Financial Sense   Home  l  Broadcast  l  WrapUp  l  Storm Watch  l  About Us  l  Contact Us

China: A Looming Crisis Or a False Alarm?
A Joe-Duarte.com Retrospective
by Joe Duarte
November 8, 2004

Editor's note:

We are suddenly living in a new world, where events and consequences are about to accelerate and lead to what at this point are uncertain conclusions.

Indeed, the re-election of President Bush has created a unique set of circumstances, politically and financially.

Many global money managers, central banks, economic ministers, traders and speculators were caught off guard by the results of the U.S. election.

That means that a great deal of activity is likely about to get under way as those who bet one way have to reassess their positions.

But, prior to the election, wheels were already turning, in rather meaningful ways.

As the U.S. election grabbed the headlines, the U.S. Dollar quietly made new lows, and interest rates began to rise.

This combination, when placed in the context of the overall explosive growth in the Chinese economy, and the state of the overall Chinese infrastructure, suggests that China, and thus Asia is in danger of an economic downturn.

If this scenario plays out, a repeat of the 1997 and 1998 global financial crises could repeat itself, with widely ranging repercussions.

In this series of articles, originally penned in October 2004, we explore and summarize the possibilities of such a set of developments.

October 20, 2004
Today's Analysis: Foreign Buyers Retreat From U.S. Bonds

Are foreigners finally bailing out of the U.S. bond market? According to the Washington Post, citing multiple sources, they are. And the implications for the trade deficit, the U.S. dollar, and the overall U.S. account balance could be disastrous.

To be sure, this has been a hot topic for may years among academics, central bankers, and bond traders. But somehow, a close look at the Post article suggests that at least in the short term, something is happening that is different.

The Post notes the following:

1) " In August, foreign private investors actually sold $4.4 billion more in Treasury bonds and notes than they bought that month, the Treasury Department said yesterday -- the first time in a year that net foreign purchases were negative. That followed a 20 percent decline in July that shrunk net foreign purchases to $18.3 billion.

2) "Bond purchases by foreign central banks also dropped sharply in July, falling 76 percent, to $4.1 billion. A rebound in August brought them back to $19.1 billion. The recovery was timely: Without it, the dollar may have taken a serious hit, said Ashraf Laidi, chief currency analyst at MG Financial Group in New York, who headlined yesterday's (10-18-04) client newsletter, ["Foreign Central Banks Save Dollar From Disaster."]

3) "Foreign purchases of stocks are off as well, going from net purchases of $9.7 billion in July to a net sell-off of $2.1 billion in August. Over the past 12 months, private foreign investors have purchased a net of $17 billion in U.S. stocks, compared with $30 billion in the 12 months before that.

And 4) Measuring the combined purchase of stocks, corporate bonds and government debt, overall capital flows into the United States fell in August for the sixth straight month.

The Treasury is playing down the data. Tony Fratto, a Treasury spokesmant told the Post not to overanalyze the data, noting that "net purchases of U.S. government securities may have been low in August, at $14 billion, for example. But foreigners still bought more than $807 billion in Treasury bonds, while selling $793 billion, in a month that is usually a slow one in financial markets."

Still, the Post notes that there is a difference in the current situation as "Foreign central banks and individuals rushed to finance U.S. government budget deficits over the past three years, buying $19.2 billion in Treasury bonds in 2001, $118 billion in 2002, and $279 billion in 2003. Lending from foreign governments in particular exploded last year -- to $109 billion, up from $7.1 billion in 2002."

And there is some competition from Europe in the marketplace. "Earlier this year, both China and India diverted tens of billions of their dollar holdings to domestic projects, with China pumping $45 billion into its banks and India devoting $15 billion to infrastructure projects." This is leaving the U.S., according to the Post, more dependent on smaller nations.

This is interesting to note though. Even as foreign purchases of U.S. bonds were falling, so were interest rates. In fact U.S. Ten Year Note Yields topped in May at 4.9%; they were trading near 4% on 10-19, as we penned this article.

An old adage in the financial markets is that foreigners are the second to last to climb on a trend, right before individual investors.

