Strategic Investment

Chinese Stimulus, the Mirage of Recovery and the Double-Dip Depression

“China’s growth is getting back on track after being pulled down by the global export slump. It’s leading the turnaround in the global economy.”

– David Cohen, Action Economics

“There is only one vital time to wake up: and that is now.”

– Buddha

Consult a dictionary for the meaning of the word “recovery,” and you will find this definition: “recovery n 1. Return to an original state: ‘the recovery of the forest after the fire was surprisingly rapid.’ 2. The act of regaining or saving something lost (or in danger of becoming lost).”

So if you have normal fluency in English, you are likely to be misled by the much vaunted economic recovery the mainstream media heralds.

“Recovery” in economics is a term of art. It doesn’t mean what most people think it means. For example, if you’re whispering to yourself, “The recovery of the economy after the credit collapse was surprisingly rapid,” you’re imagining something much more vibrant than a technical recovery actually entails.

You see, in economist speak the word “recovery” does not mean “returning to an original state” (as you would intend if you said that the patient enjoyed a “rapid recovery” from his stroke). Far from it…

Economic Recovery and the Falling Man

According to modern economists, what recovery actually means is “hitting bottom” (or one of many bottoms in a series of collapses). Technically, a recovery begins when the economy ceases falling. In that sense, it has nothing to do with actually rising again… or regaining what was lost.

Imagine a man plunging from the upper stories of a sky scrapper. When he hits something, it halts his plunge; temporarily or permanently that marks a “recovery.”

If he hits a ledge on a lower floor, he may be “recovering” while he just lies there in a vegetative state.

Of course, he really hasn’t hit bottom until he reaches the pavement. This would mark another phase of his “recovery” – even if he is critically injured and cannot move.

When you think of recovery you may have something in mind more akin to the stunts of a superhero bounding off the pavement in acrobatic fashion.

In my youth, I watched “Adventures of Superman” on TV. Superman, as you may remember, could leap tall buildings in a “single bound.” You think of him jumping off a skyscraper, dusting himself off and then moving on unharmed, rather than lying in heap – a broken body awaiting a medivac helicopter for a trip to the critical care unit.

That is the kind of recovery we are really getting.

Why a Decade-Long Recovery Awaits

U.S. retail sales, for example – although stimulated by “cash for clunkers,” checks to Social Security recipients and a massive inflation of the Fed’s balance sheet – have shown little sign of recovery. Except in the sense that they have stopped becoming considerably worse.

Remember, the U.S. government has launched an unprecedented bailout and stimulus program. And it has resulted in a budget deficit that, according to Goldman Sachs, will require $3.25 trillion in borrowing before the end of this fiscal year.

The U.S. government has also taken over both GM and Chrysler – seriously disrupting the seasonal patterns of industrial production and auto layoffs.

The combination of these factors has caused the seasonal adjustments of economic statistics to artificially spike employment data and industrial production numbers.

Of course, as the warped seasonal adjustments reverse, you can expect “surprisingly bad” numbers in the months ahead. This will bewilder those who naively assume the economy has “recovered” to the state that existed prior to the bankruptcy of Lehman Brothers and the Great Wipeout of last autumn.

Those of us who have studied market reactions after past credit collapses, however, will not be surprised that the economy cannot plunge 40 stories to the pavement, then hit the ground running like Superman and sprint away as though nothing had happened.

It normally takes a decade or more to unwind the consequences of a credit collapse. That will certainly be the case this time. After all, we have witnessed the greatest credit bubble in history go wrong.

Consumer Spending Is Dead and Buried

U.S. Retail Sales
Month	2009	2008	% Change
January	342017	376262	-9.1%
February	343438	373140	-8.0%
March	339228	374845	-9.5%
April	338344	376009	-10.0%
May	339873	376662	-9.8%
June	342497	376055	-8.9%

If you smooth out the “noise” of warped seasonal adjustments and other statistical quirks, on a three-month moving average basis U.S. retail sales have been holding at a year-over-year decline of about -9% since December 2008. (For more details, see John Williams’ Shadow Government Statistics here.) This is a record low for the post-World War II era.

This decline in consumer spending has far reaching implications for U.S. GDP growth, the personal savings rate, the trade (current account) deficit and the world economy.

As recently as the early 1990s, consumer spending amounted to just about 65% of U.S. GDP. By last year it had soared to almost 72%.

This became possible because the savings rate in the U.S. plunged from about 8% to almost nothing. From the end of 2004 through last year, the U.S. savings rate has either been hovering at about 1%. or it has even gone negative.

A big part of the decline in aggregate savings in the past two decades is attributable to the fact that credit became readily available to the bottom 40% of the population, people with little or no net worth. The recent stiffening of credit standards following the subprime collapse, along with the contraction of leverage, have made it impossible for these zero net worth families to resume spending as they previously did.

To buy a home now, for example, you must make a sizeable down payment. This is unlike the situation a few years ago. Then, buyers without income or assets could buy homes for zero percent down. In some cases they could actually withdraw cash at settlement.

