What are the headwinds facing China that could slow economic growth, but still could lead to China growing faster than the U.S. Also, what is going on with Turkey and are other emerging market countries vulnerable to the same plight?
In this episode you’ll learn:
- What are valuation differences between the U.S. and China..
- What is a balance of payment crisis.
- What is driving the current economic crisis is Turkey.
- What headwinds does China face that make it more vulnerable.
Investor Who Won Big On Housing Collapse Falters With China Bets – Wall Street Journal
Sudden Stops: A Primer on Balance-of-Payments Crises – Money and Banking.com
Turkey’s currency has plunged, and its row with America is getting worse – The Economist
Turkey’s crisis is not fundamentally contagious – The Economist
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On this episode of Money For the Rest of Us, David examines China and asks the question, is China or the United States more vulnerable? He explains why economic predictions for countries are tough to make, especially for very short periods of time, and discusses the complex topic of “balances of payments.” David also outlines why he believes China to be more economically vulnerable than the US and how China can keep their economy growing in a healthy way.
Economic predictions are tough to make, especially for short time periods
A listener of Money For the Rest of Us proposed this question for this episode. He asks David, “Which country would economically bleed quicker, China or the US?” In response, David considers how China’s economic and political system might impact their level of economic success over the next decade. Irrespective of how China evolves over the next decade, accurately predicting whether the Chinese stock market will do better than the U.S. stock market over the next two years is extremely difficult.
What is a “balance of payment” crisis?
Stephen Cecchetti explains balance of payments as, “An accounting identity stating that net cross-border flows of goods and services, the current account, must be matched by net flows of financial claims.” Simply put, if one country is importing more than it is exporting from another country, it must find a way to finance the difference.
There’s also a flip side to this situation, such as what is happening with China. China is operating on an “current account surplus” because they are exporting more than they are importing. This additional income is then uses to purchase US Treasury bills and bonds. David explains why emerging markets such as those in China and Turkey are both similar and vastly different, and how this all relates to each country’s level of economic vulnerability.
Why is China more vulnerable than the US?
There are 3 main reasons why David believes China is ultimately more economically vulnerable than the United States. The first being because of heavy state intervention. The more government intervention occurs, the less productive companies are able to be. The second reason is that of huge debt balances that are continually increasing. Much of this debt is also being misallocated into primarily state-controlled companies. The United States, however, does a much better job of allocating capital. It’s not a top-down approach. Finally, the population growth of China is slowing and there are fewer workforce aged employees available. These 3 factors combine to form an economically vulnerable China.
China must do this in order to keep their economy growing
In order for China to avoid becoming more vulnerable and allow their economy to grow, they have two choices. David explains that China can either export their way out of their current situation, but given their current account surplus status, this may be very difficult as the other countries would be unwilling to have China account for 40% of the world’s trade export. Or, China can turn inward. David says, “They’re going to have to increase productivity, the output per worker, because the workforce growth is slowing, and it’s hard to increase productivity when you have a misallocation of capital, huge debt balances, and state intervention. And that is the weakness of China.” For the full story on why China is economically weaker than the United States, be sure to listen to this episode of Money For the Rest of Us.
Episode Chronology[1:07] Is China or the US more vulnerable to economic downturn?
[4:55] Why have emerging markets done so poorly recently?
[8:51] The concept of balance of payment is reviewed and examined in a case study of Turkey
[16:20] Emerging markets are doing better than in previous years
[20:35] The 3 reasons why China is more vulnerable than the US
[22:25] What China has to do in order for their economy to continue growing quickly
Welcome to The Money For the Rest of Us. This a personal finance show. It’s on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is Episode 218. Its title: Is China or the US More Vulnerable?
I got an email two weeks ago from George. This is a different George from last week that had the question on rebalancing. This George writes, “The United States economic brawl with China will continue to be a hot topic. So, which country would economically bleed quicker?” National Economic Council Director, Larry Kudlow, said in a Bloomberg television interview on Friday, “Their economy’s weak. Their currency is weak. People are leaving the country. Don’t underestimate President Trump’s determination to follow through.”
George continues, “The Communist Party does some fancy accounting, but is China’s economy weak?” And then later he wrote, “Will Xi’s Leninist Mandarin authoritarian government and economy prove superior to American capitalism and democracy in …” Well, first, in the next 10 years, is what he said.
I responded, “What does superior mean?” and he admits that’s hard to say. Are we going to measure it by which economy is going to grow the fastest because the Chinese economy is starting from a much smaller base. Its GDP, its output per person, GDP per capita, is only about 14%, that of the US. So, even if it muddles through, it could grow faster than the US. So, I don’t really know, we can’t really define superior, but we, in this episode, I want to compare what’s going on with China and other emerging markets, some of the risks there, to some of the attributes of the United States.
