Working through my daily dose of analyst reports and journal articles, I came to UBS’s recent release The Four Big China Themes from Jon Anderson where he lays out the bank’s position on four of the key trends that they are following in China.. and closely.

Always stocked with impressive graphs, and supporting analysis, this recent report I think has highlighted several of the biggest issues that anyone (investor, operator, or retailer) should keep abreast of.  those items are:

1. Liquidity tightening
2. Property Sector Rebound
3. The ending of commodity restocking
4. falling trade balance.

However, in reviewing this items, I think it is equally important – if not more so – to understand the wider context of these issues in China, what drives them, and look beyond the standard quarterly outlook to understand what it means for you.

The first is perhaps the one that I have been the least exposed to, but the most concerned about given the wider implications of liquidity.  that, when the crisis first hit, there was no bank liquidity in the market and everyone had to move to a cash system.  A system that apparently many businesses were not so profitable under, and as a result a pullback in nearly ever sector occurred.  Longer term, where this was a concern was that without credit, there was no trade, and without trade there was no real recovery. Or perhaps I should say, the balance in the recovery was not there.  That we would all have to rely on government expenditures to get us by, and the hope that it wil be enough to sustain a measure of growth.

UBS’s picture supports that.  Short term banks, after blowing out the record books on money pumped into the system, have been reeling it in.  Of course, the last 6 weeks or so there are reports that this trend is now back on the upswing, but in general the figures are coming down.  Indicating that in the very near future we should begin looking for fruits of the recovery.

On the issue of property recovery, UBS paints a rosy picture about the role of the property sector:

(i) China’s recovery to date has been more broad-based (and more market-driven) than just a lot of “last-ditch fiscal spending”, and (ii) as noted above, the macro growth numbers are about to become even more impressive as the impact of fiscal-related spending starts to hit the real economy in full strength.

Of course, with a quick look out my window (and a few recent trips to the 2nd tier cities), I can tell you that what is being shown through the graph is really occurring.  there are buildings, highways, and other inanimate objects sprouting up all over the place.  Which is money spent.

But.. will these buildings ever be occupied?  Roads be driven on?  That is the real question for me (and others).  A question still unanswered, and sadly not addressed in the report, and really should have given the trajectory of the lines their graph above clearly show as being UNSUSTAINABLE

Next on their list was commodities, and the “restocking” of these items, which as you can see in this picture could only be described as an all out spending spree.  to date, NO ONE know exactly what has motivated these purchases, or just how many years of supply have been purchased by legitimate users of the stocks, but one thing is clear.. there were many buying commodities who had no business doing so, and that their involvement in the markets have distorted not only pricing, but the analysis of what is happening.

The last issue of highlight, trade balance, and the fact that the balance has become more balanced through the recession, UBS had this to say about the potential for future movements and speculation surrounding the statistical probabilities China enters a trade deficit:

to get from here to an outright deficit next year, Chinese import spending growth would have to outstrip export demand by a hefty 25 percentage points or so – a very unlikely outcome given (i) the sequential stabilization and recovery of exports already underway, (ii) the government’s moves to remove excess liquidity from the system and thus prevent a bubble, and (ii) a pending reversal of the recent commodity import boom discussed above. In fact, according to Tao the most probable scenario is a trade surplus of around US$200 billion in 2010, smaller than this year’s to be sure but still very much in positive territory.

this, I would agree on in theory (because I do not have the numbers).  that the probability that China enters a deficit is too small to even consider, and that were it to, I can only think that it would be caused by a complete collapse of western economies combined with a massive drought that wiped out China’s food stock.  Maybe that is a bit over the top, but it would certainly take a lot to push them into the red zone.

As a wrap up, if there is one issue that I feel UBS sidestepped/ glossed over is the fact that many of the trends that they are using to highlight progress are in many ways reflecting an issue of capacity.  Not only production capacity, but also consumption capacity.  It is one thing  that residential and commercial properties are being built all over a city, and it is another to say that they will be productive.  Commodity wise, it is clear that there are firms who have “overstocked” on steel and other commodities, and equally clear that many of them could potentially lose a lot of money should the market not react in a positive way (commodity based subprime anyone?)

