The China Vortex

Paul Midler is an experienced sourcing expert who has worked in China for many years, and publishes The China Game blog. I believe that he is the first person to coin the term “quality fade”. Quality fade is, according to this article published in Forbes:

This is the deliberate and secret habit of widening profit margins through a reduction in the quality of materials. Importers usually never notice what’s happening; downward changes are subtle but progressive. The initial production sample is fine, but with each successive production run, a bit more of the necessary inputs are missing.

It seems a long time ago, but last year, a great deal of ink was devoted to covering the issue of defective products from China. In some cases, lives were lost in the US.

If I have one criticism of Paul Midler’s criticism of this very real problem, it is the impression it gives that somehow unscrupulous Chinese exporters are deliberately seeking to cheat and harm Americans, when in fact, many more Chinese have been injured and even killed by defective products coming out of Chinese factories. It’s just that the US media does not pick up these stories because the victims are, well, Chinese.

But if we are going to be fair about this problem, then shouldn’t we talk about the Chinese and other non-American victims of this problem as well? I think so.

Now, when it comes to the credit bubble problem, the issue of quality fade becomes even more interesting. This time, the culprit is not Chinese, but American. For a problem of such immense proportions, which is getting bigger and bigger by the day, amazingly, no one has identified the human culprits responsible for the bad decisions. But then, accountability never been a strong point for this US administration.

In China, when there was a problem with deaths caused by tainted drugs, the head of the Chinese Food and Drug Administration was sentenced to death and executed. No one yet knows the size of the credit bubble, but I have heard numbers from $15 billion to $45 billion bandied about. Mind you, the US economy is a US$12 trillion a year economy, so we are basically talking about anywhere from 1 year to four years of economic output disappearing.

Americans are losing their jobs, many are losing their homes, and the Fed has been scared into a series of panic interest rate cuts and into subsidizing the purchase of Bear Stearns by JP Morgan Chase and offering a Fed-backed unlimited credit lending facility to US investment banks.

In this article from The Washington Note, Steve Clemons talks about how the US exported poisoned financial products.

So, while Chinese factories have on occasion exported defective products, the US has exported defective financial products. And the US government participated because Treasury sold T-bills which were backed by these defective financial instruments.

Hmmm….

Now, back to quality fade. Let’s see if we can modify his definition of quality fade to capture the credit bubble situation:

This is the deliberate and secret habit of creating the illusion of increased purchasing power through the creation of fiat credit derivatives of dubious value. Exporters usually never notice what’s happening; downward changes are subtle but progressive. The initial credit derivatives are fine, but with each passing year, lose their value as more credit derivatives are created until there is a gradual collapse and new currencies and trading rules have to be established.

(The italics are where I have made changes to Paul Midler’s original text.)

When it comes to quality fade, the Americans have been wholesalers, while the Chinese are just occasional retailers.

Technorati Tags: China, credit, currencies, derivatives, economy, financial, globalization, instruments, lending, mortgage, products, qualityfade, subprime, trade, US

The past week has shown that the subprime credit mortgage crisis in the US has metastasized into something bigger, and is spreading into other parts of the economy, and is now beginning to affect bond markets in the US. This is a worst-case scenario gradually unfolding before our eyes, and the Fed under Bernanke and the politicians seem unable to do anything to stop it, which is why they talk so little about it.

The issue made me think about something. Several years ago, a report was issued (I believe it was Goldman Sachs), which said that the Chinese economy would become the same size as the US economy by 2040 based on current trends. The key term here is “based on current trends”, something which almost never happens, as things almost never continue smoothly in politics and economics.

The present crisis in the US is causing what I call a double shrinkage. The size of the economy is shrinking as highly-leveraged credit derivatives are slowly worked out of the system. As these derivatives, which were as good as cash just two years ago, creating more money in the system than the Fed are worked out of the economy, the GDP of the US economy will shrink. It is not a question of whether it will shrink, it’s just a question of how much. That is something the market, the politicians and policy-makers are figuring out.

But it does not shrink just on the GDP level, it also shrinks on the US dollar level, which has been losing value steadily, and will likely continue to lose value as US interest levels fall. (The problem for the Fed is that although interest rates have fallen, US banks have tightened up their lending qualifications.) This means that US goods will become cheaper, and more foreigners will go to the US to buy real assets.

Roger Ehrenberg has written an excellent article about what US headlines will look like over the next 2-3 years on his Information Arbitrage blog. No wonder that even companies like Apple are looking overseas for sales growth in the face of slow growth in the US market.

