Understanding China and Japan

I usually don't put a post that's just a review of a post on some other blog...but I'll make an exception for this one...Here's a conversation posted in John Mauldin's Outside the Box section, with Vitaliy Katsenelson (VK), the Chief Investment Officer of Investment Management Associates Inc., and the author of Active Value Investing.

Long but amazingly well-done interview...real perspectives on China and Japan, put in a simple way, with applicability to the rest of the world, more specifically, the US.

I'll summarize VK's point of view on China, but this summary will be as much a substitute to the interview as a trailer is for a classic movie...so do watch the trailer, but don't miss the movie...!

China is a bubble which will burst eventually, due to the following reasons:

• High degree of State Control - on practically everything...which is ok sometimes (like bringing them out of recession much faster) but leads to more bureaucracy and corruption.
• Instances of excesses are too many - from Real estate (building massive malls which are empty to building ghost towns altogether), to infrastructure, to lending and borrowing, to manufacturing, to keeping their currencies low (to facilitate exports). These excesses will be a drag (oversupply) once the music stops...once they have no more bridges to build, no more real estate buyers, etc. And that will happen at some point of time. So its like (VK says) the movie Speed, where the bomb in the bus is timed to blow up if the speed came down below 50 mph. The bus just can't slow down now...
• Poor demand from US and Europe will have a huge impact on China. In China's $ 5 trillion economy, domestic consumption covers about $ 2 trillion. While in US + EU 's $ 30 trillion economy, almost $ 20 trillion is contributed by domestic consumers. [So a 10% decline in the latter, needs practically a duplicate set of the entire Chinese population !] It's really difficult for Chinese to completely replace lack of demand in US and EU with domestic consumption.
• The real estate bubble in China is scaling new heights every year. There are some 64.5 million apartments which do not use electricity, as they are vacant ! Also, there, one needs to pay almost 30-40% as down-payment. So when the real estate bubble crashes, there's going to be real pain...as a lot of money from people is going to get sucked in into the crash...and crash it will, when there is no incremental buyer left in the market.

Japan's also going to get into some real trouble sometime in near future due to the following reasons:

• Japan slowed down in the early 1990s. So the Japanese government lowered taxes and increased government spending, thereby increasing their deficit drastically. To fund this deficit, they sold bonds, initially at a high interest rate, then at lower rates. Most of these bonds were bought by Japanese people themselves as they thought of this as a good form of saving. So the government kept selling bonds, and kept lowering the interest rates (which helped them raise money cheaply).
• Now, every 4th Japanese is over 65 yrs old. Not just are demographics bad, the savings rate is declining, which means the young Japanese is not saving as much as the earlier generation...(why should they, when interest rates are next to zero).
• [I think Japan's deficit is now almost over 200% of their GDP...and still growing.] They need to sell more bonds, which if, the new-gen Japs don't buy, they have to sell outside Japan. 
• In this case, the bonds will compete with those from US and Germany, due to which Japan will have to raise interest rates on those bonds to make them more attractive to the markets....which increases their cost of debt...leads to even more deficit...And the only way out of this cycle is to print more money to repay debt / interest....which will lead to hyperinflation....which will just kill the currency.

Now, if China goes down, it takes with it its major commodity trading partners - Australia, Russia, Canada. Both Japan and China are amongst the largest holders of US Treasury bonds...which they may try to sell...which might make things difficult for US, ('coz it'll push the prices of bonds down, US will have to pay higher interest to sell further). 

As of now, markets worldwide are hoping that demand from China will not subside, 'coz that's one of the major factors keeping the markets up...but once that's done...the markets will realize they were peering down a gun barrel...and the clock just stopped ticking !