Published July 25, 2012

Gordon Chang: Big Trouble Ahead in China?

Dear readers,

As you may recall from Monday's Daily Dispatch, I've just returned from China and shared some thoughts about the place. This would seem to be a good time to share one of our last video conversations from the Recovery Reality Check Summit we held in Florida three months ago. Please note that while my tone was more bullish on China than this conversation – and I stand by my observations – that bullishness is regarding the mid to long term. In the near term, I'm quite sympathetic to the idea of more bubbles popping in China, and serious consequences ensuing for the global economy, as outlined by Gordon Chang in this interview.

I also note that since this conversation was recorded, Gordon has been shown right regarding China's increasing reliance on the US; the US has officially become China's top trading partner, displacing the EU.

Also, while in China last week, I heard of a young man sentenced to four years in jail for spray-painting "CCP Game Over" on a wall. The China Communist Party was never known for its sense of humor, and it seems to have much less of it these days. Several political observers I met in the country think the power struggle will ultimately be positive for China, resulting in the country moving toward greater freedom. In the meantime, it could have negative economic consequences, as per Gordon's views below.

On the bright side, Gordon agrees with me that whatever happens, even in the near term, the trend in China is bullish for gold.

Whether we agree or disagree with all that Gordon has to say, the topic could hardly be more important for our investments. I hope you enjoy the conversation.


Louis James

Senior Metals Investment Strategist
Casey Research

Gordan Chang, author of The Coming Collapse of China and Nuclear Showdown: North Korea Takes on the World, was a faculty member of the last Casey Research investors' summit. The next conference – Navigating the Politicized Economy – will be held in sun-drenched Carlsbad, California, September 7-9 and is being co-hosted by Sprott, Inc.

This timely investors' conference is designed to help further your understanding of the world's increasingly centralized economies so that you can profit from the market dislocations they are creating. Many financial luminaries will be on hand, including David Walker, former United States Comptroller General; Karl Denninger, author the daily market commentary The Market Ticker and operator of Ticker Forum, an online trading community; and G. Edward Griffin, author of the best-selling book on the founding of the Federal Reserve Bank, The Creature from Jekyll Island.

These are but a few of the new faces you'll see in Carlsbad. Also appearing will be our own Doug Casey, resource investing legend Rick Rule, who founded Global Resource Investment (now part of the Sprott Group of companies), and Lacy Hunt, executive vice president of Hoisington Investment Management Company (HIMCO) and the attendees' favorite speaker at our last Summit.

This is just the tip of the iceberg, as we'll have many more speakers, not to mention special sessions on alternative investments, precious metals, the energy market, and more. Plus, we'll have roundtable discussions on the best investment strategies to implement right now, question-and-answer sessions, and specific stock recommendations that could pay for the cost of your Summit registration many times over.

Right now you can reserve a seat at special early-bird pricing, but you need to act fast, as this offer expires July 31. Learn more and lock in your early-bird discount now.

Interviewed by Louis James, Editor, Casey International Speculator

Louis James: Welcome, ladies and gentleman. We're at the Casey Research Economic Recovery Reality Check Summit. We're here with Gordon Chang, who is a China expert, which is of course a major mover in the markets these days, something people have a lot of questions about. So, Gordon, welcome; and can you give us a quick version of your talk for those who weren't here?

Gordon Chang: This morning I talked about how the commodity markets were going to be affected by China. I said that essentially there were two important factors determining China's need for commodities this year. First of all, there is the general state of the economy, which affects almost every commodity but one. And the second factor relates to gold. I mentioned how the Chinese economy is growing at only 5% or 6%, not the 8.1% that Beijing claims in the first quarter of this year, and that eventually this will affect China's requirements for iron ore, copper, crude oil. Gold's a different story for a number of reasons. The Chinese people are buying it as an inflation hedge, also as a substitute for capital flight, and the Chinese central government looks like it's acquiring gold as a way of avoiding US sanctions on Iran that go into effect at the end of June. So if China pays for Iranian oil with gold, it avoids the financial sanctions that are pretty strict and could have a measurable effect on China.

