Sino-Forest Corp. (TRE), the Chinese tree- plantation operator accused by a short seller of overstating timber holdings, soared the most almost two weeks after Wellington Management Co. said it owned an 11.5 percent stake.
Sino-Forest rose 30 percent yesterday in Toronto after the Boston-based investment firm said in a regulatory filing it held 28.3 million shares as of June 30. The stake was valued at C$90.7 million ($94.5 million) on that date. Wellington, which manages $663 billion, held 79,700 Sino-Forest shares, or 0.03 percent, as of Dec. 31, according to data compiled by Bloomberg.
“Maybe they know something the bears don’t,” Arthur Salzer, Toronto-based chief executive officer of Northland Wealth Management, which oversees C$200 million, said in a telephone interview.
Sino-Forest plunged 82 percent last month after Muddy Waters LLC, a research company founded by short seller Carson Block, said in a June 2 report that Sino-Forest overstated its tree-plantation holdings. Sino-Forest, based in Hong Kong and Mississauga, Ontario, has rejected the allegations. Wellington’s purchase of the Sino-Forest stake suggests it’s the timber company’s second-largest shareholder, according to data compiled by Bloomberg.
“If they believe Sino has more licenses than Muddy Waters thinks they do, there might be value there,” said Salzer, adding he toured Sino-Forest’s plantations in China in 2005 and doesn’t own the shares.
Independent Probe
Sino-Forest has commissioned an independent investigation and appointed PricewaterhouseCoopers LLP to assist. Sino-Forest said June 14 the probe won’t be completed for two to three months.
Robert Toner, Wellington’s vice president and counsel, didn’t immediately return a call seeking comment during the U.S. Independence Day holiday. Stan Neve, an external spokesman for Sino-Forest, declined to comment when contacted by e-mail.
Sino-Forest climbed 95 cents to C$4.15 at 4:09 p.m. yesterday in Toronto Stock Exchange trading, the biggest increase since June 22. The shares, which fell as low as C$1.29 in intraday trading on June 21, have gained 80 percent in the past four sessions.
“When the stock goes down to C$2, the investor base totally changes,” Marcus Xu, Vancouver-based director of equity investments at Genus Capital Management, which oversees C$1.7 billion, said in a telephone interview. “There’s definitely a lot of value you can argue for just on the simple probability of Muddy Waters being wrong on some of these points.”
‘The Risk’
“Right now Sino-Forest could very well be a good bargain for those investors who have the stomach for the risk,” Eric Yan, who helps manage about C$2.7 billion at Matrix Fund Management Inc. in Toronto, said in a telephone interview. “But we need more information from the company and a trustworthy independent source like PricewaterhouseCoopers.”
Paulson & Co., the hedge fund that had been Sino-Forest’s largest holder, said last month in a letter to clients it sold its entire 12.5 percent stake and had lost C$462 million since May 31 on Sino-Forest. Davis Selected Advisors LP held 30.9 million shares, or 12.6 percent of Sino-Forest, as of April 29, according to the Bloomberg data.
“I’m just as certain today that the company is a fraud and that the stock is a zero as I was on the day that we published,” Block said last week in a Bloomberg Television interview with Erik Schatzker.
To contact the reporters on this story: Christopher Donville in Vancouver at cjdonville@bloomberg.net; Matt Walcoff in Toronto at Mwalcoff1@bloomberg.net.
To contact the editors responsible for this story: David Scanlan at dscanlan@bloomberg.net; Simon Casey at scasey4@bloomberg.net.
After the kind of year the coffee market has had, both investors and consumers are finding the price a little hard to swallow. But while coffee may be due to come off the boil for the short term, its long-term investment potential may just be heating up.
That’s because while the short-term rally in coffee over the past year has been all about supply shortages, coffee’s longer-term prospects are all about demand. And, as with a lot of commodities, the focus there is on China. Put simply, the Chinese are developing a taste for the joe.
Crop woes are easing
At their peak in early May, commodity-market prices for coffee(KT-FT2.64-0.02-0.73%) had more than doubled in less than a year. The culprit for the spike was a shortage of supply, as the coffee crop was hard hit by bad weather. Droughts in Brazil and heavy rainfalls in Colombia hurt crop yields in the past year.
“Fluctuations in coffee supply are often larger than the changes in consumption, and are therefore central to price movements in the short term,” said Ross Strachan, commodities economist at Capital Economics in London, in a recent report.