So, while the foreigners were selling, someone was buying, and buying big. Who was buying? And why? These are more important questions. The amount of money that has gone into U.S. bonds while the foreigners are selling, suggests to us, that while Europe, China, and India are selling, somebody has been making big bucks in the bond market while they sold on the cheap.

One thing is certain, George Soros has been known to make big moves, and so has Warren Buffet. Both of them are anti-Bush stalwarts in the current presidential campaign. Soros, although he is no longer supposed to be an active investor, does have some ties to his huge Quantum fund, and has also been rumored to talk directly against what he is actually doing in the markets.

It would be ironic that while the two billionaires were badmouthing the President, they were loading up on U.S. Treasury bonds. More ironic is that at some point, whoever is buying the bonds, will be selling them. And if history is correct, it will be the foreigners who buy them, somewhere near the top.

One inside Washington source did note the following to us: "There is pretty good awareness in this town that the trade deficit is a disaster waiting to happen. But there are lots of corporations making profits from the current state of affairs. Trade is a difficult issue and difficult issues don't get dealt with in Washington in advance of a disaster -- solutions require the stimulus of a disaster."

October 22, 2004
Today's Analysis: China: Bubble Or Real Economic Adversary To U.S.

China's economy could provide a negative surprise in the near future.

The global economic recovery, in the eyes of many, has little to do with President Bush's tax cuts, or the reasonably steady rebound from the post 9/11 recession. Indeed, in the eyes of many, the main reason for the global bounce has been China's incessant demand for oil, commodities, and capital.

But, there are signs that something bigger is afoot.

According to the Wall Street Journal, on 10-22: "China reported Friday that its economic growth slowed to 9.1% in the third quarter from 9.6% in the second quarter, adding to evidence that Beijing's efforts to cool the overheated economy are taking effect. China's leaders have been trying to slow growth that they say is fueling inflation and straining the country's resources and fragile financial system. They have ordered banks and local governments to cut back on construction projects and redundant industrial investments, so far with limited results. The government also reported Friday that Chinese consumer prices moderated slightly, with a 5.2% increase in September from a year earlier, a trend that may ease concerns over surging inflation."

To be sure, those are not numbers that suggest that China's economy is about to fall off a cliff. But a closer look reveals that there are indeed things to be concerned about.

According to Stratfor.com: "The Chinese government held a bond auction Oct. 21 which was unique in that investors practically crawled over each other to buy up the bonds, and the Chinese offered some of the bonds in euros. The euro aspect demonstrates a rapidly evolving mindset on the part of the Chinese, and the popularity of China's debt demonstrates that most investors do not fully realize what they are getting into."

Stratfor continued: "The Chinese bonds were in such demand -- ["oversubscribed]" being the technical term -- that the interest rate China will have to pay was pushed down to 4.25 percent on the 1 billion ($1.26 billion) in eurobonds, and 3.75 percent on the $500 million in U.S. dollar-denominated bonds. It is not so much the size of the auction that is atypical, but the interest payout."

The point, according to Stratfor is that there is something wrong with the market's perception of the underlying value of China's economy, and its government's ability to deliver on the inherent promise embodied in the debt. "Paying such low rates is, to put it bluntly, not particularly bright. Despite all the warm fuzzies investors have about the Chinese economy, its credit rating -- not to mention its underlying economic resiliency -- does not warrant this level of demand. The dollar-denominated bonds sold at a rate only 0.6 percent higher than their equivalent U.S. government bonds -- widely considered to be the entity in the world most likely to repay its debts -- despite the fact that Beijing's credit rating is several notches below Washington's. That might make sense for short-term debt -- at $515 billion China's currency reserves preclude any chance of the country being unable to pay off its debts -- but these are long-term bonds, many with a maturity not until a decade from now."

To put it bluntly, if we follow Stratfor's analysis and logic: "That means someone -- a lot of someones -- is taking an inordinately unwise risk. China, despite its roaring economy, suffers from a very basic lack of transparency and financial market regulation that should give investors pause. Bidding up the debt of a developing state to such levels is classic bubble behavior: Investors bet that the good times will last forever and so are willing to throw their money after ever-slimmer returns. The end result is always a bubble, followed by a crash and potentially even a default in which millions of investors lose their shirts. After the recent spate of multi-billion dollar sovereign defaults in major countries such as Pakistan, Russia and Argentina you would think they had learned."