Equally, the disappearance of home equity for many millions of American homeowners has taken home equity loans with it. This means cash-strapped households no longer have the option of reverting to the home equity ATM to finance consumption.

Each dollar that Americans save is a dollar that will no longer be immediately spent. Although higher savings for the long run are essential – the savings rate will probably double from the 5.2% recorded in the second quarter – a higher saving rate means less economic activity in the U.S. and in countries that produce goods for American consumption.

This takes on a special significance when you consider that, according to the McKinsey Global Institute, consumer spending decreases by more than $100 billion for each percentage point the savings rate goes up.

Although Warren Buffett argues that it has never been profitable to bet against the appetites of the American consumer, the extraction of leverage from the credit system has imposed a slowdown in consumption that is unlikely to be reversed any time soon.

You see, the rise in savings to this point is not just a matter of chastened consumers realizing the folly of profligate living. It is also a matter of structural limitations on credit expansion to uncreditworthy borrowers.

And as unemployment rises due to the continued slowdown in consumer spending the savings rate will rise further as credit is withdrawn from more and more consumers.

The “green shoots” of recovery everyone is so excited about are, at best, plastic flowers the government has sprinkled about the economic landscape in order to mobilize greater consumer confidence than can be justified on the facts.

And the “recovery” you are getting is more mirage than reality – an artifact of stimulus/bailout efforts magnified in the light of unrealistic projections.

China: A Danger to Your Wealth

This crisis is not just confined within the borders of the U.S. It is global. Thus the search for “green shoots” in far flung corners of the world.

A lot of recent enthusiasm over the prospects of Chinese recovery, for instance, can be explained by the dark hunch that something more than the “shop till you drop” disposition of American consumers is needed to sustain a real recovery.

David Cohen’s comments quoted at the top of this article epitomize the common misconception that China is “leading the turnaround in the global economy.” This is a misreading that could be dangerous to your wealth.

First, it is arguable whether or not there is any “turnaround in the global economy”. Second, far from contributing a solution, China’s stimulus program is aggravating the underlying problem. It is adding supply to a world plagued by excess capacity and collapsing demand.

As China expert Michael Pettis has convincingly argued, China’s massive stimulus program is stimulating the wrong things. And it’s making the ultimate adjustment required for world prosperity more difficult by setting the stage for another credit collapse and a greater contraction of global GDP.

This from a recent article by Pettis titled “Will China’s Trade Surplus Soar?”

I know this all sounds drastic, but the imbalances have to be worked out one way or the other. Rising savings in one part of the world, even assuming no change in global investment, requires declining savings somewhere else, and although it may be unrealistic to expect no change in global investment, the plausible prediction is that global investment will actually decline, which increases the pressure. This is just another way of saying that changes in trade deficits in one part of the world require equal changes in trade surpluses elsewhere. This is also just the obverse of saying that declining consumption in one part of the world requires rising consumption elsewhere (or sharply rising investment, which since it represents future production only postpones the need for consumption growth) or else global GDP must contract.

Pettis’s important argument needs to be read closely to be understood. What he is saying is that the fall in U.S. consumption means there must be a contraction in global GDP – unless consumption picks up somewhere outside the U.S. to replace U.S. spending.

He doesn’t think Chinese consumption can expand fast enough to supplant lost consumption from Americans who never could afford the standard of living they were enjoying and can now no longer borrow to keep it afloat.

An Orgy of Lending

Pettis doubts that the Chinese can sustain the 7.1% growth rate they enjoyed in the first half of 2009. For reasons I explore below, growth cannot be sustained for long by ever increasing amounts of government-financed investment.

To the contrary, flushing trillions of dollars worth of investment into an economy at low rates of return for many years is a recipe for creating a credit bubble that is bound to collapse eventually – with dire consequences, as we have seen in Japan since 1990.

The U.S. stimulus package is overwhelmingly biased towards increasing U.S. consumption and creating/maintaining employment to sustain that consumption. The Chinese stimulus package, although it is definitely oriented towards maintaining employment, is heavily geared towards subsidized investment.

Consider the following facts…

In the first half of 2009, China’s GDP rose at a 7.1% yearly rate. Fully 88% of that growth was attributable to investment. The money to fund this surge of investment was provided through an orgy of lending by Chinese banks – mostly to state-owned enterprises.

The political point of the lending, which the Chinese government pressured banks to make, was to forestall unemployment – especially at inefficient state-run enterprises.

But there is general agreement among Chinese experts that most of the investment funded through this stimulus bubble is in projects with very low or even negative returns.

The People’s Bank of China keeps interest rates artificially low to subsidize production at the expense of Chinese consumers, who must settle for nugatory interest rates on bank deposits. That means if a non-subsidized interest rate were applied, the return could well be negative on almost all of the trillions of yuan invested in the Chinese stimulus binge.

A Growing Oversupply Problem

You see, Beijing has flushed trillions of yuan into expanding capacity in sectors already suffering from collapsing demand and an overhang of capacity.

