Archive for January, 2010

Will gold mining shares hedge against deflation again since the Great Depression?

Sunday, January 31st, 2010

During the Great Depression, gold mining stock prices were the only bright light in the darkness. As one of our readers found a 1931 newspaper quote,

Gold mining stocks have been among the strongest performers since year-end; earnings this year seen exceeding both 1930 and 1929; miners are benefiting from stable price as production costs decline.

As we quoted the most deeply buried Austrian School 1936 classic (originally written in German), Crises & Cycles by Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?,

Leaving aside the industry of manufacturing books on crises and cycles, there are two big industries likely to prosper inversely to the depression, the armaments industry and the gold-mining industry.

Does that mean that gold mining shares are going to do well in times of deflation because it did well during the deflationary period of the Great Depression?


Here, we have to be careful in applying the lessons learnt from history correctly. There is a reason why gold mining shares did well during the Great Depression. Unfortunately, that reason does not apply in today’s context. What is the difference between today and the Great Depression?

The gold standard.

You see, back in 1931, one ounce of gold was defined as approximately US$20. Back then, as we introduced the history of money in our book How to buy and invest in physical gold and silver, currencies (e.g. dollar, pound, franc) were merely warehouse receipts for physical gold. In a sense, the central bank was a government granted monopoly gold warehouse.

In other words, the Federal Reserve was the only institution in the world that would buy and sell gold at a guaranteed fixed price (because the US was the only country still under the gold standard). The were two implications:

  1. There was an infinite ‘demand’ for the produce of gold mining companies.
  2. The price of the what the gold mining companies produced had a minimum price.

As the Great Depression was a period of deflation, prices of everything were falling. That means the costs of gold mining companies were falling as well. So, if you have a business in which the things that it produces:

  1. Have infinite demand
  2. Have a guaranteed minimum price
  3. Are getting cheaper to produce

Wouldn’t that be a windfall for you business? Indeed, that was the fortunate position faced by gold mining companies back then. That’s why their share prices were rising. Today, no country is under the gold standard and thus, currencies are backed by nothing. Therefore, gold mining companies are facing an entire different situation:

  1. Their produce have finite demand
  2. Prices of their produce fluctuate
  3. Costs of producing are increasing

Even if real deflation is to happen today, falling cost of production will be accompanied by a fall in price of gold.

So, if you find any experts, tip-sheets and research reports justifying buying gold mining shares as a hedge against deflation by using the example of the Great Depression as the basis of their recommendation, then you know what to do.

Protecting yourself against currency crisis

Friday, January 29th, 2010

Today, we will continue from the final question asked at Next phase of GFC is when governments go bust,

When governments go bust, we will have currency crisis. How do you protect yourself against this?

First, let us begin with understanding what a currency crisis is. From the Wikipedia,

A currency crisis, which is also called a balance-of-payments crisis, occurs when the value of a currency changes quickly, undermining its ability to serve as a medium of exchange or a store of value…? Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country’s own currency reserves or its foreign reserves (usually in euros, US dollars or UK pounds).

Basically, a currency crisis occurs when there is a problem in a country’s balance of payments (see Understanding the Balance of Payments). The currency will depreciate very rapidly and as a consequence, cannot be used as money and cannot function a store of value effectively. This usually manifests itself as sky-rocketing price inflation, which undermines everyone’s standard of living. When Hugo Chavez recently announced the planned devaluation of the Venezuelan currency (that’s not technically a currency crisis, but this is just an example to show you its effects), people rushed out to buy consumer goods in anticipation of price inflation.

From this, you can see that obviously, the key to protecting yourself from a currency crisis is to diversify your savings away from the affected currency (e.g. foreign currency, gold, silver, etc). Does it mean that all we have to do to hedge ourselves is to go to our local bank branch, open a foreign currency account and then transfer some of our savings to that account?

Unfortunately, that’s true only in a perfect world. In reality, when there’s a currency crisis, there’s a high chance that a banking crisis will come along with it. For example, in Argentina’s currency crisis (1999-2002), the government froze bank accounts in an attempt to prevent a run on the banks. In some cases, governments may even impose capital controls (especially in pegged currencies), which basically means your money will be stuck.

In such an environment, Black Swans abound, which means the financial system may be dysfunctional. That means your foreign currency stored in your local bank’s foreign currency account can be, for all intent and purposes, useless. In today’s modern economies, since exchange of physical cash forms a tiny percentage of commercial transactions, a dysfunctional financial system will affect most commercial transactions in the economy, which in turn implies that the economy will be paralysed. Even if the financial system is working, price inflation will make life miserable for most people.

