Part I

May 13 , 2004
The Chinese Trade Game
Part II: What are the dangers associated with relying on a transitional economy for global growth?
By Brady Willett & Todd Alway

The Catch Up Economy

China has (is) piled a lot of money into cement production, but reports like this one continue to arrive daily:

“A shortage of concrete, fueled by China's hunger for cement, has threatened to lower the boom on South Florida building.”  Miami Herald   May 7, 2004

Until these reports stop arriving, the China led boom remains an inflationary threat to the global economy. However, when the inflation threat dissipates, the extra capacity that has been built up to serve China’s raw material needs will immediately beckon a deflationary nightmare.  Such are the problems of relying upon a transitional economy to fuel global growth: it does not constitute a structurally distinct basis upon which to build a new round of global capital accumulation.  Unlike the cases of the United Kingdom in the 19^th century and the United States in the 20^th, China appears to be playing a game of “catching up” rather than redefining the nature of the economic landscape. Global deflation, therefore, appears to be inevitable. It is only the timing of the boom/bust commodities cycle that is open for debate.

Connected But Not Calibrated

Well known for his gloomy outlook on the US economy and financial markets, Morgan Stanley’s Stephen Roach has a different take on the Chinese economy:

“The wise men of China have no doubt that the current leadership has learned the lessons of macro management well. They lived through China’s soft landing a decade ago, and are convinced that the authorities are perfectly capable of pulling it off again. I couldn’t agree more…”     The Wise Men of China April 23, 2004

The argument could certainly be made that Roach is overly optimistic in the case of China and overly pessimistic when it comes to the US.  After all, Roach – who believes the ‘Stymied’ Fed should raise interest rates by 200 bp because ‘the perils of another burst asset bubble far outweigh the costs of another recession’ – ignores the fact that equally ominous bubbles to those seen in America could be developing in China (See Xie, Friedman, Business Week, Asia Times). Moreover, Roach seems complacent with regards to the connections between the US and China. As an Asian Times article suggested earlier this year, US and Chinese ‘growth rates are tied in ways that neither seems to want to admit too loudly.’  For whatever reasons, Roach is one of those who doesn’t want to admit it...

“If the US economy sinks and Americans stop buying Chinese goods, then it will compound the US slump as China first stops buying US bonds that have inflated the American bubble and then moves on to selling them. On the other hand, if the Chinese economy falters and it stops recycling dollars into the US economy, then the boom stops anyway.” China-US: Double bubbles in danger of colliding January 23, 2004

Given that Chinese ownership of US debt has been flat since December 2003 (as of February 2004), and that this has not had any ill effect on the US economy (i.e. interest rates have not skyrocketed) the above argument appears to be flawed.  However, surface analysis is often times not all that is required to grasp the larger picture.  To be sure, over the past year China has taken in 40-50% of Asia’s imports. Moreover, China was responsible for all of Taiwan’s export growth last year and approximately 50% of Japan’s export growth.  Accordingly, although China’s penchant for US debt has recently cooled, other nations that have come to rely more heavily on the Chinese market are increasing their purchases. Would Japan have purchased more than $100 billion in US debt since October 2003 (Taiwan $10 billion since July 2003) without strong export growth?  Probably not. In short, take growth in China out of the equation and - other things being equal - US interest rates would be a lot higher than they are today.

The fact of the matter is, in order to fathom the nature of China’s influence on the global economy, the character and extent of its global interconnections must be traced. To offer an example, Rotterdam is planning to expand its port capacity – a plan that has been reborn after sitting on the shelf for 11-years – because of the belief that Chinese capital will simply invest/ship elsewhere if they do not.  Remember, the perception is that ‘China represents growth, and China is the future’.  This belief, as the battle between ports to take part in China’s historic expansion and as strong increases in FDI into China will attest to, has an important impact on the financial markets and economies.

The question is, what are the short to medium-term ramifications of a concerted expansion in port facilities by so many players at the same time? Given that this expansion is being driven largely by a desire to service the import/export needs of one economic player – China – are there structural peculiarities to the Chinese economy that might make the global economic situation more volatile? In other words, as the Rotterdam’s expand are they effectively utilizing capital today, or simply creating tomorrows underutilized bad assets?

