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What US Candidates Need to Know About China

August 19, 2012

This weekend, I was quoted in The Weekly Standard about what Mitt Romney and Paul Ryan need to know about what is happening in China.  It begins by noting that Paul Ryan, Romney’s surprise VP pick, came out swinging the other day on President Obama’s handling of China:

“Free trade is a powerful tool for peace and prosperity, but our trading partners need to play by the rules,” Ryan said. “This challenge focuses on China. They steal our intellectual property rights, they block access to their markets, they manipulate their currency. President Obama promised he would stop these practices. He said he’d go to the mat with China. Instead, they’re treating him like a doormat. We’re not going to let that happen. Mitt Romney and I are going to crack down on China cheating and we’re going to make sure that trade works for America.”

Soon after the Ryan pick was announced, I had an email exchange with my old boss Bill Kristol, editor of the Weekly Standard and one of the most prominent voices to urge Ryan’s selection.  In it, I outlined a few key points that are likely to shape the discussion about China in the months ahead and in the next president’s first year in office:

1) China’s economy is not just slowing, it is entering a serious correction.  The investment bubble that has been driving Chinese growth has popped, and there are no quick “stimulus” fixes left.  There is the very real possibility of some form of financial crisis in China before year’s end.

2) China is in the midst of a once-in-a-decade leadership transition that has not been going smoothly.  The transition will take place, but it has paralyzed the Chinese leadership’s ability to respond to the country’s growing economic troubles.  China’s leaders believe time is on their side; they do not “get” how serious and urgent the situation is, and that what has always “worked” is no longer working.

3) China’s economic problems spell trouble for the U.S. on several fronts.

  • First, China is flirting with devaluing its currency to boost exports—a move that will put it in direct conflict with Mitt Romney’s commitments on this issue.
  • Second, China is already dumping excess capacity in steel and other products onto the export market, a tactic that is likely to inflame trade tensions and reinforce imbalances in the global economy.
  • Third, in a worst case scenario, China may be tempted to provoke a conflict in the South China Sea to redirect popular discontent onto an external enemy.

My advice is not really partisan in nature.  The points I outline are equally relevant for any other candidate, Republican or Democrat, to take into account.  Nor are they meant to inflame China-bashing rhetoric.  In fact, they reveal that fears of an unstoppable Chinese juggernaut are misplaced or outdated.  What we really should be worried about is a China that is stumbling badly and doesn’t know what to do next.

There’s an interesting personal history here as well.  Back when I worked for Bill Kristol in the early ’90s, Paul Ryan — who is my age and, like me, was fresh out of college — was my counterpart working for Bill Bennett and Jack Kemp at Empower America.  We were colleagues, and I always thought he had a bright future ahead of him.

At the time, it occurred to me that there were really two issues that would define America’s future in the 21st Century, which were worth devoting oneself to.  The first was entitlements.  The second was China.  The former poses the greatest internal challenge to America’s potential and its place in the world, the rise of the latter poses — for better and for worse — the greatest external challenge.  Paul’s mastery of the entitlements debate has taken him far.  My path led me to China — “far” in a more literal sense.  It certainly is interesting, where life’s paths lead.

Apologies to readers who have been waiting patiently for the next installment(s) of my in-depth analysis of China’s summer real estate “rebound.”  I have been busy writing several articles for publication and — I admit it — enjoying summer with my family.  It is coming, and (I hope) will be worth the wait.

20 Comments leave one →
  1. Roger Charlesworth permalink
    August 19, 2012 11:57 pm

    How can the US complain about China’s “currency manipulation” when the US is hell-bent on Dollar Devaluation? The Chinese are simply piggy-backing the dollar down while still allowing a degree of appreciation.

  2. August 19, 2012 11:58 pm

    When are NPLs going to create a banking crisis? They keep getting rolled over but when does it catch up and how many trillions of dollars of bad debt are hidden? Wenzhou is talked about but no one is talking about systemic collapse. Is the financial crisis you refer to at the end of the year going to be caused by NPLs and how does that unfold?

  3. Joy Chen permalink
    August 20, 2012 2:25 am

    Patrick, another beautifully written and incisive piece. Seems so several of my smartest China friends are predicting a scary near-term future for China. And what an interesting personal connection with Paul Ryan. Indeed it is amazing where life leads us.

  4. August 20, 2012 2:29 am

    Yes, “they” need to play by the rules. However, in this case, “they” are playing by their own rules, whether good or bad or indifferent, like any successful business person and enterpreneur will do. If you always have to play by the rules set up by others, you will never succeed. That is what I have learned in my 40+ years in business. Therefore, I suggest all politicians think first before they express their opinions, In many cases, they come across as being too naive and/or stupid, especially the current crop of American politicians.