Who's at risk? According to Stratfor, it's Asian and European investors. "Nearly all of China's dollar-denominated debt -- 80 percent in this auction -- is held by Asian investors. Asian money tends to stay within the region, but at the first sign of trouble, it also is the first to bolt for the relatively sound U.S. market. Much of the disruption from the 1997-1998 Asian financial crisis was not caused by Western money, but by local money sensing a downturn and leaving for the safety of the U.S. financial markets. The Chinese are well aware of their vulnerability to their neighbors, and so issued the eurobonds in an attempt to diversify their investor base. The most notable aspect of the Oct. 21 eurobond issuance is that it worked. Some 83 percent of the purchased eurobonds were snapped up by Europeans -- mostly Germans -- with the bulk of the remainder purchased by, again, Asians."

Their conclusion: "For the Chinese this is wonderful. The Europeans both have deeper pockets and are more likely to take the long view when trouble hits. They also are the investors that got hit the hardest when Russia fell, and Argentina, and …"

It's Much Bigger Than Chinese Bonds

What we are seeing is much bigger than Stratfor's article hints at. Indeed, we are watching politics influencing money flows, a very bad combination in the best of times, and one with disastrous implications in the current global war environment.

Asian and European investors are flocking to China as a hedge against what they see as bad U.S. policy, namely the war on terrorism, or more precisely the war in Iraq.

The falling dollar, coupled with the rapid fall in Chinese bond yields is the key to the puzzle. Money is indeed leaving the U.S. Or more specifically, lesser amounts of new money are coming to the U.S.

The problem is twofold. If there is a global financial crisis, there is no way that China can become the global reserve that the U.S. has been historically. China's financial system is too riddled with bad debt, corruption, and the lack of sophistication required to engineer the kinds of dramatic solutions engineered by the Federal Reserve during global crashes of the last twenty years.

History shows that when money stampedes into safety, it moves at the speed of light into U.S. bonds, and the U.S. dollar. An event that leads to capital flight could decimate the Chinese economy.

On 10-20, we highlighted an interesting situation that has been developing over the last few months that show that this time it is different, at least in the eyes of some. Based on a Washington Post article we listed four important developments:

1) " In August, foreign private investors actually sold $4.4 billion more in Treasury bonds and notes than they bought that month, the Treasury Department said yesterday -- the first time in a year that net foreign purchases were negative. That followed a 20 percent decline in July that shrunk net foreign purchases to $18.3 billion. "

2) "Bond purchases by foreign central banks also dropped sharply in July, falling 76 percent, to $4.1 billion. A rebound in August brought them back to $19.1 billion. The recovery was timely: Without it, the dollar may have taken a serious hit, said Ashraf Laidi, chief currency analyst at MG Financial Group in New York, who headlined yesterday's (10-18-04) client newsletter, ["Foreign Central Banks Save Dollar From Disaster."]

3) "Foreign purchases of stocks are off as well, going from net purchases of $9.7 billion in July to a net sell-off of $2.1 billion in August. Over the past 12 months, private foreign investors have purchased a net of $17 billion in U.S. stocks, compared with $30 billion in the 12 months before that.

And 4) "Measuring the combined purchase of stocks, corporate bonds and government debt, overall capital flows into the United States fell in August for the sixth straight month."

Conclusion

It is clear that money is aggressively flowing into China. It is our opinion that much of that movement is being influenced by political decisions, not fundamental and economic ones.

That means that people, institutions, and governments are making decisions of great importance, with long-term implications, with their hearts, not their brain.

That means that it can't possibly end well, as at some point, reality will set in.

There are two clear possible endpoints.

1) This time is different. All empires meet their Waterloo. And we are witnessing a key watershed event, as this is the time when the United States will finally meet its match and relinquish the number one position in the world's financial rankings. Indeed, it is possible that we are watching a transition at the top of the heap.

Or, 2) Investors are, as Stratfor notes, making a big mistake and buying into yet another emerging market bubble that will burst and lead to a global market meltdown.

