China’s future deconstructed: Holmes vs. Chang

Author and Commentator Gordon Chang literally wrote the book on why investors should be wary of China’s growth. His book The Coming Collapse of China has attracted attention from the likes of the LA Times and Asia Times and many other publications in between. He has made appearances on Fox News and regularly contributes to Business Insider, Barron’s, National Review and Forbes magazines. When he lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai as counsel to the American law firm Paul Weiss, he saw the ghost cities and environmental challenges up close.

“The debate is a direct response to attendees who need to know if China is on a course to grow, slow or blow,” said Nicole Evans, president of the Cambridge House International Conference Division. The Gold Report called these two experts to find out the numbers behind why they have such different predictions about how this enigmatic country will fare in the coming years.

Frank Holmes: This veteran investment advisor based his positive prognosis for China and its Eastern neighbors on a combination of tacit knowledge learned firsthand through travel and observation of geopolitical conditions along with explicit knowledge of history and the markets.

He studies S-curve patterns, modeled on economist Simon Kuznets’ 20-year long cycles. For example, the world’s population has grown from 1 billion in the 1800s to 7 billion today, which has drastically affected commodity consumption and infrastructure buildout. “Nowhere is this more evident than in the emerging markets, such as China,” Holmes said.

“When governments have invested in infrastructure, there has been a powerful impact on gross domestic product (GDP) numbers.” For example, he pointed to the 1950s, when Eisenhower signed the Federal Aid Highway Act, allowing commerce to expand across the nation, with restaurants including Dairy Queen and McDonald’s experiencing tremendous growth over the next several decades. “Paved roads from coast to coast helped sustain a more than tenfold increase in U.S. GDP,” Holmes said.

“Whereas the U.S. connected 160 million people with nearly 47,000 miles of freeways, by 2020 China will connect 700 million people across 250 cities, spanning more than 47,000 miles of interstate and 18,000 miles of rail,” Holmes explained.

Holmes estimated that over the next 25 years, about $41 trillion will be spent on global infrastructure—$6 trillion has been approved for the 2011 through 2013 timeframe with China projected to spend half of that $6 trillion. He believes these investments will result in rising GDP per capita and trigger a consumption economy.

“Once China connects its super cities, it will enable more Chinese to travel around the country, resulting in a completely different consumption pattern. You will see train stations with 50-story condominiums along with U.S. restaurants that have already been expanding in China, including McDonald’s, Dairy Queen and Starbucks. Major hotel chains, such as Wyndham, Starwood and Hilton, along with luxury goods businesses including Cartier, Hermes and Gucci will compete for market share. Infrastructure will change the face of the economy in China just the way it did in the U.S.,” said Holmes.

“We are big believers that government policies are precursors to change, so our investment team continuously tracks the fiscal and monetary policies of the world’s largest countries in terms of economic stature and population. The G-7 (industrialized) countries are 15% of the world’s population but 50% of the world’s GDP and growing only about 1%. Western countries seem to be focused on cutting back infrastructure spending and raising taxes to pay for entitlements. At the same time, E-7 (emerging) countries comprise 50% of the world’s population with 20% of the world’s GDP. However, these countries are growing at 7% to 8% and include a rising middle class of some 60 million people out of a total 2.2 billion people. But, 60 million people making $30,000 a year is very significant. Think about the movie “Slumdog Millionaire”—this is what is happening throughout Asia. That is why companies such as Gap and GM and KFC are focusing on expanding in China where its residents love American products and pack the stores in Beijing.”

Holmes also saw important policy changes in the works that could improve China’s economic outlook. “Over the past 10 years, we have seen a slow migration of more property rights being given to people in China. The largest transfer of real estate in the history of mankind took place in China seven years ago when more than $500 billion of real estate value was basically transferred to farmers. That was followed by condo building. Additionally, to attract public companies, Shanghai adopted the Hong Kong Stock Exchange listing and bankruptcy systems, which are based on common law. This is significant because if you look at all the countries that have had financial problems over time, no common law system has ever gone bankrupt. Civil law has. China is slowly adopting a rule of law system.”

