This spread is a reflection of the refinery capacity problems in the United States (which cannot use the cheaper low grade oil). So while US oil has gone from $34 - $54 this year (~+60%), Dubai oil has gone from $29 to $40, which is only a 39% increase. While there is no doubt that oil prices have moved, for Asia they have moved a lot less than for the US and a lot less than most economists think".

Interestingly, this notion recouped well with an idea developed by Charles in a recent piece (see Oil Backwardation). Specifically that the current spike in oil prices was mostly due to panic buying by US oil refineries. Indeed, because it is impossible to "temporarily" shut down a refinery (if you do, when the refinery starts working again, it usually explodes), fellows running a refinery are forced into panic buying anytime a threat of a disruption appears. And this summer has been rich in possible disruptions (from the Yukos crisis, to the Nigerian tensions, to the hurricanes...).

In such temporary panics, it stands to reason that the contract for immediate delivery will stand at a much higher price than the contract for delivery in the distant future. This phenomenon in commodities is called "backwardation". We have computed the backwardation for oil, using the spot price and the average of the sixth contract, lagged six months, and it gives us the following graph. Today, oil backwardation is over two standard deviation from the norm. Hereby highlighting that the current rise in oil prices is a period of panic buying. Not a smooth uptick in demand from a new important player.
 

The idea that China isn't out in the world market buying oil at whatever price is also disproved by anecdotal evidence (and common sense!). Indeed, as the price of oil increases, the demand for oil in China is bound to slow. So far, examples are mostly anecdotal; but for example, the South China Morning Post ran a story earlier this week highlighting how Hong Kong's fishermen were no longer going out to sea for the simple reason that the cost of the fuel to run the boats was now above the price of the prospective catch!

We firmly believe that

1. the current spike is not linked to a big increase in demand from China,
    

2. that China's demand for oil is more price-sensitive than the market currently acknowledges and
    

3. that the Chinese government will continue to invest in large energy projects to ensure China's energy independence (large dams, nuclear power...).

Misconception #2: China Will Remain A Deflationary Force For the World Because of its Excess Labor Pool

One of the more commonly believed assertions about China is that the country has an excess labor pool of between 150m to 300m people, and that labor costs can therefore not rise. From there, most people assume that China will remain a deflationary force for the world.

The interesting thing is that this belief remains prevalent despite the fact that in recent months, labor costs in China have been rising! In other words, why let the facts get in the way of a good prejudice? Indeed, all over the Pearl River Delta, and in the Yangtze River Delta, a number of factories have had to deal with striking workers, asking for increases in pay from the usual RMB600-700/month to a slightly less inhumane RMB 1000/month. That's a hefty 40% increase in some cases!

Now, why were workers able to get away with strikes, and wage augmentations? The answer there is simple: most of China's booming coastal provinces are suffering from an acute shortage of labor. A recent study published by the Chinese Ministry of Labour and Social Security showed that Guangdong (the province behind HK) suffered from a lack of 2m migrant workers (10% of the total labor force). Shenzhen alone (the special economic zone directly on the other side of HK) is short of 400,000 workers. But how can this be, when China supposedly has an army of 200 million people sitting in the countryside, waiting to come work in the cities?

The first explanation is that the "army of unemployed" people is willing to come work in the cities...but at a price. And this price apparently no longer is RMB 600 (or US$75)/month. It might have been that price when the harvests in China's countryside were really weak and the farms could not support a large staff. But as we have been highlighting in numerous Daily reports over the past month, the harvest this year is proving to be very satisfactory. So farm hands need not come to the city to look for gainful employment. They can find that at home.

The second reason behind the misconception could be linked to cultural prejudice from Westerners confronting China for the first time. Indeed, most Westerners on their first visit to a Beijing train station will most likely be overwhelmed by the size of the crowd, and frightened by the number of "farm hands" sitting around, waiting for potential employers to swing by and pick them up. By the same token, most Westerners on their first Chinese factory visit will most likely be struck by the extent to which most workers look alike, and inter-changeable. And here, at the risk of sounding inconsiderate and unveiling some great secret, it is also true that, to most Westerners who experience China for the first time, most Chinese people do tend to look alike (same hair, same color of eyes...). And from the above experiences a belief/prejudice is born: that Chinese workers are totally interchangeable. But of course, they are not! For a start, workers often need to be trained; and this takes time. More importantly, different industries require different kinds of workers. Manufacturing, electronics, textiles, etc... usually hire 15-30 year old women. Construction hires 18-30 year old men etc...