In such a bleak environment, we can imagine people resorting to barter, physical cash (both foreign and local) and even physical silver and gold. Hopefully, local governments and communities will take the initiative and come up with complementary currencies so that the economy can still function (otherwise, everyone will be reduced to primitive bartering). In Argentina, a spectrum of complementary currencies had emerged, in such a large scale that some of them are even called “quasi-currencies.”

Personally, we feel that the best way to protect yourself from a currency crisis is to leave the country before TSHTF. If not, stock up some physical cash (both foreign and local), physical gold and silver (see our book, How to buy and invest in physical gold and silver) and supplies- these will tide you over while the sh*t is hitting the fan. For the longer term, you may want to move some of your savings overseas- you may not be able to use them in the midst of the crisis, but when it is all over, the local currency may no longer exist (e.g. you may have to convert the old currency to a new one at unfavourable rates).

Note: All these are NOT personal advice- they’re just ideas for you to consider.

Currency crisis: UK, Japan and US

Tuesday, January 26th, 2010

Continuing from Currency crisis: first countries in the line of fire- PIIGS, we will discuss more on the next sequence of events to happen. As we said before, we are not ?predicting? or forecasting the future- what we are presenting is just a rough sketch of what may possibly happen.

After the PIIGS countries, the next country to be in danger of public debt default or currency crisis is the United Kingdom. At the current rate of deterioration of its public finance, the national debt of UK will reach 17% of GDP in 2010 and 100% by 2013. Niall Ferguson, author of the famous The Ascent of Money series, said

We?re not Iceland or Ireland, but we?re closer to them than we are to the U.S.

The reason why the UK is in a more vulnerable than the US is because,

The big difference between the two countries is that the U.S. issues the world?s No. 1 currency and is regarded, partly for that reason, as a safe haven,? Ferguson says. ?The U.K. used to be, but we?re not anymore. That means we have much more currency risk here.

Of course, this does not mean that the UK government will default or that the pound will face a currency crisis. But certainly, the risk is increasing as shown by the increase in price for the credit default swaps (CDS) of UK government debt. The time-frame for a currency crisis in UK is around the vicinity of 3 to 5 years.

The next country in the line of fire is Japan. We all know about the demographic time-bomb in the United States (see How is the US going to repay its national debt?). But Japan’s population is ageing earlier than the US. Worse still, they’re ageing at a time when their government debt is twice the size of their GDP. The reason why Japanese government debt could get so high in the first place is because Japan is a nation of savers. Currently, only 6% of their national debt are held by foreigners, whereas it is 57% for the United States. However, the problem for Japan is that as their population ages, their savings rate will have to fall. That implies that buyers of Japanese government debt will turn to sellers. That means that the Japanese government will have to look to borrowing from foreigners. Time-frame: say, 5-10 years time.

Finally, the next in the line of fire is the United States. We had already mentioned about them at How is the US going to repay its national debt?, Is the GFC the final crisis? and America?s balance sheet. The time-frame is around 10 to 12 years. Others believe it is 5 to 10 years time. That’s why President Obama is pursuing health care reforms. As he admitted on TV, if the US does not solve its health care issues, the Federal government will go broke (see Ladies and Gentlemen, the US Is Insolvent).

On that note, Australia is not in better position either. As PM Kevin Rudd warned recently (see Work harder to support ageing Australians: Rudd), Australia’s time-frame is around 15 years time onwards.

Money & politics to cause more sell-off ahead?

Sunday, January 24th, 2010

Today, we are supposed to discuss the “next sequence in the time-line” from our previous article. But before we go into that, we will discuss some new developments that is more urgent.

As we all know, last week was a very bad week for the global stock markets. On Wednesday, various markets (including the commodity markets) had hit the trend lines in price charts. What this means is that prices had reached the minimum in which the up-trend was still regarded as being intact by technical analysts. On Thursday, many trend lines were breached simultaneously. The last time such a similar event happened was in August 2008, which heralded the Panic of 2008.

Is this the beginning of the correction that many (including us) since September last year (see Aborted correction)? Back then, stocks were already in highly overbought territory and some contrarian traders were even shorting stocks. In the reverse sense, that was very similar to November 2008 when stocks were in highly oversold territory and many were anticipating a rally. The rally did not arrive until March 2009. In the same way, has the long anticipated correction finally arrived?

