This week we look over the Pacific pond to China and Japan, in an interview with my friend Vitaliy Katsenelson by David Galland, who is the managing editor of The Casey Report. Vitaliy is the chief investment officer of Investment Management Associates, Inc., and author of Active Value Investing. Profiled in Barron’s in September 2009, Vitaliy, who was born in Murmansk, Russia, and moved to the U.S. in 1991, is an adjunct faculty member at the University of Colorado at Denver’s Graduate School of Business.
Long time readers know that I just don’t get China or Japan. I think both are bubbles, but as Vitaliy notes, many bubbles can outlast the reputations of those predicting their demise. Timing is everything.
For those interested in subscribing to the Casey Report, which focuses on special situations and natural resources, you can get a risk free trial subscription by going to the following link. It is one of my favorite reads.
Have a great Thanksgiving week!
John Mauldin, Editor
Outside the Box
Shadow over Asia
by David Galland, Managing Editor, The Casey Report
An interview with Vitaliy Katsenelson
TCR: What our readers are looking for is a better sense of China and Japan, both of which are very important in the context of the global economy. As we have to start somewhere, let’s start with China.
Today the conventional wisdom is that somehow the Chinese economy is better managed than its competitors, very similar to how people viewed Japan in the 1970s and 1980s. Back then people were absolutely convinced that Japan was the superior country with superior policies and that its economy was unstoppable. We all know how that ended.
So, let’s start there. Is China’s system better than everyone else’s? Is it really possible the Chinese economy can keep steamrolling along?
VK: A few months ago, I watched a movie about Ayn Rand and it talked about how Americans in the 1930s looked at the Soviet Union’s flavor of managed economy as being superior to the American version of capitalism. At the time America was just coming out of the Great Depression, so that view made a lot of sense. So in the short run, and especially after the ugly side of creative destruction has paid us a visit, the grass of managed economy may look greener.
So when we look at China, the conventional wisdom says that the government is very, very smart, and therefore they can do a very good job in steering the economy in the right way. Chinese government may have the best intentions, its leaders may have IQs of 250 each on a bad day, but it is impossible to centrally manage an economy of China’s size.
I am a big believer that in the boxing match between a visible and an invisible hand, though the invisible hand may lose a few rounds, it will win the match every time. Last century we had the most amazing economic experiment take place when after World War II, Germany was split into two countries with different economic and political systems. But they were the same people, with the same language and culture, separated by a wall. We know how that story ended.
Of course, for a time, having government control over the levers of the economy can have advantages. For example, by taking prompt action, the Chinese government was able to pull the economy out of the recession remarkably fast, basically by fire-housing the stimulus package that was equivalent to 12% GDP. That’s the advantage. The only problem is that these kinds of short-term advantages come with long-term, painful consequences.
For example, when you have a huge government presence in the economy, you also have a huge bureaucracy, and bureaucracy brings corruption. This is one of the reasons why China is rated so poorly on Transparency International’s annual corruption rating. Corruption breeds misallocation of capital, because the capital flows not to the best use, but it basically flows to whatever the political connection or whatever the bribe is directed to.
In addition, when you have a government-managed economy, it creates excesses. China has huge excesses in the industrial sector, as well as in commercial and residential real estate. We see plenty of evidence of these excesses, but they are likely to be much greater than we can measure today as they are covered up by robust economic growth. The true magnitude of these excesses will come to the surface once the economy slows down.
TCR: In essence, you’ve got a relatively small group of individuals who are making big decisions about China’s economy and where production should be, in what sectors, etc. If history is any guide, that really can’t last, yet many people seem to think it can. That said, China’s economy has certainly done remarkably well in the global economic crisis. In fact, according to their government, their GDP is almost back to where it was pre-crash. Why?
VK: Sure, the growth you see today in China is there, but it’s not a sustainable growth. It’s not a growth that you’ll see a few years from now. That is an important point for readers to understand.
TCR: Why is it not sustainable?
VK: Because the growth is being induced by government spending, by a misallocation of capital.
I’ll give you an example. The vacancy rate on commercial real estate in China is fairly high, but they still keep on building new office buildings because they think they will always grow. So therefore as long as they keep building, that activity will be registered as growth, until they stop. And when they do stop, they’ll drown in overcapacity, and they won’t be building new skyscrapers for a very long time.
TCR: We read that note you sent about the South China Mall, which is pretty stunning. It’s the second largest mall in the world but is mostly empty.
VK: That’s right. But as outrageous an example as the South China Mall is, there’s an even more outrageous example – namely that the Chinese built an entire city, Ordos, in Inner Mongolia for 1.5 million residents and it is completely empty. These are classic examples of the sort of excesses going on in China.
TCR: The equivalent of building bridges to nowhere, but on a very large – Chinese – scale.
VK: Exactly. There are no shortcuts to greatness. As long as they keep building new bridges, the economic numbers will register that there is growth, but at some point the piper will have to be paid, and these projects have a negative return on capital.
TCR: It seems the Chinese are following the script Japan used to dig itself out of its postwar doldrums, deliberately keeping their currency low in order to build an economy on the back of low-cost manufacturing. But that game inevitably has to end – already we see more and more things being made in Indonesia, Pakistan, India, and so forth. If China loses the manufacturing core of their economy, won’t they be in big trouble?
VK: Well, once you move manufacturing to other countries, it’s very difficult to get it back. So you could probably argue that China will maintain its manufacturing advantage for a while.
The problem with China is pretty much the same as with any bubble. Though it may have had a solid foundation under it, it is simply a good thing taken too far. If you look at the railroad bubble in the United States, the country did need railroads, but we built too many.
The same thing happened with the technology bubble in 1998. The Internet was transformative to our economy, no question about it. But, again, it was taken too far.
There are some other countries that are lower-cost producers than China, but they probably can’t do it on the same scale that China can. But my point is that China is just a good thing taken too far, and if you add government involvement and corruption into the mix, you will get a bubble that is taken a lot further than you would normally expect.
One way of thinking about it is that the actions taken by the Chinese government, especially after the recent global recession, have basically supersized the bubble that was already forming.
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