So, while the short term analysis may be sound thanks to the government’s commitment to support the markets, the fact is that many of these trends are highlighting unsustainable trends that each present their out dangers and opportunities for different groups.

If you would like a copy of the report, send me an email, and I’ll be happy to provide.  Otherwise, I’ll encourage you to take some time to do research on the issues you feel are the most critical to you.  To think that we are somehow out of the woods because the DOW crossed 10,000 or because a few retailers are reporting in the positive I think is still premature.

For more on the overcapacity story, I HIGHLY recommend Michael Pettis’s post China’s September data suggest that the long-term overcapacity problem is only intensifying

Following  my post last week  on Shanghai’s aspirations to overtake HK, I was sent Cheng Li’s recent article for China Leadership Monitor Reclaiming the “Head of the Dragon”: Shanghai as China’s Center for International Finance and Shipping (Download here):

In March 2009, in the wake of the ongoing global financial crisis, the Chinese central government took another drastic turn and endorsed a blueprint to designate Shanghai as a “global financial and shipping center by 2020.” Once again, Shanghai has had a set of favorable policies bestowed upon it by those in power. This essay examines the economic motivations, policy initiatives, political backgrounds, and international implications of this new phase of development for China’s pace-setting metropolis.

A huge fan of CLM’s work over the years, this 18 page essay offers a lot in the way of history, current state, and the potential opportnities that exist.  Li’s perspective is one that I largely see as accurate  in so far as he is of the opinion that while Shanghai has clearly come very far (he gives a lot of credit to Shanghai’s growth), that Shanghai still has a long way to go before it is able to compete with the more established markets (regionally and globally).

Over the past few months, a new trade related story has begun to pick up steam, the settlement of crossborder trade in various currencies other than the US Dollar.  At first glance it is a story that does not catch the eye, because it is often laden with economic analysis that is less than exciting, however its impact (over the long term) could be significant.

As my good friend Denis McMahon highlights in his article today, Banks Sign Agreements on Yuan Trade, and in his previous piece, China Sets New Yuan-Clearing Process, China has started a process within Asia that would (potentially) remove the USD from trade contracts.  A move that, over time, could significantly reduce it USD surpluses, its need to sterilize vast amounts of USD, and its need to purchase USD denominate Treasuries.

Working on a solution to diversify its currency holdings through trade, this is not be a process that will lead to immediate short term relief for Beijing, particularly those who are worried about the value of the US Dollar.  If successful, it will alleviate future pressure over the short-to-near term from additional USD stock piling, but more importantly, it would build the business case to further expand the program on a wider basis (below the equator economies first) and to reduce the pressure of central bankers to have to offload the USD they currently maintain.

A story to keep a close eye on going forward.

With my post earlier this week graphically showing China’s recent export trajectory, the news that April 2009 saw a 33% Y-o-Y dropmay suggest we have yet to truly turn the corner.

Not only is it 5% more than expected by analysts, it is the first month in the last 3 where the number has eroded from the previous month. Perhaps indicating the dead cat bounce may be over, and we are at the top of the next downhill slide (A topic Andy Xie’s recent piece speaks to).

With only the first reports in, it is hard to give much of an analysis at this point – or more appropriately the context behind the number, however a few lines from the Forbes article Amid Green Shoots, China’s Exports Still Barren offers a few interesting quotes:

The spring China Import and Export Fair, which ended last week, saw orders fall 17% from the fall fair, according to J.P. Morgan.

and

Exports in textiles, toys and plastics have shown signs of improving. But there are concerns that the stabilization is on the back of a restocking of depleted inventories, rather than a demand rebound. Li & Fung, a major supplier of consumer goods to Wal-Mart, said last week that some U.S. customers have been reordering to restock inventory levels, which are down from seven to four weeks, according to J.P. Morgan.

Most concerning for me, given the long term nature of this:

Morgan Stanley analysts have warned that China investors face a profit letdown, as the state-owned industrial sector prioritizes protecting jobs and produces in excess despite depressed prices. That excess output will still need to be absorbed by the West, as Chinese domestic demand cannot rise fast enough. With a boom in bank lending, China is making a “leveraged bet” on Western demand recovery by next year, rather than decoupling, they concluded.