The answer lies in the bond market. As we noted on 10-20, even though foreign money is leaving the U.S. bond market, bond yields have dropped almost a point over the period, as measured by the U.S. Ten year note. That means somebody is buying large amounts of U.S. treasuries. That means that there is still some smart money out there, or that the Fed is actually propping up the bond market.

Either way, we are watching a rubber band stretching. And at some point it will break.

One thing holds up though, foreigners are historically wrong in their timing of the U.S. markets, buying too late, and left holding the bag.

Is this time different? To be honest, we're not sure. But, unfortunately, we may get to find out soon enough. Event risk is too high as the election nears. The odds, we think, are not on the side of the Chinese.

October 23, 2004
Today's Analysis: China: Bubble Or Real Economic Adversary To U.S.

October 2004 may be a historical month. The first Hooters restaurant opened in China, and the Federal Reserve continued to forecast higher interest rates. What is underlying both situations is the connection between the actions of the Federal Reserve of the United States and the Chinese economy.

According to a 10-22 report from Dow Jones Newswires: "The Federal Reserve can continue to raise interest rates at a ["measured pace"] as the U.S. economy remains buoyant and inflation under wraps, Federal Reserve Governor Susan Bies said Saturday."

Dow Jones added the following from the Fed Governor: "After having moderated a bit in late spring, partly in response to a substantial rise in energy prices, aggregate demand appears to have regained some traction," Ms. Bies said in prepared remarks to the Washington chapter of the American Association of Individual Investors at an event in Virginia. Consumer spending has been expanding at a ["faster pace,"] housing activity remains ["strong"] and business outlays for capital equipment seem to be on an uptrend, she said. But the recent pace of job creation has been ["disappointing,"] she said. Nonfarm payrolls have grown by an average of 101,000 a month from June through September after growing at nearly triple that pace the previous three months, Ms. Bies said. Even so, Ms. Bies said with financial conditions still accommodative, she expects the U.S. economy to keep expanding at a ["solid pace"] the rest of this year."

Ms. Bies is spouting the Fed's current line, without the voice of soon to be former Fed Chief Robert McTeer, the first Fed voice who noted that the dollar was heading lower, in early October. Since McTeer's remarks, largely unnoticed by the election obsessed mainstream media, the dollar has fallen apart, and the U.S. stock market's gains have been increasingly choppy. Indeed, if the action in the U.S. stocks markets, the U.S. bond market, and the U.S. Dollar is any indication of what the smart money is betting on, it's not a good outlook.

So why is the Fed hell bent on raising interest rates? There is a good deal of evidence that suggests that the central bank may be slowly coming to grips with the notion that it might be in a very tight box, mostly of its own creation, and that it is trying to both act and talk its way out of it.

And although there is no real evidence of it, it seems that McTeer, the lone voice against leaving rates alone for sometime, is voting with his feet, as he is likely to become the Chancellor at Texas A & M University in early November, according to multiple reports, including a recent story in the Dallas Morning News.

The Real Situation

The American Enterprise Institute (AEI) summarizes the global economy as follows: "Outside of the United States, Japan's highly touted growth surge ended in the spring, while China has applied selective measures to cool off its economy and met with mixed results. Europe, especially Germany, continues to languish at low growth levels while monetary tightening by the Bank of England has cooled the housing bubble in the United Kingdom and slowed the economy. Forecasts of 2005 global growth, already set below 2004 levels, are contingent upon an oil price of $30 to $35 per barrel. Even though oil is above $50 per barrel and the effects of U.S. policy stimulus have largely run their course by now, few analysts have been discussing the likelihood of a global recession, but such an outcome is looming. Acknowledging that possibility instead of denying it is a necessary condition to avoid a recession next year."

According to John Makin, resident scholar and the director of fiscal policy studies at AEI, there is one major dynamic that is driving the global economy at the current time, excess capacity. When the macro situation is looked at based on this premise, several things become apparent.

First, "The basic distinguishing factor of the unusual global economy and attendant market behavior we have witnessed over the last several years is the existence of excess capacity-especially in global markets for traded goods."

Indeed, Makin reprises a point that has not been talked about much lately.