Those who enjoy having adrenaline rushes may want to take the courageous step of shorting the S&P 500 index. Historically, years ending with zeros tend to perform badly (for whatever reason that we have no idea). Also, election years tend to be bad for stock markets. 2010 is the mid-term election for the United States.

The Chinese government’s decision to halt lending (after an orgy of lending in the first couple of weeks of 2010) was the initial pin-prick against the up-trend. Commodity prices in general fell, with the exception of palladium and platinum. But Thursday’s news that Barrack Obama is going for the jugular of Wall Street (you can read the details from the mainstream press) was the trigger for the reversal in trend that even brought down strong and steady palladium and platinum. Since 2010 is the year for mid-term elections in the US, it is hardly surprising that Obama is embracing populism with stronger gusto. Also, there are rumours that Ben Bernanke, who is perceived to be too soft on Wall Street, may be ousted as chairman of the Federal Reserve (in a vote by senators). It is no secret that Wall Street is perceived to have looted Main Street. So, in an election year, politicians will pander for the support of Main Street.

In principle, we support Obama’s stand against Wall Street. But we disagree with his counter-productive way of dealing with Wall Street by imposing more regulations. The reason why we believe this is counter-productive is because in general, more regulations:

  1. Implies more red-tape
  2. Increase costs of doing business
  3. Restrictive on the good guys as well

Instead, we take the same approach as Jimmy Rogers, whom we quoted at Jimmy Rogers: ?Abolish the Fed?,

More regulations? You want Alan Greenspan and Ben Bernanke? These are the guys who got us into this situation. They are supposed to be regulating the banking system for the past 50 years. These are the guys who let it all happen. I don?t want more regulations. Let the market regulate it. If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys [Wall Street] start to go bankrupt.

Obama’s plan requires the approval of Congress. We can be sure that Wall Street, with their money, will lobby Congress and fight tooth and nail to frustrate Obama’s plan. That goes without saying.

Not only that, we believe that Wall Street will step up the pressure against Obama by dumping everything in sight on the stock market, perhaps even going to the extent of doing naked short-selling (see Short selling, who loans their share?). Since selling begets more selling, a plunging stock market will bring back memories of the Panic of 2008 to Main Street, which in turn can do damage to consumer sentiments (see Do sentiments make the economy or the economy makes the sentiments?). Of course, this is just our conjecture. If our theory is correct, then it implies that there will be more sell-offs in the days to come.

This is indeed money and politics.

Currency crisis: first countries in the line of fire- PIIGS

Thursday, January 21st, 2010

In our previous article (Next phase of GFC is when governments go bust), we wondered how can someone protect their savings in the event of currency crisis. Since the word “currency crisis” is a very broad term that can cover all kinds of scenarios, there is no one-size-fit-all solution to this problem. Hopefully, our musings will give you a better idea of where to start investigating and seek professional advice.

As we mentioned before in our previous article, there is a downward trend in many governments’ credit rating. The next stage of the GFC will see governments going bust. The main thing to understand is that this event need not necessarily be imminent. Also, you must not make the mistake of seeing that as a singular event- in reality, it will be a sequence of events punctuated by calm in between, as each country is at different stages of the fiscal cycle. The reason why we say that is because there are plenty of investment tip-sheets, newsletters and reports persuading people to buy their wares by giving the impression that government defaults are imminent events that will happen all at once. The mainstream media is not too helpful too. As investors, you have to be clear that there are time-frames and order of sequences in these events. Not only that, some of these events may not happen at all.

With that, we will continue. Please note that we are not ‘predicting’ or forecasting the future. What we are presenting is just a rough sketch of what may possibly happen.

Currently, the most vulnerable countries to default are the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain). It does not mean that all of them will blow up tomorrow. Marc Faber reckons that a couple of them will blow up within the next two years. Even though we do not know which ones and when exactly it will happen, one thing is clear- since these countries uses the Euro, the viability of the Euro as a currency will be put in question. As we said before in Is this a bear market rally or a turning point?,

The European Union is an economic union but not a political union. Therefore, the European Central Bank (ECB) does not have the same level of authority and political support as the US Federal Reserve. Individual nations using the Euro as their currency cannot simply print money to bail out their financial system because they have surrendered their economic sovereignty to an intra-national authority. To do that, there can be a situation whereby taxpayers of say, Germany, are asked to bail out the taxpayers of say, Spain. Politically, this is too much to ask.

