Will China in 2011 turn out to be our generation’s 1929 USA?

When it comes to China futures, American stock-betting guru Hugh Hendry is at the opposite end of the scale from Goldman Sachs’ Jim O’Neill – whom he dismisses as ‘Permabull’ in a manner that suggests he’s talking about more than just bear and bull. Some weeks back, he made this remark about O’Neill’s bullishness on the Chinese economic outlook:

“I love Jim O’Neill. I love that Goldman Sachs guy. He says you either get it, or you don’t. I don’t get it. In the future there will be a Confucius saying: wise man not invest in overcapacity. The flaw of the business model – at the center of it – is a craving for power as opposed to profit.”

I think this is a real insight, and it confirms what a contact in trade negotiation said to me last year about the Chinese governing elite:

“They’re not capitalists, whatever Times and Newsweek might say…they’re imperialists. They believe in China, not money – money is just the means. That’s why they don’t know what all the fuss is about with the Yuan’s value…they see other nations moaning about its undervaluation as western capitalist bullshit. These guys don’t do Harvard Business school case histories – they’re born rulers.”

Anyway, Hendry sees China as the ultimate bubble. He is investing in everyone and everything he thinks “will benefit when China goes bang”.

“There are striking parallels with Japan in the 1920s, when ultimately the whole system collapsed,” Hendry told Business Week recently “China could precipitate a much greater crisis elsewhere in the world.” His thinking is that whereas Japan had an isolated economy then, the original source of the term Xenophobia – China – is today a global player.

None of this is rocket science, but as Hendry has built up his firm into one looking after $420 million in shrewd funds and assets, The Slog thought it was worth digging around a little.

As regular Sloggers will know, my hunch is that Goldman’s O’Neill is talking up China to make profit for his employers,who would hope to carry out superfast, untraceable short selling on its economy. (Or in other words, the opposite of what he seems to have just done for Goldman in Europe on the Euro). Whether all this is correct or not, my water certainly tells me that Hendry is on the money about China. That is, he may have a point when he says this is all uncharted waters for the Chinese….and they may make Page One mistakes.

Hendry (also, like O’Neill, a Brit) privately asserts that he does not have the conflict of interest so blithely denied by Goldman, a company he clearly doesn’t like. He told people for years with a degree of prescience that global regulatory authorities were “asleep at the wheel” after 2002, and boy was he ever right. The fact that he’s better at predicting behaviour and cockups than others does not make him a worthy hate-figure, he says: he does not “fuck with countries in trouble”. He gave this example to The Independent today:

“It seems unlikely that the European Central Bank would raise interest rates, because if it did, it would precipitate further financial duress and strain upon a vulnerable country. I have substantial investments which are betting that interest rates will not go up this year. If they do, I will lose money, but if I’m right, I could make a return of about 20 per cent of the size of my fund.I don’t think that makes me a bad guy.”

I agree. Because if it does, that makes The Slog a bad guy too. But is he right about China’s economy and its leadership?

For one thing, the Party leadership didn’t display much subtlety when they decided to stimulate domestic demand after the West’s 2007 crash. “China’s stimulus measures were more akin to a blunderbuss than a sniper’s bullet; everything that could be done, was done,” wrote Standard Chartered’s Stephen Green recently.

Over the last two years, China has been soaking up domestic demand and letting things rip. The Beijing elite relaxed lending restrictions massively. This and the lack of much else to invest in sent the property market through the roof.

Up to this point, traditional Chinese culture had played a part. Until that credit relaxation, the ordinary Chinese citizen – when allowed to by the Party – had always been a saver: the nation’s savings ratio stood at 54 percent of gross domestic product in 2008, the highest among major economies in the world. But the Chinese are also innately shrewd – so the pace of savings moving from cash to asset caught the Government by surprise.

The domestic economy, lending and house prices all roared ahead. Inflation (unsurprisingly) rose – but this too seemed to catch Beijing on the hop. The more inflation grew, the more the Chinese citizen saw property as a hedge against it….so the more property prices rose – I mean, like by 13% in April 2009 alone. Over last year as a whole, land prices doubled in China. Given the only thing Noel Coward ever said about China was “very big”, that is an astonishing statistic. This year in April, property prices rose 11.7% again.

In 2010 so far, the Beijing regime has been through the whole gamut of stamping on growth. The China Banking Regulatory Commission has ordered the banks to cut consumer lending by 20%, and stop lending to those projects that are backed only by expected fiscal revenues.

In turn, the Chinese central bank has twice this year raised the amount that banks have to set aside as a reserve against failed loans. The view seems to be ‘capitalists have sub-prime disasters, we don’t’.

So overall then, this looks like the untutored actions of people unfamiliar with either capitalist theory or social anthropology – the two things that tend to mark out Leftist command apparatchiks from the rest of us. There is thus every chance that once the men at the top get really tough, more steam-hammers will be aimed at beechnuts in the way they do it.

Stephen Wyatt, commodities commentator for the Australian Financial Review,argues that if Chinese policy makers “over-tighten” to cool down the Chinese property sector, this will cause a contraction so rapid in the Chinese construction sector, global commodity markets could have their balls squashed by a debt-burdened Europe and a contracting China at one and the same time.

His view is supported by the latest official Chinese figures released yesterday showing that, from a full-speed gallop last month, China’s property boom has stopped abruptly dead. Making half the world’s population suddenly volte-face like that is not a great idea – especially if you’re not schooled in how free individuals respond.

The contact I referred to earlier in this piece told me that if you mention the overseas ramifications of their actions to Beijing officials, they tend to stare back as if to say “And your point is….?” This is clearly an oversimplification, but there’s definitely a sense of naive amateurism about some of the Government’s policies.

I’ve known Chinese families for much of my life. They are careful, thrifty, and suspicious of currencies. Don’t forget, it’s not just the Government buying gold: the Chinese middle class revere it above any other item too. Above all, the Chinese glass is half-empty: they expect bad stuff to happen (their history suggests they’re right) and so they value a roof under which to live, and stuff with which to barter.

Earlier this month, the China Review (a Government-controlled helicopter view of all things Chinese) hinted that there could soon be a new problem: if the lending-axe comes crashing down – and the triumphant defeat of inflation is everywhere in a controlled press – your sharp average Chinese may well soon think ‘Trouble ahead – time to start saving again’. Thus did the CR put as its No 1 question for an upcoming seminar:

‘How can businesses convince people to open their pockets and consume more?’

In other words, having overdone the stimulation and overdone the squeeze, the Ageing men of Beijing may now be overestimating how quickly its citizens will join in the next boom. Plus of course, they also don’t have A-Levels in mass negative equity and stock market panics.

This is where Hendry’s 1920s Japan parallel looks compelling: a newly-gained, superficial experience of global economics produces a system which suddenly collapses in an ignorance-fuelled panic. But as he says, the difference this time is that the US needs a stronger Yuan to start China’s growing middle classes buying its stuff….and buying its bonds. If it gets weaker (which would be bizarre) and Chinese consumption of exports dwindles….then the United States of America – and even Australia – are in big trouble.

There’s a great deal of logic – and sound, commonsense people-watching – to what Hugh Hendry does and says. Also he has (as far as one can tell) no hidden agenda. I think he’s right – that perhaps we’re ascribing too much inscrutable genius to the Beijing Government. In the long term for sure, this will be no more than a nasty bout of whooping cough for China. As with Japan’s second attempt at an economic marvel, they’ll learn from mistakes – and eventually dominate everything.

But for the immediate future, as an investor I’m now inclined to steer clear of the place.