Thursday, 31 July 2008

UDB meltdown

We have often spoken of the UDB (Universal Debt Bubble) and how it had permeated nearly every asset class and geography. It's existence is the reason that we have often chided believers in economic "decoupling" as fantasists. We wrote about the structural weaknesses of the Asian economies in China Syndrome and Silent Scream. The trend has been quite clear lately as India teeters on the edge of recession and Japan's trade surplus collapses. Today we receive additional confirmation (as if any were needed).

The last bastion of the "decoupling" fantasy is China. Yes OPEC and Russia can remain strong as long as oil prices stay high but that scenario rests on the further assumption of nearly unlimited demand growth out of Asia (especially China). Chinese growth had continued to be high even as it trended down for 5 consecutive quarters. Now we see a report that the industrial sector is SHRINKING outright over there. Bloomberg reports that Chinese PMI fell to 48.4 in July (anything below 50 indicates contraction). Naturally, there will be apologists who will blame the entire decline on the Olympics and the shutdown of industry in the Beijing area. I present for their edification import orders:
The output index fell to 47.4 in July from 54.2 in June, while the index of new orders dropped to 46.2 from 52.6. The index of export orders declined to 46.7 from 50.2.
Clearly, there is no correlation between demand for exports and the Olympics. While that is likely and aggravating factor, it's a long way from the heart of the problem. Exports are the be-all and end-all for China's economy and they are going down in no uncertain terms. This should be no surprise as the end demand in their trade partners is clearly weakening. This is horrible news for China, as their entire economy is a pyramid leveraged to exports. What we wrote in China Syndrome less than a month ago has particular resonance given this report:
Essentially, everything will be fine as long as everyone there believes the economy will continue to expand at a breakneck pace and invests accordingly. This is virtually the definition of a pyramid scheme.

The most likely trigger for a fall in China's capex is weakening exports. They don't even have to stagnate to trigger real problems, much less fall. When the current investment pattern is predicated on rapid and continuous growth, material decline in the growth rate should be sufficient to kick off lower capital spending. An event the magnitude of 1980 would cause a direct hit of 12% of GDP in China in addition to any multiplier effects and that is hardly unthinkable. Keep in mind that exports themselves account for 33% of Chinese GDP so any outright decline there would be a real problem for them - likely triggering a minimum 20% fall of GDP. Frankly it will be difficult for them to avoid it given the economic and political climate in their trading partners.
China is simply following the same pattern that we have already seen in India. In China's case, the slowing of demand may have been masked by the massive construction projects and inventory building prior to the Olympics. In many ways, this event is similar to the Y2K phenomenon that marked the top of the tech bubble. It is a date-certain occurrence which inspired massive spending and investment as well as hoarding and stockpiling (for different reasons). That date also marks the absolute cutoff of all related investment and spending as well as a potential inventory draw down. In this instance, the cycle is exacerbated by the reduction or cessation of industrial activity in and around Beijing. So instead of a gradual reduction in industrial production growth like India, China looks to be set for a sudden end to growth.

We see problems globally, not just in the US and Asia. Deflating housing bubbles in Spain, the UK, Italy and Australia. Retail sales falling across the developed world, with their supplier nations beginning to follow suit. This is no ordinary credit crisis. It is the beginning of the end for the largest and most extensive credit bubble in all of human history - the Universal Debt Bubble. No nation, no asset class will escape the effect of the bubble bursting. Preserve your wealth, reduce risk and get ready to buy assets on the cheap on the other side of this mess.

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