China au contraire with Dr. Jim

As Marshall McLuhan famously remarked decades ago, the medium is the message.

These days, the explosion of visual media has led to the dominance of the sound byte, which along with content increasingly provided by a whole range of professional opinion masseurs, has replaced the balanced coverage of complex issues once offered by the in-depth print article. In other words, this is the age of the official party line.

It’s as true in most economic reporting as it is in any other kind. Certain economic views are now heard so often they’re taken for bedrock truth – for example that China will shortly overtake the US to become the world’s leading economy.

In the context of this, Dr Jim Walker comes across as a cool contrarian Scots breath of fresh air. Since December 2007 he has headed up Hong Kong-based Asianomics. Prior to that, he was leading regional research and brokerage firm CLSA’s chief economist, and regularly voted Asia’s best regional economist.

The art of myth-busting

In his remarks, Dr Walker’s first point of contention was the growth of China, or rather that the nature of this is something miraculous with a bevy of wonders yet to come.

“You can grow at 9% per year for 20 years. But if in the decade before that you were going backwards at about 9% per year, you’re really just catching up a bit,” he quipped.

As regards being China is well on its way to overtaking the US, he had this to say: The standard reasoning is that if the PRC grows at the same average growth rate that it did between 1978 and 2008 into the future, while the US grows at the same average rate that it did over the same period into the future, China will overtake America by 2036. And, if that time frame with the comparable growth rates is shortened to the last ten years, when the Chinese currency started to appreciate, then it gains extra thrust in closing the gap. Thus, by this metric, the convergence point would by 2020.

So what does this imply?

Not a lot, Walker contends. Because these are measurements that really don’t matter.

The population factor

If China’s per capita GDP growth rate over the past 30 years is projected forward against its equivalent in the US, by 2050 China will be 45% as rich as the US. That’s a great leap forward compared to today, where the equivalent number is only 7%. By this measurement, it would take until more or less the end of this century for the PRC to reach parity.

But seen another way, with the shortened perspective of the equivalent numbers for both countries between 2000-08, China’s per capita GDP will overtake the US by 2032.

This is the key indicator, he says, because it was only when the US overtook the UK by this measurement that it became the most influential country in the world.

The point, however, is that this is not likely to be the way it will work out.

Over the next 40 years, China’s population is projected to grow by only 4% overall, whereas over the last 30 years it’s grown by 42%. By contrast, over the next 40 years, the US population is estimated to grow by 28%, seven times faster than China. And over the last 30 years, US population has grown by 40%.

“So all the bets about the growth and overtaking of the Chinese economy are based on the notion that it can keep up the growth rate of the last ten years with constantly slowing population growth, and in particular, relative to the richest country in the world today,” Walker contends. “It’s unlikely China will ever overtake the US in terms of per capita GDP growth, unless the US dollar collapses and the RMB is de-pegged.

An L-shaped recovery?

He has a similarly unorthodox view of the prospects of the global economy – and its resonance in Asia – and the V-shaped recovery most think is now well under way.

He reckons nothing could be further from the truth, and that whatever recovery there is is more likely to be L-shaped.

“The fact is there has been very little in the way of solutions to the global crisis enacted by governments or central banks over the past year. Ben Bernanke, the chairman of the US Fed, is now being lauded with saving the economy, which is a great thing for the guy who crashed the car in the first place. It’s like getting praised for taking the injured to hospital. But the really unfortunate thing is that he’s mistaken the hospital for the crematorium. Because that’s where people are going to end up, very badly burned in this rally which is sweeping equity markets across the world just now.”

As Walker sees it, the rally is a massive correlated bet on the continued weakening of the USD – and that’s all. As evidence he notes that the BOVESPA is 100% correlated with Australian dollar/US dollar exchange rates, which in turn are 100% correlated with commodity prices, which are more or less correlated with equity markets in Asia.

“The fact that equity markets in Asia (with the exception of China) have moved almost in tandem with each other is a testament to the fact that nobody is looking hard at where they’re putting their money. Because it suggests a belief that all Asian countries are more or less identical, with all the stock markets equally weighted in every single industry. Which is obviously far from the truth. These are incredibly diverse countries with equally diverse stock markets. So with barely a razor blade’s difference in their performance this year the driver is clearly a wall of money. And the problem with that is that it’s going to disappear about 2010.

“This has been the easiest year in history for financial companies to make money. But what you need to ask, when central banks do as they have done over this period, is where the money goes in the first instance?”

Money flows uphill

Walker denies that he is a contrarian. Rather, he is a disciple of the Austrian school of economic thought. One of the aspects of the Austrian view which is very different from its mainstream counterpart is that it doesn’t assume that money, when it enters the system, is neutral.

As an example, he cites concerns about Hong Kong real estate prices a few years back, after the Asian crisis of 1997-98. The assumption among mainstream adherents was that they would plummet to Shenzhen levels (across the border in mainland China) before recovery could begin in earnest. The rationale was that “money flows downhill”, meaning to the cheapest areas first.

This is totally at odds with the truth, in Walker’s view:

“Money always flows uphill, to the most expensive places, the most inflated places, because that is where the gains are; which is why Hong Kong’s property prices have always been above Shenzhen’s, as New York’s are relative to, say, Chicago’s, or London’s compared with the rest of the UK.”

More broadly, the same thing has occurred this year in terms of asset prices. That’s because after the central banks sent this tsunami of money into the financial systems, the latter had two choices as to what to do with it: lend it to the real economy or buy assets. With the news that credit is contracting in the US, Europe and much of Asia (again excepting China), it’s obvious what choice was made. And that naturally spawns inflation, meaning a short-term feelgood factor, but one that will require even more in the way of capital injections to continue the upward trajectory currently seen. And Walker is not alone in thinking that won’t happen. Nor, he says, will the real economy recover anytime soon.