A statement that, if true, would lead me to believe that any further fallout could have a knock on effect that would be greater than planned for. That essentially, China has built in a lot of risk into their plans, and should the plans not materialize for whatever reason, we could see effects whose ripples are large/ wide

UPDATE: From the FT China’s factory output slows in April, it appears that exports are not the only thing to slow down.

When China’s PMI figure was released earlier this week, it set off a flurry of economic analysis that (in my mind) failed to represent what we were seeing on the ground.

That while there was an improvement from December, the reality on the street reflected something diffrent altogether. A point made by my friend’s email when describing the current conditions in the global cargo market.

Another view from the street is provided by the article Shanghai trade fair sees deals fall 39 percent.

Held earlier this week, I had someone from the office go by pick up the catalog of attendees, and the report was not good. To her, it was not as bad as the Canton fair last year, but it was not good.

What I found interesting about the statistics is that while the foreign visitor statistics were only off 5%, the orders were off 40%:

During the fair, orders to the U.S. fell nearly 47 percent to $310 million, while sales to Japan fell 27 percent to $656.9 million. Europe deals fell 40 percent to $524.4 million, the organizers said in a statement.

Like the falloff in FDI that I began worrying about middle of last year (that is a sign of longer term issues), these results provide another source of anecdotal evidence that orders are not coming back anytime soon.

Three big announcements and 2 juicy rumors today highlight the fact that the scale of the global downturn is growing. Fast.

Big Announcements:
1) Intel shuts Shanghai factory and lays off 2,000 to move inland
2) Electrolux closes refrigerator factory in Changsha as part of a wider move to move from low end products to high end
3) McDonald’s cuts prices on 4 meals by 30% to 16.5RMB to, in the words of Jeff Schwartz, McDonald’s China chief executive:

do our part by helping stimulate domestic demand in the restaurant sector

Big Rumors (both unconfirmed)
1) Yum brands will follow McDonald’s lead and cut prices tomorrow
2) KPMG will ask China staff to take one month non-paid leave

Clearly the impacts of the global downturn are beginning to have an impact, and my feeling is that we are only beginning to see the iceberg expose itself. There is now a lot of chatter about how China’s auto part manufacturers are growing very concerned and there could potentially be some big loses.

In a recent email Northwestern professor Victor Shih has reviewed NYU Professor Yasheng Huang’s recently released book Capitalism with Chinese Characteristics: Entrepreneurship and the State.

A book that has been recieving a lot of praise in the Shanghai community (I have not read it), Victors opinon of the book was very favorable, and in his words:

This book is a must-read for anyone considering long-term investment in China because it unearths a story of China’s growth that is more sobering and unsettling than the conventional one.

In wrapping up his review of Huang’s work, Victor writes the following. It is perhaps one of the most important questions I have seen a qualified economist write, and I hope you will take some time to think about the possible answers:

Huang ominously predicts that “The Shanghai model will come back to haunt Shanghai if there is an external shock. “(209) Not just Shanghai, but much of China. That external shock is arguably happening right now as the global recession leads to a decline in export and a slow-down of FDI, previously the two genuine bright spots in the economy. If Huang’s account is correct, the coming months may truly test the limits of capitalism with Chinese characteristics.

I must admit that it is hard now to fall into the trap that has been laid out here.

There is a lot to worry about economically right now, and it is not my intent to add any more fuel to the fire. however, I hope the above will enduce some debate on what the real risks are to China’s economy, whether or not the current system is strong enough to overcome an “external event”,, and if not.. what is THE external event?

I will have some posts later this week that will look through one industry in particular, but in the meantime I invite your comments on the book or the questions asked by it..

While reading up more on the issues, I came across a 20 minute Youtube series from CCTV where Zou Ye interviews Peking University Professor Huode Ming.