Moreover, and to expand the analysis somewhat, given that ‘China's banks are technically insolvent, with bad debts making up 45% of their loans’ (BBC) – the example of Rotterdam becomes equally applicable to the Chinese economy itself, and is why speculations swirl that the Chinese banks/economy could sink.

The Boom

After failing to materialize in 2001 and 2002, the proverbial ‘second half recovery’ finally arrived last year.

To appreciate just how strong the global economic recovery was, and still is, consider the Maritime Research General Freight Index. What this chart tells us is that freight activity (the G-Freight index tracks all the major routes) exploded upwards in the second half of 2003.  Moreover, the chart (current only as of March) also suggests that this explosion in freight activity has not yet ended.*


The increase in freight activity has coincided with numerous port throughput records, and, as discussed in Part I, is compelling many ports to enact expansion plans.  However, the dramatic increase in the freight index has also coincided with two other notable events: increasing tanker rates, and a widespread increase in commodity prices.

Given that tanker rates and commodity prices are subject to the sometimes irrational whims of investors, the port statistics provide a more objective take on current supply/demand fundamentals. To be sure, a bombing in Saudi Arabia – whether actually damaging to supply lines or not – sends oil up a couple dollars a barrel whereas the Port of Los Angeles reports factual TEU totals each month. In other words, if global freight activity is on the rise it is almost a certainty that the global economy is growing.  Similarly, dwindling activity in freight is usually a surefire sign that mainland growth is slowing, or will soon slow. That freight activity is a leading indicator of economic activity and that commodity prices can sometimes trade inside of their own bubbles is certainly worth remembering.  More on this in a moment.

Pricing Pressures Not Confined to Seas

With skyrocketing port activity comes higher commodity/tanker rates. Similarly, higher port activity means that more product is being shipped from ports to inland destinations. Confirmation of this arrived three weeks ago when some major US trucking companies raised prices on freight for the first time since 2000. The hike in trucking rates was presaged not only by higher fuel costs, but also by a dramatic rally in freight activity in the US.  As the Freight Service Index and numerous inflationary indicators have recently suggested – the TSI index reached an all-time high in January – the Fed needs to cool things down.


Forgetting about the Fed, the broader inflationary trend is ominous – the CRB spot index is up more than 40% since April 30, 2003 (Excel). In the case of oil, China now demands 6.14 million bpd - up 20% from 2003 (as of March, China imported an average of 2.2 million bpd, up 28% from 2003). In the case of copper, nickel, aluminum, steel, cement, etc….well, if you have any, China wants it.

In short, the pricing pressures seen in shipping rates have already begun to trickle down. China, being responsible for and/or a large part of this shipping boom, will undoubtedly play a key role in where prices move next. Again using oil as the example, Chinese oil demand is now second only to the United States, and even the International Energy Agency - which has historically been overly conservative when it comes to forecasting oil demand in China - believes that Chinese oil demand will increase by 10.4% in 2004. With oil tanker rates nearing 30-year highs earlier this year, predictions that tanker scrapping will be higher than expected in the coming years (Teekay Oulook), and Chinese demand for imported oil expected to climb strongly in the future (IEA - pg8) weaker commodity prices do not seem like an imminent threat.

Unfortunately, the future economic landscape is not as clear as the above suggests.  In fact, what needs to be stressed, and this is the key to understanding the consequences of relying on China to drive global growth, is that China is a ‘transitional economy’ (Clarksons) rather than a transformative economy.  It is transitioning towards a mass production model that is already pervasive throughout the industrialized world rather than transforming the basis upon which production and capital accumulation take place.  Accordingly, demand spikes for raw materials will, unexpectedly, lead to wild price crashes.  Two charts help profile this trend - the first being an historical snapshot of China’s import growth and the second a comparison of China’s imports to two other transitional economies, Western Europe and Japan. While the cases of Western Europe and Japan are not entirely analogous for the periods highlighted -- they were both reconstructing after WWII rather than transitioning towards market economies (as is the case in China) – they do parallel the Chinese case insofar as they represent cases of competitive “catching up” rather than constituting a fundamental alteration to the structural characteristics of the global markets.  Thus, the comparison – and the common volatility revealed – is valid.




