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A view from across the PacificHow big can China grow? A view from across the Pacific|
Published on: December 24, 2010 - 00:59
More in: Business
By Tensing Rodrigues
Vitaliy Katsenelson is the Chief Investment Officer of Investment Management Associates Inc., and an adjunct faculty member at the University of Colorado at Denver’s Graduate School of Business. In a recent interview to David Galland, the Managing Editor of The Casey Report, he spoke about the bubble that China could eventually prove to be.
Katsenelson begins with a very apt analogy : USSR in 30s. He reminds us of how depression harried Americans in the 1930s looked at the Soviet Union’s managed economy as being superior to the American free market. “So”, says Katsenelson, “in the short run, and especially after the ugly side of creative destruction has paid us a visit, the grass of managed economy may look greener.” But he reminds that in spite of its short term attractions, state control is an inefficient path of development. “Sure, the growth you see today in China is there, but it’s not a sustainable growth. It’s not a growth that you’ll see a few years from now.”, says Katsenelson.
And he puts forth the reason for saying that : “The growth is being induced by government spending, by a misallocation of capital.” He cites two flagrant instances of the same. South China Mall is the second largest mall in the world, but is mostly empty. Chinese built an entire city, Ordos, in Inner Mongolia for 1.5 million residents and it is completely empty. “As long as they keep building”, concludes Katsenelson, “that activity will be registered as growth, until they stop. And when they do stop, they’ll drown in overcapacity”.
To show how China could be a difficult to decipher bubble, Katsenelson draws analogies with American railroad boom and the technology bubble of 1998. “The problem with China is pretty much the same as with any bubble” says Katsenelson. “Though it may have had a solid foundation under it, it is simply a good thing taken too far. If you look at the railroad bubble in the United States, the country did need railroads, but we built too many. The same thing happened with the technology bubble in 1998. The Internet was transformative to our economy, no question about it. But, again, it was taken too far.”
According to Katsenelson Chinese government has no choice but to keep the frenzy going. Chinese economy grew at a very high rate for a long period of time. When the global economy slowed down, their economy slowed down as well (though official numbers did not show it). The Chinese government is extremely concerned about the economy slowing down because that is likely to lead to political unrest. A lot of that potential friction comes because a lot of people moved from villages to the cities. China has an almost nonexistent social safety net system. So people, who lose jobs don’t complain they riot. Chinese government is afraid of political unrest, and therefore they quickly released a tremendous amount of stimulus into the economy, then followed it up with encouraging bank loans equal to 29% of GDP in 2009, a huge increase. When you infuse this much debt into an economy, it’s impossible to have good capital allocation decisions. While the economy is growing, the bad debt won’t be so apparent, but it certainly will be when the economic growth slows down.
Manufacturing is the mainstay of the Chinese economy. But manufacturing calls for a lot of fixed costs. The high level of fixed costs doesn’t afford China an economic slowdown; but when it happens, the consequences will be devastating. High fixed costs are great when sales are growing fast. But they are devastating to profitability when sales decline.
And that is where China’s biggest risk lies. China’s domestic market is just 1/10th of its total market; the rest is constituted by overseas sales. As a result, a very small decline in consumption in the US and Europe has to be compensated by a huge increase in consumption in China; and that is going to be very difficult. Going ahead, says Katsenelson, Chinese government has to choose between the devil and the deep sea – cool down its overheated economy so that the bubble does not grow too big, and the looming contraction of its market in US, Europe, Japan. And that is not going to be easy.
Vitaliy Katsenelson’s interview in The Casey Report is titled “The Only Question About The China Crash Is When”.