Long on China, Short on the United States

Daily Article by Tim Swanson | Posted on 1/20/2009 12:00:00 AM

The year is 1969. Chairman Mao is beginning to construct underground escape tunnels throughout
Beijing and anticipates a Soviet invasion and bombardment within days. The PRC has just detonated its
first hydrogen thermonuclear device in Lop Nur and the countryside is seething in a book-burning
cultural revolution. To many foreign observers, the end of China is imminent.
The year is 1979. Soft-spoken minister Deng is quickly drawing up agricultural-reform plans to prevent
widespread famine and to stymie civil unrest. Border skirmishes between the PLA and Vietnam turn
into a hot war involving tens of infantry divisions. Total foreign investment amounts to a mere
$800,000. To many foreign observers, the end of China is imminent.
The year is 1989. Perestroika-minded Gorbachev visits Beijing to repair diplomatic dialogue.
International media outlets cover the bilateral event while thousands of students simultaneously occupy
Tiananmen Square.[1] By the end of the summer, tanks roll through the city and multinational
businesses leave once again. To many foreign observers, the end of China is imminent.
The year is 1999. President Jiang continues reforms and privatizes thousands of state-owned enterprises
putting more than 4 million Chinese temporarily out of work.[2] Currency collapses sweep across East
Asia smothering South Korea and Thailand. Industry leaders such as Daewoo go bankrupt. The IMF
lends tens of billions of dollars to several emerging countries as their stock markets crash. During this
period, China's GDP drops more than 2.5% as exports slow. To many foreign observers, the end of
China is imminent.
The year is 2009. China's GDP growth slows to an unimaginable 5%. Exports to the developed world
nearly stop as demand shrivels into the single digits. Half of all toy-exporting factories have closed,
sending tens of thousands back to their family farms. [3] Many foreign owners have quietly left the
factories, leaving behind unpaid workers.[4] Mainland stock markets continue to dip as listed firms
repair balance sheets and account for losses from overseas investments. To many foreign observers, the
end of China is imminent.
Another decade, another purported crisis in the Middle Kingdom. The same exercise can also be done
in the reverse, starting with the fiery 1960 Nixon-Kennedy debates involving the Taiwanese Strait
Crisis or the 1948–1949 civil war or even the Japanese invasion and occupation of the 1930s. Yet time
and again, China somehow manages to survive.
Over the course of more than 5,000 years, it has endured every imaginable crisis — both man-made
and natural — and will undoubtedly survive this latest man-made disaster.
However, once again, to many foreign observers, such as Time magazine, the end of China could be
imminent. And mainstream pundits such as Nouriel Roubini and überbear Marc Faber forecast a "hard
landing" for the world's most populous nation.[5]
Yet the truth of the matter is, no matter how hard or soft China's recession will be, the West and in
particular, the United States, will be hitting every limestone rock across Mount Everest's northeastern
face and then will continue tumbling across the Tibetan plateau. And if the next administration plays its
cards right, the United States could very well end up in the Challenger Deep instead of just the Turpan
Basin.
 Saving Itself Out of a Recession
Arguably, the worst thing that could happen to China this time around is a growth recession similar to
Japan's in the 1990s.[6] No Zimbabwe. No Argentina. No Weimar. No Iceland. No United States. In
fact, commentators such as Joseph Salerno and Peter Schiff have noted that, despite its spendthrift
government and zero-interest rates, Japan managed to still grow and (relatively) thrive because of its
enormous domestic savings, current account surplus, and robust manufacturing capacity. [7]
Likewise, the average Chinese citizen not only has little debt but actually saves more than half of his
annual income.[8] Student loans, auto loans, and credit-card loans are as plentiful as purple pandas.
Very few municipal or provincial governments are running deficits. Oh, and home equity — what is
that?
Yet according to the NY Times, this fiscal responsibility is a bad thing and is the root cause of the
current crisis. The Asian people saved too much money, lent the United States and other Western
governments money at cheap rates, and therefore created an asset bubble.
This increasingly popular line of reasoning was reiterated in a recent episode of Dialogue on CCTV in
which two American professors, Michael Pettis of Peking University and John Attanasio of SMU,
noted that in 1998, Americans began spending and shopping like never before. Pettis suggested that
Americans were funded in part by Asian countries, which, having experienced a calamitous financial
crisis in 1997–98, sought to park their savings in safe havens (e.g., US Treasury bonds). As a result,
this immense savings distorted the marketplace and caused the ensuing bubble.[9]

Rewriting the Narrative

In the current frenetic marketplace, it has become all too clear that methodology is still important to
effectively analyze the health of relative economies. As noted above, numerous outlets, including CNN
and Bloomberg, have had front-page articles highlighting the purportedly faltering economies of Asia,
in particular China.
Several of the articles have noted that in places like Guangdong province — the world's manufacturing
basin — factories are closing by the hundreds and in the process laying off thousands of low-skilled
employees. Bloomberg recently noted that in the past 11 months, more than ten million workers have
lost their jobs. China's once perpetually smoldering steel mills have cut back on ore orders from
Australia, and even bottom-dollar scrap metal from Japan goes unsold to the dieting Chinese.
The commentators are also quick to note that declining exports — measured in the form of lower cargo
tonnage — illustrate a deleterious trend that will only increase as Western consumption continues to
dry up.
To make matters worse, the commercial-construction bubble has popped, with property sales dropping
precipitously, as much as 40% in large coastal cities like Shanghai and Shenzhen, and even 55% in
Beijing.
And if things couldn't be any more dreadful, China's two main stock indices have each lost nearly two-
thirds of their value since they peaked a year ago.
Clearly China is in for a world of hurt, and the first solution is to implement a universal car-ownership
scheme, build hundreds of aircraft carriers, and reduce interest rates to zero across the board.
Thus, in a Keynesian framework, the Chinese save too much, spend too little, and are destined for low
economic growth. Furthermore, in a Keynesian world, entrepreneurs going bankrupt are a sign that
markets are failing.
Maybe not.

