The Vulnerable Side Of China

Posted By on October 5, 2010

From Art cashin on the floor of  The New York Stock Exchange……

Not Quite What They Seem – Our UBS pal in London, Andy Lees, put out an eye-opening piece on China this morning.  Andy sees China becoming more vulnerable because of their growing energy dependence.  The piece is too big to fully reproduce but here are some key parts:

Conventional wisdom is that the western world has entered a period of contraction, that the US is falling from its pedestal and that China is regaining the position it lost 500 odd years ago as the dominant power in the world. This kind of superficial picture is worse than that spouted in the 1950’s and 1960’s involving the extrapolation of former Soviet growth to the point where Khrushchev famously declared “We will bury you”.  Like the Soviet Union, China’s economic strength has mainly been driven by factor mobilisation rather than efficiency and productivity gains, explaining why Green GDP (its total balance sheet) is said to be flat over the last 20 years – (the Chinese government actually published a form of Green GDP in 2006 re 2004 data which supported this finding, but the following year they blocked the publication and stopped its use). It uses more energy than the US economy which is about twice the size, and nearly five times as much as Japan’s economy which is of similar size. It clearly uses more labour and according to The World’s Water 2008 – 2009, it uses ten times the water per unit of industrial output than developed countries in general. As with the Soviet Union, state direction of capital means that imbalances can be sustained for a long period of time, only being limited by the exhaustion of resources or by social unrest, which is only likely if the economy is slowing down, hence why China will continue to drive at full speed into the eventual brick wall.

As resource countries benefit, they suffer from the so-called Dutch Disease. As oil exports become more valuable driving the currency higher, the competitiveness of other domestic industries deteriorates causing imports to rise and exports to fall. Within the country itself, the high returns available from the oil industry act as a magnet to capital, increasing the cost of funding for other industries. Some sort of capital control or internal subsidy is therefore necessary to maintain the value added within the country. This acts to hollow out the energy importers and cause large international imbalances to continue accumulating; it taxes efficiency and rewards inefficiency unlike a free market which would do exactly the opposite. The reason this is relevant to China and its capital controls is that, as the world’s largest energy producer by some margin, it also suffers from the Dutch Disease. Without capital controls its natural inefficiencies mean it is unlikely to be able to compete on the world markets or even domestically against foreign imports.

Andy goes on to point out that China has managed to use its vast coal reserves as a crutch.  Those reserves will not sustain its energy needs in coming years.  Andy also notes that China may be hearing footsteps in the trading area.  Several smaller Asian nations are selling much more than China.  Japan has pulled dead even on trade.  Even Mexico is gaining market share at China’s expense.

Here’s how Andy concludes his thoughtful piece:

We are told that China has been the main driver of global growth in recent years as indeed it has. We shouldn’t forget however that by using its massive production of fossil fuels to impose capital controls on the rest of us, this growth has to a large extent simply been transferred from abroad, and in particular it has been taken from investment in productivity advancement. Though quite stunning, China’s growth has been at the expense of global economic advancement as it has used its fuel to support inefficient domestic industry rather than export the fuel to countries that could produce more with the energy. To be fair to China, not many countries wanted their coal as it didn’t necessarily suit our greener credentials; it was preferential to see China pollute its own environment and sell us the goods. It is here where the US could quite easily turn the table back on China by imposing an equalising tax on the embedded carbon within all manufactured goods. This would likely get wide public support and would go down extremely well in Japan and Europe. As very energy efficient manufacturers, it would effectively offset the impact of NAFTA and help tie them more closely to a US centric bloc, the scale of which would dwarf China and therefore gradually isolate it. Whilst I would generally not support taxes as an efficient method of allocating capital, in this circumstance it’s actually quite clever, taxing inefficiency. Whether such measures are imposed or not, the fact that capital is being allocated badly will eventually result in an economic bust for China in just the same way that it did for the USSR.

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