This is where the uncertainty lies. There will be political and legal wrangling on what to do with these wayward PIIGS nations. Will the Euro survive the wrangling? No one knows. Since financial markets hates uncertainty, the Euro will continue to face downward pressure (which is happening right now). Of course, if it is suddenly clear that the Euro will not survive, then its value will be zero straight away. Should that happen, there will be a currency crisis, derivative meltdown (as an effect of PIIGS default or implosion of the Euro) and another global financial panic this very second. Since it is not clear yet, the Euro will continue its orderly descent. In the meantime, the financial markets will keep on guessing while the European authorities will not reveal much of what’s happening in the discussions behind closed doors.

Now, the question is, against which currency will the Euro depreciate against? Someone once said, if currencies are in a beauty contest, the winner will be the least ugly one. The US dollar, even though it is flawed and may not survive as a currency in the long run, has more time on its side. It is less ugly than the Euro. As far as the eye can see, it is more likely to survive longer than the Euro. Therefore, we will see the US dollar ‘strengthening’ against the Euro.

If you are one of the citizens of the PIIGS countries and if it so happen that it is your country that is going to blow up, then there’s no better time to prepare than right now.

In the next article, we will turn our eyes to the next sequence in the time-line.

Next phase of GFC is when governments go bust

Tuesday, January 19th, 2010

10 months have passed since the Panic of 2008 brought global stock markets to a low in March 2009. Since then, we had the “green shoots” of recovery (where economies were getting from worse to bad) and hopes of recovery. By today, we have some semblance of ‘recovery.’ But this ‘recovery’ is very uneven. For example, unemployment is not turning around yet in the United States. Much of Europe and Japan are still in the doldrums. Australia, on the other hand seems to be recovering and China is roaring ahead with an expected growth of 10% in 2010.

During the Panic of 2008, we had financial institutions and businesses going bust like dominoes, threatening to pull the world down into a Greater Depression. Governments all over the world suddenly became Keynesians and switched on their massive money printing press to bailout, rescue and spend, spend, spend in the name of ‘stimulating’ their economies. But as we said before in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven?t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

So, with economies seemingly on the path to ‘recovery’ (especially in Australia and China) from a near death experience, this looks like a free lunch from the government isn’t it?

Unfortunately, the answer is “No!” Then what is the risk of governments putting economies on a crutch for an extended period of time?

As we quoted the BIS in July 2009 at Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

As we said before, during the Panic of 2008, we had financial institutions and businesses going bust like dominoes. This time round, governments will be going bust like dominoes. Today, if you read the financial press, you will find this disturbing trend: credit rating agencies are downgrading and threatening to downgrade the credit ratings of government debts.

While we do not trust credit rating agencies (since they are the ones who gave sub-prime CDOs triple-A ratings), we will treat their ratings as overly-optimistic in the first place. For investors, what is significant is not the ratings themselves. Rather, it is the pervasive trend of more and more downgrades that is much more indicative. As this article compiled a non-exhaustive list of news excerpt of sovereign debt downgrades, we noticed a very disturbing fact- a large number of countries (some of them are major countries) are involved.

Can this trend turn around (i.e. governments become more prudent in their fiscal management)?

We doubt so. As we said before, the word “stimulus” is a weasel word that is misleading and deceptive. Economies suffering from debt deflation cannot be ‘stimulated’ into self-sustaining growth. A better word is “crutch.” The problem with using crutches to prop up economies is that the longer they are in place, the more dependent economies are on them. Eventually, if they are in place for too long, the economy will descend into stagflation (see Supplying never-ending drugs till stagflation). Once you understand this, you will be able to read between the lines of this BBC article,

The International Monetary Fund head has warned that the global economy could experience another downturn – a so-called double dip recession.

Dominique Strauss-Kahn said countries should not exit from stimulus packages that have bolstered growth through huge amounts of government spending.

The longer governments delay from removing economic crutches, the bigger government debts will become. That, along with Medicare and social security liabilities for the growing ranks of retirees and shrinking rank of workers means that eventually, governments will become insolvent (not technically because they can resort to printing money).