To cite one example, which has been highlighted by Chinese officials themselves, Li Yizhong, chief of the Chinese Ministry of Industry and Information Technology, has proclaimed that China will withhold approvals of new steel projects for at least the next three years.

Li told a press conference on August 13 that oversupply has become a serious problem because China’s annual production capacity of 660 million tons exceeds estimated demand by an astonishing 190 million tons.

One of Li’s spokesmen put it this way: “The industry must produce according to market needs and avoid adding to the excess capacity. They should avoid reckless investments. The government must also take action to curtail additional investments by companies that are already in excess.”

The particular case of malinvestments in steel – a sector suffering from vast excess capacity – probably came to be a focus of official comment at least in part because the stimulus had unintended consequences: it frustrated Chinese attempts to stockpile iron ore at low prices.

This has been a particular focus of attention for the Chinese. You may recall that the general manager of Rio Tinto’s Shanghai office, along with three other RTZ employees, have been under arrest in China since the July 4 weekend on charges they “stole state secrets.”

Not incidentally, at the time of the arrests the Rio Tinto employees were engaged in contentious negotiations over iron ore prices with Chinese steel mills.

I know nothing about the specific charges of spying. But I would judge that the frustration of China’s ambition to take advantage of the global depression to stockpile iron ore at low prices is due more to the scramble for iron by China’s subsidized steel mills than the clandestine maneuvers of a the Shanghai office of Rio Tinto.

Currency Devaluation – No Way Out

Quite apart from the melodrama over stealing state secrets, what is not a secret is that China’s program to expand capacity through indiscriminate lending will compound the difficulties of world recovery.

Justin Lin, chief economist of the World Bank, suggested in a speech last month that there was a danger of economies being trapped in a vicious cycle of deflation. According to Lin, “Significant excess capacity has been built up, and unless this issue is addressed we will face a deflationary spiral and the crisis will become protracted.”

Lin said capacity utilization had tumbled to 72% in Germany; 69% in the U.S.; 65% in Japan; and as low as 50% in some developing countries, “touching lows not seen in modern times.”

And he went on to suggest that the conventional remedy for countries caught in slumps is to devalue their currencies. This would improve the terms of trade and allow them to gradually recover their health through export earnings.

But currency depreciation to stimulate exports as a remedy for recession will not work today because the crisis is global.

“No country can count on currency depreciation and exports as a way out of recession,” says Lin. “Unless we deal with excess capacity, it will wreak havoc on all.”

Will Stimulus Trigger a Deflationary Spiral?

So you can see that far from leading a turnaround in the global economy, China’s stimulus program may have compounded the risk of a deflationary spiral.

This is true for three important reasons.

1. An investment driven program to increase capacity can only exacerbate the problems of global excess capacity in the face of insufficient demand.

2. The massive program of subsidized lending to increase capacity in China has negative feedback effects on world trade that could contribute to growth-stifling protectionism.

Another consequence of China’s stimulus has been that the country’s share of the U.S. trade deficit has grown enormously. From 2000 through 2008 China’s share of the non-oil U.S. trade deficit ballooned from 26% to 69% – a compound annual growth rate of about 13%.

According the Economic Policy Institute, so far this year China’s share of the non-oil trade deficit has leaped to 83%– a jump of more than 20% in an environment in which the U.S. trade deficit has been dwindling. This means exporters from countries other than China are “being killed,” as Pettis describes it.

When you consider that world trade in the first half of 2009 took the deepest plunge in 80 years (U.S. imports dropped by 30% this year), there was very little prospect that countries whose tradable goods exports to the U.S. were squeezed out by the Chinese goods could readily find other markets in which to make up for the loss of sales.

This implies a growing threat of protectionist measures. It is not hard to predict that protectionism will grow – with negative consequences for total world trade. Other things being equal, more barriers to trade mean a greater deflationary impulse. That’s because the total demand for goods across the globe will fall as trade barriers rise.

3. Perhaps the greatest risk of further financial stress (with ultimately deflationary consequences) arising from the Chinese stimulus package is the likelihood that the Chinese will follow in the footsteps of Japan.

Is China the New Japan?

As you know, in the 1980s the Japanese experienced a massive asset bubble that was set in motion by policies similar to those China is now pursuing.

Charter subscribers to the original Strategic Investment will recall that we were disappointed in September 1985 to have made only a few thousand dollars from accurately anticipating the Plaza Accords (which led to dramatic increases in the values of the Japanese yen and the German mark.)

Unfortunately, the agreement was announced on September 22 1985, a few days after expiry of the September Japanese yen futures contract that Strategic was holding long. Had the accord been struck a few days earlier, we would have profited by many tens of thousands of dollars.

We made up for the money we left on the table, however, when we profited for a second time from the misguided efforts of the U.S. government to staunch the U.S. trade deficit via currency manipulation. We made a fortune shorting the Japanese stock market when it collapsed.

