This is the first major post of 2010 (the previous post was more for our readers’ entertainment). Today, we will look ahead at a likely hazard facing Australia in 2010 and beyond- an interim crash in China.

First, you may wonder why we used the word “interim” before the word “crash?” To answer this question, you may recall what we wrote in June 2007 at Will the China boom go in a straight line?,

… one of the common stories we hear is this: since China is an ascendant superpower, its demand for commodities will increase in the decades to come, and hence, the commodities super-cycle will have a lot more room to go for a very long time.

…

However, the market always latches on to the generalities of a story and takes a simplistic projection of the story too far into the indefinite future. What do we mean by that? Put it simply, we do not believe that the rise of China will take on the path of a straight line. Instead, there will be ups and downs, booms and bust and progress and setbacks. Anytime when the path does not look like a straight line upwards and take a temporary dive, the market will flip to the other extreme of this story and project extreme pessimism into the indefinite future.

In other words, when we say that a “crash” is coming in China, we do not mean that China will collapse into a heap of total anarchy, civil war, foreign invasions, internal divisions by warlords, etc as in the first half of the 20th century. Instead, as we wrote before, such a “crash” will be a major setback in the bigger scheme of things.

In this new year, this is the theme that investors (especially the highly leveraged property speculators in Australia) should be watching out for. Australia is highly leveraged to the Chinese growth story, both in terms of financial leveraged (look at Australia’s debt level) and population leverage. The word “population leverage” will sound alien to you because this is a phrase that we invented in this article. To understand this phrase, consider this: the entire population of Australia can fit into population of just one major Chinese city (Shanghai) if you include the ‘unofficial’ migrant workers. Because of the colossal size of China, if every Chinese reduce their consumption by 1%, then its effect will be much more than 1% reduction in income on Australia. 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.

The Panic of 2008 should be the year whereby a major correction in the Chinese economy could have occurred. Indeed, in late 2008, one newspaper headline in the Sydney Morning Herald was screaming of a great “stall” in the Chinese economy. Indeed, it seemed at that time that what we wrote in January 2008 at Can China really ?de-couple? from a US recession? was coming into fruition.

However, what stopped the major correction in the Chinese economy in its track was a massive government stimulus and ultra-loose monetary policy. The former is concentrated on fixed asset and infrastructure investments (e.g. construction boom, bridge building, etc), while the latter is basically force feeding loans into the economy (see How big is the credit bubble in China? and Is China setting itself up for a credit bust?).

The problem with these government policies is that, while it may have averted a major correction, the structural imbalances in the Chinese economy are being exacebated. To understand the gravity of this situation, consider this simplified line of thought:

1. Prior to the GFC, the Chinese economy was highly geared towards capital investments in the form of productive capacity for exports.
2. A contraction in demand in the US/Europe led to a disproportionate contraction in Chinese economic activity (see Can China really ?de-couple? from a US recession? to understand the theory behind this reasoning).
3. Chinese economic activities that are related to exports suffered the worst of this contraction.
4. Chinese government stimulus and ultra-loose monetary policies led to increased economic activity in the Chinese economy mostly in the area of capital investments for infrastructure.
5. Overall the economy ‘grew’, but a lot of them are wasted and ‘leaked’ into mal-investments, asset market bubbles, corruption (see Will China succeed in navigating its way out of the Global Financial Crisis (GFC)? for a juicy story about corruption in China) and trophy projects.

You see the problem here?

Chinese government policies are accentuating the gap between investments in future productive capacity and current consumption of the Chinese people. To further complicate the picture, infrastructure investments produces capital goods (e.g. bridges, roads, highways) that cannot be exported. If Chinese consumption cannot grow fast enough to catch up with huge expansion in productive capacity and American consumption cannot recover enough to fill the gap, then what will happen to those investments?

Obviously, these investments will, at best result in a dismal return and at worst, result in bad debts. And we know bad debts are the roots of a credit crisis.

We believe consumption growth cannot catch up fast enough. As we wrote in Can China really ?de-couple? from a US recession?,

The needs of the Chinese consumption economy is different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built. As we said before in Overproduction or mis-configuration of production?, the issue is not a simple case of overproduction. Rather, it is the mis-configuration of production that is the issue.

Because of the structural imbalance between consumption and investments, a lot of these forced investments are leaked into asset speculation (e.g. look at the massive property bubble in Shanghai alone). To understand this point, consider what we wrote in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

The ultra-loose monetary policies in China resulted in too much money and credit sloshing around in the financial system. The structurally weak and mis-configured domestic consumption market means that there’s not enough avenue for appropriate investments. Hence, a lot of money and credit ended up as speculations in the asset market.

To structurally streghthen the Chinese domestic consumption market, the gap between the rich and poor has to be narrowed. Anecdotal indications suggest that the opposite is happening, thanks to inflation (see Does monetary inflation increase the rich-poor divide?). The bubble in the asset markets is worsening the situation.

By now, you should be able to appreciate the gravity of the situation. The ‘success’ of the Chinese government seems to have averted a major economic correction. But in reality, they are just postponing it for a greater bust in the future.

What is the implication of this in the financial markets? Keep in tune!