China: One Coin, Two Faces

John Mauldin | Thoughts from the Frontline
January 21, 2005

This week we begin what will be a series of occasional letters on China. The topic, like the country, is so vast that it cannot be adequately dealt with in one short letter. Today, we will take a long range view into the future, looking at how China will develop vis-a-vis the developed world.

There is a mountain of material on China, as I can personally attest to, having gone through hundreds of pages of reports, essays, and data in the past few weeks. Much of the writing falls into two camps, it is like they are holding the same coin but only looking at one of the two sides. The first camp sees China as an emerging empire which will eclipse Europe and the US in a few decades, offering a rival military power to balance a uni-polar world. They will stop purchasing US debt, precipitating a major decline in the US and force us into a long and permanent recession. After reading some of the extremes of this group, I feel like buying a shovel and digging a hole so we can just go ahead and bury ourselves.

And then there are the Chinese skeptics. Yes, they admit, China is a good story today, but when the inevitable crisis comes along China will not be able to maintain its stability. China is dependent upon massive amounts of foreign investment, which will at some point dry up. Its recent boom is construction related, and that cannot continue. It has huge pollution problems; a top down administrative economy which almost never works, and is creating more and more problems; cannot sustain its pace of growth because there will simply not be enough energy; will have a major crisis when its people demand an end to the massive and pervasive corruption and desire true democracy; has a banking system that is essentially bankrupt; has no real system of capital markets and so on and so on.

Things rarely happen at the extremes. And it is my belief that China will not evolve at the extremes as well. China is an odd mix of problems that will have to be dealt with and opportunities that will shape our world in ways far different than we might now imagine.

Who could predict, merely 25 years ago, that the US would be for all intent and purpose the sole world Super-Power? That Europe would be united with one currency and a market size greater than the US? That Eastern Europe would have free democratic elections and an exponent of flat taxes? That Russia would be a third world country with nukes? That China would be moving rapidly to becoming a free market powerhouse and major supplier (and creditor) to the US?

The consensus forecast usually takes current events and projects them into the future, not noticing the subtle changes that are happening under the radar screen. Thus governments think tax cuts will mean a loss of revenue or economists think current rosy conditions will persist, ignoring the warning signs at the leading edge of the economy.

For the next few pages, let's look at where China is today and where "the experts" think it will be in a few decades, where its advantages and disadvantages will be and how they might interact. We start with some dry statistics to give us some way to make comparisons.

When Will China be Larger Than the US?

Goldman Sachs attempted to answer that question in October of 2003. Sometime this year, China, in terms of GDP, will be larger than the UK. Around 2010, they will surpass Germany, Japan by 2015 and will catch up with the US around 2040.

(As an aside, they also think that India will surpass France and Germany in the early 2020's and Japan in the early 2030's.)

And even more optimistic scenario is offered by the banking giant HSBC (Hongkong and Shanghai Banking Corporation. Their staff projects that banks assets in China would surpass those in the United States by 2034.

There seems to be so much inevitability tied to such projections, and much hand- wringing. What is to become of the US if they (we) are only #2? Will we slide into some economic oblivion, with ever dwindling economic lives? Will the Chinese dominate everything, forcing the poor citizens of the US to live at a lower standard? Hardly.

In that world of 40 years from now, China's GDP per capita will still be less than 40% of the per capita US GDP. Of course, they will have four times more citizens, so they should be a larger country in terms of GDP.

Let's look at a few comparisons of where we are today. You can look at a country's GDP in several ways. First, you can look at it in absolute terms, as the Goldman study mentioned above does. Looking at Gross Domestic Product in terms of dollars, the United States is roughly $12 trillion dollars. (All of Europe - the so-called EU 25 - is slightly larger.) China is now the #7 ranked country, with a GDP of around $1.6 trillion. Japan is $4.7 and Germany is $2.7 trillion. (Source IMF)

It gives you some perspective that Italy is bigger in terms of GDP than China. If California were a nation, it would be larger than China. (My favorite statistic in that regards is that the Netherlands with a population of only 16,000,000 and no natural resources is bigger in GDP terms than Russia with 143,000,000.

Then you can look at a country in terms of its Purchasing Power Parity or PPP. This is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciate in order to return to PPP. The basis for PPP is the "law of one price." In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.

Using PPP to compare countries changes our perspective a bit. On a PPP basis, the US accounts for 21% of the world's total GDP. But China is second at 13%, with Japan third at 6.8%. India is fourth at 5.8%. China looks pretty solid by that standard.

