China and the rule of 70

There is a rule of thumb in finance. If you want to know how long it will take for an investment to double, divide 70 by the annual percentage increase and you’ll get the number of years it will take. This will get you within a few months of accuracy. It works for any other number as well – population growth, or the growth of an economy.

China’s Gross Domestic Product has been growing at a rate of between eight and thirteen percent for the past couple of decades. It averages around ten percent. The math works out, since it has been faithfully doubling every seven years or so.

Here’s a chart I copped from Paul Kedrosky of China’s present share of world commodity resources.

 

 (Click to enlarge)

Try to imagine the year 2018, when China (theoretically) will be using 6.4% more than all the concrete that the world now produces, essentially all the iron ore now produced, plus 90% of all the coal, steel, and lead produced today. Add to that roughly three quarters of the present production of zinc, aluminum, copper, and nickel. I think I’m going to have to knock back a shot of Scotch to imagine that freely.

As vital as these commodities are, consider that China, if it continues on its present growth trend, will use 20% of the world’s oil, a number approaching our own. Try to imagine that with growth in oil production stagnant, despite a geometric growth in spending on oil exploration. That extra 10% will have to come out of everybody else’s share.

Short answer: it can’t happen. None of these commodities are on a trajectory to double in seven years. China would have to take demand shares away from other countries, which would quickly become self defeating as the economies of customer nations would suffer. Commodity prices would soar, driving down consumption.

Take one commodity, lead, as an example. It is vital for storage batteries and electronics. World lead production has been essentially flat since 1976. It hit 3.69 million metric tons in that year and didn’t reach that level again till 2007. It’s not going to obligingly rise to 7.4 million tons per year just because China needs it.

World zinc production has doubled – since 1971. It’s not quite keeping up with the seven-year plan. Aluminum production has been doubling on the 20-year plan and copper around 23 years.

World iron ore production has actually doubled in the past seven years or so. At the same time, the price per ton has gone from below $20 to above $170. Could production double again in the next seven years? I’m doubtful, and I wonder what price we will be paying at that time. Let’s say it does.

How will the Chinese mine and process iron ore minus the lead, zinc, copper, and aluminum needed for the motors, transformers, cables, and electronics of the production infrastructure? The production of any one of these commodities depends on the production of many others. The products that China sells to the world are mostly combinations of multiple commodities. What is the probability of all of these commodities doubling production on schedule? If they don’t, will the prices be doubling, and what will that do to demand for Chinese made goods? And what about that demand? As we slog through the beginning of our lost decade, Europe scrabbles at the cliff-edge of currency collapse. It isn’t a promising growth market.

A couple of decades ago the Chinese government cut a tacit deal with its people. Ditch the pursuit of democracy in exchange for prosperity. So far, they have delivered. Chinese GDP per capita has gone from around $200 in the early 1980s to over $3,500 today. It isn’t evenly distributed, but China does have an emerging middle class and some opportunities for the poor to get ahead, however unsatisfactory by our standards. I can’t see the opportunities keeping up with expectations over the next seven years. Even if the Chinese turn their focus away from exports and towards their own infrastructure and internal consumption they will still require those absurd increases in material supplies to fuel their present rate of growth.

If I were a member of the Chinese political elite I’d be planning my exit strategy right now.

Economic Mysteries

Ὁ βίος βραχὺς,

ἡ δὲ τέχνη μακρὴ,

ὁ δὲ καιρὸς ὀξὺς,

ἡ δὲ πεῖρα σφαλερὴ,

ἡ δὲ κρίσις χαλεπή.

Life is short,

the scope of our art is large,

opportunity fleeting,

experiment fallible,

judgment difficult.

 Hippocrates, Aphorisms, Sect. 1, No 1

A while back I had the audacity to write a piece about our debt to the Chinese central bank. It was called “Mutually Assured Economic Destruction,” and it was wrong. Not completely wrong, but significantly. In it, I compared the U.S. international debt situation to a bunch of guys in a closet, each with a grenade strapped to his chest, each with a finger hooked in the pin of the next guy’s grenade. Everybody wants out, but nobody makes a move for fear of a) not getting out in time, and b) getting his own pin pulled. The grenade, in this labored analogy, stands for the instant devaluation of the dollar if anybody stops buying our debt, and the resulting financial chaos. Nobody likes holding a shaky currency, but nobody wants to end up underneath the stampede away from it, either.

There are a few problems with this story. One is that China has its currency, the renminbi, pegged against the dollar. That means that a dollar is always worth a certain number of renminbi, that number being 6.8 for the past few years. Everyone outside China considers the renminbi undervalued because the exchange rate effectively discounts Chinese exports. The conflict with my previous thesis is the reality that China can’t stop buying U.S. debt unless it is willing to see the renminbi rise. The only way China can maintain the exchange rate is to offer to buy U.S. Treasury bonds, as many as are left on the market, at 6.8 renminbi to the dollar. If the renminbi rises, Chinese exports fall, and Chinese unemployment rises, along with social/political unrest. Catch-22 for Hu Jintao. The Chinese government, in response to widespread criticism, has made a vague statement about letting the renminbi float higher against the dollar. A number of observers have pointed out that they have promised exactly nothing, and that the renminbi has stayed within its previous trading band.