There is no more vivid testimony to the enduring stupidity of the U.S. Congress than that its distinguished members are today agitating for an increase in the exchange value of the yuan, just as they agitated 25 years ago for an increase in the value of the yen in the misguided notion that a lower exchange value for the dollar would extinguish the trade deficit.

It won’t.

If their simpleminded view of the world was correct, you could have expected the U.S. trade deficit to have disappeared long ago. The value of the yen rose from an average of ¥239 per $1.00 in 1985 to ¥94.18 as I write.

Japanese Yen vs the U.S. Dollar

Déjà Vu All Over Again

You may wonder how my editorializing bears on the question of the moment: How will China’s stimulus program informs economic developments to come?

I believe it does. Bear with me.

You see, we are in a situation of the sort that Yogi Berra described in his classic phrase: “This is like déjà vu all over again.”

China is doing more or less what Japan did between 1985 and 1990 when it created one of the greatest asset bubbles to that date – a bubble that went on to collapse in a deflationary crisis the country has yet to escape.

As you may recall, land valuations during the Japanese bubble reached preposterous extremes. The Tokyo Imperial Palace was said to be worth more than all of California at the height of the bubble!

Such fantastic valuations came about because Japanese authorities understood one thing better than the U.S. Congress. They knew that even a 55% appreciation of the value of the yen that followed the Plaza Accord would not necessarily lead to a decline in the Japanese trade surplus with the U.S., as many Congress folk and other fools contended at the time.

Japanese leaders were content to see their currency double against the dollar, while their trade surplus with the U.S. actually surged. They understood that a country’s trade surplus or deficit is an expression of the gap between what it produces and what it consumes.

See, absent a huge surge in the U.S. savings rate (which began a secular decline in about 1985), the U.S. trade deficit was destined to explode. It did.

An October, 2007 study by the Federal Reserve Bank of St. Louis noted the following:

It is striking to see how closely these numbers match: the increase in the trade deficit ($762 billion), the increase in consumption due to a rise in consumption’s share of personal income ($802 billion), and the increase in revolving credit outstanding (about $800 billion).

Unfortunately for the Japanese and the world, they played along with U.S. political posturing to push the value of the dollar down because doing so staunched the agitation for protectionism in the U.S.

How Free Money Killed Japan

Although the Japanese may have seen beyond the simpleton’s view that currency depreciation would quickly bring the U.S. trade account into surplus, they were much less perceptive in foreseeing the catastrophic consequences of the “work-around” that the Japanese Ministry of Finance and the Bank of Japan devised in response to the currency accord.

What the Chinese are doing today is much like what the Japanese did in the mid-1980s. Fearing a fall-off in the earnings of Japanese business from trade, Japan’s Ministry of Finance directed a torrent of low-interest bank loans into the manufacturing sector that were backed by a “nod and a wink” from the Bank of Japan.

The big banks knew they could lend profitably to manufacturers because the government implicitly guaranteed the loans. The manufacturers took the money at low nominal interest rates. It was, after all, almost free money.

Naturally, Japanese manufacturers found themselves awash in liquidity. And they looked to deploy this cash in asset speculation, rather than spending on capital goods or other aspects of the real economy.

It became obvious to us here at the time at Strategic Investment that the Japanese assets bubble was destined to burst.

After a trip to Tokyo in the summer of 1987, my co-editor, Lord William Rees-Mogg, wrote a lead article titled “Japanese Bubble to Burst.”

It informed readers that in 1986 “no less than half of the major companies of Japan made part of their reported profit from speculative trading on the Tokyo stock market. In some cases, their trading profits were larger than their profits from normal business.”

In Tokyo this month I have been left in no doubt that both the stock market and real estate values are dangerously high. […] The market value of Japanese real estate, small geographically as Japan is, has now overtaken that of the U.S. A two-bedroom apartment in central Tokyo can cost $8 million to $10 million. Houses go for up to $50 million. Hardly any business in Tokyo would trade at a profit if it paid full market rent.

Lord Rees-Mogg went on to forecast that “Tokyo markets could be in catastrophe when the bubble burst”… as it did only a few years later.

A New Bubble Is Born

Flash forward to today, and we find another Asian economic superpower has replaced Japan as the world’s largest trade-surplus country. And it is now making the same mistake that Japan made in the 1980s.

China’s leaders have instructed Chinese banks to lend trillions of yuan (CNY7.4 trillion so far) to Chinese manufacturers. These are mostly old-line state-owned enterprises that are in the least productive sectors of the Chinese economy. As a result, Chinese M2 money supply has increased by 28.5%. And yuan based lending has soared by 34.4%.

You can be absolutely sure that the lending is implicitly guaranteed by the Chinese government.

Consider the following hint… Chinese bank stocks plunged in early July on rumors that the extravagant and unsustainable growth of banks loans would be curtailed. Obviously, if the banks were acting on their own in such a potentially ruinous lending spree, prudent shareholders would welcome the news that it might be brought to an end. But the fact that bank stocks sold off on rumors of restraint says that the market understands the lending is a “no risk” win for the banks because the government is backstopping the losses.

