China – It’s Economy, It’s Leadership & It’s Military

The past few weeks have been full of intense media coverage of China, its comments about the US Dollar, its holdings of US Treasuries, its domestic stimulus and the recent naval incident between the Chinese & US Navies in the South China Sea.

We shall try to cover these issues in this article. A detailed article on such a broad topic is beyond the space constraints of this blog and we shall be content to make a few salient points and provide references for further reading.

China’s Economy 

It is hard to watch financial television in America without hearing about the great Chinese stimulus program and how it is going to lead America out of the current recession. Our own view about the Chinese economy is quite different. Briefly, we feel that the unprecedented amounts of money that flowed into China have created extreme overcapacity in almost every aspect of Chinese economy and such overcapacity almost always leads to a bust. These views were expressed in our two articles: 

• “Jim Cramer – Balanced Thinker But Wrong On China” – January 9, 2009 – https://cinemarasik.com/2009/01/09/jim-cramer–balanced-thinker-but-wrong-on-china.aspx and
  
• “Chinese Slowdown – Revenge of the Austrians?” – November 15, 2008 – https://cinemarasik.com/2008/11/14/china–dubai–revenge-of-the-austrians–does-the-size-of-the-stimulus-indicate-the-size-of-the-problem.aspx .

Other observers have published a more draconian analysis of the Chinese economy by comparing China in 2008-2009 to America during its Great Depression in the 1930s.

In the April 2009 issue of the Atlantic, James Fellows writes “Idle factories, moored container ships, widespread bankruptcies, massive migration back to the hinterlands, strangely clean air—the signs of depression are everywhere in China. Because it makes so many of the goods the world isn’t buying now, China stands to be worse hit than the rest of the world —just as America was during the Depression, when it was the world’s sweatshop.” (see www.theatlantic.com/doc/200904/chinese-innovation).

China’s export machine and its resultant currency reserves are often used to portray China’s strengths vis-à-vis the USA. Howard Simmons of Bianco Research argues the opposite. In his words, “China is in that Treasure of the Sierra Madre position mercantilist countries have found themselves in forever. Exports are a cost to an economy; Someone else is consuming the fruits of your labor, you receive an uncertain asset (our debt) in return and you are dependent on the importer’s health.”

This is why we wrote in our January 9 article that “Unlike America, China is NOT the master of its own destiny..When Americans were spending and China was growing, the world’s hot money flew into China. Today, there are clear signs that this hot money is exiting China. China’s foreign exchange pile has been shrinking since September 2007.”

Michael Pettis, Professor at Peking University’s Guanghua School of Management takes a similar view. He writes “ ..there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.  This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply. This may be the biggest unexpected risk China faces. We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency  terms (emphasis ours), the PBoC has limited ability to manage the domestic money supply.” (see http://mpettis.com/2009/01/there-are-monetary-echoes-from-the-1930s-too/).

This limited ability irks China. It must be galling to the world’s second largest power to be forced to put its foreign reserves in US Dollars, the currency of its main competitor for global status. Besides emotional damage to Chinese ego, its investments in American assets act as a severe constraint against any military adventures it might be itching to undertake. After all, any serious confrontation with the USA would allow the USA to freeze all Chinese assets in America just as the USA has frozen Iranian assets.

This, we believe, is the principal reason for the recent Chinese drive to establish a new global currency reserve system under the auspices of the International Monetary Fund.


Is Chinese Leadership Basically Ignorant?

This would be viewed as heresy in most American media circles. China’s leaders are toasted in American media as very smart, intelligent and far above the middling American leadership. Many analysts have described them as the world’s smartest capitalists.

We disagree. In our opinion, China’s leadership lives in a bubble. They just don’t realize it. In contrast, President Obama has already begun describing the White House as a bubble and he makes it a point to get out to meet real Americans as often as he can. Chinese leaders are just the opposite. They only talk to their own colleagues and associates.

China’s leaders remind us of the “bubble boy” of the famous Seinfeld episode- spoilt,  truculent, constantly demanding of every one around him.

Besides living in a bubble or perhaps because of it, China’s leadership appear to have become momentum players. They allowed the overcapacity bubble in China to build to enormous levels without once pondering the consequences of a burst bubble. Their deep belief in the permanency of prevailing trends (typical of momentum players) persuaded them to invest in American equities at the peak of the bull market and lose approx. $80 Billion in the process.

They also seem ignorant of how free markets work. In China, the leadership has the power to guarantee any investment or seize any investment. They do not see why the USA cannot do the same. This ignorance is what led to them to invest the vast bulk of their US dollar reserves in Fannie Mae and Freddie Mac obligations. The near collapse of these “government agencies” shook Chinese authorities to the core. As a result, they have been selling most of their other US assets and buying short term US Treasuries with the proceeds. 

These experiences are behind their recent DEMAND for guarantees of the safety of their American investments from the US Government. As we said, they simply do not understand that the US Administration cannot do so in American markets.

Such deep ignorance is very dangerous. When leaders do not understand their adversary, they tend to make dangerous mistakes. Scholars have argued that ignorance about America and it’s thought process played a critical role in Japan’s decision to launch its war in the Pacific in 1941.

Everyone knows that the USA finally came out of its Great Depression when it began mobilizing for World War II. Wars cause inflation and therefore wars have been the traditional antidote to depressions. What does this imply about future military adventures by China? Authoritarian societies have always directed domestic anger towards real or imagined foreign enemies and gone to war.

China’s leaders made an enormous mistake in the 1980s by forcing a one-child policy on Chinese families. As a result,  China today has a 1.23:1 male-female ratio. Howard Simmons of Bianco Research writes “no society in history has had to deal with that number of unemployed and unattached young men (“I ain’t getting paid, and I ain’t getting …”).

Dennis Gartman of The Gartman Letter writes “..I am worried about the fact that there are not enough young women, with their “civilizing” influence upon young, testerone raging young men. A population laden with young men of the age of 15-30 becomes dangerous, for they need to brought into control and that usually means military service. So I have feared China’s propensity to become a militant, expansionist country to simply make certain that this excess population of young men are sent abroad.”

Note that the People’s Liberation Army (“PLA”) of China is already 2.5 million strong, bigger than the combined armies of USA and India.


The Recent Sino-USA Naval Incident & The Ambitions Of The PLA

In every authoritarian society, the military calls the shots in the final analysis. China is no different. We believe that the civilian leadership of Hu Jintao and Wen Jiabao exists at the pleasure of the PLA.  As long as the economy is sound and there is no civil unrest, t
he military will be content to let the civilian leadership run things. If it feels that the civilian leadership is not doing a good or the right job, it will exercise its muscle.

The world already sees signs of the PLA exercising its muscle. So far, it has been content to browbeat India all along the long border from Afghanistan to Myanmar*. The Chinese Navy has developed long range plans to combat the Indian Navy in its own backyard, the Indian Ocean*. A few weeks ago, there was an incident between the Chinese and Indian Navies in the Gulf of Aden in the Indian Ocean.*

Two weeks ago, the Chinese Navy escalated the stakes by creating a confrontation with the US Navy. The Financial Times quotes Michael Swaine, a China expert at the Carnegie Endowment as saying “It is to reduce the ability of the US to operate freely along their coast”.