Global Macro Notes: China’s Biggest Export — Deflation

December 17, 2010
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Quick, off the top of your head: What is China’s biggest export?

Gym socks? iPods? Wal-Mart knick-knacks? Neo-colonial African infrastructure (e.g. bridges and ports in Congo)?

We’ll hypothesize here that China’s biggest export is deflation.

Consider — during the boom-boom Bretton Woods II years, everyone talked about “the China price.” As in, “if you can’t beat the China price” for some manufactured good, you didn’t really have a chance of competing.

China’s low-wage army and all-encompassing state-run utilization of resources exported the “China price” all over the world, lowering not just the cost of finished goods, but the wages of Western world workers to boot.

Consider this excerpt from a recent NYT piece, ostensibly about wind power but actually about something else:

TIANJIN, China — Judging by the din at its factory here one recent day, the Spanish company Gamesa may seem to be a thriving player in the Chinese wind energy industry it helped create.

But Gamesa has learned the hard way, as other foreign manufacturers have, that competing for China’s lucrative business means playing by strict house rules that are often stacked in Beijing’s favor.

Nearly all the components that Gamesa assembles into million-dollar turbines here, for example, are made by local suppliers — companies Gamesa trained to meet onerous local content requirements. And these same suppliers undermine Gamesa by selling parts to its Chinese competitors — wind turbine makers that barely existed in 2005, when Gamesa controlled more than a third of the Chinese market.

But in the five years since, the upstarts have grabbed more than 85 percent of the wind turbine market, aided by low-interest loans and cheap land from the government, as well as preferential contracts from the state-owned power companies that are the main buyers of the equipment. Gamesa’s market share now is only 3 percent.

With their government-bestowed blessings, Chinese companies have flourished and now control almost half of the $45 billion global market for wind turbines. The biggest of those players are now taking aim at foreign markets, particularly the United States, where General Electric has long been the leader.

The story of Gamesa in China follows an industrial arc traced in other businesses, like desktop computers and solar panels. Chinese companies acquire the latest Western technology by various means and then take advantage of government policies to become the world’s dominant, low-cost suppliers.

Deflation, baby. The big “D” in full effect. One has to wonder — how long will Western companies follow this pattern:

  • Get lured into China by the promise of massive markets.
  • “Give away the store” in a cut-throat intellectual property environment.
  • Get eaten alive by competitors fed and nourished with Western know-how.

Not a call to protectionism here, just an observation. China is a deflationary force.

In some cases that’s a good thing. We all benefit from falling price trends in technology, for example — especially given the tendency for technology to improve as it gets cheaper.

But the flip side of this will prove to be persistent long-run pressure on Western wages, and a general inability to relieve that pressure in most cases.

The “China price” — and later the Indonesia price and the Bangladesh price etc. — ain’t going away.

Vendor Financing, Capex and So On

Now hold on, the devil’s advocates say. It’s not all deflationary. China has contributed to inflation too — in some ways massively. That’s a fair observation, as based on the following:

  • The “vendor finance” aspect of mercantilism and Bretton Woods II. Prior to the global financial crisis — remember that quaint world? — part of the reason the leverage and finance orgy got so wild is because long-term interest rates stayed persistently low. This was the “conundrum” Greenspan famously referred to. And why did that conundrum exist? Because the major “vendor financer” players — foremost China, secondarily the big oil exporters — were happy to constantly recycle their $USD flows back into long-term treasuries, perpetuating the binge-and-boom cycle.
  • The commodities / infrastructure / capex boom. You know this angle — China the ravenous dragon. China the great consumer of every commodity in sight. China the facilitator of ports and bridges and mines and highways being built in Africa and Australia and all corners of Asia, all linked to the needs of an upcoming superpower.
  • The Beijing Put. You’ve heard of the Greenspan Put… then we got the Bernanke Put… and now we can start pondering the Beijing Put. Namely, China has such a massive stash of currency reserves, it can go in and throw cash at Greece or Ireland or whomever it chooses to keep the global party going. (Note recent loud overtures from China on investing in Greece, and Portugal’s request that China buy its bonds.)

All of those are reasons to paint China as an inflationary force. Except, of course, from the “crack-up boom” perspective in which inflationary juice now begets deflationary pain later.

To wit, China can pump stuff up, but it can’t keep stuff from blowing up:

  • The aftermath of the Bretton Woods II orgy, in large part greased by mercantilist UST purchases, was a massive deflationary bust.
  • To the degree that rising food and energy prices act as a regressive tax on consumer discretionary income, even China’s commodity buys have a deflationary twist.

It’s that last bit — the threat of China implosion, or least equity market implosion — that has our attention now. Consider tidbits like this (via Bloomberg):

Chinese consumers are more concerned about rising prices than at any time in the past decade, underscoring the pressure on policy makers to step up efforts to counter inflation running at a two-year high.

A price satisfaction index fell to 13.8 this quarter, the lowest level since data began in the fourth quarter of 1999, the central bank said on its website today.

Authorities have held off on adding to October’s interest- rate increase, instead ratcheting up banks’ reserve requirements and using tools such as sales of food reserves to tackle inflation. The Commerce Ministry said today it will “closely monitor” prices over the next quarter, especially during holiday periods, and keep releasing stores of pork and sugar.

Out of Control?

The relevant question is whether it is too late… whether rampant inflation in China has already gotten out of control.

Recall that China played “Santa Claus to the world” in 2009 with its massive $586 billion stimulus package, rammed down the throats of the banks via state-ordered lending. Now the inflationary reckoning approaches.

Talk of “closely monitoring” the situation at this late date sounds laughably quaint — on par with Homer Simpson “closely monitoring” his station dials as the Springfield Nuclear Reactor threatens to blow.

Of course, some say “never short a country with two trillion in reserves.”

But in-country China watcher Michael Pettis neatly demolished that argument earlier this year:

China’s foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.

But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP. My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.

The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short.

We Mercenaries were “dumb enough to go short” China (via FXI) in a semi-bluff reversal play on November 12th, and have built on our exposure since then.

(All trades time-stamped both in real capital and the Live Feed archives.)

As of this writing, China’s charts emphatically say “down.” In addition to pyramiding FXI, we have rounded out our bearish Asia exposure with vehicles such as FMCN, PGJ, and EWH.

It seems others share at least a modest concern that, in spite of Beijing’s love for Keynesian style ramp-up, the threat of populist backlash against rising cost-of-living pressures can no longer be ignored.

And if the dragon really gets its “big D” implosion on, look out below…

JS

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