Know Thy Enemy

There's an old Chinese proverb, believe half of what you see, and nothing that you hear.

I keep hearing from the media and those that put credence in what they hear, we've been downgraded to a second rate world power.

China is supposed in the drivers seat for manufacturing, technology, commodities pricing and the overall economic base. This suits me just fine, because perception is not reality, money is.

We have morphed over the last 3 decades, and China is now in the same position we were in during the 20's, when Made in The U.S.A. was stamped on everything.

Following are some developments that were brought to your attention over the last year. Since Q304 China had a 70% pullback in floor space being constructed. Since April 2004, the Shanghai index had a 40% pullback.

Chinese industrial output growth slowed from 19.4% in the first two months of 2004 to 14.4% by December. The annual 36% increase for all of 2004 slowed to just 8.9% in January 05.

So far in early 2005, a major proxy of Chinese export activity, the Baltic Dry Indexe's y-o-y % comparison has gone negative for the first time since the 2001 recession.

China's economy is lacking in self-sustaining support from domestic demand. Those $29 a week laborers cannot afford to buy what they are producing. China's export driven model is reliant on the U.S. Consumer.

There's a big difference between the U.S. during the 20's and today's China. The Chinese model is a communist central controlled model, the bulk of entities are government fronts, and the banks are extensions of the state.

The state gives the business some real estate, then the state bank lends to the business at low rates, the labor is dirt cheap and the currency is kept artificially low.

In a "free" market, these are referred to as government subsidies. Initially this model works, but later there's trouble. The real costs of operation are masked by the government subsidies, which allow for lower ramp up costs and gaining initial market share through predatory pricing.

As competition rises, overcapacity occurs, producer prices go down, input costs go up, pricing power is cut, and so are profits. The margin squeeze is then compounded by the government and the bank wanting a return on their money.

This is the point when the business cannot afford to operate. This means the books have to be cooked. As a result, 60% of the bank loans in China are for working capital, because the Chinese have no pricing power, and their profits are meager.

Many foreign investors in Chinese manufacturing have come to learn the hard way, once the mask of low government subsidized entry costs is taken off, manufacturing at home costs the same as in China.

There are similarities in our situations, but the gravity for the Chinese is far worse. China's auto sector is now in a bust phase and the hyper inflated housing sector is over extended.

Foreign cash flows due to low interest rates have overliquified their economy. The severity is to the point where raising interest rates has had no effect. Over speculation in real estate, bad lending decisions and fraudulent book keeping have all contributed.

The Chinese government has $195Billion in dollar denominated bonds. If they stop buying our bonds, the dollar might devalue, and for every 15% drop in the dollar, there would be a 5% hit on Chinese GDP.

Putting China in perspective using current-dollar GDP, the market value of a nation's output of goods and services. 2004: U.S. $11,994.8 billion, China $1.644.8 billion @ 8.3 yuan/dollar. China's GDP is less than 14% of our GDP, if you believe their numbers.

The severe water shortage and industrial poisoning of the environment are not helping matters either. The cheap labor source is getting agitated, the number of riots and demonstrations is on the rise.

The Chinese are hooked, proverbially, between a rock and a hard place, having to keep the RMB pegged and eat our debt at the same time. With imminent crises, how much more influence will we gain in the Communist Central Planning Committee?

We beckoned them to the table, and preyed on their proclivity for gambling and overproduction. Now, the Chinese Central Bank will welcome higher interest rates and a stronger dollar, this will allow them to participate in our bond arbitrage, and thus eat from the same plate as the Japanese.

In closing, There's an old Sicilian saying, you keep your friends close, and your enemies even closer. Come, let us sit, eat and discuss amongst ourselves...I think its time for another Morley.