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Mark's Market Blog

8-5-11: The Age of China? I think not.

By Mark Lawrence

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Markets continued down in a historic trend; this is one of the ten worst declines ever. It's far from over, folks. There will be a couple times in the coming months when the markets go up for a week or two; we call these "bear traps." US debt has been downgraded by S&P, our budget and budgetary process are both clearly out of control, and the PIIGS look like they're about to go boom. Empty words and minor gestures from various politicians will not change these facts.

S&P 500 February 7 2011 to August 5, 2011

Standard & Poors (read: David Beers, JotY) downgraded US debt from AAA to AA+. Fitch and Moody's, the other two worthless ratings agencies, have not changed their US rating. There are now four US companies with AAA ratings, higher than the US government: Microsoft, Exxon, Johnson & Johnson and Automatic Data Processing. Also the UK and France remain AAA, which personally I think in simply hilarious: these two countries in particular are quite close to serious banking trouble.

The S&P downgrade will have little effect on treasury interest rates or government policy. In fact, the single biggest loser in this event is obviously Obama, who will have to field campaign allegations that his budgets resulted in the first US downgrade since 1917. Although I personally don't like Obama's policies very much, I even more dislike unelected individuals like David Beers entering the political scene with this big of a splash. Here's what a few people had to say about the downgrade:

Unemployment in this country is barely budging off the bottom. We have about 17 million unemployed. Why don't we get them jobs? In the Great Depression, dust bowl conditions plus automated reapers and pickers meant millions of farm workers, especially in the south, were laid off. They were never rehired on the farms, of course. They did eventually find jobs working on the new manufacturing production lines of the north. In the Great Recession, millions of workers have been laid off from manufacturing, as computers, robots, and the internet replace production line workers and inventory / purchasing workers. Millions more have been laid off from construction as it's discovered that we actually have too many houses and commercial buildings in this country. These people will not be rehired in manufacturing or construction, any more than okies returned to Oklahoma to farm. The question you have to ask is what industry will be the next employer of millions of substantially unskilled workers? When I ask myself that question, the answer I get is 'no one in the US.' I think most of these people are permanently unemployed. Notice in the graph below there are two clear difference with this recession: it's far deeper and wider than previous ones; and previously the jobs came back about as fast as they went away, this time they're coming back far more slowly. Now, imagine what this graph will look like a year from now if there's a new recession starting sometime on the next few months.

Unemployment for post-WWII recessions, aligned at the bottom.

According to the British Centre for Economics and Business Research, Italy is likely to default, but Spain might just avoid it. Germany's Angela Merkel and France's Nicolas Sarkozy announced an emergency conference call on Friday. I'm glad the leaders of Europe are obviously taking quick and decisive action, Friday in the form of an emergency conference call. Maybe this coming week they'll actually meet, shake hands and pose for cameras. Germany is staunchly against a bailout of Italy. Since the bulk of Italian bonds are held by French banks ($500B) not German banks ($190B), Germans think the French should bail out Italy. Like the US, the interest rates on UK, French and German bonds are dropping as people flee to safety. When these bonds rates start to go up, it's time to get religion.

How are those PIIGS doing? Below I've put together some graph of their interest rates. As a free bonus I've included Belguim. Belgium is split in half, Flanders in the north (think Germans / Dutch), Walloon in the south (think French). The northerners in Flanders want to have an economy like Germany, where people work hard and save; the southerners want an economy like France where people work 32 hour weeks, get 8 weeks paid vacation, and drink a lot of wine. The result of this is that the last election was hung, and Belgium has not had a government for 14 months. Belgium is not the center of stability in Europe. Greek bonds have been over 6% for over a year. Last October Greece was joined by Ireland and Portugal in the over-6%-club. In the last few weeks Spain and Italy have also joined. Belgium doesn't look all that far behind, and personally I'm pretty worried about France and the UK.

Interest rates on 10 year notes

What will happen when the PIIGS default? That's still several months off, in my estimation - although things have been developing far faster than I had imagined. When a country defaults, there is a run on the banks. Therefore there must be a plan in place to save the banks, and then default must be announced quickly with no warning. When Greece defaults, there will naturally be a run on the banks of Ireland, Italy, Portugal, Spain; and perhaps France and the UK. If you ran the governments in these other countries, you would be thinking that if one defaults, all should default at the same moment; the laggards will suffer a likely collapse of their banking system. I'm expecting that sometime in the coming months most of the PIIGS default and perhaps exit the Euro, all at the same time, likely some Friday evening. Monday morning their banks will re-open and start issuing Drachmas and Lire and Pesos and Pounds to customers instead of Euros. Trust me on this, you'll know when it happens, but probably not before.

For a couple years now I've been saying that Fed attempts to stimulate the economy would fail, as we are deep in a liquidity trap. A liquidity trap is where there is no one to whom the banks are willing to loan, so if you give them more money they just sit on it. Here's the strongest evidence yet for my statement: The Bank of New York Mellon Corp. announced last night that customers that have deposited more than $50 million will be charged 0.13%. They don't want the money, they already have more than enough deposits and they cannot find a way to loan more out and make money. You walk in with a deposit of $50,000,000 and they ask you for a $65,000 deposit fee. Of course your account pays no interest. Now you have no choice, you have to buy treasuries. This is one reason the S&P downgrade will not raise treasury rates.