Consider these countries:

  1. Japan, the world’s second largest economy, is a welfare superpower with a rapidly ageing population. Twenty years of economic ‘stimulus’ under debt deflation has resulted in government debt of almost 200 percent of GDP.
  2. The US government is the next to arrive, as they are currently where Japan is 20 years ago, with an unfunded Medicare and social security liabilities looming (see America?s balance sheet).
  3. As this Financial Times article warned,

    After crunching the data, McKinsey estimates that the gross level of British private and public debt is now 449 per cent of GDP ? up from 350 per cent at the start of the decade.

    And even excluding the liabilities of foreign banks based in the UK, the ratio still runs at 380 per cent ? higher than any country except Japan (closely followed by Spain where debt has also spiralled dramatically, according to a McKinsey report issued today.)

  4. Then we have the PIIGS countries, namely Portugal, Ireland, Italy, Greece and Spain, where Marc Faber warned that one or more of these governments will likely blow up in the next couple of years. This will plunge the viability of the Euro as a currency in grave doubt. Will a default trigger a derivative meltdown?
  5. Then we have the other European countries like Latvia and Ukraine…

When governments go bust, we will have currency crisis. How do you protect yourself against this? Keep in tune!

Turkeys fattened for slaughter in the Chi-tralia bubble

Sunday, January 17th, 2010

In our previous article (Is the coming ?crash? in China not a real crash?), one of our readers sent us a link to a very good article (Trapped Inside a Property Bubble) written by a former Morgan Stanley economist named Andy Xie. He is a very contrarian and provocative analyst who called China’s economy as a “Panda Economy” (named after the cartoon movie,? “Kung Fu Panda”). His bearish call on the Chinese economy attracted a fair amount of criticism from Chinese government officials.

One of our readers, Pete, had highlighted sections of Andy’s article, with some good questions and comments…

Once a country loses export market share on rising costs, it stagnates because property bubbles during high growth periods deter consumption while overwhelming the middle class with housing expenses.

As property bubble grows further, debt servicing burden will grow as well. That in turn will deter consumption further as more and more of income will be spent on repaying debts. The only way to increase consumption whilst debt servicing burden is increasing is to increase debt further. Obviously, if a consumption-based economy is dependent on increasing debt to sustain consumption, then it is an economy that is addicted to debt. Once credit growth stalls, the die is cast for the economy. Back in January 2007, we wrote in Myth of asset-driven growth,

… asset-driven growth magnifies the consumption debts of the economy, which will have to be serviced in the future. By deferring the burden of debt servicing to the indefinite future, it can only mean that the nation?s wealth will shrink in the future. Hence, asset prices cannot rise in perpetuity. Eventually, the weight of future debt servicing burdens dooms the bubble to collapse under its own weight.

Since the Chinese economy is still dependent on cheap labour to achieve low cost production, labour costs increase will kill its competitiveness. As a result, exports will decline. If at that point in time, citizens are burdened heavily with debt, there is no way they can increase their consumption to replace the lost exports.

Similarly, Australia is already a highly indebted nation. The only thing preventing the Australian economy from falling into deflation is Chinese demand for Australian resources. As we wrote before in Hazard ahead for Australia- interim crash in China,

Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

There are some signs that Australian consumers are binging on debt once again. Should this translate into a resumption of increasing credit growth, it will mean that Australia is increasing its vulnerability to any slowdown in the Chinese economy. Worse still, Australia is selling more and more of its businesses, capital and resource companies to China, which means that more and more future economic growth will no longer benefit the next generation.

Enough about Australia. Let’s look at Andy Xie’s article further,

The dollar has bottomed. The Fed will begin raising interest rates in 2010.

Andy Xie reckons that the US dollar has bottomed and that the interest rate cycle has bottomed as well. What are our views?

As we wrote in Permanently low interest rates for Uncle Sam?, the more indebted the US government is, the harder it is for them to raise interest rates. According to Marc Faber, currently, 12 percent of US government’s tax receipts goes to interest payment on their debt. In 5 years time, it could be at 35 percent. Should the US raise interest rates to combat any potential price inflation, that will increase the debt burden of the US government unless the US economy can put on a miraculous feat of super-turbo-charged growth. This means that the higher interest rates goes, the higher the risk of the US government becomes insolvent sooner.

Next, Andy Xie wrote,

One possible way to prolong the bubble is to appreciate the currency, as Japan did after the Plaza Accord, to contain inflation and attract hot money. Such a strategy will not work in China. Japan’s businesses were already at the cutting edge in production technologies and had pricing power during currency appreciation. They could raise export prices to partly offset currency appreciation. Chinese companies don’t have such advantages but rely on low costs to compete.