The new money has been used to refinance bad loans previously on the books. And it has underwritten a surge of capacity in a number of sectors. It has also leached into the stock market and real estate, just as it did in Japan.

A number of highly placed Chinese leaders are acutely aware of this danger. Wu Xiaoling, former vice governor of the People’s Bank of China, has stated, “Under conditions of overcapacity, excess money supply will not lead to rises in price indexes, but it could generate asset bubbles.”

There actually is no need to wonder whether asset bubbles will result from all this funny money. According to Wei Jianing, a deputy director of the Development and Research Center of China’s State Council, “Chinese new bank loans worth an estimated 1.16 trillion yuan ($170 billion) were invested in the stock market in the first five months of this year.”

It’s little wonder that the Shanghai Composite Index has soared by 100% off its November lows. And that Chinese real estate has skyrocketed in nominal value.

Make no mistake. We have a situation very similar to Japan in the mid-1980s.

“Speculation, Overexpansion, Wasteful Expenditures”

In China now, as in Japan then, the early stages of the bubble are being mistaken for a grand success. ‘Experts’ applaud China for “leading the turnaround in the global economy.”

But closer examination reveals that China has simply inflated another potentially disastrous credit bubble – one that will aggravate the imbalances in the global economy and increase the danger that the rest of the world will be sucked into an intensified financial crisis and a deflationary spiral.

No less an authority than President Herbert Hoover warned, early in the 1920s, while he was serving as secretary of commerce, that:

Booms are times of speculation, overexpansion, wasteful expenditures in industry and commerce, with consequent destruction of capital. […] It is the wastes, the miscalculations and maladjustments, grown rampant during the booms that make unavoidable the painful process of liquidation. The obvious way to lessen the losses and miseries of depression is first to check the destructive extremes of booms.

Hoover was talking about the U.S. during the Roaring Twenties. But he might as well have been describing the gigantic bubble the Chinese authorities are unwittingly inflating now by force feeding of credit into the country’s flagging economy.

I think it unlikely that the Chinese will prove more adept at finessing the collapse of their bubble than the Japanese were.

It’s obvious to the discerning eye that the rosy reports of “recovery” in China describe something far less encouraging. China is attempting to replace its export-led prosperity with investment-bubble ‘prosperity.’

This bubble will collapse, causing an even greater crisis than that which sank Japan into its “lost decade” almost 20 years ago.

James Davidson

Editor,

Strategic Investment

An Unusual Way to Profit
from the China Collapse

“We can’t develop like this any longer. It’s a dead end. And the crisis has placed us in a situation where we will have to make decisions on changing the structure of the economy.”

– President Dmitry Medvedev on the double-digit decline of Russia’s energy dependent economy in the Q2.

The “fantastic” growth of the Chinese economy this year is exactly that – fantastic in the sense that it departs from reality.

The Chinese are inflating a real, not an imaginary, bubble. But the impression of growth given by the government’s claim of a 7.1% GDP increase in the first half relies on anachronistic GDP accounting left over from the days of Stalinist central planning.

Perhaps President Obama’s statisticians will drill in and learn something about levitation from the Chinese. If U.S. politicians could claim GDP growth by simply allocating spending in a stimulus program, U.S. GDP would be half a trillion dollars higher this year because of stimulus spending Washington has announced but not yet spent.

Obama signed the $787 billion stimulus law on February 17. But through July the government has only disbursed $60 billion. Under Chinese accounting, the whole $787 billion could have been counted in the GDP accounts in the first quarter. (Or rather $499 billion could have been counted; the other $288 billion consisted of tax cuts.)

Equally, if we could claim production in state-run companies at full retail value, Obama’s car czar could instruct GM and Chrysler to run their assembly lines around the clock. Every vehicle that rolled off the assembly line could be counted in the GDP statistics at full price – even if none of them were sold. (Production counts in U.S. GDP at wholesale value.)

That would do more to goose the statistics than all the shuffles and gags introduced to GDP accounting within the last quarter century.

You get the point.

China’s boom, upon which a lot of global optimism has been capitalized, is not what it seems. The apparently robust first-half GDP growth of 7.1% is a strange amalgam of statistical illusion and a genuine, but unsustainable, investment bubble.

Can We Predict Bubbles with Math?

Didier Sornette, a professor of geophysics at UCLA, has developed a model he and his team claim can identify an economic bubble and provide guidance on the likely time that it will burst.

Sornette and his team have stated, “By the very nature of the model, this result gives two conclusions: Firstly, there exists a bubble in the Shanghai Stock Exchange Composite Index. Secondly, it will reach a critical level around July 17-27, 2009. This will lead to a change in regime which may be a crash or a more gentle bubble deflation.”

Among other things outside the normal realm of geophysicists, Sornette has been fascinated by “super-exponential growth” of human population and economic output over the past centuries.