But on a per capita basis using PPP, the picture changes yet again. Norway and the US (with Ireland close behind) are roughly equal, with tiny Luxembourg ranked #1.

China's PPP per capita GDP is about 14% of the US and close to the bottom of the 40 or so countries we surveyed. India, for what it's worth, is at the bottom. If you look in actual dollar terms, China comes off even worse. The GDP per capita of the US is roughly $40,000. For China that same number is only $1,213.

But those numbers do not tell the real story. The real story is one of free markets and a massive population who are being allowed to chart their own individual destinies. Barely 20 years out of massive repression and an economy that could barely feed its people, a wave of entrepreneurs are transforming the way China does business. Think what China will look like when its entrepreneurial class actually has access to capital (more below).

China is already the largest user of steel and cement and is poised to overtake the US in consumption of everything from copper to soybeans. China has gone from being an exporter of oil to a voracious consumer. Its energy needs will triple over the next few decades, and they are moving rapidly to increase the number of nuclear power plants from 9 to 39 in the next 15 years, some of which will use entirely new nuclear processes. They are turning to coal liquefaction, building a $2 billion dollar plant in Mongolia along with several on the drawing board which together will produce enough diesel fuel annually to cover China's oil needs for 12 days by 2015.

As China, India and the rest of Asia emerge into fully developed nations, they will drive up the demand for every form of commodity. It is a message that Jimmie Rogers has been preaching for years, and his recent book "Hot Commodities" tells that story well.

Recent economic data shows that in 2003 China consumed one half of all cement in the world, one-third of all steel, one-quarter of all copper and one-fifth of all aluminum. Chinese automobile sales doubled in 2003 and grew dramatically in 2004. Analysts believe that China is now the world's number one market for mobile phones and the number two market for personal computers. Economists are forecasting that China's growing middle class will reach 250 million by 2005 and could reach 350 million by 2009, making the Chinese consumer market larger than the population of the United States. Although one must note that the definition of middle class is somewhat loose, as an income of slightly more than $3,000 is considered enough to begin to think about car purchases.

250,000 Engineers a Year and Counting

Each and every year China now graduates 250,000 engineers and scientists. The US graduates only 50,000. How long before they overwhelm not only the US but Europe as well in the area of technology? If we lose our lead in technology, how can we hope to continue to find whole new industries with high paying new jobs to substitute for the ones we have lost?

China is now making chips. Last year Wired magazine named China "the first cloning superpower." They just put a man in space, are using bio-engineered crops and have made advances in stem cell research. They have mapped the genome for rice in a very short time, and beaten a Japanese team in a race to map the 530 million chemical letters of the silkworm. They are making carbon nanotube threads. As noted above, they are pioneering a new and more efficient as well as safe nuclear technology. (Fortune)

All this is pretty powerful stuff, but it needs to be put into context. From the latest figures I can find from 2001, China's R&D expenditures were 1.1% of GDP, or about $12.5 billion. The US spent 2.8% of its GDP, much of it privately funded, for a total of $281 billion. The US spends 200 times as much as China on Biotech research.

Further, pretty much all of China's R&D is fairly basic and for more immediate needs. That is why the focus on the rice genome, as they need to develop better, more nutritious and stronger strains of rice. Much of the US R&D is devoted to "pure sciences" which will not produce benefits for many years, but becomes the foundation for major future advances.

Fortune Magazine did a great issue on China (October 4, 2004). For those interested in China, it is an excellent and balanced resource. They had the following to say about the Chinese and technology. After describing a research center:

"...Research at places like this genome center promises to make China as formidable an innovator as it is now an imitator. That will take years - but when it happens, look out: A billion-plus people bouncing off one another will generate a lot of creative sparks. And history shows that inventiveness is firmly planted in China's DNA: Gunpowder, rocketry, wheelbarrows, cast iron, compasses, paddle-wheel boats, block printing, stirrups, paper making, and mechanical clocks - all came from China, often centuries before they appeared in the West.

"Already China is emerging as a force to be reckoned with in delivering lucrative but incremental advances, like designing chips for consumer electronics. But its bid to become an economic superpower will ultimately depend more on its fecundity in basic research than on its ability to engineer me-too or me-slightly-better products. World-changing innovation are hard to arrive at - the American scientific and engineering culture [which] brought forth such miracles as color TV, Kevlar, the laser, gene-splicing, and the Internet took decades to build. For all its progress, China is still at least a decade - possibly much more - from serious scientific competition with the U.S., Europe, and Japan.