That’s a reason why China cannot let the yuan appreciate too much too soon. Next, Andy wrote,

China has been trying to promote consumption for a decade. However, consumption’s share of GDP has declined annually. The reason is the policy environment has been squeezing China’s nascent middle class through high property and auto prices along with high income tax rates.

Recently, there’s a Chinese soap opera titled “Dwelling Narrowness.” That was a very highly popular show because it strikes a cord with the Chinese middle-class, who are burdened with taxes, corruption, high property prices, inflation and so on. Unfortunately, that soap opera was terminated early by the Chinese government.

As we wrote in Chinese government cornered by inflation, bubbles & rich-poor gap,

In other words, the paradox is that the further the Chinese government delay in tackling inflation, the more reliant they will have to rely on American consumers, which means it is harder for them to let the yuan appreciate.

The inflationary policies of the Chinese government are hurting Chinese consumption more and more.

Andy wrote further,

China’s property market is creating winners and losers based on timing. All other factors ? including education and experience — have been marginalized as the economy rewards speculators. And as more play the game, the speculator ranks rise and fewer people work, perhaps contributing to a labor shortage.

Our reader, Pete was wondering how could it be that China can have labour shortage. Our take is that it is skilled labour shortage that China is increasingly short of. Anyway, as we wrote in Harmful effects of inflation, an economy based on inflation and asset price bubble to sustain growth is an economy that rewards speculation instead of hard work.

Finally, Andy wrote,

The killer is inflation driven by a surge in money printing. The average lag between currency creation and inflation is 18 months in the United States. China’s lag could be two years since the government uses subsidies to suppress inflation. By 2012, China could experience 1990s-like inflation. And that’s when the property bubble will probably burst.

We will add this: in a highly indebted society, price inflation without adequate wage inflation will contribute to the bursting of the asset price bubble.

Many of what Andy Xie wrote also applies to Australia. When the Chinese bubble burst, Australia’s bubble will burst too. Marc Faber, while he agrees with Jim Chanos that China is in a bubble, believes that the implosion of the Chinese economy will not happen soon (see China bubble will not burst right away: Marc Faber). If this is true, it means that many Australians will be suckered into more debt (property prices may even be inflated further), which is akin to a turkey being fattened for the day of slaughter. The difference between 2008 and that day of reckoning is that more Australian businesses, mines and capital will be under Chinese control by then.

Is the coming ‘crash’ in China not a real crash?

Thursday, January 14th, 2010

By now, you would have known that we have grave reservations on the quality of China’s post-GFC economic rebound. We are not alone in our reservations as there are many experts, both in the mainstream and non-mainstream media who share our view. But there are also many others who seems to hold the opposite view, including Jimmy Rogers.

For those who are looking for answers, all we can say is that China is very difficult to read. It is a country with many mirrors. When we Westerners try to interpret China through a Western lens, culture and context, we may end up misinterpreting, misunderstanding and missing the subtleties of China.

Economic data from China is something that investors should not swallow entirely without question as no one knows how accurate they are or how much of them are made up. As data flow from the bottom to the top layers of the vast Chinese bureaucracy, from the local government to the provincial government and finally to the central government, we wonder how much of the information are lost, misinterpreted, fudged, revised, falsified, misrepresented, hidden and added? Or perhaps we are too cynical?

But if you hold the view that a a big economic correction is coming to China and wants to ‘short’ the country, you have to be aware of what you are betting against. First, you are betting on deflation in China, symptoms of which include falling asset prices, rising unemployment and bankruptcies. Governments, on the other hand, would prefer to err on the side of inflation. When you have an authoritarian government that can make and change the rules, you can be sure that they will draw out the big guns to fight against deflation. For example, what if a trade war threatens to do serious harm to the Chinese economy and social stability? We wouldn’t be surprised if the Chinese government whips out nationalistic sentiments, point the finger at the nations that started the trade war and in the extreme case, start a shooting war. According to Marc Faber, he reckoned that the same would apply to the US too.

But let’s not get too carried away with expecting an almighty economic ‘crash’ in China Let’s play the devil’s advocate for now and examine the reasons why Jim Chanos (the guy who publicly wants to ‘short’ China) may be wrong.

As a whole, China is not too leveraged (unlike countries like Australia, US and UK). The people in major cities (especially Shanghai and Beijing) are highly leveraged and share many similarities with highly indebted Australians and Americans. For example, the housing bubble in Shanghai is much bubblier than the one in Australia. Credit card habits of the city young adults are just as bad as their Western counterparts. Since the financial system in China are still very much primitive compared to countries like Australia, US and UK (the financial sector in those countries are probably too big), the debt disease have yet to reach everyone in China, especially the hundreds of millions of rural peasants.