He has published a paper titled “The End of the Growth Era?” that suggests world economic growth is destined to be snuffed out by “a drastic and unavoidable change of regime around 2050.”

According to Sornette, “A spontaneous singularity has been created by the increasing growth rate! This process is quite general and applies as soon as the growth rate possesses the property of being multiplied by some factor larger than 1 when the population is multiplied by some constant larger than 1.”

He goes on to say that, “Singularities and infinities were anathema for a long time. […] They are not fully present in reality, only the precursory acceleration is there and foreshadows an important transition. In the present context, they must be interpreted as a kind of ‘critical point’ signaling a fundamental change of regime.”

Sornette is Malthus with a computer. He’s projecting a long-term Japanese “lost decade”-style collapse of growth for the global economy. (From 1996 through 2002 Japan’s per capita income increased by a bare 0.2%)

In future issues, we’ll look more carefully at Sornette’s gloomy “secular stagnation” forecast, which corresponds to Sir Isaac Newton’s projection that the world would end sometime around 2060.

The good news is that even if Sornette and Newton are correct, we have a few decades to think about it.

A Shanghai Market in Lalaland

I have no specific explanation of how Sornette and his team teased out the notion that the Shanghai Stock bubble was destined to burst, or at least begin a slow leak, sometime between July 17 and July 27. (He is an expert in complex systems, so I doubt any mathematical algorithms he employs could easily be translated into English.)

But we already know why the Shanghai market is in Lalaland…

China has roughly twice the industrial capacity needed to supply all the consumer goods that U.S. consumers demanded before the credit bubble popped year. And despite the disappearance of demand from their best customers, the Chinese have responded with an investment-led boom to create still more capacity.

This could be an extraordinary statement of faith in Say’s Law – that supply constitutes demand. Alternatively, it suggests that the Chinese are just blundering along like the rest of us on the momentum of past success.

In terms of our current crisis, it is hard to credit that the Chinese are rejecting Keynes, who included an attack on Say’s Law in his General Theory of Employment, Interest and Money.

How to Profit on the Short Side of China’s ‘Boom’

Be that as it may, the Chinese market is ripe for a correction. The communist regime there has too many problems and contradictions in its economic policy for this stimulus bubble to end happily.

There are several ways to short China.

An indirect play on China weakness is to sell short commodities such as copper and oil. That’s because Chinese stocks and commodities tend to trade along with each other.

But I don’t recommend this approach at the moment. We already have a short position in oil. And it has not been working because of investor enthusiasm about the “recovery” theme.

Although oil has rallied, natural gas – a commodity that reflects many of the same fundamentals as oil – has fallen to multi-year lows. My conclusion is that oil has risen on speculative enthusiasm rather than on fundamentals.

Probably the purest play on the supposition that China’s boom cannot be sustained would be to short or buy longer-term put options on the big Chinese ETF, the iShares FTSE/Xinhua China 25 Index (NYSE:FXI), which tracks the FTSE/Xinhua China 25 Index.

Or you could buy an inverse fund that profits when Chinese stocks fall. For instance, the ProShares UltraShort FTSE/Xinhua China 25 (NYSE:FXP) is an “ultra-short ETF on the FTSE/Xinhua China 25 Index.

Be aware though that you should only use the UltraShort ETF’s for shorter-term moves. That’s because over the long-term it loses its leverage advantage.

Another way to play the move is to short The Greater China Fund, Inc. (NYSE:GCH), a proxy for the Shanghai Stock Exchange. The Greater China Fund recently suspended dividend payments; making it less costly to short then before.

My analysis of China reveals that the country’s investment driven ‘growth’ cannot last. It does not prove that Chinese policy will change this month or that market forces will presently deflate the bubble. Remember, the Japanese continued to inflate their bubble for five years before their collapse.

On the other hand, Shanghai may already have started to gently pop – more or less in the time frame projected by professor Sornette.

The third week of August was the worst week for Chinese equity funds since early in the first quarter of 2008. A 4.7% drop in the Shanghai Composite Index – its third straight weekly decline – made it the world’s worst performer this month.

Shanghai Index

Based on this recent market movement, now may be a good time to take a short position in China.

An Unconventional Spread…

Another bold strategic play also occurs to me in a world desperately seeking for signs of growth. That is to buy Brazil and short China.

As far as I know, Strategic Investment is the only advisory service in the world recommending this spread. That is to say it is not conventional thinking.

There may “safety in numbers” if you’re storming the Bastille. But when you’re entering a trade, the ultimate returns are better if you’re implementing fresh thinking – provided, of course, the underlying idea makes sense.

In this case, it does. Here’s why…

We know that the “BRIC” economies (Brazil, Russia, India and China) are the most vital and developed of the so-called “developing countries.” We also know that China, the largest of the BRIC economies, is following in the footsteps of Japan in inflating a massive stock and property bubble that seems destined to end in tears

We know all the BRIC countries followed the U.S. into recessionary bear markets – peaking after the S&P 500 and recovering before it.