Louis: Okay. Can you give us a little bit of data, then? Why are your numbers different from the official numbers?

Gordon: The most important thing is that the official numbers don't correlate with other official numbers that have been issued. By far the most important indicator of Chinese economic activity is electricity output; and we've seen in the first quarter of this year, electricity output increased by only 7.1-7.2%, instead of the 8.1% that Beijing claims. Now, because the growth of electricity always outpaces the growth of the underlying economy, China's economy can't be growing more than 6%, and there are other indicators that show that it's probably growing even less than that. When you look at poor import growth, bellwether car sales, manufacturing, which looks like it's still contracting – all of these factors indicate that the 8.1% number clearly cannot be right. This does not fit in with everything else the Chinese government tells us.

Louis: Wow, okay, that's quite plain. If that's true –

Gordon: It is true.

Louis: Okay, taking it for true, I have heard from friends of mine in China that the whole system really requires that extraordinarily high growth rate to keep things together. If it drops under 8%, there can be much more social unrest. China is in fact not one people but several cobbled together. Are there social consequences to this other than just impact on the global economy, and what happens to China?

Gordon: There will undoubtedly be social consequences to this, especially when we start looking at unemployment. The real problem right now – and the immediate problem – is that the Chinese political system at the top is fracturing, with the Communist Party leaders really in a very intense, disruptive fight amongst themselves for power. The fourth-generation leaders led by Hu Jintao are slated to give way to the fifth at the end of this year, and in connection with that there have been a number of unbelievable incidents. We had one provincial party boss invade another province with an army, the surrounding of the US Consulate, and at least three sets of coup rumors this year. We've had the senior leadership warn of another cultural revolution in China, and we've had rumors of assassination plots. When the senior leader in the country, Hu Jintao, has to publicly remind the Chinese military – the generals and admirals – that they are subordinate to the Communist Party, when he does that in a public manner and he does it frequently, you know that there're real problems. So not only is the economy faltering, you have the Communist Party fracturing, the authority of the central government eroding, and military leaders breaking free of civilian control. This is a very dangerous situation.

Louis: Okay. But let's say that it doesn't come apart and it continues roughly as it was going forward, but at a lower economic rate; what are the consequences for the global economy of that? What happens to Europe and America?

Gordon: I think China will have very little effect on Europe. It's Europe affecting China. China's problems really started with European customers not taking up Chinese manufactured goods in the same magnitude that they had before. And we started to see real problems in the Chinese manufacturing center in October, in September, even as far back as August. So because of the European Union – the 27 nations of the European Union are China's biggest trading partner – this is really creating problems for the Chinese manufacturing sector, and it's another reason why you can't have 8.1% growth.

China is extraordinarily dependent now on the United States as Europe becomes less and less of a factor for China. Last year 190.5% of China's overall trade surplus related to sales to the United States. That number is up from 90.1%, which was already enormous in 2008. Something else that people don't focus on is that Europe is sending less and less capital to China, so with the foreign direct investment statistics, we see that China is relying more and more on American money. Right now the United States holds all the high cards when it comes to the economy. The Chinese really need the United States at this moment.

[Editor's Note: China's trade surplus is larger than its overall trade surplus, because its trade balance with some other countries is negative, resulting in an overall net that is less than its surplus with the US.]

Louis: That's very interesting. So: investment implications. Let's not go into big, world-changing events because, who knows? The cards are all off the table at that point. If things continue in generally the trend that you're seeing, what should investors do? What are the implications for that?