At the same time, the rich-poor gap in China is much wider than in Australia. For example, there are still hundreds of millions of poor peasants living in under-developed or undeveloped rural areas. Large swathes of China have yet to develop and catch up with the affluence of the coastal cities. A deflationary crash will affect the highly indebted city folks much more than the rural peasants. Since the fruits of China’s economic boom have largely bypassed the latter, they will hardly miss the loss of wealth due to an economic correction because they have not gained much in the first place. Whether boom or bust, these people will still go about their business everyday.

Deflation, in fact, will benefit those on the poor side of the rich-poor divide. The economic boom has a very detrimental effect on them as the price inflationary effects actually made them poorer (we heard stories of migrant workers in Shanghai who are too poor to even buy food). Deflation re-distributes wealth to these people. Currently, the Chinese government is in the process of developing the poorer regions in China. That, plus deflation may re-distribute economic resources and activities to those areas. For example, those same migrants workers who are too poor to buy food in Shanghai may want to return to their home villages because of better opportunities (from government development) and better standards of living (food are probably cheaper and affordable there).

If this theory is correct, it means that a ‘crash’ in China should not be interpreted in the same way as a crash in Australia, Japan or the US. In the Western world (including Japan), an economic crash means that the standard of living for everyone in general will decline. For China, because of its relatively wider rich-poor gap, it may just be a wealth re-distribution exercise in which some will be better off and some will be worse off. On paper, a Chinese ‘crash’ is bad in terms of GDP growth and demand for resources. But socially, it may not be such a bad thing as it may be China back into a more sustainable growth path.

That could be the reason why people like Jimmy Rogers are still optimistic on China. Investors like him are probably not investing their capital on the frothy affluent cities. Instead, he is probably investing in sectors of the Chinese economy that will still be humming along and going about their business even when the ‘crash’ hits the economy. Unfortunately for many investors, the ‘China’ that their investments are in will probably not survive the ‘crash.’

Overcapacity in steel production and surging demand for iron in China?

Tuesday, January 12th, 2010

Currently, economists in general are at a consensus regarding China. As this news article reported,

As the Great Recession wanes, there?s no better example of the Great Consensus than China. The overwhelming view is that it can grow 10 per cent indefinitely, its potential is boundless and it?s run by omnipotent geniuses who can?t lose. China is today?s New Economy and anyone who disagrees just doesn?t get it.

When the herd is all crowding at one side of the story, it is time to check out the other side. As you can read from our previous articles at Chinese government cornered by inflation, bubbles & rich-poor gap and Hazard ahead for Australia- interim crash in China, we have made our case for being sceptical on China’s post-GFC recent growth. While Western nations are mired in the ghosts of post-GFC deflation, China is the only major economy that managed to engineer a crack-up boom (see What is a crack-up boom?).

Unfortunately, many economists believe that this crack-up boom is a sign of ‘prosperity.’ The trouble with a crack-up boom is that there are only two possible outcomes:

  1. If the government wakes up to their mistake and decide to rein in the crack-up boom, the result will be deflation (falling asset prices, rising unemployment, bankruptcies).
  2. If the government have no guts to allow deflation to happen, hyperinflation will be the end result.

China is now at a critical junction- should they rein in the crack-up boom or should they let it continue?

From what we observe, they seem to be trying to walk the middle-ground. So far, they’re taking half-baked measures in an attempt to cool things down. That is, they’re trying to engineer a soft-landing. Although the former Chinese premier Zhu Rongji was successful in achieving that in the 1990s, there’s no guarantee that they will succeed again this time. In fact, there’s always a risk that they will tinkle with the balance too much and make a mistake that result in tipping the economy into a crash. Or a pin will appear from outside (e.g. trade war) and pop the bubble. Or they will do too little and let the economy overheat. Either way, it will be disastrous.

It is in this backdrop that the infamous short-seller, Jim Chanos is looking to short China. Since November last year, we first heard that this shark was on the prowl, examining China’s books (see Is the Chinese economy a house of cards?).

