Why China won't cause a commodity crash (yet)

Edward Morse at Citi (via Business Insider) has made a bearish call on the commodity supercycle based on a slowing Chinese economy and re-balancing growth away from infrastructure spending toward the consumer.

I beg to differ. The secular commodity bull cycle is not ending this cycle, but in the next downturn.


More of the same-old-same-old?
That's because the new leadership are not reformers and these "princelings" are showing little inclination to re-balance growth away from SOEs and big ticket projects, where many of the elites made their money, toward the household sector, which would benefit the Chinese economy longer term but would gore the CCP cadres' ox. Here is a typical view (out of many) from Forbes [emphasis added]:

At least four—and maybe as many as six—of the new Politburo Standing Committee are so-called “conservatives.” In the Chinese context, this means they are not predisposed to stopping the backward drift evident in Beijing since the middle of 2006. Then, Hu Jintao began to undo the legacy of Deng Xiaoping, whose transformational policies were encapsulated by the phrase “reform and opening up.”


Hu’s policy of closing the country down was popular inside Beijing for many reasons, but it became China’s new paradigm because it had the support of what David Shambaugh calls the “Iron Quadrangle,” state-owned enterprises, the security apparatus, the People’s Liberation Army, and Communist Party conservatives. “The coalition of these four power interest groups ‘captured’ Hu, who was too weak and disinclined to stand up to them, and they stalled reforms,” writes the noted George Washington University professor. Others define the constituent elements of the conservatives differently—many identify “powerful families” as being inside this circle of power, for instance—but it’s clear that entrenched interests now dominate politics in the Chinese capital.

The Forbes analysis went on about the conservative bent of the new leadership:

Apart from Li [i.e. Li Keqiang, the new premier], the Standing Committee looks reactionary. The No. 3 leader is a North Korea-trained economist, Zhang Dejiang. Zhang will almost certainly represent the interests of state enterprises in future deliberations. The member slated to get the economics portfolio is the last-ranked Zhang Gaoli, another defender of vested interests. He is expected to block any reform initiatives that Li Keqiang may hatch.

Corruption becoming a legitimacy issue for the government
I wrote about this before (see China beyond the hard/soft landing debate). China has become, in the words of John Hempton, a kleptocracy. The boom was maintained through the financial repression of the household sector and the composition of the latest Poliburo suggests that financial repression, which has enriched many Party insiders, will continue.

The obscene wealth accumulated by the princelings and other officials, i.e. corruption, is becoming a problem of legitimacy in China. Michael Spence wrote about how Singapore, which is another country governed by a single party, could be a role model for China: [emphasis added]

Like Singapore, Japan, South Korea, and Taiwan in their first few decades of modern growth, China has been ruled by a single party. Singapore’s People’s Action Party (PAP) remains dominant, though that appears to be changing. The others evolved into multi-party democracies during the middle-income transition. China, too, has now reached this critical last leg of the long march to advanced-country status in terms of economic structure and income levels.

Singapore should continue to be a role model for China, despite its smaller size. The success of both countries reflects many contributing factors, including a skilled and educated group of policymakers supplied by a meritocratic selection system, and a pragmatic, disciplined, experimental, and forward-looking approach to policy.

The other key lesson from Singapore is that single-party rule has retained popular legitimacy by delivering inclusive growth and equality of opportunity in a multi-ethnic society, and by eliminating corruption of all kinds, including cronyism and excessive influence for vested interests. What Singapore’s founder, Lee Kwan Yew, and his colleagues and successors understood is that the combination of single-party rule and corruption is toxic. If you want the benefits of the former, you cannot allow the latter.

Good corruption, bad corruption
Kate Mackenzie at FT Alphaville highlighted analysis by Andrew Wedeman on distinguishing between "good corruption" and "bad corruption" and how the two affect a country's growth path:

“Although there is no good corruption,” Wedeman writes, “there is clearly bad and worse corruption: the corruption that has negative effects, and the corruption that can have potentially catastrophic effects.” The science of kleptocracy separates the behavior into two basic types: “developmental corruption” of the kind we see in Korea and Taiwan, which does not ultimately prevent the economy from recovering, and “degenerative corruption” of the kind that ruined the economies in Zaire and Haiti.

In other words, "good corruption" involves insiders milking the economy because they see opportunity. They therefore re-invest their new wealth back into that economy, which would enhance growth potential. "Bad corruption", on the other hand, typically involves dictators and other insiders looting the economy and then sending their wealth abroad instead of re-investing the proceeds back into that economy. FT Alphaville also pointed to an article in the New Yorker by Evan Osnos that concluded that China has many elements of "bad corruption":

Investors, says Osnos, assume China resembles growth-friendly Korea and Taiwan, more than Zaire and Haiti. But Wedeman found that assumption is incorrect; China has the ‘worse’, or growth-unfriendly, type of corruption. As Wedeman told WSJ’s China RealTime:

China is different because the Communist Party does not depend on injections of cash from the private sector. As a result, whereas dirty money was an integral part of the developmental success in South Korea, Taiwan, and Japan, in China corruption fits the classic definition — the misuse of public authority for private gain.

In the long run, this type of corruption creates an incredible drag on an economy. It will eventually slow growth and the commodity supercycle will crash. In the short run, the composition of the current leadership suggests that it will continue to try to stimulate through more of the same, such as infrastructure projects, in order to boost growth. This will mean that commodity demand will continue - for now. At some point in the future, the global economy will turn down. When that happens, the Chinese economy will experience a crash landing, i.e. negative GDP growth, rather than the crash landing (sub-par GDP growth) that investors fear.


Watching the Vancouver residential property market
I am often asked about how to time a China slowdown. I am fortunate to be living here on the Canadian west coast in Vancouver where I have a bird's eye view of Asia and the Pacific Rim. In particular, I am monitoring the residential property market here in Vancouver (non-residents see Vancouver RE and then some), where we are seeing some of the "leakage" from China. The market has slowed considerably here (via The Economic Analyst):

Despite the slowdown, the market continues to be over-priced on an absolute basis (see this comparison from Vancouver Condo Info of what you get for $2.5 million).

As the Chinese economy stabilizes and its growth revives, I will be watching the Vancouver residential property market as a secondary indicator of China's economic health. This will have important implications the growth path of the global economy and for the commodity supercycle.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.


None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.