And we know that there is a lot of hot money flowing around the globe to back the thesis of “decoupling.”

The international editor of Newsweek, Fareed Zakaria, has been a strong advocate of this theme. He argued in a June 8 Newsweek column, “Boom Times Are Back – Just Not Here in the United States,” that the global economy is dividing into a tale of “two worlds.”

In one camp, he places the rapidly emerging economies such as China, India, and Brazil. In the other, he puts the fading “bastions of wealth and power” – the U.S., Europe and Japan.

Zakaria’s basic contentions are correct. China, Brazil and India are certainly in better fiscal shape than the U.S., Europe and Japan. Of these countries I think Brazil has the most innate strengths.

Therefore, I think that the eventual downturn in China will leave Brazil as the strongest emerging economy.

The Best of the BRICs

On a superficial basis, this may seem unlikely. China is Brazil’s leading trade partner. And Brazil mainly sells China commodities and passenger jets. A first order consequence of China’s growth slowing down would therefore be a fall in commodity prices and, presumably, a fall in Brazilian exports to China.

That may be true. But the question is: What happens next?

Brazil is far better situated to recover in a world where export surpluses of the kind that the Asian economies have cultivated with the U.S. dry up. Brazil has fewer structural obstacles than China to developing its own vibrant domestic consumption.

I suspect that hot money flowing out of China will be more prone to go to Brazil than India or Russia.

This was signaled recently by record outflows from emerging-market equity funds. Funds investing in developing nation stocks lost $946 million globally in the week ended August 19. Asia (excluding Japan) funds lost $810 million – the most in 24 weeks – while Latin America, Europe, and Middle East and Africa funds saw “modest inflows.”

An “Unmistakable” Recovery

Just as China’s troubles with bad loans and runaway stimulus of industrial capacity have come into focus, the growing strength of the Brazilian economy has been more vividly in evidence.

Unemployment in Brazil unexpectedly fell again in July to 8%. “The recovery of the Brazilian economy is unmistakable,” said Alexandre de Azara, chief economist at BRZ Investimentos SA in Sao Paulo. “The unemployment number in July was much better than expected.”

Brazil’s July unemployment rate was the lowest this year and down from 8.0% in July. The drop surprised 23 of 25 analysts surveyed by Bloomberg.

Source:ibge.gov

Unlike the U.S – where the unemployment rate of 9.4% excludes lots of people who believe they are unemployed – the Brazilian unemployment rate is more comprehensive. It includes economically active persons over the age of 10; if U.S. unemployment were calculated according to Brazilian methods, it would be at least double the Brazilian rate.

Consider the following analysis from John Williams’ Shadow Government Statistics.

During the Clinton Administration, “discouraged workers” — those who had given up looking for a job because there were no jobs to be had — were redefined so as to be counted only if they had been “discouraged” for less than a year. This time qualification defined away the long-term discouraged workers. Adding them back into the total unemployed, unemployment in line with common experience — as estimated by the SGS-Alternate Unemployment Measure — held at about 20.6% in July.

[See the Alternate Data tab at www.shadowstats.com for a graph and more detail.]

I previously indicated a prejudice: I am married to a Brazilian. This has given me both a better vantage for understanding Brazil and an incentive to look more closely.

I have detailed in recent issues some of the considerable strengths of Brazil’s economy. Among other points, Brazil is a vast continental economy with a large young population and an active entrepreneurial class. India looks big on the map. But there is a single state of Brazil that is larger than India.

Brazil also has a totally solvent banking sector. Its consumers and businesses are almost completely unleveraged – the majority of Brazilian home sales are made without a mortgage. And although Brazil has run a significant trade surplus, it is not greatly dependent on exports. Exports make up only about 10% of Brazil’s GDP, as compared to 35% of Chinese GDP.

I see Brazil as the country most likely to achieve balanced domestic growth – just as the U.S. did in the late nineteenth century.

We have already analyzed why China’s growth prospects are dependent upon U.S. recovery. Brazil’s trade is much more evenly distributed. About 26% is with the E.U; Latin America accounts for 25%; Asia counts for 16%; and U.S. accounts for just 14.3% of trade with Brazil.

Brazil also has more arable land and fresh water resources than any other country on the planet. This will be increasingly important as the twenty-first century unfolds.

Put simply, Brazil is the world’s largest dealer in protein, selling more beef and poultry than any other country. And although Brazil lags the U.S. in the total volume of all agricultural exports, its agricultural sector is more dynamic and by far the most profitable in the world. U.S. farmers grow more of certain crops – but Brazilians make more money doing it.

For these reasons, I expect Brazil to continue to grow based on the capacity of the Brazilian consumer to increase demand as credit becomes available in housing and other consumer sectors.

Brazil is already one of the largest markets in the world. Unlike China, it is capable of growing internally. China is funding a bubble to ramp up GDP by building more capacity for export. And for this reason alone I think Brazil’s economy will outperform China’s over the next few years.

