on this website that I thought I should share with the Minyanville community:

The post, written by Vitaliy Katsenelson, VP with Investment Management Associates and a teacher of equity analysis at the University of Colorado, entitled, "The Great Bubble of China?" posts China is "living through one of the greatest historical bubbles."

Katsenelson sees China as a manufacturing country built with high interest debt. He sees China's fall occurring due to factory overcapacity, a rise in the cost of money, and/or a slowing U.S. economy. Katsenelson even has titles for the books he sees being written after the fall: "The Chinese Conundrum" or "The Great Chinese Bubble" or "Irrational Exuberance 2." The author's investment advice is to take your money out of commodities and to forget about investing in Chevron (CVX), Exxon Mobil (XOM), or Conoco Phillips (COP). Katsenelson equates the idea that all companies need a China strategy to the idea in the late 90s that all companies needed an internet strategy.

Call me part of the bubble, but I disagree with Katsenelson on all points. China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising and even if they were not, I could see manufacturing tailing off and stabilizing, but I cannot see it crashing. If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising. On top of this, China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.

I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China. Secondly, the U.S., though obviously of huge importance to China, is not everything. Thirdly, though I do believe there will be a slowdown at some point (there has to be!), a slowdown is not a crash.

It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

I was glad to see interest in the article and it got me thinking more about the discussion. Let me try to reply to every point made:

"China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising... "

I actually agree with this statement, at least in part. China is likely to transform to a broader economy over the years, but it will take time. And with manufacturing making up such a large sector of the economy, it will take awhile (decades) before the services sector will be able to make meaningful contributions to the economy.

"I could see manufacturing tailing off and stabilizing, but I cannot see it crashing."

The operational and financial leverages are likely to prevent a normal slowdown, as revenues fall the costs will not fall as fast (by definition of leverage) and thus profitability will suffer.

"If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising."

Business Week had a small article last year making the case that China saw some double digit wages in inflation, but I think this is not true for the whole economy, but more common in specific industries. If the Chinese economy implodes, I don't think the wages will be rising, the implosion will be deflationary for China and the rest of the world. I agree that if labor costs in China become high enough, companies will start looking for a cheaper alternative.

"China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers."

I agree.

"I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China."

This comes back to my point of leverage - China has plenty of that. A U.S. slowdown will decrease incremental demand and depending on the amount of the U.S. slowdown it may be enough to decrease incremental demand to send many Chinese producers into red. Also, something I did not mention in the article is the bad loans are a real issue in China, a number I saw was 40% of GDP. Once the economy slows down they'll come to the surface.

"It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

As I mentioned in my article "But, as with any bubble timing, the pop is very difficult, Bears are usually too early to call it and Bulls are usually too late to see it." I really have no idea when it will take place. The Chinese government plays a very large and important role in China's economy, thus it may postpone the crash by intervening. But the longer it intervenes the great the decline will be. I have no idea when it will happen, but I am aware of the risk and thus we structure our firms portfolios accordingly, trying to minimize our exposure to a slow down in the Chinese economy.


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