However, welcome rains have come to Brazil and the overall coffee crop this year is expected to be bigger than last year’s. That, combined with a general pullback in commodity prices, has contributed to a drop in the coffee price to below $2.60 (U.S.) a pound from more than $3 in early May.
But while coffee prices could still be due for a further pullback, Mr. Strachan expects them to remain well above their levels of a year ago. That’s because of the demand side of the equation – and China.
China demand percolates
“Demand from emerging economies continues to grow rapidly, as coffee becomes increasingly fashionable,” he said. “In particular, coffee shops are increasingly popular with young people in China, especially in major coastal cities.”
Mr. Strachan noted that while Chinese coffee consumption has been rising for a decade, it still remains low by global standards. Per-capita consumption is less than 2 per cent of that of the United States; even in neighbouring South Korea, per-capita coffee consumption is about 25 times higher. That suggests loads of growth potential for coffee drinking among China’s massive population. (He noted that Starbucks plans to more than triple its outlets in China, to 1,500 stores, by 2015.)
“In contrast then to our expectations for many other agricultural commodities, where the evidence of changing consumption patterns is weaker, we expect buoyant demand to keep the price of coffee high by historical standards,” he said.
“The near-term risks are on the downside, given our expectations of a small increase in coffee production over the coming year and a general investor selloff from commodities. But the chances of a collapse in prices are relatively low.”
Even in the midst of a potentially life-threatening challenge, TransCanada Corp.’s (TRP-T42.35----%)Mainline carries more natural gas than any other pipeline system in North America. Quiet and unseen, it is Canada’s underground energy superhighway, a network of pipes crossing from Prairies to Canadian Shield to urban centres that for more than half a century has carried Alberta’s gas to the eastern stretches of the continent.
The Mainline fuels assembly lines, power plants and home furnaces from the Alberta-Saskatchewan boundary to Montreal and beyond. It has long been so important to Canada that it is routinely compared to the Canadian Pacific railway, both ribbons of steel that have sewn this country together.
Trouble on the Mainline, then, means trouble for the country – and there is indeed trouble on the Mainline. It isn’t moving enough gas. In the past five years, contracted volumes for its cross-Canada service have fallen 70 per cent. Its once-full pipes now run, on average, half empty, and as a result, it is nearly 2½ times more expensive to ship a molecule of gas from one end to the other as it was five years ago.
Eager to slash those costs, some who ship gas through the Mainline are seeking ways to force TransCanada to mothball parts of the system, urging a move that would force the company to erase billions in asset value.
The unrest comes amid a series of profound changes in how energy moves across North America. The Mainline is a 14,101-kilometre system built to connect the gas-rich west with the gas-poor east. Now, however, companies are discovering huge new quantities of shale gas in places like Pennsylvania, New York and even Quebec. And it’s no longer a given that those in the west want their gas to flow east, as companies explore numerous ways to export product to Asia.
In regulatory documents, TransCanada acknowledges that it is “acutely aware of the competitive situation of the Mainline,” although its chief executive officer argues that there’s little reason for worry. “Our system has been in place for almost 60 years,” Russ Girling said in an interview. “It will be in place for another 60 years.”
But increasingly, those looking at shifts in the continent’s energy geography see a threat to the very foundation of his biggest asset. If the east has its own gas, and the west wants to send its gas across the Pacific, what’s left for the Mainline?
“I don’t know how they keep it alive,” said Ian Mondrow, a Gowling Lafleur Henderson LLP lawyer who has represented Ontario electrical generators against TransCanada in an ongoing battle over pipe tolls.
“If there’s a lot of gas in the east which is cheap and easy to move around, then no one’s going to ship gas from Western Canada,” he added. “That would basically end the relevance, to a large extent, of that Mainline pipe.”
The Mainline is a major pillar for TransCanada, providing a fifth of the company’s pretax earnings. But the viability of the Mainline is not merely a corporate concern. It poses a set of vexing but critical questions for Canada’s energy policy. Significant parts of the country have no other source of natural gas. And the health of the Mainline plays an important role in Canada’s economic well-being. Problems with the pipe have already raised the cost of gas in the east, and those costs stand to threaten Canada’s industrial competitiveness.
Further, any move to have Eastern Canada rely more heavily on U.S. gas also threatens to erode Canada’s energy independence. For these reasons, even critics of the Mainline are rooting for it.
“I don’t see any advantage to be gained in the market by TransCanada failing,” said Murray Newton, president of the Industrial Gas Users Association, whose members represent about one-third of Ontario and Quebec’s industrial gas consumption.