"In short, the idea that China will soon leapfrog the U.S. in any major area of science is at war with the facts (with the notable exception of research on new energy sources). Even in pursuits in which China has made headlines, it is unlikely to catch up anytime soon. Turning stem-cell experiments into therapies such as replacement organs will require expertise in genetics and clinical medicine that's relatively undeveloped in China, Yang Xiangzhong wrote in the Nature report. At best, China might emerge as 'one of the leading nations' in stem-cell research in five to ten years, concluded Yang, a native of China who directs the Center for Regenerative Biology at the University of Connecticut. Seriously competing with the West in other areas is likely to take even longer, says Jing Cheng, CEO of Capital Biochip, a Beijing biotech company. 'To construct a research building takes a year,' Cheng notes. 'To fill it with something really meaningful easily takes ten to 20 years.' "

All that is not to say that China will not become an economic powerhouse by the middle of this century. They will. But it will not be at the expense of the US or Europe. Chinese growth will be a major benefit to them and to the world. Any problems the US or Europe has will be of their own making, stemming from their own inherent troubles like an aging demographic, stifling bureaucracies, bloated social security systems which cannot be sustained and so on. It might be easy to scapegoat China and India, but it will not be the true source.

The Greatest Migration in History

The most astounding thing I know of about China is its ability to deal with the greatest migration of human beings in the history of the world. Each year 20,000,000 people come looking for jobs from the west to the east coasts. A reported 200,000,000 people have migrated to coastal China looking for jobs, and most have found them. They are low paying jobs by almost any standard, but it is more than they made on the farm.

That presents both opportunity and danger. Being able to be the low cost provider for numerous manufactured items has attracted large numbers of manufacturers from around the world. That capital has enabled China to undertake a remarkable build-up of its infrastructure, which creates the demand for all the commodities mentioned above.

But is also creates expectations. The Chinese populace now expects economic and job growth. "Normal" growth of 3-4% would simply not create enough new jobs, but too rapid growth will create the potential for inflation and a bust. While the Chinese government has been able to slow their economy to "only" 9% growth, there are worries about whether such actions can result in a soft landing, or will result in a recession.

Right now it looks they might actually pull off a soft landing, but that misses the point. China has not somehow found a way to avoid the normal business cycle that has plagued mankind since the Medes were trading with the Persians. They will eventually have a hard landing. It would be miraculous if they did not, given the lack of tools that the central bank of China has in its arsenal, an economy that is being controlled by an administration, and thousands of state owned companies which will never be profitable in their current structures.

Further, while the banks of China are doing better, they cannot by any shape of the imagination be called strong. Non-performing loans at banks in China are over 13%. Some observers think the real number may be double that. Let's look at what Jean Luc Buchalet of the JCF Group has to say:

"At the end of the first half of 2004, according to official figures, Chinese bank loans amounted to $190 billion, or 13% of GDP and 13.3% of all outstanding credit. To this total should be added doubtful loans held in defeasance structures. Although the latter no longer appear on bank balance sheets they remain economic facts. The four State banks have transferred loans worth $205 billion to these structures, raising the grand bad loan total to not far short of $400 billion, or 27% of GDP. And given that the banking regulators have probably of GDP...outstanding loans amount to 145% of GDP, a world record. The ratio of non-performing debt to total outstanding [debt] is officially 18.6%, and unofficially 27.6%"

While the Chinese government has taken some of its massive reserves and put it into some of the larger banks, there is still much more to be done. Their bad loans will cost them hundred of billions when it is all said and done, which is a huge number for China. I expect to see several of the larger banks either form partnerships or be bought by western banks in the next few years. The Chinese government is clearly getting a few of them ready to be bought. Others will be listed on exchanges as well.

Just to put this into perspective. If the ratios in the US were the same, we would have bad loans of between $3 and $5 trillion dollars, with total outstanding loans of almost $18 trillion dollars. Kurt Richebacher would finally have ample reason to declare the US goose cooked. It would take as much as 5 years of total US corporate profits, or more than 2 years of total taxes just to pay off the bad loans, not including interest.

But that brings up other things that have to be developed in China on the fly. They do not have an internal Chinese capital market, so private capital has difficulty getting to deserving entrepreneurs. They need private venture funds. Accounting standards in China are not up to developed world standards. There is no rating agency for debt, so there can be little confidence in the debt markets. Their equivalent of the SEC is lacking, so the stock market is a rather wild and woolly one.

In a country where the people save 43%, there is no way for them to see their capital allocated to their internal needs. The government is still the source of capital. When that changes, you will see China change in an even greater fashion.

They will develop these of course, but it is unrealistic to think it can be done in a short time. It will take years, just as it has in every other country that has a capital market.

