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SOVEREIGN MAN

Why China is headed for a fall

November 10, 2011
Manila, Philippines

There’s a key concept in economics called the law of diminishing returns. It sounds complex, but it’s actually very easy to understand.

Imagine for a moment that there are two towns cut off from each other by a vast river. Communications and trade are infrequent at best. But if you build a bridge, you’ll get a tremendous boost to the possibilities for trade and commerce.  Economic activity rises dramatically.

Build another bridge a half-mile from the first one and you’ll ease congestion, speed up travel times, and create some further improvement in the region’s economy.  But the additional returns on investment for the second bridge pale in comparison with the first.

So on and so forth for the third, fourth, fifth bridge that you build. Each successive bridge provides less and less of a boost to the regional economy.

What China has been doing for years now, is the equivalent of having built thousands of bridges, each one providing diminishing returns to its economy. Even more concerning, China has been building these economic bridges, so to speak, even though when they weren’t necessary.

Consider that the share of fixed asset investment in China, at more than 65%, is the highest for any major economy in modern history. What’s more, China’s own electricity authority recently reported that there are 64.5 million dwellings in China where absolutely no electricity is being used. The investments they’re making are producing little return.

When I was back in Wuhan this summer, I saw exactly this phenomenon.  You may never have heard of it, but Wuhan is an important commercial city of more than 10 million.

Barreling along one side of an 8-lane highway towards the airport with hardly another vehicle in sight, we passed apartment block after apartment block, sitting empty like a construction graveyard.

Eventually we crossed a gigantic new bridge over the Yangtze River.  Barely half a mile downstream, another equally vast and expansive bridge was nearing completion… and others further down the river.

I was astounded. There was no traffic. No commercial activity. No people. No tolls. Just empty space, and a lot of ridiculously expensive bridges. It was something out of a bizarre zombie flick.

There are thousands of similar projects all over China, many funded by debt.  And, with no direct cash flows earned back and the ongoing maintenance required, these infrastructure projects have become huge liabilities on the Chinese government’s balance sheet.

The conventional wisdom is that China’s economy will continue to grow 8% or 9% per year indefinitely. And a lot of people are drinking this Kool-Aid. It sounds a lot to me like the other old songs that we’ve heard over the past few years, like “real estate always goes up in value.” Famous last words.

I live by another rule:  “All booms bust.  The only question is when.” And China has had one of the biggest economic booms in history over the past decades. In fact, per capita consumption of cement in China is at the same levels as Taiwan and Japan right before those infrastructure-boom economies hit a brick wall.

One of my favorite speculations right now is to short the stocks of companies whose business model is based on eternal Chinese growth.

To give you an idea, I’m researching an Australian company for SMC premium members. It ONLY sells iron ore, and it ONLY sells to China. They’re in the process of tripling capacity at a time when demand in China is slowing markedly and iron ore prices have fallen by nearly 25% in the last few months.

Granted, shorting companies is always a risky endeavor (though you can limit your exposure by buying put options instead of shorting the stock). Bottom line, though, I’d urge you to have some healthy skepticism the next time you’re thinking about investing in a company based on the “China growth story.”

About the author: Born to a Danish father and British mother, in Dar Es Salaam, Tanzania, Tim Staermose has led an international life since the day he was born. Growing up, he also lived in Egypt, Denmark, and Singapore, before eventually settling in Australia, where he completed his education and took out citizenship. Since then he has also lived and worked in Hong Kong, and Manila, Philippines, in the field of equity research — both for a bulge-bracket Wall Street investment bank, and for an independent investment research firm. Today, when not traveling the globe looking for investment and business opportunities for the Sovereign Man community and catching up with his diverse, multinational group of friends, he divides his time between Hong Kong, and the Philippines.

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Comments on this entry are closed.

  • http://twitter.com/llboyd El Boyd

    You guys at SM have good points sometimes.  I also don’t want to sound negative b/c I agree with a lot of what you say.  But I think I speak for a lot of your readers when I say, I can’t tell if you’re completely full of it or not.  If you’re really out trotting the globe – show us some pics that go along with your “boots on the ground” information. Otherwise, I have to assume you’re just regurgitating a lot of the info that others in front of computers at some random place in the US are spewing. 

  • Ben

    Yea, but China has a big thing going for them: their undervalued currency. Once they allow this to appreciate, and get a stronger currency, they can make the shift from production to consumption. That will make paying off their debts to foreigners that much easier, and allow them to pay off those liabilities on their balance sheets you speak of. 

    • Wyrdless

      It will also allow Chinese commoners to afford to own an AK-47 and ammunition…..

  • disqus_TLcMqwnySr

    The Chinese government makes the rules. At the moment and from what I know, foreigners are largely prevented from owning property or engaging in business ventures in China. A change of those rules would most likely see an influx of capital and commerce. If that were to happen at a particularly inopportune time for western nations, it could solidify China as the world’s financial capital.

    In addition, projects funded by debt built upon more debt are highly geared toward infrastructure. It’s a risky bet, but for whom? If value of the debt is in the process of being inflated away, China has already extracted the real assets from that value well before evaporation. Meanwhile, a lot of foreign investors and their Chinese business partners will take the hit in any situation where either the fiat-denominated asset value depreciates, or the fiat itself is depreciated. Exposure is almost exclusively external to the country. That’s a win-win for China.

    With all of the ghost cities erected during the past several years and no return on investment, it is increasingly likely that developers will take the loss. When they finally do, market forces can rapidly revalue existing real estate. Thus, China may grow into these environments over the next several years while western nations engage in fire sales to offload their own.

    Current situations are prone to change, especially with such turbulent times. Considering the interplay of illusory value-basis fiat currencies versus real assets, a default only matters when ownership of the latter is involved. It’s a lot harder to reclaim a building or road than a bunch of zeros in a computerized ledger. China is no fool.

  • The_UK_is_a_corporatocracy

    “China’s own electricity authority recently reported that there are 64.5 million dwellings in China where absolutely no electricity is being used”

    “recently”???

    That was doing the rounds nearly 18 months ago at Zerohedge. Are you quoting that article or has there been another report and the figure is exactly the same.?

    http://www.zerohedge.com/article/china-has-been-covertly-funding-housing-bubble-five-times-larger-us-65-million-vacant-homes-

  • http://www.AsiaMarketingManagement.com James Chan

    I like the expression of “bizarre zombie flick.” When I first went to Wuhan, China in the summer of 1982 to sell English-language scientific books, the city was vast but very poor and drab.

    The plethora of uninhabited buildings are found in many Chinese cities, not just in Wuhan. It must give one a hauntingly eerie feeling to be at those places with no or few sights of humanity. Maybe one day they can be turned into “theme parks.” Chinese cities are so crowded that “ghost cities” may become appealing!

  • samcarmx

    It’s crazy. Typical prejudice of developing countries: they all want to put the money into the “show” of “development.” Then look at their pathetic countryside and contrast it with the coast. Think of what they could have done with all that money, labor, and material for their rural areas, which are incredibly poor. Economies built on the export model are always favored by rentier elites, because it’s a hell of a lot easier and faster than actually building a productive economy within their borders, and also easier to skim and get rich off of, especially when you own the resources. Look at Mexico, for instance. Same deal: a few billionaires, monopoly economy, islands of super-rich in an ocean of poverty.

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