This Month’s Recommendation

I recommend spreading the iShares MSCI Brazil Index ETF (NYSE:EWZ) long against either a short position in the iShares FTSE/Xinhua China 25 Index (NYSE:FXI) or a long position in the ProShares UltraShort FTSE/Xinhua China 25 (NYSE:FXP)

EWZ does not directly track the Bovespa Index on the Sao Paulo Stock Exchange. It is tied to Morgan Stanley’s proprietary MSCI Brazil Index. However, it should work to capture the divergence I expect.

If you are an international investor, there is a French ETF on the Bovespa, the Lyxor ETF Brazil (LON:LBRZ), which is traded in Europe.

You may need to call up your broker in order to buy those shares.

As the Chinese bubble shows more conclusive signs of bursting, we’ll be back with additional recommendations for profiting from this situation, including some currency spreads.

James Davidson

Editor,

Strategic Investment

Pulse of the Global Economy

Sometimes a picture is worth 1,000 words.

It is no different when it comes to the state of our economy – a few good charts can relay more valuable information then an entire page of words.

In a day and age when talk of ‘green shoots’ dominates the mainstream media, I find it important to show you the true state of the domestic and global economy.

The first thing I’m going to show you is a chart of credit conditions here in the states

This shows you the sharp increase in credit cards and residential and commercial real estate delinquencies since the credit crisis started.

We’re seeing a slight flattening in consumer credit card delinquencies. But with the unemployment rate at nearly 10%, delinquencies have nowhere to go but up.

These delinquencies will undoubtedly lead to more bank failures.

We’ve had 81 bank failures this year, costing the FDIC about $20 billion. We’re on pace to see 150 bank failures, nearly doubling the cost to the FDIC to $40 billion.

One prominent mainstream analyst, Dick Bove from Rochdale Securities recently speculated that “perhaps another 150-200 banks will fail” this year.

As of August 27, there were about 416 banks with assets totaling $299.8 billion that were on the FDIC’s Problem Bank list. These are banks that are either receiving cease & desist lending orders, or under a written, formal, or supervisory agreement with the FDIC.

While not all of those 416 will fail, we could reasonably expect half of them to fail.

The Problem with Bank Failures

Anytime a bank fails, it causes the amount of credit in circulation to drop. That means credit to businesses and the consumer is cut, stifling demand for purchases and upgrades that might actually add something to GDP growth.

We’ve already seen the amount of consumer credit – the stuff that fuels the buying of stuff at your neighborhood Best Buy –drop by the most in 50 years.

The drop isn’t over yet.

You see, banks don’t plan on increasing lending yet.

According to Dave Rosenberg from Gluskin Sheff “We just received the monthly data on commercial bank lending in July and it showed a record contraction of $64.0 billion, which is the equivalent of a 12.0% annualized decline. This was the third month in a row of declining bank credit to households and businesses during which the contraction has totaled $149.0 billion (again, an unprecedented 9.0% decline at an annual rate). We are not sure if a recovery can be sustained without credit creation — we haven’t seen it happen in the past, but maybe there is a new paradigm of a credit-less recovery awaiting us.”

Indeed, in a credit-based fiat economy, a contraction in credit is a contraction in money supply.

That’s because people use credit like they use cash. They buy TV’s and space-cushioned beds with their plastic.

If credit is cut… or if they lose their job… they are less likely to spend money or pay back the debts that they owe.

This kills exporters that sent their electronics and t-shirts to the US.

Across the globe the contraction of available credit has caused a 25% drop in trade.

Of course, ‘green shoots’ economists will point to that small increase in 2009 and tell you that a bottom has been reached.

This begs the question, where does trade recover to? Will it stay at this level for the next ten years? If it does, we’re not likely to see the earnings growth we witnessed just a few short years ago.

We’re in a Secular Bear Market

One chart courtesy of Michael Shedlock explains it all.

For the past ten years we’ve been in a cyclical bear market, at least according to the Nasdaq.

If you look at a chart of the S&P 500, you’ll see it’s near the levels it traded at in 1996.

Worst of all, this market was driven by excess credit – a condition we won’t see for some time. Remember, consumers have to repair their balance sheet. Those that choose not to will see their credit score suffer… and get cut off from credit altogether.

The savings rate already moved to 5.1% from negative numbers as a result of what’s happening. This rate should move higher over the next few years.

And as the savings rate moves north, I just don’t see how the economy can expand.

This is one of the reasons why James Davidson and I believe in an eventual collapse of the Chinese investment bubble.

The Chinese are investing to boost capacity at a time when demand for their goods continues to drop.

This will push prices for its goods down as it floods the market with its products. At the very least, it’s adding bad debt onto the balance sheet of Chinese national banks.

We are seeing the makings of the next big banking crisis. Except this time it will take place in China. And the repercussions will be extraordinary.

Staying prepared is the most important thing to do right now. That’s why James has recommended you position yourself for a drop off in the Chinese economy.

Until next month,

Charles Delvalle

Associate Editor,

Strategic Investment

August 2009 Issue

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