And this is where it gets interesting. Because, as is well known to all, China embarked on a "one child policy" in the early 1970s. And more often than not, this "one-child" ended up being male. So today, industries that depend on young women workers are finding it tougher to find workers. And this problem is a structural one which argues for a drift higher in manufacturing wages.

In any event, both anecdotal evidence, and recent government reports point to the fact that large factories in coastal regions are having an increasingly hard time to find workers. Or if they do, these workers come at a higher price (i.e.: RMB 1,000/per month instead of the previous RMB700). So the myth of China's ever deflationary pool of labor is melting before our very eyes. Yet almost everyone continues to talk about it as if it was a pre-ordained, and ever-lasting certainty.
 

Misconception #3: China's Massive Bubble Infrastructure Building is Very Deflationary

Since we launched GaveKal a few years ago, we have had the chance to witness several bubbles come and go. And, as we have never tired of writing, bubbles are never the same... but they do show similar patterns. In fact, we find two different kinds of bubbles. The first kind of bubble takes place on non-productive assets (typically land & real estate, but also tulips, or gold...). The second kind of bubble takes place on productive assets (canals, railroads, telecom lines). In the first kind of bubble, prices are bid higher due to a "rarity" factor. In the second kind of bubble, prices rise because investors misjudge the future returns of the assets. When the bubbles burst, in the first case, we are left with no more land (or gold, or oil...) then what we started with. In the second case, we have put into place productive capital which can still be exploited, either by its current owners, or by a new set of owners.

An example of the first kind of bubble would be the tulip-mania of 18th century Holland. An example of the second is the US and UK railway bubble of the 19th century or the telecom bubble of recent years. In Holland, when the tulip bubble burst, people were left with their eyes to cry with. In the US and the UK, when the railway bubble burst, the domestic economies still had trains to ride. All around the world, when the telecom bubble burst, consumers were left with the ability to make cheaper calls and transfer data cheaper. In turn, this led to much higher levels of productivity (i.e.: birth of Indian and Philippino call centers), growth and a higher standard of living.

Another difference between bubbles is in the way that they are financed:

1. If the bubble is financed by banks, when the bubble bursts, the banks' capital disappears and the velocity of money collapses.

2. If the bubble is financed by capital markets (corporate bonds, junk bonds, and equities...) those owning the overvalued assets take a beating. If they hold those assets on leverage, then the assets get transferred to more financially sound owners. Otherwise, the buck stops with the overpriced assets' owners.

So the worst possible bubble (i.e.: the most deflationary) is a bubble in unproductive assets (gold, land, tulips...) financed by banks. The best possible kind of bubble (i.e.: one that does not hurt growth too badly) is a bubble in productive assets, financed by capital markets.

The Japanese bubble of the late 1980's was a "bad" bubble. It was mostly in real estate and was financed by Japanese banks. By contrast, the US bubble of the late 1990's was a "good" bubble. It was mostly in technology (too much telecom and computing expansion) and was financed by capital markets (junk bonds and equities). This simple difference might explain why Japan is still mired in a deflationary bust, while the US economy barely shrank as it adapted to a post-bubble world. But what of China's massive infrastructure spending bubble?

So far, China's bubble has not really been on land and real estate prices are still decently low except for a few isolated pockets (i.e.: Shanghai). The bubble has instead taken place in infrastructure spending (i.e.: the world's fastest train links Shanghai to its brand new airport), factories (i.e.: China has over 300 car manufacturers) and construction.

And the capital spending has been financed mostly by one of two ways: either foreign direct investment, or direct bank lending (or both at the same time).

Which brings us to another point that we have made on several occasions before (see our June 2003 Quarterly Strategy Chart Book). Namely that China's banks are not like banks in other countries. In China, banks are an extension of the government. Indeed, the way the system works in China is that, instead of granting a subsidy to a struggling steel producer in Manchuria, the government pressures the local bank into giving the steel producer a loan. As a result, instead of having a debt to GDP ratio of 40% (or 105% like Italy, or 120% like Belgium...), China's banks carry bad loans on their books equivalent to 40% of GDP.

And this brings us to an important question: who will own China's bad assets once the cost of capital moves above the returns on invested capital? As expressed above, a number of investors today fear that, because of the impressive capital spending wave taking place in China, returns on invested capital are bound to fall. And, in turn, this fall in ROIC pushes the world closer to a deflationary bust. But will it?