As The Slow Down Arrives, China To Tap Breaks

The immediate direction of tanker/commodity prices is largely unpredictable. However, with port activity (freight) some semblance of matter of fact data is found.  *The data, according to the more commonly followed and recent Baltic series of indexes, is in free fall (BDI Chart - More)

Incidentally, neither the MRI Freight Index nor BDI is followed that closely.  Rather, commodity prices and tanker rates are considered the more legitimate indicators of global trade/inflation. Each of these indicators – commodity prices and tanker rates are weakening due to China slow down fears (not oil) – is, similarly, dropping.

Why the slow down?

Part of the reason for the topping of commodity prices has to do with the dangers of overinvestment (over capacity).  In the case of China, the country logged a 173% increase in steel investment in the first two months of 2004, and steel plants under construction are expected to be able to produce 330 million tons of steel in 2005.  Domestic demand in China is not expected to reach 330 million tons until 2010. Aluminum factories under construction in China are expected to triple production in 2005 to more than 10 million tons (or twice domestic demand), and a 78.6 billion yuan is being poured into Cement investment (a 133% increase year over year).

Suffice it to say, having China threaten to do everything possible to slow down its economy is not what commodity bulls want to hear. Rather, given that the US economy is likely to grow more slowly with or without interest rate hikes in the second half of 2004, and that investment in China may soon loosen tight commodity markets (again, not oil), news that China is scared of an overheating economy has a doubly negative effect on the investor’s psyche.

The Uncertain Transition

The long-term outlook for China is almost universally bullish even though everyone recognizes that many near term shocks will arise. The potential shocks are widely covered: If, and more likely when, the Chinese ‘real estate bubble’ pops a full fledged banking crisis could ensue. If the US economy enters recession Chinese exports will fall off of a cliff.  If China raises interest rates growth could cool considerably.  If China allows the Yuan to float 1980s Japan will repeat itself...

‘Ifs’ aside, the Economist speculated in 2001 that China “is about to undergo some wrenching changes.”  Given that change (and growth) in China has seemingly come easy, the lesson here may be to not make bold near-term predictions.

On the topic of transition, Clarksons notes that “If past trends are any guide, when growth slows the change could be pretty dramatic.”  However, Clarksons is at a loss to speculate when exactly growth will slow. Stanley’s Xie concludes – quite convincingly – that ‘Today's Inflation May Cause Tomorrow's Deflation’. However, who is to say that – dumbfounding everyone – the US economy continues to create jobs, wages increase, and deficit fears vanish for a period of time? Textbook analysis regularly points out that the dollar is overvalued.  Nevertheless, the text books have been wrong for years.

The Bust?

You would think that since the US Fed is preparing to raise interest rates and Chinese officials are trying to slow down an overheating economy that there would be cause for concern amongst investors. However, this could not be further from the truth. Instead, IPOs are being lined up¹, berths and cranes are being constructed, and Chinese ports – which have quickly become a leading indicator of global growth - are booming!

Should the blackouts, bad debts, real estate bubbles, and overinvestment issues in China be forgotten because ports are booming!?  In a word, no.

Yes, after failing to materialize in 2001 and 2002, the proverbial ‘second half recovery’ finally arrived last year. However, because China is trying to forcibly slow growth rates going forward (to say nothing of the longer-term structural limitations to growth in a “catch up” economy) there is the increasing possibility that a second half meltdown is in the cards for later this year. The debt fed US economy/consumer is still in control of the world. Nevertheless, it is China - the supercharged little dictator - that is largely responsible for renewed growth in the Asian region and the commodities bull market. With industrial activity clearly multiplying at an alarming rate in China, one wonders how fruitful to global economic growth the end result of this expansion will be. 

The wise men of China are wondering aloud these days, and investors are finally taking notice that China is one of the most important nations at dictating global booms and busts. Remember, growth in China indirectly enables China’s trade partners to continue to purchase US debt. However, also remember that growth in China has spurred a commodities bull, which has brought back inflationary worries. The fear is not whether China’s transitional economy will grow choppily in the coming years, but of the global fallout that may ensue when Chinese growth stalls.  Given China’s increasingly important role in sustaining low US interest rates and commodity prices, a deflationary nightmare may re-arrive on the scene quicker than most people think. To be sure, with US and Chinese officials signaling higher rates, and freight/commodity statistics already having shown a retreat, tomorrows shipping news may be that of ports of hope.




1. Chinese ports, Tianjin Port Group and Shenzhen Yantian Port, have listed shares on Shanghai A-share market and others – including Qingdao Port Group (May 5) – are announcing plans to offer shares in the future.