China's Economy Isn't in the Same Boat as the 'Developed' World

Wednesday, 04 March 2009

There've been quite a few China experts predicting doomsday for China recently, thus eliminating the last best hope for the world economy. I beg to differ. Yes, China is anything but detached from the rest of the world and indeed has all the major symptoms of the developed world: A housing bubble, bank bad assets, demand destruction, unemployment. But the degree of suffering for China is much less severe in every one of these respects. The residential mortage market in China is still in its infant stage. Securitization is non-existent. Down payment routinely goes to 40%, even 50%, in most of the localities except for the few big cities like Beijing and Shanghai. Therefore, for the same 20% drop in housing prices, the impact on homeowners and lenders is much less in China.

In addition, the percentage of commercial homeowners in China is still tiny in comparison to Europe and the U.S. Most city dwellers live in government and/or employer subsidized housing and owe little to nothing on them. Virtually all country folks live in houses they built with cash.

Financial reform in China had been widely critized, both domestically and internationally, for being too conservative, even paranoid. Of course, now in retrospect, the conservatism/paranoia shielded the country from disaster. Except for a few companies going through Hong Kong, there's virtually no exposure to derivatives of any kind except commodities futures, which is tiny on the macro level. Bank leverage remains very low. Commercial banks and investment banks are still strictly segregated. It's hard to make any credible estimate on the scope of bad assets in Chinese banks. But even if it turns out to be as bad as the most perssimistic estimates say, at least we can be sure there's no chain-reaction mechanism in the system.China 'the export country' is perhaps the biggest myth in the modern global economy. Yes, they do export a lot.

But unlike Japan or Korea, China's exports for the most part are more accurately classified as re-exports. To export is to buy iron ore or steel and sell $50k cars. To buy wool and sell sweaters is hardly an export from a macroeconomic perspective because the value added is so small. As a result, what happens to the Chinese economy in a demand destruction scenario is that both imports, a big part of which are the raw materials and components for its re-export industry, and exports fall more or less in tandem.

This has been shown by the relatively small drop in Chinese GDP as well as overall trade balance in Q4 '08 vs. the dramatic drop in Japan and Korea.In fact, such a proof already presented itself in 1997. Almost all of China's export competitors had their currencies devalued up to 80% while the Yuan stayed almost constant. There was tremendous domestic pressure to devlue the Yuan, and the deafening cry of a Chinese export collapse from international experts. Yet nothing happened. Export tax rebates cannot possibly be used to explain more than 10% of the cost savings.

The reason is simple: the Chinese economy was mostly re-export driven. As the cost of buying raw materials and components dropped for a large portion of manufacturers, costs also went down. Yet the world continues to blindly call China 'the export country'.Domestically, anecdotal evidence I've heard shows that what China's government, both centrally and locally, has been doing to stimulate consumption makes Helicopter Ben look like a timid amateur. They hand out cash and/or shopping certificates to whole cities of people.

They order all shops to have 30% sales. Is this an overreaction? A sign of desperation? Will such draconian measures bring dire consequences later on? These are all legitimate questions. But at least you can't blame them for not trying. And the shock-and-awe Yuan carpet bombing apparently has been making some impact so far. It's much harder to make Chinese people spend than most westerners imagine.Finally, there's unemployment. Numbers like 20 million have been thrown around in China expert circles like asteroids heading to Earth. I'm sorry, this is just plain ignorance to the vast difference in lifestyle between Chinese peasants and westerners. An average US homeowner may lose their home within months of unemployment.

But a Chinese migrant worker from the countryside can easily go back to their old lifestyle and live for years, purely on the savings from the few years' city jobs they had, without as much a psychological trauma as losing one-night's sleep. Metropolitan life in China is still largely based on cash and savings. Rural life in China is still mostly self-sufficient on top of cash and savings -- you don't need much cash and savings at all to get by.More likely than not, China will escape any severe downturn and remain one of the few growth spots throughout this global recession. And it would not be any miracle, just a combination of fundamental factors, as well as a bit of luck.

What does this mean?1. China will probably be one of the better equity markets for 2009, and possibly beyond.2. Chinese bonds, if you can get your hands on some, are probably cheap. CDS on Chinese sovereign debt is going for ~250 bps. It may come down a lot once the world realizes the above.3. The commodities fall may not last as long or be as severe as doomsdayers predict.4. Upside pressure on the Yuan will probably resume as soon as the world economy stabilizes somewhat and the USD carry trade unwind stops.

Source: Seeking Alpha