“Matter of fact, I think that would be catastrophic for everyone. It would be catastrophic for Western Canadian producers, for gas marketers, for the Canadian market and the U.S. northeastern market. All of TransCanada’s stakeholders have an interest in TransCanada’s Mainline becoming more competitive and more healthy.”
Yet he believes the Mainline is faced with “long-term issues, fundamental issues that need to be fixed as soon as possible.”
Even those who played a major role in shaping the Mainline admit the path forward looks rough. Gerry Maier led TransCanada, first as president, then as CEO, then as chairman, from 1985 to 1999. He is not optimistic about the pipeline staging a strong recovery. The Mainline will, he says, remain – without it, eastern homes from Saskatoon to Boston would go cold and new natural gas power plants might not have enough fuel. But he warns that the coming years for the Mainline will be tough ones.
“I don’t think it’s going to be a picnic,” he said.
The ‘great pipeline debate’
On the afternoon of June 6, 1956, Dr. John Lorne MacDougall, a Liberal MP from Vancouver, dropped dead in a fifth-floor washroom in the House of Commons. His death came as a shock, not least for the fact that the heart attack appeared to be prompted, at least in part, by a pipeline. Mr. MacDougall had been up past 3 a.m. that day, as debate raged over whether Ottawa should build the $118-million Northern Ontario leg of a country-spanning natural gas connection, and provide financial assistance to Trans-Canada Pipe Lines Ltd. for the remainder.
It had been a vicious political fight. Three other MPs were hospitalized as it proceeded, their ailments also blamed on the stressful intensity of the debate. The day after Mr. MacDougall died, the Louis St. Laurent government succeeded in passing the legislation that would enable the pipeline’s construction.
Winning the “great pipeline debate,” as it would come to be called, came with a price: The next year, voters booted his government from office. But for years, the Mainline worked, its energy nourishing a flourishing western petroleum industry and fuelling an eastern industrial establishment.
“We’d have two or three years where we were going flat out and expanding as quickly as we could. Then suddenly you’d hit two or three years where there would be no expansion,” recalls Bob Reid, TransCanada’s former president of energy transmission, a role that had him overseeing the Mainline. The last period of major growth was in the 1990s, a decade that saw a 65 per cent increase in the Mainline’s capacity. Mr. Reid remembers a three-year rush when the pipe was expanded so quickly that TransCanada “used every contractor that was available and all the pipe capacity that was available.”
But even then, there was worry. While the Mainline was growing, a competing natural gas pipeline, called Alliance, was also moving forward. It offered a direct connection to the Chicago area, and it was embraced by gas producers, who committed to fill it. Every molecule of gas flowing into Alliance was a molecule lost from the Mainline. The frenzied construction period had resulted in too much pipe, a possibility Mr. Reid had warned about.
“I testified before the NEB, saying that I was concerned about building all this capacity,” he recalls. He was told his concern was overstated. “I said something like, ‘Don’t be too sure about that. The sky will fall some day here. Because there’s just too much capacity now.’ ”
He was right. In 2000, the year Alliance entered service, Alberta’s gas output peaked. It has since fallen more than 20 per cent, leaving even more empty pipe.
In other words, vacant space on the Mainline is not new. But the advances in natural gas production sometimes referred to as “the shale gas revolution” have the potential to exacerbate it.
Today’s Mainline can carry 6.5 billion cubic feet (bcf) a day across the country. (That is enough to heat more than 26 million average homes.) Yet in northeastern B.C., at least four groups are working to bring gas to the coast to liquefy it and export it to Asia . Their plans are largely preliminary, but as much as four bcf in exports is being contemplated. Another partnership is looking into converting natural gas to diesel fuel in Alberta or B.C.; that could take a further 0.5 to one bcf. Growth in the oil sands will also suck up increasing amounts in future years.
At the same time, the sudden rise of shale gas from plays like Pennsylvania’s Marcellus is driving major changes in the east. For decades, Alberta gas has been transported through Ontario to the U.S., where it is a major energy source for places like Boston and New York. But in May, U.S. regulators approved a project that will allow gas from the Marcellus to flow into Ontario for the first time. Two other proposals are working toward a similar goal.
They aren’t distant prospects: By 2012, their backers hope they have opened a billion cubic feet of capacity from the U.S. into Ontario.
What, then, will be left for the Mainline?