Gordon: I think the implications are that investments in China generally are not going to be that good. The Chinese stock market does not move according to the economy; it moves according to government plans. And so when the government in Beijing says it's going to stimulate the Chinese economy, the Chinese stock markets go way up. So if people are thinking of playing the Chinese markets, you can almost forget the underlying economy in a sense. It's a question of trying to predict what Beijing is going to do – but in general that's a very difficult game. It's a game where you have to know and you have to be up all the time on what's going on. But in general it makes China a not very good investment destination. That's not to say that the rest of the world is going to be any better, but China right now is in a very difficult position. I think one of the things for investors is the external perceptions of the Chinese economy have not really caught up with what's going on. There is a negative spread, if you will, in terms of that, because I think that people believe that China will continue as it has for the last 35 years of virtually uninterrupted growth. But we have hit an inflection point, and I don't think the investors in the world have really caught up with that yet.

Louis: I remember the last time we had a conference and you spoke – you said this was coming. You said you saw a sea change coming. I guess hats off on that, but it hasn't actually hit a wall. You want to put odds on that? I won't stick your feet in the fire. I won't require you to pay for making a mistake. But is there a time in which things actually have to come undone or that you would project that if they fall apart any more they'd go completely off the deep end?

Gordon: Yes. There's no time that the Chinese economy has to come undone, but if you look at underlying trends, it's very difficult because all the reasons that created three decades of growth either no longer exist or are disappearing fast. So, for instance, China's no longer reforming, the international environment is no longer benign, and China's demographic boom has turned into a demographic bust, which means that Chinese leaders are no longer being propelled by trends going forward. They are going to have to succeed in spite of them. Now this is not to say that the Chinese economy will fall apart at the second part of this year, but it could very well do that.

The thing that's really disturbing, if you look at China, is that Chinese leaders are not paying attention to the Chinese economy. They're not looking at the reserve requirement ratio. They're not looking at interest rates. They're not looking at anything. They're too busy involved in this enormous political struggle at the top of the Communist Party. If you go back to 2008, Premier Wen Jiabao, chief economic officer of the country, reacted very, very fast and decisively to the growing global downturn, and that's why he had this enormous stimulus program and that's why he did a number of other things, but he acted very quickly and with a pretty strong program.

Louis: Yes, I remember that. The new renminbi hit the market right away.

Gordon: And so China had enormous growth in 2009, but this time, despite the obvious downturn – which we could see from the middle of last year – they've done relatively little. They've had two minor increases in the reserve requirement ratio. They haven't changed interest rates. They haven't done so many things that you would expect them to do given the severity of their problems, and the question is: "Well, why not?"

Part of it is because there are some economic constraints on them that didn't exist in 2008, but more important, they're not acting because of the problems in the political system. So this is a political problem, and unless they get their political house in order and do that quickly, then we're going to see the natural momentum of the Chinese economy, which is all to the downside right now. And so day to day, we are witnessing a dynamic that is increasingly difficult to reverse. If you want a "feet-in-the-concrete" prediction, I would have to say that in reality we are going to see a Chinese economy growing at somewhere about 3%-4% in the fourth quarter of this year. China, Beijing, the National Bureau of Statistics won't admit it, but I think that analysts will come to that agreement when we start looking at things like electricity production, car sales – all the indicators that will show, I think, that China will be growing in low single digits.

Louis: That's pretty bearish for something near and dear to my heart, which is the metals part of the natural resource sector. Have you looked at any possible consequences on metals prices? Do you go to that level of detail?

Gordon: Well I talked about, for instance, iron ore and copper and oil, as well as gold this morning. With the industrial commodities, obviously China is going to have to start buying less. They can do some stockpiling, and they've done stockpiling in the past. There are some political reasons for them to stockpile, such as dressing up their trade statistics and things, but nonetheless, the overall economic reality is that as the Chinese economy slows, they're going to need less of commodities. And it also means that they're going to be buying less on global markets. There are just a couple of exceptions here.

For instance, oil, they have a strategic reserve. It's only about one-sixth full. It's 700 million barrels. You can do the arithmetic; they probably will be buying oil despite the general trend in their economy because they do want to fill that reserve. But they could fill it very slowly, which means we may not see a big push on oil prices that we would normally expect. Things like iron ore and copper and tin – all that stuff, I think the prices are going to have to come down if we are just looking at the China factor.