Where I enjoyed this interview is simply that the the Professor’s comments are not full of doom and gloom, a common theme right now.  He rightfully highlights a number of the issues and provides some analysis on the recent moves by the government, but his opinion that everything will work itself out in the next 6 months I think has muted his reactions.

Part 1:

Part 2:

I won’t say that I agree with everything, but where I share the professor’s concern is in how the money is spent.  HE does a really good job of highlighting the fact that this money should be spent in ways that bring long term returns to the economy, investment, and dismissing the need to simply give people money directly that would provide a short term stimulus.  That is a theme I wish others would consider more carefully, as to truly address the problems that the economy is facing, we need to look at how to create long term solutions that sustain themselves.

In Brad Setser’s recent piece Secrets of SAFE: A sharp slowdown in reserve growth and large “hot” outflows in q4…. I found the graph below

Speaks volumes.

Anyone care to predict the next three splice for M12 2009, M12 2010,  M12 2011?

With little doubt in anyone’s mind that the impact of the global crisis impacting China, the focus has changed.  It has become a guessing game of what the impact points will be, and how severe those impacts will be.

One of the more interesting questions relates to the impact of layoffs.  We began hearing about layoffs in October through the toy factories, and over the last 6 weeks the layoffs have becme more frequent.

Frequent enough for journalists to pick up on th fact that millions of migrant workers were returning home early, and frequent enough for some to debate what the millions of unemployed would do when they returned home.  Would they simply take an extended Chinese New Year?

Or would they stew and start causing trouble…  leading economists Wang Tao and Victor Shih addressed this issue head on.

Wang Tao of UBS in her latest report Will job losses lead to social unrest? argues :

The severe unemployment outlook has increased the risk of social unrest significantly. Most of the job losses are expected to occur among migrant workers, who are not covered by any formal social safety net, and are often owed back pay up to a year. Migrants have few formal channels to be heard and get compensated, and localized social unrests may be hard to avoid.

Nevertheless, we think large-scale unrest that threatens general social stability and overall investor confidence is unlikely. The scale of job losses, as large as it might be, is not really unprecedented in China.

For Wang Tao, the reasons that any unrest will be minimized are simply (1) Even at 15 million (UBS estimate), the numbers are not statistically large enough (2) History – 10 years ago the large numbers of SOE workers laid off did not go out and riot, so therefore neither will the migrant populations of today (3) that because migrants have land, they will keep busy (4) the government can fund migrant relief in a way that SOE workers never saw (5) migrants are unorganized

Points that Victor Shih, of Northwestern, addresses with in his RGE Monitor article“Will job losses lead to social unrest?” My Take:

The arguments sound quite reasonable:
1.  Job losses will only be about 15 million, or 3.5% of non-agricultural employment.
2.  Migrant workers, who are hit the hardest, can’t organize effectively anyway.
3. China weathered the last wave of unemployment, which saw unemployment level at around 35 million, with little difficulties in the late 90s.  And, China had less money back then.

Victor however has a vastly different take on the size of the problem:

I find the 15 million figure highly unlikely, even for now, much less for 2009.  A Ministry of Labor and Social Security official revealed recently that some 10 million migrant workers have already been laid off and returned to the countryside.  It seems extremely optimistic to say that total unemployed migrant workers in 2009 will be 15 million.

In fact, Victor points out that the current layoffs are already likely higher than the 15 million, and that when you take into consideration that HALF of college graduates this year may come out without a job… China could see more than 30 million unemployed people.. possibly 50 million

which would significantly impact the ability to subsidize the peace and quiet:

if the unemployed force reaches 50 million, the Chinese government would only have to pay (50 million*100dollar*12 months) 60 billion USD (408 billion RMB).  That is a substantial sum, but China can surely handle it for two to three years, suffering perhaps slightly lower credit ratings.

So, while not a small some of money, it is a sum that the government could afford (in a vaccuum) .

For victor though, there is something that he feels Wang Tao fails to appreciate:

unlike the layoffs in the 90s, which mostly affected middle-age or elderly SOE workers, the current wave of layoffs affects a young and vibrant cohort most capable of carrying violent collective action against the state.

A very important point, and the basis for an interesting dialogue between two experts.