And that brings up a concern. Various analysts believe that the Renminbi (RMB) is under-valued by anywhere from 20-30%. The world somehow believes that if China allowed the RMB to float, it would rise relative to the dollar, helping to relieve the US trade deficit, as presumably prices would go up and we would buy less. Money would rush into China in anticipation. Over time the RMB should rise, but things may not unfold according to plan.

If you are a Chinese investor or business, and know how bad the shape your banks are in, might you not want to diversify your RMB holdings, looking for solid financial institutions? If you look at the wealth gap and wonder what the reactions will be if the masses are not brought along? If you study historic economic trends and understand the problems china will inevitably face as they grow and expand, might not you want some diversification? And while you cannot say anything publicly, you understand your government will not willingly let go of power yet that is where the markets and people are going, so there is the real potential for a crisis in the future, which can have very unpredictable results, possibly very, very good for you but maybe not, might not a little money spread around the globe make some sense?

We in the western world see China as this great and grand land of opportunity, growth and dynamic power. Surely, we think, their currency will rise as soon as the dollar peg is removed. The money trying to flow into China to simply take a currency bet is quite large. Many are investing in their stock market thinking the currency gain potential will hedge them against any bear markets.

Of course, there is the opposite side of that trade. Many international investors will want to diversify their currency holdings into what they see as opportunity. Will it all balance?

Over the intermediate and long course of time, I expect the RMB to rise. I am just not so sure it will do so in the manner that the world is betting. There might be some real volatility associated with a removal of the peg. That is also why I think the peg will be removed gradually, to allow the markets to absorb the volatility on a measured basis.

It's a Long, Long Way to Chongqing

Chongquing. The city you have likely never herd of is in the west of China, 360 miles up river from the Massive Three Gorges dam. By 2009, ocean going freighters will be able to pull into its port. The city is already 11,000,000 people and is undergoing one of the most massive infrastructure programs in China, where planners hope it will become the gateway to western China and its 250,000,000 people. There are scores of cities throughout China with 1,000,000 plus populations that you have never heard of.

In Chongqing, according to a Fortune article, half of the economic activity is now from private business, up from 30% only six years ago, which is an amazing growth rate. It's almost hard for me to imagine such growth, investment and entrepreneurial spirit. I mean, sure, if your town is a few hundred thousand people, a few large firms coming into the area to build a manufacturing plant could change the local climate, but in a city of 11,000,000? (They claim 31,000,000 if you add in the 20,000,000 farmers in the more remote part of their province.) Last year their growth rate was 12.4%. Sure, it will slow down at some point, as much of it is fueled by the massive multi-billion dollar construction going on everywhere.

Is there any city in the West (including Japan) that can boast such numbers? In china, there are dozens of such cities. Given such dynamics, how can we not think China will be larger and more important than the US in a few decades? Let me offer a few observations.

First, freedom and free markets are coming to China, and we should expect that it will result in growth and a major improvement in lifestyle and wealth. They have four times the people with massive natural resources. Over time, it is inevitable that China will be a larger economic country than Europe or the US, as long as they do not revert to their former command and control economic policies.

If Denmark had 300,000,000 people and the resources of the US, then it would be the largest economy in the world. Free markets and free governments combined with infrastructure, education and a work ethic will result in economic success. There is nothing special in that regards about being from the US or Europe.

Second, China will be subject to the business cycle, and will not grow in a straight line fashion. Given that so much legal infrastructure has to be built, so many new systems developed, it is likely to be a rougher ride than it has been for the past few years.

Third, my bet is that it is going to take a lot longer than the Goldman Sachs study suggests for China to overtake the US in size. Right now, much of the boom is from construction and foreign investment taking advantage of lower labor rates. They will have that advantage for many years, but at some point that benefit will fade.

In the 70's there were those who thought Japan would overtake the US because of the lower labor costs. Remember when it seemed like everything said "Made in Japan?" How could the US compete with Japan? Now, Japan is the second largest economy in the world. But who thinks Japan will one day be larger than the US? Now, Japan complains about cheap Chinese labor, when they're not building plants in China.

In 20-30 years, China will have an aging population as a result of its One Child policy. Its economy will be more mature, and the days of 10-15% growth will be long behind. China will be complaining about how the cheap labor in the Islamic democratic republics (am I an optimist or what?) is taking away its manufacturing base and jobs, as they struggle to move up the economic food chain.

As noted above, the difference in R&D expenditures between China and the US is enormous, and that is where the long term growth and future industries will come from. The biotech, nanotech, energy initial boom waves and the second wave of the information age will be kicking into high gear, all at potentially the same time, boosting US growth.

