A Bear in the China Story: Opinion

NEW YORK (TheStreet) -- The China bulls haven't given up in spite of all the evidence that China's economy is in trouble. Only massive governmental projects are keeping economic activity from contracting. Capital investments from the government are now about five times greater than in developed countries.

That obviously leads to lots of "mal-investment," waste and corruption.

The large, government-controlled enterprises get the benefit of these projects. Their top management is usually from the families of the top party officials. They are able to siphon off hundreds of millions of dollars from the top. They not only control these large firms but also the powerful, official party organizations. It's blatant incest, typical of all communistic regimes.

The current prime minister has a well-publicized "anti-corruption" agenda. Is it show or real? It's curious that at the same time the government has passed a law that any articles or blogs critical of the government or insinuating corruption at local and central levels of governments or fraud at corporations is punishable with prison. Investigative reporters are usually the ones who have exposed such misdeeds. How can this law be part of an "anti-corruption" agenda?

In 2011 the People's Bank of China issued a report that said 18,000 public officials had stolen assets of around $100 billion from 1995 to 2008 and fled the country. I wonder what the "unofficial" number is?

Let's look at the economy.

The debt in the economy has soared over the past six years to astronomical levels. During that time, banking sector assets (i.e. loans) have grown by about $14 trillion according to Fitch credit rating service. That's equivalent to the size of the entire U.S. banking system.

Some private estimates are that perhaps 40% to 50% of these loans are "non-accruing" -- in other words, basically in default.

This happened in the late 1990s, and the government restructured the banking system by forming "bad banks" that took over the bad loans from the banks. Then the government sold shares in the bad banks to investment vehicles, some those of the government's including foreign investment firms. That's how that problem was resolved. It could be done again.

That leaves the $7 trillion to $10 trillion of debt in the "shadow banking system," which is beyond governmental control or regulations. No one really knows the size, nor where all these loans are. Therefore, it would be difficult to bail those creditors out, which is mostly off-balance sheet "Wealth Management" entities of banks.

The loans are experiencing huge defaults now as are many of the borrowers, mostly smaller companies. They are in financial trouble because of a huge profit squeeze as costs rise and sales decline. Regular banks won't give them loans. So they go into the "shadow" banking system.

China's great growth days are over. The limiting factor is dictatorial Communism. Some estimates are that by 2015 China manufacturing will have lost all of its cost advantages for U.S. companies based on rising wages, rising freight costs, rising yuan currency, etc. This is where entrepreneurship should kick in, but under Communism it can't.

Economists usually make statements about "debt producing growth." Just as in the U.S., they say that over the past decade "each dollar of debt is producing less GDP growth." They work from the wrong premise -- namely that debt causes economic growth. Actually, there is no evidence of such a cause and effect. Economic growth produces rising debt as businesses borrow money to expand. There is no evidence that debt growth causes economic growth.

In fact, when there is no economic growth, debt growth is a huge burden and is actually anti-growth and deflationary. Universities continue to teach this fallacy.

Since 2005, GDP growth in China has averaged around four trillion yuan per year. However, new loans have grown at a rate almost 2.5 times faster. The significance is that the slow economic growth makes it more and more difficult to service the debt.

Let's look at the popular ratio of "debt to GDP" of a country so often seen in the media, although I say that for me the relationship is dubious. Nevertheless, on that basis, China's ratio is as dismal (high) as that of Greece. In fact, economist Larry Lang wrote that every province in China is a "Greece."

One organization says the short-term debt of local governments in China is so high that 78 cities and 99 counties in China would need 100% of their budget just to service the debt.

You see, local governments financed as much as 50% of their expenses through land sales/leases to real estate developers for many years. But now those sales have significantly diminished. That leaves a big hole in their budgets. By law, they cannot raise money through debt. Eventually, the central government will have to develop a bailout program for them.

China's working population will start declining the next several decades, largely because of the "one child policy." The year 2012 was the first year in which the working population actually declined. Over next 20 years, China's labor force is expected to decline by 11%.

That means steep wage increases as companies compete for the educated and experienced workers. Many U.S. firms are already moving manufacturing to Mexico as a better low-cost manufacturing alternative. That's another huge headwind for China.

U.S. analysts have generally cheered the positive economic stats coming out of the China government the past several months. I caution these economists to beware of someone trying sell them the Brooklyn Bridge. There now seems to be competition between China and Washington on which can produce the most misleading economic number.

China's economy slowed this quarter as growth in manufacturing and transportation weakened in contrast with official signs of an expansion pickup, a private survey showed.

The New York-based China Beige Book International released a report in late September based on a survey of 2000 China businesses and 32 in-depth interviews. The president of the organization, Leland Miller, said the results "show the conventional wisdom of a renewed, strong economic expansion in China to be seriously flawed." The data "reveal weakening gains in profits, revenue, wages, employment and prices, all showing slipping growth on-quarter -- no disaster, but certainly not the powerful expansion suggested by the consensus narrative."

Western luxury firms, such makers of designer handbags, jewelry, and gift items, are reporting China sales declines of 20% to 30%. Even restaurant firm YUM! ( YUM) is reporting dismal results in China, it's major source of revenue. Caterpillar ( CAT) and similar firms cite China as the reason for their disappointments.

The China government predicts GDP growth will not drop below 7%. In China, that's not a prediction, but a message to the statisticians to assure the accuracy of that forecast. Actually, my work suggests that the private sector is barely growing at all.

Why should U.S. investors be interested in China's economy? Because that is the locomotive for all of Asia. If China gets a cold, Asian countries will get pneumonia. That will infect the globe.

Example: About 29% of Australia's exports go to China. Australia real estate bubble is much bigger than the one in the US preceding the 2008 crisis. When that implodes, it will be painful. Furthermore, the main customer for many of Asia's emerging countries is China. Its debt has soared to unsustainable levels over the past five years. Once foreign capital starts flowing out to a safe haven, China will not be able to service that debt. The fragility is worrisome for the entire globe.

Morgan Stanley wrote recently: "Corporate Asia now has the world's most leveraged balance sheets."

An economic slowdown in Asia will feel like a deep recession. I remember in the 1990s when South Korea's growth slowed from 10% to 7%. A Korean friend who had a large company of 11,000 employees told me, "It feels like a depression."

As credit availability shrink and Asian banks become very cautious about lending, the squeeze will intensify. Standard Chartered Bank estimates the average corporate debt to GDP ratio in Asia excluding Japan rose from 76% in 2007 to 97% last year. Asia's emerging countries such as Indonesia, Malaysia, Thailand and South Korea are especially vulnerable.

When debt can't be rolled over, the game is up. As Warren Buffett used to say, "When the tide goes out, you see who has been swimming naked."

That's why U.S. investors should be interested in what happens in China, especially in 2014. Beware of China and the emerging markets.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Bert Dohmen is founder of the Dohmen Capital Research , now in its 34th year. He also is editor of the acclaimed Wellington Letter, now in its 34th year, and author of the Special Report The Coming China Crisis. Dohmen also wrote two books: Prelude To Meltdown (2007) and Financial Apocalypse (2011). He has been rated top market timer, including the No. 1 rating (Timers Digest).

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