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Is China Condemned to Repeat America's Mistakes?


With naivete comes unreliability -- both in products and information.

"Be skeptical of everything in China."

That's the most popular piece of advice I've received from friends and family wishing me a farewell on my upcoming move to Shanghai. Sadly, they have good reason to offer it.

While China has come a long way since Mao Zedong's rule, emerging into a more vibrant capitalistic economy, it's still far from reaching a mature market status. The country is still immature in many aspects and with immaturity comes unreliability.

This is why it's not so easy to believe all that comes from China is the real deal -- be it physical goods or governmental information. The country has been spotlighted by the media for its tendency to send the US substandard items, such as counterfeit pharmaceuticals, defective drywall, and tainted toys.

It's no surprise, then, that a few analysts -- including me -- are beginning to question the recent growth of China's economy. In what seemed like a stunning recovery, China announced second-quarter GDP growth of 7.9% earlier this month.

It's not that I think China is simply making up a number close to its 8% target to please the global economy -- though they very well could be. I'm more concerned with the strategy China's using to achieve this growth, in a similar fashion to how I'm dubious about public companies that churn out exciting growth and meet earnings expectations using special accounting techniques.

There's immense pressure on China to prove itself and save the rest of the world from a persistent recessionary state. This has created a huge incentive to China to deliver the numbers the world wants to hear.

Like management teams that sugarcoat financial statements, I suspect China may be finding ways to mask what's really going on behind the scenes. It may be priding itself on its ability to report such dazzling GDP growth when the rest of the world is half dead. But like some of the products it exports, its growth may not be real.

As if the Chinese are taking advice straight from the pages of Alan Greenspan's The Age of Turbulence: Adventures in a New World, the government is throwing yuan into the system every which way in hopes of stimulating recovery.

In the first 6 months of 2009, M2 money rose 29% and the banking system reported that lending in June was 4 times as large as last year. China's officials are draining liquidity into the Chinese economy, but the problem is that it's not going where it should be: 20% of the new lending was invested in the stock market in the first 5 months of this year. And the minimum mortgage payments were cut from 30% to 20% to help drive up home sales.

This brings me to my next point of skepticism: the Chinese stock market. The Shanghai Index has risen over 75% since November 2008. The best performing country in the world can't justify such drastic marketing upswings, let alone an economy that's struggling to find the strength to get back on its own 2 feet without the help of US credit-compulsive consumers.

That kind of upward momentum screams equity bubble. Even worse, the Chinese housing market is starting to mirror the US housing market several years ago. Mortgage standards are being lowered -- albeit not anywhere close to where US standards fell to -- and banks are being told to raise coverage ratios for an expected rise in non-performing loans. In fact, I've read reports that an increase in vacancy of unfinished buildings is being spotted.

It's deja vu. And we already know the outcome of this story. The US is experiencing its last chapter right now.

The Chinese government needs to step in and mop up the excess liquidity, or things are going to get messy. Monetary policy is too loose and both stock market and real estate bubbles are clearly in sight. As long as the government continues to flood the market with yuan, the bubbles will continue to balloon.

If both of these asset bubbles collapse -- and they likely will -- all of the capital the government lent will be wasted. Long term, that means no real economic growth will have been created.

In order to create real growth, China must alter its current recovery method. The government needs to find ways to drive personal consumption. The Chinese have a tendency to save for a rainy day. They prefer to invest in stocks or a home, rather than spend or borrow to purchase frivolous goods.

While the Chinese should never strive to emulate the spending habits of many Americans, the government needs to provide incentives for the Chinese to buy the goods they make -- the goods that we Americans can no longer afford. Otherwise, real growth won't be achieved.

As critical as I've been on China, I do have faith in the country. Heck, I'm moving there because of the great opportunities the country has to offer. However, I'm certainly concerned about the recovery strategies the country is taking, and fearful that I could end up being smack dab in the middle of the same crisis I just lived through here in the States over the past 2 years.
No positions in stocks mentioned.
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