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China, Greenspan, and More

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By Rozanovitch
May 12, 2004

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Why follow Chinese economy?
I would like to add the rationale even though there seems not to be any interest for investors. There is a trend in the markets, when China burps words like slowing its growth in their economy, the world's financial markets go into a tailspin.

Even though Wen Jiabao, the current Chinese premier, is hardly a household name even in his own country, he carries more weight in the financial markets than those of Federal Reserve Chairman Alan Greenspan. How can that be? Sheer size, the individual behavior of China's estimated 1.3 billion people can change the global economy. Here's Jubak's current favorite from an estimate by Chicago agricultural forecasting firm AgResource: If every person in China consumed one more tablespoon of soybean oil annually, world trade in soybean oil would double.

China has leverage:
1. China's economy is labor-light and commodity-heavy. Cheap labor adds up to a bigger part of the whole.
Leverage: The Chinese economy is far more weighted to commodities than the economies of the U.S., Europe or Japan.

2. China has become the marginal consumer that sets global commodity prices. Blame this on tight worldwide commodity supplies. Take the worst case: the global supply/demand story for oil and natural gas. The International Energy Agency estimates that global demand for oil will climb to 79 million barrels a day by the end of 2004. Supply will stay ahead of demand, climbing to 82.3 million barrels, but that's not much of a margin -- only 3%.

That margin seems even smaller when you factor in the growing Chinese demand for crude oil. It was up 9% in 2003. In fact, the IEA says, China accounted for 35% of total global growth in oil demand in 2003 and will account for 30% of demand growth in 2004. The drop isn't due to moderation in the Chinese appetite for oil. The real reason is increased oil demand in Japan, the U.S. and elsewhere.
Leverage: As the buyer at the margin, China "sets" key commodity prices.

3. China is now the world's marginal producer and sets global inflation rates. This is the result of cheap labor and a glut of manufacturing capacity. A lot of companies have moved manufacturing from, say, Chicago to Shanghai. China may be ready to export inflation.

Inflation in China rose to 3.2% in the 12 months ending in December and 2.8% in the first quarter. So far, much of that increase has been in the cost of food. Here's where the commodity-heavy nature of the Chinese economy could become a real problem. As commodity prices rise, Chinese manufacturers must pass on much of that increase to their customers.
Leverage: As the supplier at the margin, any uptick in inflation in China quickly travels around the globe.

4. Local political pressure and realities make it hard for China's central government to engineer a soft economic landing. Remember local politics -- not economic efficiency -- control the market more often than not. The danger here is that bamlomg measures might overshoot their targets. Rather than slow things down, they could actually stall the economy. That was the pattern in the early 1990s.
Leverage: The government's effort to slow the economy produces a bust instead of a soft landing.

5. While China is a global manufacturing juggernaut, its financial sector remains underdeveloped. Bill Mann cautioned on this item. There's a race on in China between the central government's efforts to improve the financial condition of the banks by injecting capital and reducing bad loans and the next economic downturn. Default is not likely, but a bailout could raise investor double. Any decline in Chinese stocks could send international investors to the sidelines. And the decline would feed back into the banking system as well, by lowering the price of equities held by the banks and the value of collateral for many of their loans.
Leverage: The Chinese financial sector is weak enough to turn a nasty short-term dip into a long-term problem.

No one knows for sure how this slowdown in China will turn out with a tooled slowdown. Commodities will drop more and should provide the investor with an opportunity or two.

News of today
John Taylor, the U.S. Treasury Department's under secretary for international affairs, will visit with Chinese officials next week during a swing through Asia, Treasury said on Thursday "to discuss the Chinese economy, progress on financial liberalization, the state of the banking system and issues related to China's currency.

Federal Reserve Chairman Alan Greenspan said today he expected booming Chinese economic growth would slow to a more sustainable pace, and that this should in turn moderate surging commodity prices.

"That the current growth rate of China will slow down I think is an easy forecast. Indeed, the Chinese authorities are wholly aware of a rate of growth in numbers of industries which are not sustainable and they are working ... to slow the rate down."

"Obviously a goodly part of the current acceleration in commodity prices, in scrap steel, aluminum, copper, lead, zinc, tin -- I think all of them, in fact, have shown fairly significant increases -- and they seem to be attributable to the increased marginal demand coming out of China."
"Clearly if the rate of growth slows down, we are going to see a backing up of some of those prices. And indeed, we've already seen it. Scrap steel prices are down quite significantly from their peak several weeks ago and a number of the other metals have either flattened out or edged lower."

This makes me think he believes in a soft landing for China's economy, something Jubak and others say there is no guarantee.

Besides China, Greenspan is worried that uncontrolled federal budget deficits will dampen U.S. economic growth. This year's federal deficit could top $500 billion. Greenspan told a banking conference that the federal budget deficit was a bigger worry to him than America's soaring trade deficit or the high level of household debt because those two problems can be corrected by market forces. He said one of the biggest concerns was that the deficits now were occurring right before the first wave of baby boomers will begin retiring. Greenspan is now back in the groove, deficits are bad.

So what does the small investor do? Deficits, rising interest rates, and inflation are here. Some say keeping cash on the sidelines for awhile might be the way to go. Others say stay invested. If the rate sensitive groups appear vulnerable, which sectors look attractive? Tough call, this is a near market in transition.

Short answer might be energy. Paul Erman writes that the looming oil crisis will dwarf 1973.

What might the most scary force to an economic recovery and the bull run? Stupidity by politicians gets my vote. Optimism in the markets reigns and what happens? We get those gruesome pictures of prisoners in Iraq, the problem in prisons being known for many months with no action. The point here is that our politician's credibility is in the dumper. How can we be viewed as trustworthy? More and more investors are discovering that Washington's secretive politicians cannot be trusted to tell us the truth about the war. And like it or not, this really is World War III if you examine the players.

Investor confidence is based on trust, not half-truths, secrets and lies. Seen as untrustworthy on the war, how much truth is in the economic, deficit, program cuts or programs reports we get. You know politicians can't have it both ways in terms of credibility. In this election year, all bear scrutiny and analysis.


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