  5. August 20, 2012 7:33 am

    There is a problem with Chinese devaluation of the RMB – and dumping the market.
    This will happen only to a limited extend, as energy cost will raise.

    The risk is rather a Chinese revaluation – for China, as that will make food imports cheaper; but destroy the export market. Now that won’t happen; but the revaluation will come through higher oil and food prices.

  6. Emmet Moorehouse permalink
    August 20, 2012 10:54 am

    Is there at least the possibility of a Japanese style scenario unfolding where the economy sort of goes nowhere for a while but does not necessarily collapse? Good Lord, it sounds like I am bargaining with fate.
    Might the central government engage in another “asset”-management style exercise to clear up the banks, while using fiscal policy as a tool to spur domestic consumption and rebalance the economy?
    Is there any chance that this moment might be grasped as the moment to pursue the kind of liberalization that the country needs?

  7. Jason permalink
    August 20, 2012 11:51 am

    Why do so many people focus on the fact that the Fed is pumping the system with money, therefore the currency is devaluing. What’s actually happening in the real world, is the strengthening of the US dollar to every currency but the Swiss and the Yen. Really I guess that’s dollar devaluation to you. You just see what you want to see.

    • August 20, 2012 11:51 pm

      What has happened is that the US market fell away – and that forced China to continue undervaluing the RMB. But now the emphasis is on UNDERvaluing the RMB, as imports (and the 3 trillion in reserves are going to be spend). So China starts buying EUR bonds – which of course press up the EUR/USD rate of exchange.

      Splendid – if China was importing from Europe – which they don’t – the exception being Germany (but then everybody imports from Germany).
      Now China finds out to their chagrin that the bonds they bought (Spanish f.i.) weren’t of a very good quality.
      The effect is that everybody wants to change to German Bund bonds which are a very good quality – but that comes at a price: The interest rate for shorter term German bonds are NEGATIVE.
      In fact the Germans have to borrow debt from Spain (and Italy – not to mention Ireland) to get a reliable supplier of debt! Only thus can Germany produce enough bonds to supply the booming demand for German bonds.
      This production of German Bund does of course depress the EUR in relation to USD.
      The problem with trying to overvalue the RMB relative to the EUR is that China does not want to import from Europe! Europe hasn’t energy nor raw materials and their net export of food (grain) isn’t worth mentioning.

      Now as the RMB is undervalued relative to the USD – and that is where China wants to buy stuff and food – raw materials (that is more or less history, though) and food. As the exchange rate can’t be touched, there is only one thing that can give in: The price of raw materials and grain! Now raw materials can’t go up for ever – as China winds down; but the price of food CAN!

      That should make Chinese farmers rich; but it doesn’t as the Chinese consumer can’t afford higher food prices, so China will have to buy expensive food from the US (and South America).

      China has manoeuvred themselves into the worst possible situation:
      1) Overvaluing the currency of the chaps they are buying food from.
      2) Undervaluing the currency of the other bunch they are trying to sell to.

      Now Russia benefiting from high oil-prices and (to a very limited extend grain) is starting to go shopping (their infrastructure is horrible!), but they will shop in Europe (Germany – that has all the suppliers they need inside Europe) – not China, nor the USA.

      • August 21, 2012 1:58 am

        I think it is more like “overvaluing” the RMB since its fiat value is based on fake CCP numbers that people are foolish enough to believe.

        Germany runs a low deficit and has AAA so its bond yields are going to be low. It doesn’t have to do anything special to sell them when it is one of the most stable markets and very few places to one can be safe.

        China can’t peg to the dollar and undervalue as low as the Euro has fallen. To do so would require the sell off of massive FOREX or let the currency float “down” to its natural level exposing the real financial position of China Inc.

        The imports China wants from Europe are luxury goods and aircraft. CCP is tired of exported tourists spending all their money overseas avoiding state tariffs. Then they want to absorb as much technology as they can from Airbus and Eurocopter so Comac can build free of technology constraints. There will always be a Chinese luxury market for French wine, the elite are addicted to it.

        China buys most of its food from US or African farms. You have to watch out for their colonisation projects on the Black Continent. They will ween themselves off US farms over time at the rate of expansion.

        Russia will live off its raw materials until they run out… they aren’t much of a factor in the global economy apart from it.

  8. Steel trader permalink
    August 20, 2012 4:10 pm

    I visited several steel mills in China last week. 2 out of 5 had stopped production completely. 3 were working at less than half capacity.