It seems to us that investors are taking their experiences (such as we described in our "must-read" paper, Theoretical Framework for the Analysis of a Deflationary Boom) of the supply-side cycle and applying that understanding to their readings of China. In a supply-side cycle, the economy is led by capital spending. New inventions and new territories create a double impetus: the capacity to satisfy the demand for the new products (or to develop the new territories) has to be built together with the capacity needed to create from scratch such a new stock of capital (so far this mould fits China).

As long as the return on invested capital is perceived to be higher than the cost of money, there is no problem in the system. However, there comes a time when the returns on investments fall below the cost of money. Sales start falling in the capital goods sector and/or in real estate. Needless to say, given the long delays, the momentum in the capital spending sector does not stop immediately and as such overcapacity is created (so far so good, for the China parallel).

Given that large proportions of investments have been financed by "an inflation of debt", we run into a debt crisis. The creditors are alarmed and try to call their loans; as a result money supplies shrinks. Banks go bankrupt. The price level goes down. The weight of the debt in real terms goes up faster than the repayments can be made. More bankruptcies follow. In such a world, happiness is a positive cash flow. In a supply-side cycle, the economy moves in three phases:

1. The asset inflation (or debt inflation) part of the cycle always takes place with the assertion that "this time it is different", which for most of the period is true. In the upswing we always find two components: the belief in a new paradigm and the use of financial leverage. Indeed, the excess returns earned on assets acquired through leverage lead eventually to a massive increase in borrowing, and later on to overcapacity.

2. The crisis occurs when most of the market participants suddenly realize that the cost of money is now higher than returns on capital. Usually the crisis is short. The chief result of the panic is to change massively the relative prices of assets between the new paradigm sectors and the rest of the economy.

3. The debt deflation can then start: the cost of money moves even higher above the return on invested capital. The prices of assets put as collateral on loans collapse. Bankruptcies and bank failures multiply. The money supplies contract. Prices fall across the board. Real interest rates go up, leading to more bankruptcies...

The end of the process takes place when the productive assets have moved from financially weak to financially strong owners. The rate of return on invested capital then moves above the interest rates (at a very low nominal level). And the next cycle can begin.

But the challenge in China is that the cycle can not unfold in this way for the simple reason that the current end-owner of all the "weak assets" is the government. And the government will unlikely become a "forced seller"!

The recent sharp increase in capital spending in China has not been financed by private lending institutions but by state-owned government banks. A big part of China's growth is occurring either directly on the government's balance sheets (i.e.: spending by local authorities, towns and regions...) or indirectly on the government's balance sheet (i.e.: commercial banks). If/when the returns on capital fall below the cost of capital, we are unlikely to see a fire sale of leveraged assets typical of a supply-side cycle deflationary bust; if for no other reason that a lot of the assets are on the government's book. In China, the government is the loser of first resort.

So the important question on China is: what will the government do with its unproductive assets once their returns are below the cost of capital? Using History as a guide, it seems likely that the government will a) sell off its bad debts for cents on the dollar to foreigners willing to buy them (and take the loss on its books) and b) print money to cover its losses and ensure that the cost of capital does not rise too fast.

In other words, China is not experiencing a supply-side cycle but is instead going through the expansionary phase of a demand-led cycle. The demand led cycle is what the Western World experienced in the 1960s and 1970s; and it is a cycle that most of us have forgotten about. The demand-led cycle was characterized by excess demand more or less all the time. This excess demand found its sources in an ever-present budget deficit which, more often than not, was monetized by a central bank very seldom independent from the political powers.

As such, a demand-led cycle is not deflationary. Instead, it is highly inflationary! When, in the 1970s, the British government paid British Leyland workers to produce cars they themselves did not want to drive, the end result was highly inflationary for the UK economy. Why? Because money was being created out of nowhere without a corresponding good, or service. We believe that the same thing is occurring today in China.

We consequently feel that investors who worry about China exporting more deflation in the future because of today's mis-allocation of capital might be missing something. China in the near future will likely experience an acceleration in its inflation rate (not a deceleration).

And this is what is already coming through in the data. China's inflation rate is accelerating!