"Starting in 1996, the U.S. stock market bubble drove down the cost of capital, especially in the tech sector, so that over-investment in turn drove down the return on new and existing capital. The spillover into broadly higher stock prices also artificially depressed the cost of capital and created excess capacity."

In fact, Makin finally makes the elusive connection between the China phenomenon and the effects on the global economy when he notes that: "Excess capacity in global goods markets has been severely exacerbated by the emergence of China's production platform, which has attracted capital from domestic and foreign investors to combine with huge reserves of cheap domestic labor."

Makin notes that "This is not a criticism of China. It is simply a fact with which policymakers and the global economy and financial markets must reckon. "

And perhaps the central tenet of his thesis is this: "It is important to remember that a world where demand is scarce, rather than supply, does not fit underlying assumptions of most economic models, which are driven by assumptions of the need to allocate scarce resources in a supply-constrained world.

Thus, the world finds itself in a fairly unique situation, which is the opposite of the traditional view points expressed by the mainstream, and to some degree both political parties, especially on the campaign trail.

What is in effect happening is that the global economy has yet to work off the effects of the bursting of the Internet bubble. Thus, the rally in the stock market since the 2003 bottom may indeed be in the early stages of reaching a top.

The Long Term Effects Of Greenspan's Bailouts

Here is where many things suddenly coalesce: "The persistent excess-supply problem has evolved over several phases since the mid-1990s. First, both the U.S. tech bubble and accommodative Fed policy since Alan Greenspan's famous December 1996 ["irrational exuberance"] address to the American Enterprise Institute drove an investment boom in the United States and Asia. The Asian investment bubble almost collapsed in 1997 and 1998 but was reinflated by the Fed's rescue of Long-Term Capital Management in the fall of 1998 under the banner of avoiding ["systemic risk."] That event solidified the view that the Fed would indemnify financial risks attached to aggressive lending and investing. U.S. stocks soared until the bubble burst in March 2000 after the Fed started to withdraw some stimulus during the last half of 1999."

In other words, Makin's analysis concludes that Greenspan's multiple global market bailouts created the current environment.

Here are some interesting details:

1 ) "U.S. investment spending collapsed after mid-2000 and did not turn positive until the second quarter of 2003. To deal with an extreme excess-capacity problem in the United States, massive monetary and fiscal stimulus was employed. Much of this stimulus (especially the monetary stimulus) spilled over into China by virtue of its currency peg to the dollar, which effectively makes the Fed China's central bank."

2) " During the ten quarters following the end of 2001, after sharp rate cuts by the Fed in response to fears that households would stop spending after the September 11 attacks, the U.S. economy has grown at an average rate of 3.5 percent. Over that same period, consumption growth has been somewhat lower, averaging 3 percent, suggesting that a substantial portion of the U.S. stimulus spilled over into foreign markets. Indeed, U.S. imports rose at an 8.3 percent annual rate during the same ten-quarter period since the end of 2001 after having contracted sharply for a year and a half prior to that."

3) " The U.S. effort to alleviate excess capacity by boosting demand ironically contributed to a global capacity problem by creating a rush of lending to Asia that helped to boost global supply. This combination, of course, contributed to a surge in America's external deficit that has widely been associated with the expectation of a weaker dollar. The spillover of U.S. demand-boosting fiscal and monetary policy into Asia, awash with a swelling supply of traded goods, was accommodated and recycled by Asia's central banks. Aggressive purchase of dollars and recycling of those dollars back into U.S financial markets via purchases of U.S. government and agency securities helped to sustain U.S. demand growth at stable interest rates and prices.

Mankin concludes that due to higher oil prices, the world might experience a recession in 2005, without central banks raising interest rates further.

"The unusual landscape in global markets and the global economy is a broad manifestation of excess capacity in the traded-goods sector. It represents a classic post-investment bubble scenario. The effort to sustain U.S. growth in the face of symptoms of that global excess capacity (including weak U.S. employment growth) has spilled stimulus into Asia, where substantial excess capacity still exists. Prices of commodities, especially oil, have begun to constrain growth as China and other Asian producers are driving up those prices to sustain production of finished traded goods at extraordinarily low prices. The combination of those two trends puts producers in other industrial countries in a serious terms-of-trade squeeze."