    They are indeed trying to sell/dump but at the moment very few takers at any price.

    Enjoy your holiday Professor.

  9. bab permalink
    August 21, 2012 12:23 am

    The Ryan pick is a disaster, and I view it as a desperate move. With the Ryan pick, the independent, thinking folks are gone.

  10. August 21, 2012 2:55 am

    Reply to Armand: We agree more than You think!

    There is definitely a flight towards quality by the investors – wherever they might reside, that will help the German bonds – note the local government and county bonds are just as many as the sovereign bonds.

    But there is another development You have to factor in: The Euro has become the second reserve currency, which is a pretty darned miracle – considering that Germany is hardly having a deficit, and though their debt is considerable (they bought East Germany – cash) it is not possible to be a net creditor and have a reserve currency – normally that is impossible.
    So in order to have sufficient debt, they use the debt of the other European nations (which have plenty).
    You might think the Euro is a reserve currency; but in reality it is the German sovereign bond that is the currency.
    A mistake the Chinese leadership committed, when they bought heavily into Spanish sovereign bonds – that will cost them a fair penny.

    This leads me to my recognition of the original authors point about the transition of power in China.
    Not only have they to deal with the paralysis of getting the power structure in place – appointing the right people to the right post and so on ….
    But this has to be done a time where their whole world is changing.
    China is changing from an export oriented economy to an import oriented.

    The flippant dismissal of Russia is based on the popular and fundamentally flawed concept that the world is running out of natural resources – which neither Russia nor the rest of the world is – and definitely not in any relevant economic sense: The stone age didn’t stop because the world ran out of stone.

    Be that as it may; but the open question is if the Russian infrastructure is going to get the overhaul it needs. If it gets that, then Russia will be a player on the food market again: there are vast grain growing areas that can’t ship their product.
    The question is: Will it be possible to make that infrastructure for grain, that is only used once a year – at a profit? That remains to be seen.

    • August 21, 2012 9:17 am

      Of course Germany is the pivot foot of the Eurozone, but France is the next foot and can’t be discounted in the path of economic policy coming from the ECB. The two countries set the rules in concert and cannot move forward without agreement. The future of the Euro rests with the economic stability of France, if it keeps itself together it has a bright future. If not the entire thing will fall apart. PIGS are being aided by ECB QE so jumping the Euro ship so they can do their own QE becomes redundant. ECB is quite capable and willing to do it as devaluing the euro helps all members. I haven’t seen China moving to buy into the Euro bailout bond, instead buying up bankrupt assets.

      The stability of the leadership transition depends on the fiscal health of the state. With state liabilities of 180% of GDP, probably higher taking to account GDP being overstated, it is a matter of how well the party can hide its debts. The reason I ask Pat about NPLs is that it looks like it will cause insolvency in the Chinese banking system. With FOREX that is already leveraged against other debt, they have no response to a massive wave of NPLs and the capital flight that ensues. When the capital leaves, FOREX is automatically drained. Bank deposits are leveraged 2-3 times already.

      Pat, how much longer can PBOC keep this Ponzi scheme going???

      • August 21, 2012 10:28 am

        Now it wasn’t my intention to turn this into a discussion of Europe, where I have not seen any qualified opinions outside Europe, and few inside.
        I’m just pointing out, that as the EUR has become another reserve currency – partly with Chinese encouragement – the idea of playing the USD and the EUR against each other is not intelligent.

  11. Martin permalink
    September 2, 2012 8:48 pm

    China is in a dilemma. And there is no easy way out. But we need to stop trying to interpret this the western way.

    How many times have we read about the housing bubble and that it will pop … I am sure there is one and that it will burst … but not the western way. We will not see dramatically falling prices, foreclosures and a possible credit crisis.
    No one has an interest in seeing prices falling. The state does not want the real estate developers go broke. The state does not want any foreclosures or or the owner of new apartments loose money due to falling prices due to fear of social unrest. The local governments don’t want to see prices falling, since a big part of their income is related to land sales. Falling prices would seriously harm their income (btw. this is also the reason, why the wish for affordable housing will not be successful). The banks don’t want bad debt, and since a big part of their credits are backed by real estate assets, the risk is huge.
    What we will see is less new projects and therefore falling commodity prices, less employment and less income for local governments (from the real estate sector).

    This could be manageable if it would be the only issue. But local governments have a lot of not performing assets on their balance sheets. Most, if not all recent infrastructure projects are not performing: highways, airports, railways, you name them.

