“Something Enormous” in China

I’m concerned that inflation is taking hold in China and will accelerate into hyperinflation that sends China’s economy over the edge. The following appeared in the Want China Times last week: “China continued to be the largest money-supplying country in 2010 as its M2, a broad measure of money supply, was up 19.46 percent at the end of November from a year earlier. This compares with 3.3 percent and 2.5 percent of annual M2 growth in the US and Japan respectively over the same period.”

The article noted that China’s broad money supply is now “larger than that of the US and Japan” and that the past ten years have seen China’s M2 expand at 19 percent a year as its GDP averaged annual growth of only 11 percent and it “needs only 14.1 percent of growth in money supply to sustain its economic development.”

The article quotes Wu Xiaoling, vice chairman of the Financial and Economic Affairs Committee of China’s National People’s Congress saying that for the past three decades China has “used excessive money supply to rapidly advance our economy.”

One reason for the explosive growth in China’s money supply is its legal requirement to release a $1 equivalent amount of yuan for every $1 increase in foreign exchange reserves. The annual growth rate of China’s foreign exchange reserves hit 28 percent after it joined the World Trade Organization in 2001. That’s why by the end of last September, its foreign exchange reserves reached a level more than 18 times bigger than they were in 1998.

This ramp-up in foreign exchange reserves coupled with the matching yuan injections have created a money supply “phenomenon unprecedented in the history of the world economy.” The article concludes:

The excess money flows into the property market and any assets available for making investments, causing land, housing, and commodity prices to surge.

Since 2003, land prices in Beijing and its surrounding areas have increased nine times. Furthermore, the prices of approximately 70 percent of agricultural produce in 36 cities in China have risen since July last year.

That’s the data that most investment analysts are examining and is the reason you’re seeing red flags fly up in global finance journals. I, however, am in possession of even more convincing evidence that something unpleasant is rising from China’s out-of-control money supply growth.

I stay in touch with a network of business associates throughout Asia and have found that the best way to keep tabs on Asian economies is by talking with small to midsize Japanese manufacturers who outsource operations to the Asian mainland, primarily China. Because Japan is an island economy with almost no natural resources, its business leaders have become experts at watching global commodity price trends to carefully manage inventories. Nobody knows commodity patterns better than people who’ve made careers out of managing resource scarcity.

Last month, my accounting contact sent me a report from a Japanese client whose company outsources the manufacturing of clothing to factories in China. For the first time ever, the client said the company may need to exit China entirely due to runaway inflation. His prices are rising 35 percent per month and many of his larger competitors have already fled to factory contracts in Bangladesh, Malaysia, and Vietnam. Because his firm is smaller, it’s harder for him to relocate his overseas operations. He’s worried that he won’t be able to get out of China before “something enormous happens” in 2011.

Something enormous?

Yes, he said, and explained that he hasn’t seen anything like the current environment since the oil shock of the 1970s. Ahead of the shock “everybody used extra money to hoard supplies they didn’t need. They adapted to make something from the supplies they’d bought, but then all the raw materials were gone in the shock.” He remembers a shortage of toilet paper because the raw materials for it disappeared into the voracious maw of a runaway money supply.

The same thing is happening now. The raw material of cloth is harder to find in China and some of the outsourcing factories are sitting idle for lack of it. The ones still operating are guarding their supply so closely that the Japanese client must pay for materials first in cash, then the factories will make the clothing to order. He calls it a dangerous situation that violates the tradition of partial payment which protects both signers of a contract from undue loss. It’s easy to see how that could unravel in a hurry if a factory is tempted to accept more cash upfront than it has cloth in storage.

I’m watching this closely and will share more as I receive it.

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  1. MarkM
    Posted January 12, 2011 at 1:55 am | Permalink

    Jason, if perception turns out to be reality the implications for our markets would be dire. We how have Hussman, Barrons and others pointing out that now is not a good time to committing additional cash to stocks. Anyway, I think patience and prudence will be rewarded – much lower prices will be forthcoming. Although I subscribe to your letter, I’m back to cash at the end of the day except for a few utilities and the HSTRX.


  2. James
    Posted January 12, 2011 at 7:43 pm | Permalink

    Let me see if I understand what you are saying. If the bottom line is out of control inflation in China, ergo everything coming out of China will cost dearly. How will this affect us?

    Won’t US and other economies simply look for a cheaper place to produce their goods? Or will that inflation translate to the global economy since China is driving the market? Yet on the other hand the bulls in the US say this is the year of the US.

    It’s all confusing as Jason states in his books yet we haven’t seen that major technical downturn to tell us to flee. I’m staying in but watchful

  3. Posted January 13, 2011 at 12:00 pm | Permalink

    Thank you, both, for the comments. I agree that the market is confusing with all of its crosscurrents.

    The basic idea with watching inflation in China is that a grinding to a halt in its manufacturing would harm the global economy at a time when it’s vulnerable anyway. Would outsourcers find new places to make their goods? Yes, but it would not be an easy adjustment. Saying that “we’d move on” is always applicable, however the bridge from here to there could be a slippery one, akin to us having moved on from the banking crisis but not without scars.

  4. James
    Posted January 13, 2011 at 10:01 pm | Permalink

    Agreed Jason. Then why all the optimism over here? Are people just blind to the downside of this?

  5. Ken
    Posted January 14, 2011 at 12:22 pm | Permalink

    Jason –

    Just finished reading The Neatest Little Guide to Stock Market Investing (2010 Edition). I am learning so much. I’m new to investing in stocks since the bottom in 2009, how much do foreign markets affect the US market? This is the first I have heard of the inflation issue in China. Thanks for the book and the advice.

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