When you make projections about 40 years from now, it is hard to calculate the economic value of innovations that are hard for us to even imagine today. Go back 40 years to 1965. Most of the jobs we now have in the modern world were not even in the government's list of employment opportunities. With change accelerating, is it likely that we will see a repeat of that process, and possibly in spades?

The economic value that will be the major factor for the developed economies 40 years from now will not be manufacturing. If China is, as I suspect, part of that club, it will not be manufacturing that is the cause, but innovation and the development of whole new products and services.

Which brings me to my final point. I think in 40 years we will look back and wonder why anyone cared which economy would be bigger. Do the Danes worry about being smaller than Germany, or do they simply see markets for their products and services and hope to find products and services which will benefit them?

The increased globalization of trade will render borders more and more meaningless. Just as trade within the United States is almost frictionless, we will see trade with most countries look the same. It will take time and will not be a smooth process, but larger and larger free trade blocs will begin to form lowering the costs of doing business wherever in the world it makes sense.

Other than some minor and pointless provincial pride, do Texans care if Alabama or Oklahoma is bigger or smaller? I do not care if China gets bigger than the US. 250,000 new scientists and engineers a year? I hope they find new medicines and products which make my life better, allow me and my family and friends (which include you, gentle reader) to live longer and healthier and to enjoy my time here as much as possible.

My job is to figure out how to be able to do something useful so I can afford the cool new stuff that 1,000,000 billion people will dream up, not to mention the billion in India and the billion in the rest of Asia. On a larger scale, each region of the world will have to find a way to adapt to the changes that are coming and develop products and services that will allow it to participate and add value in a future world.

Governments will be seen as the problem. The massive over-commitments of Europe and the US to social services which cannot be funded without monstrous tax increases or politically difficult cuts in benefits will do more to harm the ability of their future generations to thrive than any possible "threat" from a thriving China and Asia.

At least, that's how I see it today. In later issues we will deal with other topics concerning China and Asia, at the potential for investors in that part of the world is too large to ignore. And speaking of investments let me point out a new China ETF which intrigues me. It trades the Halter USX China Index.

PowerShares Capital Management LLC introduced a new exchange traded fund (ETF) based on the Halter USX China Index, the only index in the world devoted exclusively to U.S.-listed securities of companies that derive a majority of their revenues from the People's Republic of China. The PowerShares Golden Dragon Halter USX China Portfolio (AMEX: PGJ) began trading on the American Stock Exchange last December and will mirror the Halter USX China Index. Currently, 38 public companies are represented in the Halter USX China Index.

Criteria for inclusion into the Halter USX China Index include the following: companies must conduct the majority of their business within the People's Republic of China, must be listed on the NYSE, Nasdaq or Amex and must have a market-cap greater than $50 million based on the average closing price for the prior 40 trading days, as identified by the Halter USX China Selection Committee. In addition to these basic requirements, the selection committee may consider other factors including the size of the public float, liquidity and fundamentals of all existing and potential constituents.

I find the idea of investing in China through US listed companies intriguing. You can go to www.yahoo.com and type in PGJ and learn more about the fund, as well as find links to various articles about the Dragon fund. One of the best articles is by Roger Nussbaum at the Motley Fool.

La Jolla, Fatherly Pride and Great Wines

I have written this letter at various times and places over the week, rather than my usual schedule of starting on Friday afternoon. After getting a lot done on the plane, I finish up in La Jolla, California where the weather is perfect. After introducing my European partner, Niels Jensen of Absolute Return Partners in London, to what he called the best steak of his life in Texas, we are enjoying the fish in California.

Tomorrow I fly to a retreat in Santa Barbara, where the partners at Altegris Investments and I meet for two days in our annual planning and strategy meeting, at Jon Sundt's ranch getaway home. Heretofore, it has been an all guy, testosterone laden (can we say sometimes intense?) session. Tomorrow, I inject my daughter Tiffani into the process. She has been with me for over five years now, and is a vital part of the business. It is time to begin to expand her horizons more as our business is growing and I simply cannot do as much as I want. Learning to delegate will be one of my opportunities for learning this year. It helps to be able to have someone you can trust and who is smarter than you, which she is. And I must admit to a little fatherly pride.

She is actually a far stronger personality than I am, and not shy in speaking up. It will be interesting to see how the sessions go, as we all work together to find ways to serve you and our clients better.

Plus, she will get to enjoy Sundt's wine cellar. He has some great reds that have had my name on them for 20 years. There are some extra benefits to working with Dad.

Your looking forward to a great cabernet analyst,

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