China’s Rise Is Not Inevitable

06/13/2011 11:00 am EST

Focus: GLOBAL

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

The question is more when, not if, the bloom will come off of China’s plum blossom, writes Nicholas Vardy in The Global Guru.

Every generation, the United States confronts an economic and political rival that recalls the ancient battle between the chaotic democracy of Athens and the militaristic efficiency of an authoritarian Sparta.

The Cold War saw the United States pitted against the ruthless Soviet Union. By the 1980s, Japan had taken on the role of economic rival. Today, the battle is between a United States in decline and the economic juggernaut that is China.

Since China’s inevitable domination if the global economy is so deeply ingrained in conventional wisdom, it's important for you as an investor to understand just how fragile that prediction may be.

The Rise of “Sparta”: We've Seen it All Before…
Having just read David Gardner's Future Babble: Why Expert Predictions Are Next to Worthless, and You Can Do Better, I am struck by how often we've seen versions of the rise of economic rivals to the United States, each no less convincing at the time than today's story about the rise of China.

In the 1950s, the future Nobel Prize-winning Paul Samuelson, author of the most widely read economics textbook of the era, wrote that the Soviet Union would pass the US economy sometime between 1984 and 1997.

As late as 1992, Michael Crichton, author of Rising Sun, wrote: “Sooner or later, Americans must come to grips with the fact that Japan has become the leading industrial nation in the world. The Japanese have the longest life span. They have the highest employment, the highest literacy, the smallest gap between rich and poor.”

Today, you hear similar predictions about China.

In 2040, the Chinese economy will reach $125 trillion—nearly three times the output of the entire globe in 2000,” wrote Robert Fogel, another Nobel Prize winner in economics, last year. “Chinese per-capita income will hit $85,000, more than double that of the European Union, and also much higher than India and Japan.”

Yet things worked out quite differently. Paul Samuelson lived to see the Soviet Union implode and wiped off the map. Michael Crichton also saw the Japanese economy collapse and stagnate, belying his earlier predictions.

Why China's Economy is a Lot More Fragile Than You Think
For all the talk of China’s inevitable rise, the country's reputation is been battered lately.

Eighteen months ago, to be bearish on China was to be called crazy. But a bevy of accounting frauds in several Chinese small-cap stocks have left investors nursing big losses, forcing CFOs and auditors to resign and companies to de-list.

Famous short seller Jim Chanos has stated that if anything, he is not bearish enough on China. Even the Harvard endowment has quietly sold off its holdings in the iShares FTSE China 25 Index Fund (FXI), a major exchange traded fund that tracks the Chinese stock market.

There is just too much in China that can and, I believe, will go wrong eventually:

  • A huge real estate bust will saddle China with a generation of zombie banks and sub-par growth—the same thing that Japan has suffered for 20 years.
  • Once you include off-balance sheet items like local-government bond guarantees, China’s headline-grabbing public debt-to-GDP ratio of 35% becomes meaningless.
  • Throw in the billions of dollars of non-performing loans—$200 billion worth of bad loans from China's top four state-owned banks were moved "off-balance sheet" to state-run asset management companies just last year—and China's financial picture is hardly better than that of the United States.
  • And China's role as a low-cost base for global manufacturing is eroding quickly. China's pricing advantage for goods arriving in California—hardly the most business-friendly environment in the world—has declined from 22% to just 5.5%.

NEXT: The Elephant in the Room: Political and Economic Freedom

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The Elephant in the Room: Political and Economic Freedom
The longer-term threat is the rise of the middle class, whose members increasingly will demand the kind of rights their counterparts enjoy elsewhere in the world. And why wouldn't they?

China sends tens of thousands of college students every year to study in the West. How long will China's best and brightest tolerate the "Great Firewall" that keeps the Internet under government control—especially after years of freedom while studying at Berkeley, MIT, or Harvard, as the current daughter of China's vice president is doing under a pseudonym.

For a short time, they will. After all, many of these students are members of the Communist elite—like the nomenklatura in the Soviet Union.

But among the “great unwashed,” supporting a government that kidnaps children of families that violate its “one-child” policies won't stand forever.

And the more China opens up, the more paranoid it seems to get, as the government is cracking down on foreign reporting like never before. Just watch this video by Stephen McDonell of Australia's ABC, which shows what it is like to be trailed by Chinese authorities at every turn.

The recent events in the Middle East, coupled with the soon-quashed "Jasmine revolution" in China, make a blowback against government control a question of “when” and not “if.”

The list of China's woes goes on...

  • The environmental costs of China's rapid development are soaring. Cancer has become has become the leading cause of death in China, with a dangerous epidemic of "cancer villages" linked to pollution.
  • Less than 0.7% of the population owns 40% of the wealth.
  • Roughly 150 million people live on less than $1.50 a day.

None of this will dissuade China bulls from their belief in the inevitable “China Miracle.” With $3 trillion in the bank, and economy expanding at 8% a year as far as the eye can see, they “know” China will continue to grow just like they “knew” the Soviet Union—and later Japan—would.

That may happen. But there is actually a very good chance it may not. The Spartas of history—whether Nazi Germany, the Soviet Union, East Germany in the Olympics—have always boasted short-term triumphs. But they also tend to collapse, with stunning swiftness.

And that's a bet I'd be willing to make.

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