“The way I’d like you to think about the global macro-environment is that we went into this crisis at a historically high growth rate for the global economy of about 5% p.a. in real terms year-on-year for the last few years,” he explains. “We have reset demand sharply below what it was; we just don’t have the exact numbers at this point. But we can say that coming out of this recession, the trajectory will be nothing like 5%; if it’s 2% we’ll be lucky.”

Which means there’s only one way for equity prices to go.

Impact in Asia

Although Asia generally has fared rather better than the US and Europe in the aftermath of the GFC, Walker sees problems coming not too far down the road.

“Asia has a broken model, in that it hasn’t changed. It’s still an export-led region. And so the response so far in this crisis to the downturn in demand has been to re-peg regional currencies to the US dollar, the weakest currency in the world, and to initiate some government spending and cut interest rates in exactly the same way that they’ve cut them in the US and elsewhere. Which is exactly the wrong response for Asia,” he contends. “But the good news (ultimately) is that I don’t think there’s a recovery coming and so Asia will be forced to change, and that will be the day when it’s truly exciting to be invested in this region.”

Nowhere does he see the peril of clinging to this broken model as being more pointed than in China.

In a nutshell, he predicts coming inflation in Asia, and particularly China; and deflation in the West over the next 12 months.

He prefaces his dour outlook by noting that, in the Austrian view, inflation has nothing to do with consumer prices. Rather it’s got everything to do with money and credit.

“In the case of the broad stocks-vs-bonds outlook, I’d suggest you be long US Treasuries. The fact is people will be fleeing to safety, so be very short cyclical stocks. But in Asia, the problem will be much worse. Because what Asia has done by again re-pegging its currencies is to flood the system with money - which has created asset bubbles all over the place. And nowhere are these worse than in China.”

China’s late great economic miracle

“I know very well that everyone wants to be positive on the PRC,” he continues. “But the problem is that China went into probably the deepest recession in the world in Q4 last year. Had it been left to its own devices, it would have shaken out a lot of the bad investments made over the past decade or so. But that would have also meant a huge number of unemployed people. And because the government couldn’t countenance that, it inflated the country’s economy.”

The facts he cites are disconcerting. With China’s 2008’s GDP having expanded by 30% in the first 9 months of 2009, and money supply by a similar amount, it’s no surprise there is a lot of activity; this is what pundits are calling miraculous. But the real surprise is a nominal GDP growth rate of only 6% year-on-year rather than 16%.

“That should worry you all, and indicate how deep the recession in the export sectors is. Because the fact remains that presently there is no price change happening in China, to shift companies, entrepreneurs and resources out of the export sectors and into domestic-orientated industries. Sure, there’s going to be lots of infrastructure spending, and lots of government activity. But China cannot build a self-sustaining growth model until the day it grants property rights to rural farmers.”

Succinctly put, Walker says, the three variables that are storm warnings of a crisis coming are rapid growth in credit, rapid growth in fixed investment, and rapid growth in asset prices. And where are those most evident in the world today? China. Which is why he sees the country as being in the crosshairs of the next great crash.

Winners and losers

Another assumption he challenges is the notion that if the RMB became convertible, it would launch a rocket ride with a one-way ticket up. Acknowledging that the trade surplus is solidly positive, as is the current account surplus, what could make it go the other way? A simple but unquantifiable fact, Walker argues: that unlike their counterparts in the US and Canada, Europe, Australia and many other jurisdictions, the 1.3 billion Chinese have never had the chance to sell their currency. So his bet would be that, if and when convertibility occurs, after the initial spike it will reverse and plunge.
But at the same time, he doesn’t see that occurring for the foreseeable future.

Otherwise in Asia, there isn’t much to say; all major regional currencies are pegged to the RMB and therefore the only question is, which way is the dollar going – with the possible modest exception of the Japanese yen.

“You have to be crazy to invest in Japan as a positive equity bet. Rather, the country is the natural short for hedge funds. The reason for that is that if the country doesn’t grow for the next 50 years (keeping in mind its graying demographics), per-capita GDP goes up every year. And when that happens, the game changes. What is then required is no longer growth, no longer policies that engender dynamism in companies to produce export-sector growth that could add cream to the cake. Actually, they no longer need an equity market that produces positive returns. All they need is stable employment. And a strong yen means import prices don’t go up; in fact, hopefully they come down with deflation. Whereas the worst possible thing for them is a weak yen, because they’d start exporting their income to the rest of the world, and what they’d have to spend on domestic goods and services would go down; therefore, employment in Japan would go down and they’d be in trouble.”

A surprising bright spot - India

Japan aside, Walker sees one unabashedly bright spot in the region: India.

“The reason that we, at Asianomics, are structurally long the Indian equity market is purely because interest rates there are high. And what that means is that companies that invest in capital know that their return has to be much higher than the interest rate that they can get at the bank. So whereas in China, where capital is free, you don’t expect returns; in India, where capital expensive, you can safely expect returns. You might not get the same amount of growth. But you’ll get companies making decisions based on a very high cost of capital; which means that the investments that they make are high quality, high return investments.

He notes, however, that if equity markets worldwide come off the way he expects that they will, India’s will come off in exactly the same way. But once the storm is past, that’s where he’d be putting money back into, because high interest rates plus government incompetence is almost sure to produce profitable opportunities.

“The country has grown by 6% p.a. in real terms. China is faster, but not much faster. And in nominal terms, India is just as fast. In fact, in nominal terms this year, India has been growing at twice the rate of China. It’s just quite wrong to think that India has been locked in a poverty trap and is a much slower growing economy than the rest of Asia.”

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