Will China cool?

There have been a number of articles written recently that put forth the heretical view that the Chinese economy may be about to cool big time. China has been growing rapidly for essentially all of the last decade (and more). The thesis of the articles is that such growth cannot continue. The main reason for this view is that too large a portion of the Chinese GDP is going into investments which will not be able to be utilized. China is building high speed rail lines (sound familiar?), but there are not enough riders on the finished lines to even pay for the operating costs. China is building homes and apartments at a fast clip, but there is still not enough of a middle class to occupy all that are being built. Airports are growing at a faster clip than air travel. Other types of public investments are also outstripping the ability of the country to use them. The expectation is that at a certain point there will need to be a slowdown in such investment with a concommitant slowdown in the Chinese economy. Alternatively, since Chinese GDP is devoted to investment rather than to providing consumer products for the people, there will be a crash in the Chinese economy as insufficient demand for Chinese goods causes the industrial portion of the economy to falter. Indeed, if the Chinese currency rises in relation to the Chinese overseas markets, this crash may be brought on quite suddenly.

In my view, this view of the future of the Chinese economy cannot be dismissed. Many folks will remember the Japanese juggernaut of the 1980's. Near the end of that decade, the growth of the Japanese economy was so strong and the world view that Japan would come to dominate everything was so ingrained that the value of the stocks on the Japanese stock market came to be about 55% of the total value of all stock on all of the world's exchanges. Land in Tokyo also rose to absurd valuations. I recall that the Tokyo office building owned by Northwest Airlines had a higher value than the rest of the airline. Of course, right after Japan reached this height, it stopped growing and has still not recovered. china could easily follow a course like this. More likely, the Chinese economy could see a recession and then a return to growth but at a slower pace.

So what is an investor to do? My view is that a prudent course of action contains two major componenets. First, reduce one's exposure to Chinese companies. For a long time, I have had minimal investments in companies with heavy Chinese exposure. This has been on the basis that the Chinese government is both all powerful and capricious. I do not like to invest in place where the government can decide one day to take an action that will result in the near destruction of my investment. Second, reduce one's exposure to commodities. For example, yesterday, I sold the last of my holdings in Vale, the Brazilian mining giant. Companies that depend on iron, copper, and other industrial commodities will see a major decline if the Chinese economy stalls. No other country is on the horizon to take up the demand if the Chinese stop buying. There could be a worldwide collapse of industrial commodity prices.

Obviously, no one knows where the Chinese economy will be in a year from now; there are many predictions, but there is no certainty. In my view, however, there is enough of a risk of a serious downturn in China that it makes sense to reduce one's exposure to the sectors that would be hardest hit by such a decline.