Not all of the changes have been smooth. “One of the biggest things that China has been wrestling with is the fear of inflation,” Holmes said. “The government raised the minimum wage and that resulted in a big spike in food inflation. Then it had to deal with real estate inflation in Shanghai and the cities along the ocean. It required banks to keep more reserves, up to 20% in some cases, to avoid the problems now occurring in European banks. A tax on speculative real estate slowed the economy and it showed up in the psychology of the stock market.

“The spike is slowly reversing and rates are falling. Because there is so much less borrowing generally in China than in the rest of the world, prices rebound much faster,” Holmes said. “Only 25% of homes have mortgages so the impact of bankruptcies is much smaller. Also, I don’t think they’re going to print money the way they did in 2008. The Chinese government will move slowly to make sure the country doesn’t get hurt by Europe’s slowdown.”

Based on money supply, debt levels and the weakness of the dollar, Holmes predicted economic activity in the emerging countries should double over the next five years. “It is going to be between 8% and 9% this year and it has another 10 years of growth ahead of it,” Holmes said. “Investors need to understand volatility and not be fearful of it. If you are trading futures where your leverage is 10 to 1 and you have a big correction, you can get wiped out. But, if you are a cash business, you understand when these markets go through these corrections. Solid companies paying dividends can be an attractive investment over the long term.”

Gordon Chang: This China-watcher recently wrote an article for Forbes that said what others considered positive November trade numbers—exports up 13.8%, imports up 22.1% year-over-year—was actually an indication of flat consumer demand once the commodities were factored out. His conclusion was that the government was taking advantage of low prices to stockpile things like soybeans, copper and iron ore while domestic demand remained stagnant. “Since September, we have seen essentially flatlining growth,” he said.

“The growth over the last three decades has been absolutely stunning, but that was then, and this is now,” Chang cautioned. “After 35 years of virtually uninterrupted growth, the Chinese economy hit an inflection point, probably in September of this year. I think we are going to see a long-term cycle down. There are a number of reasons for it, some of them short term, some of them long term. The reasons that created this growth either no longer exist or are disappearing fast. Deng Xiaoping’s policy of reform paired with the end of the Cold War and expansion of globalization triggered growth in the 1980s. However, under current leader Hu Jintao, China has seen the reversal of reform, with the government partially renationalizing the economy. Today, we are in the second part of a global downturn, which will be much worse than what started in 2008. A trade-dependent economy like China’s is going to have real problems. Additionally, China was aided by the demographic dividend, an extraordinary bulge in the Chinese workforce, which by most estimates will level off between 2013 and 2016, leaving a demographic tax where one worker supports two parents and four grandparents.”

Chang pointed to stagnant electricity consumption, flat car sales, plunging industrial orders and collapsing property prices. “For example, in October, we saw property prices collapse 30% in places like Shanghai and Beijing, and actually across the country. That has to eventually trigger a negative wealth effect.

“Domestic growth is vital for a sustainable economy,” Chang said. “Last year, domestic consumption comprised less than 34% of Chinese GDP and it has been dropping in recent years. That means China is not restructuring its economy because the problems go to the core of the political model. The government would have to let the Renminbi float, allow banks to offer market rates of interest to depositors and state enterprises, allow workers to bargain collectively to get higher wages and provide a better social safety net, especially in the health care area. These are things that Beijing didn’t do a half-decade ago when it was growing at 9.9% and they’re certainly not going to do so now in a very difficult environment.”

On the manufacturing side, Chang referred to the December HSBC/Purchasing Managers’ Index (PMI). “It showed an absolute, outright falloff in industrial orders domestically. I think that is a really important indication of the problems,” Chang explained. Technically, the Chinese economy went from expansion in October to contraction in November when it crossed the critical 50 line. Any number above 50 shows expansion; any number below 50 shows contraction.