Another problem with the story is that now, in 2010, even the dollar is looking good compared to the Euro, compared to stocks, compared to commercial bonds, compared to just about anything. The interest rate on U.S. 10-year Treasury bonds is around 3.5%, which given long-term inflation is essentially bupkis. That means that people and institutions are willing to buy relative safety in an ugly financial world by sacrificing return.

The Euro is in trouble because of the old problem of responsibility without authority. Back when the Euro was introduced, the European Central Bank had all the Euro Zone countries cross their hearts and promise to keep their debt levels low and their finances transparent. Of course, these were a bunch of sovereign nations with varying degrees of prosperity and starkly different sets of internal political pressures. The ECB had no authority to proactively reach into any nation’s internal affairs and stop them from borrowing. Countries, both geographically and economically speaking, on the borders of Europe acted under the assumption that Dad would bail them out if they got in trouble. The PIIGS, (Portugal, Italy, Ireland, Greece, and Spain) are all deep in debt, with no apparent magic streams of income showing up to get them out. The usual options for countries in this predicament are 1) give the finger to your creditors and declare a sovereign bankruptcy, or 2) crank up the printing press and create enough paper money so that inflation makes your nominal debt smaller in real terms. Euro nations are denied both of these options. The whole wheezing, clanking, shuddering Euro mechanism perseveres or collapses together.

About 20 years ago my then-girlfriend and I saved up a few thousand dollars each and decided to blow it on a trans-European ramble. We hit the UK, France, Italy, Austria, and both West and East Berlin, changing currency all the while. I remember being in Berlin, contemplating some minor purchase, and racking my brain back through half a dozen exchange rates trying to figure out what the damn price was in dollars. The value of money suddenly seemed so airy and arbitrary. I do remember that the Italian lira was pathetic, at about 1500 to the dollar, compared to a handful for francs, marks, and schillings. All these values shifted against each other on a daily basis, according to the whims of…what?

After reading the contrary opinions of dozens of economists, one could be forgiven for believing in capricious and vengeful Money Gods. I mean gods in the old Greek style; proud, devious, horny, sentimental, and cruel. I can imagine ones that would dick with us just to while away eternity. Think of anthropomorphic figures in gold armor or robes, armed with an abacus or a ballpoint tipped spear, endlessly setting us up. Hubris, nemesis, hubris, nemesis – till in our madness humans come up with the mythology of free markets and trickle down economics, churning our portfolios according to the superstitions of priests in pinstripes.

Swinging with the Hellenic mythology for a moment, I just imagined Tony Hayward (CEO of BP) and Lloyd Blankfein (CEO of Goldman Sachs) chained side by side to a rock, like twins of Prometheus. An eagle comes every day to feast on their livers, which grow back every night, ready for the next morning’s payback brunch, forever. Hey, at least Prometheus brought us fire.

Economics a complex subject and half of it is mythology. It also suffers from the problem of too many hands on the steering wheel, all pulling in different directions at different times for different reasons. Our economy is one of hundreds of interlocking economies, markets, and sub-markets, with millions of participants, all with different sets of ideas and information. It adds up to alternating periods of weaving, stasis, and apparently decisive moves. Someone trying to call the next direction needs to integrate rational, semi-rational, and irrational actors, plus other rational, semi-rational, and irrational actors trying to predict the actions of the first set, and each other. Players who realize that most people are operating primarily from the lowest, reptilian third of the brain have a slight advantage.

The only relief from this hash of conflicts is to contemplate physical reality in the long term. The virtual world of electronic financial transactions rests on the foundation of a very real, hard world of physics, geology, and biology. This world resists manipulation and imposes its own thoughtless will in the end.

Making a living in the real world is difficult. People and businesses are limited by resources and physics. It takes effort to move things around and transform them. When the financial firms realized that they could make money, not by investing in real world processes, but by making bets on the real world, or bets on bets on the real world, they created a virtual gold mine. They could disconnect themselves from physics and make money in a world restricted only by regulations. Which, of course, they mostly dismantled. The amount of money flowing through these virtual channels still far exceeds the amount of money connected with real world activities. What killed the bubble was the physical world.

Our economy, as I noted above, is still founded on manipulating real world objects. Virtual money and software can’t feed us, clothe us, or shelter us. The real estate market collapsed when the speculative price of houses exceeded the real world ability of people to pay. Real estate was only the most recent physical asset to be used as a nominal poker chip by speculators. Remember tech companies? Telecom infrastructure? In the 1920s it was the entire stock market, in the 19^th century it was railroads and canals, and in the Netherlands a few centuries ago it was tulip bulbs. All the bubbles eventually returned to the practical value of the commodity.

As will this one. Expect real estate prices to return to their inflation adjusted levels of 1997, just before the bounce. Expect the Euro Zone economies to return to their pre-Euro levels of prosperity. Expect our long-term level of prosperity to be governed by the net amount of useful resources we can sustainably extract from the planet.

“But make no mistake: the weeds will win; nature bats last.” Robert M. Pyle