Leave Rates Alone Or Risk A Recession

His recommendation is quite sensible "The response to this scenario needs to reflect the reality behind it. Investors should bet on lower interest rates and lower equity prices. Producers should resist the temptation to add further to productive capacity, especially in the area of globally traded goods. Policymakers should be very cautious about further interest rate increases. Higher oil prices will slow growth without creating higher inflation, given the fact that substantial excess capacity produces a profit squeeze rather than higher consumer prices. If oil stays above $50 per barrel through year-end, a recession is likely to occur in 2005. The current tendency of policymakers and corporate planners simply to ignore that possible outcome is dangerous. Meanwhile, markets are flashing warning signs as interest rates and the stock market grind lower and the dollar has slipped to a six-month low."

What we note is this. Greenspan's past reflations worked because he had multiple interest rate points to drop, so he was able to pump the system full of money for extended periods. With the Discount rate at 2.25 and the Fed Funds hovering near 1.75%, Greenspan has little room to operate with interest rates.

The Fed, of late, has been suggesting that it will likely continue to raise rates, although Dallas Fed President Robert McTeer, who maybe leaving the Fed in November to become Chancellor at Texas A & M University has on several occasion called for the Fed to reconsider the current upward path on rates.

Conclusion

China may have replaced, the United States, at least temporarily, as the preferred place for international money. Sometimes, this is known as hot money.

On the surface, investors are paying for the Chinese GDP growth of 9%, compared to the U.S. GDP rate of 3.5%.

The difference is that U.S. Treasury notes are yielding 4%, while Chinese bonds recently were sold at an oversubscribed auctions for yields of 3.75%.

In effect, investors are saying that taking a higher risk for lower yields in China is O.K., despite the shaky banking system, the well known corruption, and the Chinese dependent on foreign money to continue its growth. In essence, international investors are saying anywhere but the U.S., despite the risk.

But they are ignoring one very important thing. Much of the reason for China's attraction is the peg to the U.S. Dollar, and the fact that it is U.S. dollars that have been making their way to China to finance the Chinese expansion, and thus making it possible for investors to get a chance at three times the growth rates of the United States.

The problem with this scenario is that China is not the United States. It does not have the institutions, the experience, or the financial system that the U.S. has in order to cushion, to prevent, or even to bail out investors in case of a major crash. This is illustrated by the fact that despite the fact that foreign buyers are snapping up Chinese bonds, especially those denominated in Euros, U.S. bonds have been in a major bull run for the last 5 months, shaving off almost a point from the U.S. Ten Year note yield.

That means that somebody is buying U.S. bonds, as they bet on a possible recession, or as they prepare for a potential implosion in China, and perhaps even in Europe.

As the U.S. Dollar continues to fall, for reasons enumerated above, and in our opinion for political reasons related to the war in Iraq, China faces a problem, a rising risk due to the dollar peg.

If indeed the Yuan is a dollar surrogate due to the peg, a lower dollar is eventually negative for China, and will eventually lead to a cycle of rising inflation and rising interest rates.

The 1998 Asian meltdown occurred as investors flocked to Thailand searching for rapid growth. The Thai Bhat was pegged to the dollar. The more the dollar fell, the more the Bhat fell. Until the peg was undone and the Thai Bhat began to really fall.

Is this dire scenario what awaits China? Nothing is ever the same. But, similar situations tend to respond similarly.

© 2004 Dr. Joe Duarte
Dr. Duarte's Bio and Archive

Joe Duarte, M.D.

Joe Duarte M.D. is founder and Editor in Chief of Joe-Duarte.com. Dr. Duarte is a board certified anesthesiologist, a registered investment advisor, and President of River Willow Capital Management, where he manages individual client accounts. His latest books "Successful Energy Sector Investing" and "Successful Biotech Investing" (Prima/Random House) are available on line at amazon.com, barnesandnoble.com, borders.com, Traders Press, and all major online and brick and mortar bookstores in the U.S., U.K. Europe, and Australia. Dr. Joe Duarte’s Daily Market I.Q. is a subscriber service that provides daily intelligence, trading strategies, and technical analysis at www.joe-duarte.com.