Indeed, there’s one aspect of China’s ‘books’ that we find a contradiction. Here, we turn to our readers to reconcile this contradiction:

  1. Take a read at Spot market for iron ore may sink contracts. From that article, it seems that China is trying to resist another round of price hikes for iron ore. As this article said,

    As senior executives from BHP and the two other iron giants, … , prepare to face down increasingly aggressive Chinese steel mills, prices are soaring again for the red dirt that it is essential for China’s massive urbanisation and infrastructure programs.

    So, this fit in with economists’ consensus that Chinese demand for Australian iron ore will continue to surge as their economy roar ahead.

  2. Next, take a read at China Trims Steel Capacity Amid Glut, Minister Says (Update1),

    China, also the world?s biggest producer of iron, cement and aluminum, is facing a severe oversupply of steel as mills expand faster than outdated plants are closed. The government is studying a ?more feasible? plan to tackle steel overcapacity, Li?s ministry said on Dec. 3.

Dear readers, why should there be another surge in Chinese demand for iron ore in 2010 when they are looking into closing steel mills to address the severe overcapacity problems? Does anyone have any idea on how to reconcile this contradiction?

Can emerging stock markets underperfom?

Sunday, January 10th, 2010

We have covered China in our previous two articles (Hazard ahead for Australia- interim crash in China and Chinese government cornered by inflation, bubbles & rich-poor gap). Following them, we will look at the implications for the financial markets today. This should not be interpreted as ‘predictions’ of what will happen in the financial markets. Rather, they should be seen as issues for investors to consider. Since we are delving into a complex area, we do not pretend we will get everything right here.

Firstly, as we wrote before in Chinese government cornered by inflation, bubbles & rich-poor gap, China will eventually have to tackle their inflation problem. The longer they delay tackling this issue, the bitterer the medicine will be when they have to do it. We are sure the Chinese government understands it and they are probably debating among themselves in their inner sanctum.

In the meantime, there’s a potential danger that can throw the spanner into the works- trade war with America and Europe. The sticking point is the value of the yuan. By keeping their currency undervalued, the Chinese are exporting their goods to America and Europe while the latter export their inflation back to China. The popular sentiment among many in these Western nations is that China is contributing to higher unemployment in their countries. Already, we are frequently reading news report of initiation (and retaliation) of trade restrictions between the two sides. In a sense, low-level trade wars (“skirmishes” is a better word than “war” in this context) are already happening.

To their credit, the Chinese are doing something about this. They are expanding their trade ad investment relations with the rest of Asia, Africa, Middle-East and South America. This means that with each passing day, trade relations with Europe and America will become less and less relevant, which means that China will become less and less reliant on their currency peg to maintain the status quo in their economy. As we wrote before in Rumours of China diversifying their US dollars,

Not only that, the Chinese are setting up currency swap agreements with their trading partners [mainly with the non-Western nations] so that their yuan could be directly used for trade instead of using the US dollar as an intermediary.

This is another example of what the Chinese are doing to make the US dollar less relevant. If the Chinese can trade more with the emerging nations in their own currency, then the currency peg with the US dollar will become less and less necessary. Not only that, this will give China the prerogative to export inflation to other countries (as the US is currently exporting inflation to China- see Why is China printing so much money?).

The risk is that before the Chinese long-term plan can bear fruit completely, trade war erupts between China and America/Europe. Of course, both sides will suffer in such an eventuality, which is a reason to believe that they would not want that to happen. But our suspicion is that China may suffer a bigger pain initially. The reason is because, as we wrote before in Can China really ?de-couple? from a US recession?, the fall in Western consumption has a leveraged effect on China’s economy.

To compound China’s problem, in such a context, our guess is that the US dollar may devalue, which means China’s US$2 trillion kitty of currency reserve will lose its purchasing power. This is because the US current account deficit will shrink significantly, which means China’s purchase of US government debt will shrink as well. That in turn will be less supportive of the US dollar. Also, the spigot of Chinese imports will dry up, which will translate to price inflation in the US. In a way, with commodity prices in its up-trend once again (e.g. copper prices is back to the pre-GFC level), China’s kitty is losing purchasing power once again.

In such a scenario, stocks in the emerging economies may actually perform worse than American stocks. In the Panic of 2008, as the Chimerica imbalance unwind with a big bang, emerging market stock markets fell much more than their American counterpart. The 2009 ‘recovery’ winds up the imbalance once again. Therefore, should the imbalance unwind again (e.g. due to rising trade tensions, major economic correction in China, Chinese government clamping down on inflation), it is possible that we will see history repeating itself once again.