The Mainline advantage
Being the owner of a federally-regulated piece of infrastructure comes with some downsides. One of them is the need to devote a lot of energy to doing constant battle over how best to run your business. Mr. Girling, the TransCanada CEO, is intimately familiar with the system. For more than a decade, he has been one of the company’s prime figures in negotiating and defending pipeline tolls, or rates. That has meant a lot of time spent testifying before the National Energy Board. Once, he went 11 days straight.
“If you look at any regulated utility, it has these issues associated with it,” he says. “They come in and say, I don’t like this about your rates.”
But, Mr. Girling says, “at the end of the day, the cheapest way of getting their gas day-to-day is on this system.”
This is the central tenet of TransCanada’s argument for the future of the Mainline. It’s one borne out of simple economics. A substantial portion of pipeline transportation costs come from the need to recoup the cost of building it. The undepreciated value of the entire Mainline system is about $6-billion, roughly half of its total construction cost. That works out to just under $700,000 a mile. A new pipeline costs roughly $4-million a mile to build; “we’ve been up to $10-million a mile in congested residential areas – if you can even get it permitted,” Mr. Girling says.
In other words, TransCanada believes new contenders will have trouble competing with its legacy assets. An example: This past winter, some gas from the U.S. Midwest flowed to Southern Ontario by way of Manitoba, taking a several-thousand-kilometre detour around the Great Lakes. Why? “Because new capacity [for a more direct connection] doesn’t exist yet, and trying to build new capacity is tough,” Mr. Girling said. On some parts of TransCanada’s pipe, even if the company were to double its tolls, “it’s still cheaper than a new-build pipeline. Way cheaper,” Mr. Girling said.
Mr. Girling also believes shale gas will actually help the Mainline. North-eastern B.C., he says, has the potential to produce triple the gas volumes being contemplated for LNG export. “That’s where we come in,” he says.
The company has already secured 2.3 billion cubic feet in new contracts between now and 2015 from B.C.’s two major plays. It has a further 2.3 billion cubic feet in requests for service – a less firm commitment – between now and 2020. As a result, TransCanada believes the Mainline will begin to stage a turnaround in 2013 or 2014. It’s possible it’s already happening. Volumes so far in 2011 have exceeded those in 2010, although analysts say much of that is related to the cold winter.
Either way, TransCanada believes that even with the advent of shale gas, North America needs so much gas in coming years that Alberta will continue to be an important supply source.
The company has other ideas, too, for drawing more gas onto its system. The company believes it may be cheaper to ship gas from B.C. to Quebec than to the Pacific Coast – meaning the Mainline could potentially feed Atlantic-bound LNG export terminals on the St. Lawrence River. It may even be possible to carry B.C. gas on TransCanada pipes to the Columbia River Gorge, in Oregon, where several LNG terminals have already been permitted.
A ‘death spiral’
The problem with the future is that it takes time to get there. Even if TransCanada is right and gas comes flooding back into its pipes, it likely won’t be for several years. Between now and then, it must find a way to figure out how to keep the pipe economic.
The short-term future for the line is a drama now playing out before the National Energy Board, where TransCanada and some 400 users are battling to set tolls for coming years. It’s a high-stakes battle.
Already, lower gas volumes are causing major toll spikes. The Mainline is entitled to certain revenues every year. If less gas goes through, the cost of each gigajoule rises – the reverse of economies of scale. And as tolls go up, volume tends to decline even more, as some shippers are priced out. That has prompted warnings about a “death spiral.” The end-to-end Mainline toll has soared from 94 cents a gigajoule in 2006 to $2.24 this year.
TransCanada has devised a potential solution: It wants to shift the pain. The Mainline is just one part of the company’s 57,000-kilometre gas system. In the west, it is fed by a pipe network that moves gas across Alberta. In the east, delivery pipes bring product to users.
The feeder and delivery pipes have been more robust than the Mainline. So TransCanada has sought to raise tolls on those segments, while lowering them on the Mainline. Using this strategy, the company believes it can lower Mainline tolls 25 per cent below 2009 levels.
The idea is controversial. Some power producers in Ontario say the delivery toll hike threatens to put them out of business.
