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The most vociferous commodity bulls tend to be China
bulls, and rightly so given that the price gains achieved across the
industrial commodity complex over the past 12 months can only be justified by
making the assumption that China will continue its rapid growth. China's
importance to the commodity world stems from the fact that the bulk of its
growth involves fixed-asset investment, which means that the growth is
commodity-intensive. The risk to the bullish case is that a substantial chunk
of this growth in fixed-asset investment is linked to a building boom that,
to put it mildly, does not appear to be sustainable. To put it more bluntly,
China's current building boom ranks with the construction of Qin Shi Huang's
tomb* as one of history's all-time great examples of mal-investment.
One of the most prominent bears on China is Jim Chanos, a
hedge fund manager who became well known about 10 years ago after making a
large bearish bet against a highly regarded company (Enron) that he correctly
identified as a giant scam. Chanos lays out his reasons for being bearish on
China -- and, by extension, on commodities such as iron-ore that rely heavily
on Chinese demand -- in the interview posted HERE. One of the key points is that a lot of the
residential and commercial buildings that have been constructed in China over
the past few years remain empty, and yet new buildings continue to go up at a
frenetic pace. There appears to be a complete absence of traditional
return-on-investment considerations, especially in the residential property
market, in that investors often have no intention of generating any rental
income from the houses and apartments they purchase. Renting is thought to be
pointless, because even if a tenant could be found the yield would be so low
that it wouldn't be worth the trouble. Instead, the plan in very many cases
is simply to buy a property, hold onto it for a few years, and then sell it
for a large profit. In other words, in China today the "greater fool
theory" is being put into practice on a phenomenal scale.
Monetary inflation is invariably one of the driving forces
behind a major investment bubble, the reason being that a steep multi-year
upward trend in prices could never occur within an important sector of the
economy (such as real estate) without a veritable flood of new money. The new
money and its price-related effects don't spread evenly over the economy;
rather, some prices always rise faster than others, which can set in motion a
self-reinforcing feedback loop (an increase in price attracts
investment/speculation that leads to an additional increase in price, etc.)
that eventually reaches bubble proportions. If the money-supply growth that
supports the bubble then slows or stops, the bubble bursts and the
consequences of years of poor resource allocation come to the fore.
Alternatively, if the monetary authorities decide to keep the money supply
growing rapidly in an effort to indefinitely postpone the 'day of reckoning',
the eventual result will be hyperinflation.
China has possibly now reached a critical juncture where
the monetary authorities are forced to make a choice between keeping the
fixed-asset investment bubble going and thus risking hyperinflation, or
addressing the mushrooming inflationary pressure by slowing/stopping the monetary
expansion. The choice is being forced upon them at this time by sharp rises
in food prices and the social unrest that such price rises foment in a
country where a large section of the population spends about half its income
on food. We suspect that they will try to avoid hyperinflation and will,
instead, attempt to gradually deflate the fixed-asset investment bubble.
The thing is, bubbles never deflate gradually. This is why
we remain concerned about downside risk in the industrial commodities whose supply/demand
equations have come to be dominated by Chinese demand.
The commodities that would be most adversely affected by
the bursting of the China bubble and the consequent reduction in Chinese
commodity consumption are the industrial metals. Oil also looks vulnerable to
us, but uranium does not because we expect that China's plans to increase its
nuclear power generation capacity will remain in place almost regardless of
what happens in the real estate market. We doubt that gold would be adversely
affected beyond short-term knee-jerk reactions, because gold is mostly held
for wealth-preservation purposes and therefore tends to fare relatively well
when economic problems abound.
Steve Saville
www.speculative-investor.com
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