    Additionally the tax related income of the local governments are falling … and dramatically. Interesting: Biggest losses on taxes on personal income … due to? you guessed it: a crashed 2nd hand real estate market.
    Local governments, who were facing a grim financial situation already are now in front of an even bigger problem.

    Not enough problems? Then lets take a look at the exchange rate and personnel cost. We have had over 10% salary increases year over year for far too long, a RMB gaining value at the same time and inflation far above what is being reported. It does not make sense, but that is the way it is. Biggest problem for China: exports to Europe. 1 year ago the exchange rate was ~9.4 RMB/EUR, today ~8 RMB/EUR. Thats 15%. If you consider salary increases >10%, you might be talking about a perceived salary increase in EUR of >30%.

    And then there is a what might be called corruption. Not just bribery, but business networks with the only goal of stealing money from the state with direct involvement of governmental officials. Exclusive suppliers of state owned companies owned directly or indirectly by mangers of these state owned companies, kick backs wherever you look, and so on. The dimension is fully underestimated in what generally is reported, and beyond what some might think possible.

    So here is China facing a huge economic problem. So what is going to happen in the short term? I guess it is easier to name the things that are not going to happen.

    First of all: The biggest concern of the Chinese government is social unrest.
    2nd of all: There is nothing that the Chinese government cannot directly influence. In China you do what the government tells you to do or you cease to do anything pretty soon.
    3rd of all: You only see what they want you to see or what they cannot hide anymore

    – we will not see falling real estate prices (at least not massive)
    – we will not see a credit crisis (because bank will roll the not performing credits over and over again)
    – we will not see rising unemployment (probably more investment and shifting business to state owned companies, maybe devaluation of the RMB to strengthen the export)

    What I do see is a grim future for foreign invested companies with less domestic business, lots of tax disputes regarding export business and confrontations with local governments trying to influence daily business.

    I cannot see this ending without a big crash (but probably not very soon)

    The China we see today was built on the shoulders of a cheap labor workforce financed by credit consumption of the west. Now the export is not a source of growth anymore and investment jumped in to fill the gap. To think that domestic consumption will be able to save the future is wishful thinking.

    • September 2, 2012 9:33 pm

      Very good comment:

      “I cannot see this ending without a big crash (but probably not very soon)”
      I agree – China is so huge, so things take a long time.

      “How many times have we read about the housing bubble and that it will pop … I am sure there is one and that it will burst … but not the western way. We will not see dramatically falling prices, foreclosures and a possible credit crisis.”

      Well then we could see it the other way round: Bubbles in the West are going to “pop” the Chinese way.
      Nobody is going to let Barclays, Royal Bank of Scotland or Santander – even Deutsche Bank or Commerzbank for that matter – splash and close.
      What will happen is that all liquidity will move towards Germany – except that China has bought massively in Spanish sovereign bonds (poor sods) – very much appreciated (in Spain) and missing the fundamental point:

      It is not the currency – it is the debtor! What is happening is that every sane person is buying heavily into German Bundesanleihen – because there is a (remote) prospect of seeing some value repaid eventually. As it is the yield is a joke: 1-1½% on a 10 year German sovereign bond – even the Germans have a target inflation just shy of 2%.

      Germany can’t be a reserve currency (the D-mark never was) as Germany won’t run a deficit long enough to fulfil that role. What do you do, when you don’t have enough of own debt? You BORROW debt! Spain, Italy, France are first rate debt suppliers! So Germany will issue lots of sovereign bonds to all the depositors fleeing f.i. Spain – re-lend the money to f.i. Spain at say 3% – AS LONG AS THEY FOLLOW THE AGREED PLAN.
      If f.i. Spain do not toe the line – there will be no refinancing! Greece is finding out – they can scream and they can yell, but no money before they comply!

      This conversion of debt from one sovereign to another is quite sensible, as an investors has no ability to enforce an economic policy; but – trust me – Germany has by the simple expedient of shutting the money box. Germany is getting its fee by the difference in interest rate: Germany could care less about inflation, as long as they get their fee.
      They have taken over a country once before – and they can and will do it again: I.e. they will prescribe the fiscal and financial policy of the country.

      Putin is one of the brighter leaders: He has German sovereign bonds in his currency reserve. For how long will Germany do this? As long as people will pay to lend them money!

      Do You really think Germany wants to abandon the advantage of having the Euro devalued? The major exporter in Europe? Germany has had the perennial problem of having to revalue the D-mark – thus hampering exports and above all prices on exports: The organ grinder needs his monkey!

      How is Spain going to pay – Well for starters they could start paying their taxes – and they will!


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