Grossly Distorted Plans

Let's assume that GDP is an accurate measure of growth.[10]
Let's also assume that analyst Marc Faber is correct that China has been fudging its GDP numbers and
didn't grow at 9% in the third quarter.
Instead, let's assume that China's growth rate over the past year has been 0%. What does the future
hold? Can it grow or is it bound for the abyss?
Looking at the fundamentals from a Keynesian perspective, the Chinese should stop saving
immediately and spend everything they have on bridges that dead-end into Himalayan mountains.
Construct an armada of unsound merchant vessels. Erect colossal monuments that consume vast
resources and spur economic activity.
However, from the point of view that savings in capital investment is the true catalyst for wealth
creation, China is head and shoulders above its Western counterparts.
For starters, Chinese residents typically did not get involved in exotic financial derivatives or purchase
Humvee's on credit. Chinese banks, however bloated and inefficient the West tries to paint them,
required 20–30% down payments on houses, and two-thirds of all loans are funded by deposits (as
opposed to capital markets in the debtor West).
Furthermore:
• Household debt in China amounts to roughly 13% of GDP, as opposed to 100% in America.[11]
• As shown by the IPO of China Railway, the government remains committed to privatizing state-
owned firms. This at a time when many Western governments are nationalizing entire
industries.
• China continues to implement land reforms.[12] This includes granting land-use rights to
peasants, empowering them to lease or transfer land to others — a first in a region that once
resembled the collective farms of the Soviet states.
• China has begun legalizing short selling and margin trading. In contrast, this past year the West
restricted their use or selectively banned them outright in a self-serving manner.
• China is opening capital markets through QFII and QDII, lowering real-estate taxes and
abolishing others like the stamp tax on home purchases. In addition, Yuan convertibility and
capital controls are being relaxed across the region.[13]
• China has finally restructured and privatized all of the big national banks. The Agricultural
Bank of China (the third largest) recently had its umbilical cord cut and now must sink or swim
on its own. This is the opposite of the direction being taken in the West.
• Similarly, while the housing bubble deflates, China's political class is not (yet) attempting to
prop up the real-estate sector en masse. The Fed and US Treasury are doing everything they can
to prevent price deflation by purchasing hundreds of billions in mortgage-backed securities.[14]
Surely the Chinese are doing something wrong. These shortsighted liberalizations will end in utter ruin,
right?[15]
 Why Save When You Can Spend?
Senior members of Congress, along with Fed chairman Ben Bernanke, are promoting a new stimulus
package, and the White House is looking at alternative ways to get the United States to spend itself out
of a recession. Economists Nouriel Roubini and Paul Krugman have each promoted $600–$850 billion
spending plans, and President-elect Obama has suggested that deficits won't matter under his
administration.
But the problem is, even if they can muster the political votes and citizens' approval, their plans cannot
work.
In order to finance the last $168 billion stimulus package in February 2008, Congress actually had to
borrow money from abroad. That's right: the package did not come from the vaults of the Treasury, but
rather from foreign savers from Japan, China, Russia, and the Middle East. Politicians took out a loan
that has to be repaid by taxpayers — with interest.
Upon receiving their rebate checks in the mail, many Americans dutifully spent the money as told —
shopping at places such as Walmart. Walmart in turn sent a large portion of the monies back to the
original manufacturers in places like China. And the Chinese in turn used the money to buy more US
Treasury debt.
Without the Chinese, the United States would not have had any kind of temporary stimulus. Without
the Chinese, the United States would not be able to finance its large deficit.
And without a healthy China, the United States cannot hope to finance yet another round of faux
stimulation.
In fact, blinded by Keynesianism, rather than thanking the Chinese for building and financing the faux
American dream, some have chastised them for saving too much, claiming that it was their high
savings rate that had to be invested somewhere that created the artificial credit bubble in the first place.
This fully ignores the role the central bank played in artificial interest rates and the part various federal
housing agencies played in distorting the marketplace. It also fails to acknowledge the role savings has
in economic growth.[16]
In the event that a new stimulus plan is sped through Congress, unless it includes cuts to federal
spending or tax increases, foreigners will once again fund it.
At least until foreigners get tired of the same rinse cycle and refocus their funds outside of the United
States.

Emerging on Top
As noted above, in the past year at least 67,000 factories across China have closed down and hundreds
of thousands of migrant workers have moved back to family farms. [17] While this phenomenon may
be painful in the short run, the Chinese are at least allowing bankruptcy to clear out ineffective business
models.[18]
In the United States, failure is no longer an option. In fact, more than $8.5 trillion dollars are being
used to prop up catatonic firms such as Citi, Fannie Mae, Freddie Mac, and AIG.
As a result, in the long run, China as a whole will be able to adapt to market conditions and prosper
because sick companies will have been expelled from the marketplace and capital will be reallocated to
the most efficient participants. Conversely, because the West has given up on bankruptcy and the
freedom to fail, they will continue to flounder as they prop up poorly managed firms.
Furthermore, the Chinese not only have relatively high household savings and relatively low corporate
debt ratios, but the government continues to privatize state-run firms and allow them to go bankrupt.
Thus the only unknown factor for the future is just how much damage the Fed will do to the US
currency, potentially driving away foreign holders of dollars.
If history is any guide, while China may be faced with uncertainty once again in 2019, it is backstopped
by a nearly $2 trillion foreign reserve and solid financial ground. The same cannot be said for the
United States. Perhaps foreign observers should take note.