China Brakes, World Slows

Local political pressure and realities make it hard for China's central government to engineer a soft economic landing. Hard talk from Beijing has been remarkably ineffective at slowing runaway bank lending, slowing growth or shutting bankrupt companies. Local officials have a long tradition in China of ignoring edicts from the center.

Exercising effective economic control from Beijing remains one of the biggest problems facing a Communist party that still believes in a large measure of central economic planning.

Beijing can't simply step back and let the free market allocate capital and resources. Remember, local politics -- not economic efficiency -- control the market more often than not. If a local governing body wants a new factory to create jobs, the local bank will be under intense pressure to deliver the cash. This helps explain why the economy grew by 9.9% in the fourth quarter of 2003, above the 9.1% average for the year. And this despite central government pressure to hold growth down.

The end result: The central government may be forced to take ever stronger measures to reach its goals. If banks won't slow lending voluntarily, Beijing will impose a lending moratorium. If raising capital requirements for banks doesn't slow lending, Beijing will raise interest rates. The danger here is that these measures will overshoot their targets. Rather than slow things down, they could actually stall the economy. That was the pattern in the early 1990s.

Leverage: The government's effort to slow the economy produces a bust instead of a soft landing.

While China is a global manufacturing juggernaut, its financial sector remains underdeveloped. There's a race on in China between the central government's efforts to improve the financial condition of the banks by injecting capital and reducing bad loans and the next economic downturn. If the downturn is severe enough, it could send one or more big banks to the brink of default.

Default is unlikely in the Chinese system, but even the likely government bailout could raise investor doubts about the Chinese financial system and force interest rates higher. That might put the big hurt on Chinese equities.

If the increase were big enough, it might hamstring the Chinese consumer, who has of late increasingly used debt for purchases such as cars. Any decline in Chinese stocks could send international investors to the sidelines. And the decline would feed back into the banking system as well, by lowering the price of equities held by the banks and the value of collateral for many of their loans.

Leverage: The Chinese financial sector is weak enough to turn a nasty short-term dip into a long-term problem.

Changes to Jubak's Picks

Sell Lamar Advertising. After the close on May 6, Lamar Advertising (LAMR) reports earnings. I think there's a good likelihood that the company will report further improvement in the outdoor advertising market, with billboard occupancy inching up another 3 percentage points to 80% from the current 77%. (That comes on top of the improvement to 77% from 74% last quarter.)

But that starts to push Lamar's occupancy numbers near historical averages, and I have trouble justifying an increase to my current price target of $45. That leaves me waiting around for a last 10% gain from recent price levels. I find the current market just too risky for that. So I'm selling Lamar Advertising with this column at a 2% loss since adding the shares on March 12, 2002. That 2% loss masks a lot of volatility, though. In July 2002, this position was almost 36% under water. In the last six months, the stock is up 17%. (Full disclosure: I will sell my shares of Lamar Advertising on May 7.)

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