The fact that China is reporting negative numbers is telling in itself, according to Chang, who said often government-issued statistics conflict with reports from other sources. Beijing reported 13.8% export growth in November. However, during that same period factories went bankrupt, factory owners fled because they couldn’t pay their debts and some of them took their own lives. Even more damning are container and freight statistics, including reports from mega-container shipper Cathay Pacific that showed November cargo shipments down 13.8%. “Exports to Europe have fallen off the cliff and the EU was China’s largest trading partner so something doesn’t add up,” he said.

For the final blow, Chang pointed to the actions of the Chinese government. “If China really does have robust, 8–9% growth as everybody says, why is the central government starting to stimulate the economy again? That just doesn’t make any sense. If we look at things like imports and exports, I think the economy is really in trouble.”

Chang warned of political consequences if the country is not growing at least close to a double-digit rate. “I don’t know if China can stand 3% growth—or the other very real possibility, contraction. The American government bases its legitimacy on the nature of its political system. The legitimacy of the Communist Party is primarily based on the continual delivery of prosperity. Already, the number of protests in China has increased dramatically from maybe 70,000 mass incidents a year in 2005, to as many as 280,000 last year. In addition to strikes, riots, insurrections and bombings, the standoff between villagers and the authorities in Guangdong province are threatening the future of the Communist Party.”

One solution is for the Chinese government to continue to spend millions on infrastructure to create growth as it did when it spent $1.1 trillion after the 2008 downturn. “This tactic is of limited usefulness the second time around,” Chang warned. “It may be able to play out the game for 18 months, maybe two years at the outside, but it’s pretty much done. Plus, the artificial stimulus also created a stock market bubble, inflation, ghost cities, banking weakness and property bubbles. Massive spending didn’t avoid problems, it just postponed them and made them bigger and more difficult to solve.”

Chang said that people in China are starting to see the reality of the problem. “There is a sense of pessimism. Starting in October, we saw large, unexplained transfers of money out of the country.”

The bright spot, according to Chang, is that while China will not be able to fuel a global recovery with a consumer-driven middle class, a Chinese meltdown won’t be a major blow to the U.S. either. “We have the world’s largest internal market; 70% of our GDP relates to consumption. Exports don’t really play that much of a role in the U.S. as it does in other major economies. So China can fall off the cliff in a sense, and it would have some negative effect but not very much. In fact, we might benefit from it.”

Chang’s conclusion? “People say the Chinese economy is the global engine of growth, but that’s not true. The engine has been the American consumer because we are taking every other country’s exports, and the Chinese, through predatory and mercantilist policies, have been grabbing growth from other countries. For the last 200 years, China has been a potential source of customers for other countries. Still, domestic demand isn’t that significant. China’s imports lately have been commodities and that is going to fall off because China’s exports of manufactured goods, to Europe and the U.S., are going to be stagnant or lower than they have been in the past. So China really reacts to the rest of the world. If the changes over the next couple of months are as dramatic as they’ve been for the past two, then we’re going to be looking at a very different China. The Chinese economy could fall into a big black hole with 1–2% growth or even contraction. Can the government turn it around as it has in the past? That’s the money question.”

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose Holmes as mining fund manager of the year. Holmes co-authored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.

Gordon G. Chang is the author of Nuclear Showdown: North Korea Takes On the World. His first book is The Coming Collapse of China. He is a columnist at Forbes.com and The Daily and blogs at World Affairs Journal. He lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai, as counsel to the American law firm Paul Weiss and earlier in Hong Kong as partner in the international law firm Baker & McKenzie. His writings on China and North Korea have appeared in The New York Times, The Wall Street Journal, the Far Eastern Economic Review, the International Herald Tribune, Commentary, The Weekly Standard, National Review, and Barron’s. He has given briefings at the National Intelligence Council, the Central Intelligence Agency, the State Department and the Pentagon. Chang has appeared before the House Committee on Foreign Affairs and the U.S.-China Economic and Security Review Commission. He has appeared on CNN, Fox News Channel, Fox Business Network, CNBC, MSNBC, PBS, the BBC, and Bloomberg Television. He has appeared on The Daily Show with Jon Stewart.

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