Misconception #4: China's Bank Bad Loan Situation is a Massive Train-Wreck Waiting to Happen

For reasons hinted at above, we are always surprised by the apparent concerns of the financial community at the state of the Chinese bank's balance sheets. We know that those balance sheets, just like the balance sheet of the Italian or Belgian government, are not a pretty sight. But frankly, they are more or less the same thing: in Italy, the government does its subsidy spending to Fiat or Alitalia directly. In China, the subsidizing is done through the intermediary of state owned banks. There is precious little difference and the end results are usually the same: wasted capital, lower overall returns on invested capital, and a structurally weak currency. To put it another way, we have a hard time seeing when China's bank loans will become a problem. And for whom?

Misconception #5: The RMB Should Revalue in the Next 12 Months

Talking to our clients around the world, it feels as if most investors consider a long RMB-short US$ position as a fail safe, one-way trade: tails (i.e.: a RMB revaluation) I win, and heads (the peg stays where it is), I don't lose... And fail-safe trades usually make us nervous (we tend to like the trades where there is a lot to lose... for this reason, we still have to come to work every morning!).

There is no doubt that, today, the RMB is very undervalued against almost any major currency. But this undervaluation need not be resolved through a currency revaluation. It can just as well be resolved by a constant grind down of the currency's value through inflation. And, right now, it appears that this is the course that Chinese authorities have decided to embark upon.

More importantly, it is hard to see what will make them change the course; by taking care of the overvaluation through inflation, the process is gradual, painless and face-saving. All aspects that a revaluation of the RMB does not offer!

As we look at it, an RMB revaluation is hardly a one-way trade (just like betting on a Ringgit or Baht revaluation in 1995-96 proved to be costly). Betting on a steady increase in Chinese inflation is, we believe, a safer-bet!

Open Question: Is China Facing A Slowdown in Activity?

Starting the year, most investors were convinced that China was going gangbusters and that there were few risks ahead (see The Circle of Manipulation). However, there was a risk: the fact that, as highlighted above, Chinese growth was very liquidity driven. And because food price inflation was accelerating, the government would likely clamp down on liquidity growth.

By the summer, most China related plays (H-shares, copper, Baltic...) had sold off heavily and most analysts were talking about a hard landing for the Chinese economy. At the time, our premise (see China's Policy Makers Next Move) was that the Chinese economy had slowed down because the central government had nationalized the transport infrastructure system to distribute food around (following four years of bad harvests). In consequence, a lot hinged on the harvest that would come out in September. Fortunately, the harvest was excellent. And the Chinese policy makers rapidly changed their rhetoric. The PBoC governor came out and announced that the "soft landing" had been achieved. Hu Jintao announced that there were no need for higher interest rates, etc...

And sure enough, China-related plays took off again. H-shares rallied, Copper made new highs, Baltic rebounded etc... But now, the recent rally seems to be fizzling out. Should we therefore conclude that our optimism was misplaced? That Chinese growth really is starting to roll over?

As things stand, we do not believe in the risks of a major slowdown for the Chinese economy. And this for the following reasons:

1. Chinese broad money supply growth is re-accelerating after seven months of consecutive decline. And given that China has fixed capital controls, the fact that there is more money into the system means usually means a boost in domestic activity.
    

2. The growth in Chinese Reserves is also re-accelerating (thanks in part, to stronger than expected FDI, and stronger than expected exports to the US). In turn, this should lead to further gains in domestic money supply growth.
    

3. While some indicators (copper, H-shares) have been weaker lately, others (Baltic freight rates, Dram prices...) have been rising. Taking a slightly longer view, it appears that H-shares and metals had a very solid August and September. The current downturn could be therefore be little more than a squeeze on the more speculative players in the field. Meanwhile, the "China-plays" that did not spike up in recent months continue to move ahead.
    

4. If our clients agree with our premise that China's cycle is a typical "demand led" cycle, then comfort can be found in the fact that the government's rhetoric has changed markedly over the past six months. Gone are the days of slowing down the economy. Even the high growth, previously targeted sectors such as autos or construction are getting a little bit of government help (i.e.: car import duty taxes are set to fall from 37% this year to 30% in 2005 and 25% in 2006).
    

5. Another explanation to the Chinese stock markets recent disappointing performance might have less to do with the state of the overall economy and more to do with the fact that profit margins in China are currently coming under pressure. After all, in recent months, Chinese companies have had to face rising oil prices, rising metal prices, higher transportation costs, and rising labor costs! No wonder they are sucking wind!