Gold is a special case, as I mentioned, and so one can be very, very bullish about gold, even if one has a view of the Chinese economy like I do. Matter of fact, the more one believes that the Chinese economy is slowing, the better it is for gold, because the Chinese people are very concerned about their own economy. They are using gold as a substitute for capital flight, which means that they're going to be buying more and more of this stuff. And so I think everyone agrees that in this year, China for the first time will surpass India as the world's largest importer of gold.

Louis: Well, that will be quite a high-water mark to look for, and it makes sense. Even if you're not making more money, if you're more worried about the money you have, what are you going to do? Especially with the famous ghost cities in China. The wisdom of buying real estate from before, would you agree, doesn't hold any more – real estate doesn't have quite the luster it did before?

Gordon: Well it certainly doesn't, because real estate prices have come down quite a lot and sales volumes have come down quite a lot. The ghost cities, which you mentioned… Basically Beijing has been building, building, building, and that's been divorced from economic reality. They did that because of Premier Wen Jiabao's stimulus program, which we talked about a little bit earlier. In 2009, my back-of-the-envelope calculation was that he poured about $1.1 trillion of stimulus into a then $4.3-trillion economy and that's why you had a stock market bubble and you had property bubbles: the underlying Chinese economy couldn't absorb all that cash. So, people did what was the logical thing: they put it into the stock market. That's why the Chinese stock market as measured by the Shanghai Composite increased by 80.0% in 2009. And that's why we've had these off-the-charts increases in the property market. But property you talked about just got too expensive in comparison to China's incomes, and so that's why we've seen it come off quite a lot, starting in September, but especially in October. That's going to continue. We now have Chinese developers going bankrupt; that development had started two weeks ago, and in October we saw some of the major property developers in China start offering 30% discounts on their new apartments in the major cities. So this is going to be something that is going to continue, because of the momentum of the Chinese economy.

Louis: That's bullish for gold. What about the renminbi? Any changes in the freeing of it? And the rate of freeing of it? Where are we going there?

Gordon: We're going nowhere.

Louis: [Laughs]

Gordon: There's a lot of talk of reform. So for instance just a week and a half ago, Beijing widened the trading band for the renminbi. It's allowed to trade within a band. They moved it from half a point to a point and people said, "Oh my gosh, we got reform." Well, no you don't, because the People's Bank of China – which is the central bank – still sets the reference rate around which that band is. If you set the reference rate anywhere you want, it doesn't matter what the band is. A matter of fact, just before Secretary of State Clinton and Treasury Secretary Geithner rolled into Beijing for another round of strategic talks with the Chinese, guess what? The PBOC set the reference rate in a strengthening of the renminbi to sort of diffuse all of the questions they we're going to have about China's currency.

This always happens. Every time you have a major meeting with the Chinese, the renminbi gets stronger, because Beijing wants to avoid questions about its fixing of the currency, so no, we really don't have reform that is important. The only real reform is when they allow it to float – and that's just not going to happen.

Louis: All right. Any particularly important points that we didn't get to that you want to make sure that our audience is aware of?

Gordon: I think that if you look at China, everyone says it's the engine of global growth. Well, it isn't, because Chinese consumers really are not buying in the quantities that people think they are. The retail sales figures also include government procurement and unsold inventory, and consumption's role in the Chinese economy has been dropping from a historical average of about 60% in the People's Republic to about 34% today. No country has a lower rate. The engine of global growth is still the North-American consumer, because we're the ones who are buying Chinese products. We're keeping the Chinese factories going. Depending on your view of the United States, that's going to be your view of the Chinese economy. It's very important to understand this dynamic because China is not what is driving the global economy right now. It still is the United States.

Louis: Well, we look forward to seeing how this plays out in the months to come. Thank you very much for joining us today.

Gordon: Thank you.