I had another email. This is from a member of Money For the Rest of Us Plus, and he wrote, “Given the current president and his American-first agenda, are we in a distorted long period of US market returns … essentially higher returns for the US versus outside the US, or is this period just a great time to load up on emerging markets in anticipation of a positive outcome of all these trade agreements?”
In the Plus episode I did last week, we’d been discussing, well, in that episode and on the forums, this whole idea that emerging markets have under-performed this year. It’s been somewhat painful because they’re down, on a year-to-day basis, 9.2%. This is through August 20, 2018, while the US stock market’s up 7%. So, you have this huge gap.
Emerging Markets Lagging Performance
Back in Episode … it looks like 209, we talked about why invest internationally, and I mentioned the lower valuations for non-US stocks should potentially lead to higher returns over the next decade, but that doesn’t mean every single year, and it doesn’t mean it actually has to come to pass. The US stock market, which sells at a cyclically adjusted price to earnings ratio of 29s, what is the PE, what are investors paying for earnings over the past decade, they’re paying $29, versus less than $15 for China. So, China is cheaper, but maybe China deserves to be cheaper.
Now, one thing to keep in mind is one reason emerging markets have done so poorly relative to the US year-to-date in 2018 is because the US dollar has strengthened. If we looked at what emerging markets have performed in local currencies, they’re down 4.1% instead of 9.2%. And over the three year annualized returns for emerging markets, they’ve held their own relative to the US. US has returned 11.8% over the past three years whereas emerging markets have returned 10.1% in US dollars and 10.8% annualized in local currency, so they’re doing fine.
But US has done better because it’s been getting more expensive, and with the tax cut, that has certainly boosted earnings growth, but both US and emerging markets have been posting double digit earnings growth over the past year and the anticipation by Wall Street analysts is that will continue.
Now, I do an episode on China about every two years. I think the first one I did was Episode 17. I did another one in July 2016, Episode 116, Why Investors Can’t Ignore China, and I profiled Kyle Bass of Hayman Capital. He has a hedge fund that was up 212% in 2007 based on a bet against the housing market. And since then, it’s been kind of a struggle. Through 2016, after 2007, his hedge fund has only returned low single digits and his big bet that we talked about in that episode was against China, that the Chinese yuan would depreciate significantly against the US dollars because of a banking and debt crisis in China. Been a painful trait.
2016 turned out pretty good; up 25%. But then 2017, as the US dollar weakened, the yuan strengthened, Hayman Capital lost 19%. And that’s why it’s so difficult to try to forecast returns, which my listener asked, “Over the next two years, who’s going to do better?” I have no idea. It’s just too short of time period. I’m not sure who’s going to do better over the next decade. All we can do is play the probabilities.
We can look at valuations, we can look at economic developments, and on that front, I recently re-subscribed to Capital Economics. This is a independent economics firm that I used to use as an investment advisor. My former firm carried on the subscription for a couple of years after I departed there, but I haven’t subscribed the last four or five years because it’s pretty expensive. But it’s hard to get data from China. And I feel like we’re entering a turning point over the next several years, as this economic expansion has gone on for nine years now, not that it has to end, but I just wanted better data. So, I re-subscribed to the US service and then I’m taking a look at their Chinese and emerging markets service. And I want to share some insights I gained from that source as well as other sources to see where are we in terms of is the US or is China more vulnerable.
Balance of Payments
First though, we have to review probably the most difficult concept that we discuss on Money For the Rest of Us, and that is this idea of balance of payment. This is an accounting identity, and I’ll link to a source in the show notes. It’s a website called moneyandbanking.com put together by Stephen G. Cecchetti who is a professor of International Finance and Brandeis International University and Kermit Schoenholtz, who teaches at the New York University Leonard N. Stern School of Business.
Let me read a few lines, what they write, and then I’ll try to explain it as simply as possible. They write: “The balance of payments is an accounting identity stating that net cross border flows of goods and services, the current account, must be matched by net flows of financial claims.”
Simply put, if one country is importing more than it is exporting from another country, it must find a way to finance that difference. When exports broadly defined include not only goods and services sold to foreigners but also the income earned by residents on assets abroad on their investments, when those exports exceed imports, the current account is in surplus. When exports fall short of imports, the current account is in deficit. When income falls short of spending, the result is a current account deficit.
So, let’s think about that. If a country imports more than the export, they have to come up with the money to do that. They’re running a current account deficit. They have to finance that deficit somehow, and they finance that by getting capital flows, the financial flows, from other countries in the form of debt, they borrow from outside the country, or they take investment from outside the company. Maybe they sell equity.
But these are broad based accounting identities, that if a country … it’s like the flip side is running a current account surplus like China is, that means that they’re getting money flowing into their country because they’ve now exported more than they’ve imported, so they have this additional income, which then has to be offset. That means they now have a surplus of money that they then invest overseas. That’s why China owns so many US Treasury bills and bonds. They have a surplus that they invest overseas.
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