China is also facing massive bond problems, with as much as $1.7 trillion of debt wracked up by local governments to build arenas, shopping malls, airports, even entire cities that no one uses. Standard and Poors estimates that 30% of this debt will never be repaid. Yin Zhongqing, a Chinese Communist Party official, predicted in early January that 70% will go bad. Defaults would likely lead to the third Chinese banking bailout in 20 years. "To avoid a bank default, we believe the authorities need to take decisive action to restructure local debt," Qu Hongbin, chief China economist at HSBC Holdings wrote in a report. "We see the issuance of municipal bonds as the best option." That is, issue new bonds to pay off the old bonds. The entire Chinese banking system will likely have to be recapitalized to the tune of over $1.5 trillion. So much for China's foreign reserves.

My view of China is very different from most other peoples'. Common thought is that this is the century of China, that their economy will be larger than the US and Europe put together in 40 years, that soon we'll all need to speak Mandarin. I don't believe it.

  1. The US and Europe industrialized during a time of nearly free oil. Energy is now very expensive and only getting worse. The US in particular evolved during a time when our borders were friendly and secure, and enemies were an ocean away. China's relations with their neighbors are far more strained, and oceans aren't what they used to be, what with the Internet, aircraft carriers, container ships and Boeing 747s.

  2. We were able to bring our people off the farms and into manufacturing. Today in the developed world manufacturing is all by robots and computers. China can, for a short time, bring their people off the farms and have them sew clothing and paint McToys, but when it's time for them to computerize, what happens to these substantially untrained and nearly illiterate people? They will hit an employment wall; indeed anecdotal evidence suggests that unemployment in China is already a rising problem.

  3. 60% of China' economy is building cities that no one lives in, airports where no one lands, shopping malls where no one shops, trains that no one rides. This is highly inflationary. China officially has inflation right now of nearly 10%; anecdotal evidence would suggest it's more like 30%. In the US, when food and gas go up by 10% as they recently have, we all bitch and whine but we mostly keep eating and driving. In China, where food is 40% or more of people's income, when inflation gets bad people don't eat. Remember what Lenin had to say about this: no government is ever more than three meals away from revolution.

  4. It's been estimated that China's banks have as much as $1.7 trillion of bad loans on their books due to the construction projects mentioned in (3). This is a command economy, not a market economy, so their government can simply order that the banks are recapitalized and there is no problem, but the result of this horrendous increase in money will be an equally horrendous increase in inflation.

  5. Chinese demographics are awful. The one-child policy has led to something the Chinese call 8-4-2: Eight grandparents pair off and have four children. These four children pair up and have two children. These two children marry and are now responsible in Chinese culture to raise their one child, and also to support eight grandparents and four parents in their retirement. Meanwhile, the poor single kid has seven mothers/grandmothers. Couple in improved medical care and nutrition leading to a quick increase in Chinese life expectancy and you have a situation that makes our Medicare and Social Security political problems look like a kindergarten squabble.

  6. In China people frequently abort female babies, as there is a strong preference for males. The result of this: in five years China will have more unmarriageable 20-something males than California has people - over 35 million. Brigham Young, great-great grandfather of Steve Young, once said "Any unmarried man over the age of 25 is a menace to society." How do you handle 35 million hormone-enraged menaces? We're going to get to find out soon. Happily, from an ocean and about 10 time zones away.

  7. China is quickly running out of fresh water. They have 20% of the world's population and 7% of the world's fresh water. The Gobi desert is increasing in size by a Rhode Island every year (1500-2000 square miles per year). It's a well established fact that forests and farmland cause rain, and desert and cities repel rain. As the Himalayan glaciers that supply much of China's water continue to shrink, as the Chinese convert farmland into cities (many where no one lives), as massive dams convert forests and farmland into reservoirs, as the Gobi desert increases in size, already insufficient Chinese water supplies are going to continue to shrink, not grow. Furthermore, lacking anything even resembling an EPA, more and more of China's rivers and streams are getting seriously polluted. Their current plan is to divert the Brahmaputra river, bringing drought and famine to Bangladesh and eastern India. Indian generals consider a war with China inevitable. Notice that China will have no problem rounding up men for such a war. In fact, you can make a Machiavellian argument that a war that killed a few million Indian and Chinese young men would be good for both countries.

  8. China is quickly running out of food. Their current plan is to buy up enormous tracks of farm land in Africa. And when famine strikes in Africa, or perhaps I should say gets much worse, and Chinese are attempting to truck thousands of tons of grain from "their" African farmland to African ports, I predict they're going to have to run a gauntlet of well armed and experienced African irregulars. Ironically enough, the Africans will mostly be armed with cheap Chinese AK-47s.

  9. As we speak, the middle east is moving quickly towards Sharia (muslim law); Kazakhstan and Uzbekistan are quickly becoming ungovernable as villages put up barriers and declare Sharia. Western China is substantially muslim. The prospects for unrest seem high to me.

  10. North Korea has turned into a terror state. No one wants this, but no one wants to do anything. If the North Korean government falls, China is looking at several million refugees pouring across their border, and South Korea is looking at a reunification bill that will be several times higher than what Germany paid, a bill that will nearly bankrupt them for a couple decades. This situation cannot be contained forever. Perhaps another Korean war would help everyone.

  11. China counts on Burma (Myanmar) for access to the Indian Ocean, and as a trading partner. When war comes on the Indian / Chinese border, the stability of Burma will be brought into question. Burmese are some of the nicest, hardest working people on the planet, ruled by one of the five worst governments on the planet.

I think China is headed for some seriously rough times: crippling inflation and unemployment, food and water shortages, civil unrest, armed conflict with neighbors, growing retired population, shrinking workforce. I just can't see this as the recipe to brew up the world's next economic super power.

As I've said, without question mine is a minority opinion. Most think China will be the next Japan, except 10 times larger - 1.2 billion people instead of 120 million.

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