This takes me back to the report which talked about China overtaking the US economy by 2040. The report did not take into account the shrinking of the US economy on both the GDP and currency levels. If the Chinese economy continues to grow and the US economy shrinks, isn’t it likely that the Chinese economy will overtake the US economy much sooner than 2040?

Of course, there are a lot of variables. Can China continue to grow at a brisk pace without a healthy US consumer economy buying Chinese exports? And what can the Chinese government do to curb inflation, which is growing faster than in the past 15 years?

We will find out…eventually.

Technorati Tags: , Apple, bonds, credit, derivatives, economy, GDP, informationarbitrage, mortgage, subprimemortgage, US

Yesterday, the new national aquatics center was unveiled in Beijing. This will become the venue for the leading water events of the Beijing Olympics. After the Olympics are over, it will be converted to a shopping mall for Beijing’s masses.

Beijing is now the site for some of the most exciting architecture in the world. For many Chinese though, there is an underlying uneasiness. Is all this dramatic futuristic architecture the beginning of a new and exciting future of wealth and prosperity which Chinese have never experienced in their long history?

Or is this instead a blip of prosperity, and will the future be much less bright, and will their children and grandchildren look back and see the Beijing Olympics as the apogee of what has since become a downward trajectory? And will this architectural marvel become dirty and dusty and seedy?

China has seen prosperity before, only to have its dreams shattered. Westerners today see China as a rich, prosperous and growing power, but it has run into the wall before, and on many different points in history. The first Chinese industrial revolution, when Chinese factories started making goods for the Chinese market started at the end of the nineteenth century, with textile mills and flour processing factories spouting up in the Yangzi river delta, mostly started and financed by entrepreneurs from Shanghai and Wuxi. Then China went into political chaos in the period following the revolution which overthrew the Qing dynasty in 1911.

Another period of short-lived period of prosperity came in the early 30s, this was cut short by the Japanese invasion of China in 1937.

Then, in the period following the end of WWII, China fell into civil war between the two leading political parties, with the Nationalists losing and retreating to Taiwan. Following the establishment of the PRC, China was very poor, and then made even poorer by the Cultural Revolution. In 1978, the Chinese government essentially decided that they were tired of being poor and moved ideology off the national agenda. From now on, it would be about making money.

Even today though, with all their savings and comfort, Chinese feel that it can all change and all go away. That is why they save and sit on their cash.

Americans are the opposite. Until very recently, most Americans believed that the future would always be brighter, that although there were things that they did not understand, America was the strongest and most prosperous country in the world, and that there would always be a way. This is why theyspent their savings, and when their savings were gone, they would take loans on easy credit terms, promising to repay the loans and credit when they had income again. It led to a bigger and bigger mountain of debt. And now, Americans are much less sure about their ability to repay the loans.

This is a way of thinking which is completely foreign to Chinese, and makes no sense at all to them. For Chinese, the only real money is cash. And when money goes bad in times of high inflation, they don’t even believe in cash.

They believe in land, and if the politics becomes unstable, they go to gold.

Runaway inflation is something the Germans experienced in th 1920s, then again in the postwar period. Japan experienced it too in the postwar period. China also experienced it in the postwar period when the Nationalists had to change national currencies three times in the period up to 1949. With the runaway inflation in the cities, people had to carry their money in paper sacks to do their shopping. They would go to the markets carrying bags of money to buy their groceries, then they would use the same bags to carry their groceries back home.

When the Nationalists lost control of inflation, they lost the Chinese cities and the support of the business community. This paved the way for the establishment of the PRC in 1949. The first task for the government was then to stabilize the currency.

While China was very poor in the fifties, sixties and seventies, there was virtually no inflation.

Today in China, we are seeing the early signs of inflation again in food prices and property prices. For any Chinese government, and this government is no exception, inflation is the greatest single and most frightening enemy it faces. It may creep up slowly, but it unleashes forces which can easily spin out of control.

If a government cannot maintain the value of its currency, it cannot protect its citizens, and the people end up in the poor house. It’s that simple.

This is why the Chinese government will not easily revalue the yuan upwards, and why the government keeps such a tight control on credit.

One of the upsides for Chinese businesses investing in Africa is that although the people are poor, at least they pay cash. When times turn hard, you want to be paid in cash.

For most Chinese, you aren’t rich unless you own cash.

Credit is just a derivative and in tough times, no one wants derivatives.

Technorati Tags: architecture, Beijing, China, credit, currency, derivatives, germany, inflation, japan, loans, risk, watercube, yuan