Some of the Mainline’s clients, gas shippers, believe there’s a simpler solution, but it’s not an easy one. They doubt the Mainline will ever run full again, – gas flow forecasts are extremely difficult, but consulting firm ICF International forecasts just a 4 per cent recovery between now and 2035, for example – and they think drastic action is called for. Sources told The Globe and Mail that some major gas buyers in Ontario are sketching plans to ask the National Energy Board to force TransCanada to write down part of the value of the Mainline. They suggest $1-billion to $2-billion in unneeded infrastructure could be shut down – things like compressor stations and perhaps even some of the lines that make up the Mainline network – to allow for a reduction in tolls.
TransCanada, for its part, categorically rejects any suggestion that it write down the Mainline, and analysts say a forced writedown would be a dramatically unusual step. What’s more, they say, the TransCanada cost-shifting could actually attract new gas onto the Mainline.
But unless TransCanada and its shippers can somehow come to agreement – a prospect that appears increasingly dim – it will fall to the NEB to decide how to set Mainline tolls. The decision is not just about money, or how to reconcile the interests of Alberta’s gas companies with Ontario’s electrical utilities. It’s about attempting to find a way to preserve that underground energy superhighway.
“It’s a very thorny issue,” said Carl Kirst, an analyst with BMO Nesbitt Burns who covers TransCanada.
“We continue to firmly believe that there’s very much life in this asset. It’s still a critical asset. But all of that will hinge on the NEB’s decision.”
The hard landing that I foresee for China will probably prick the global commodity bubble, which is already showing signs of topping out.
Agricultural product prices have jumped, the result of robust demand, bad weather last year in Russia, recent floods in Australia, and dry and hot La Nina conditions in Argentina.
Industrial metals such as copper were on a tear. So were precious metals, such as silver.
But much of the leap in commodity prices was due to investors and other speculators. Exchange-traded funds had already tied up much of the physical supplies of gold and other precious metals. Futures contracts held by speculators were up 12 percent in 2010 through October, with sharp increases in bullish bets on crude oil, copper and silver. Volatility forced futures exchanges to raise margin requirements on a number of commodities.
The confidence that China would continue to buy huge quantities of almost all commodities has been the bedrock belief of speculators. For example, there were rumors that China was again building its emergency petroleum reserve in the first half of this year.
I’ve studied many bubbles over the years, and concentrated on predicting their demises. Commodities show every sign of being in one.
Rare-Earth Exports
China added to the commodity frenzy last year by slashing exports of rare-earth metals used in high-tech batteries, TV sets, mobile phones and defense products. China supplies 95 percent of these elements, and consumes 60 percent, exporting the rest. Its exports of rare earths fell 9 percent in 2010, but still exceeded the government’s quota by a third.
Chinese authorities cut the export quota for the first half of this year by 35 percent from a year earlier. Japanese manufacturers of high-tech gear are seeking alternative supplies. Of course, China maintains that its ongoing trade and political spats with Japan have nothing to do with the tighter quotas. They were necessary, Chinese leaders say, to sustain rare-earth development and deal with environmental damage caused by mining.
Speculators are starting to take stock of the evidence of a hard landing in China, and industrial commodity prices, including copper, are swooning. As in the past, warnings about shortages in key industrial inputs are magically being contradicted as unaccounted-for stockpiles materialize.
Weather-Driven Supply
Agricultural producers are influenced by global demand and by weather-driven supply. I’ll leave it to others to forecast the weather. But note that ideal growing weather often follows the kind of bad weather we’ve seen lately, and bumper crops and surpluses often replace worrying shortages in a crop-year or two.
Furthermore, China imports (and might have stockpiled) soybeans and other agricultural products that would suffer from a slowing economy. Weakness in industrial commodities can easily spread to the agricultural area. Notice the close correlation among all commodity groups in recent years. The huge quantities of hot, highly leveraged money now sloshing around the world tend to end up on the same side of the same trade at the same time.
As speculators suffer setbacks in one area, they quickly bail out of other, fundamentally unrelated areas to preserve their capital.
Commodity Exporters
The bursting of the commodities bubble will be bad news for developing-country producers such as Brazil, which has thus far largely escaped recent global economic and financial woes but is a major exporter of iron ore and other commodities to China. Developed commodity exporters -- Canada, New Zealand and Australia -- as well as their currencies, may also suffer.
I’ve long believed that a hard landing in China would be preceded by a price collapse in copper and other industrial commodities. Copper prices peaked in February, and Barrick Gold Corp. (ABX)’s agreement on April 25 to acquire copper producer Equinox Minerals Ltd. to gain mineral resources outside its area of specialization is a classic sign of a peak.
Another classic sign of a speculative price peak was the sudden appearance of copper inventories where none were thought to exist. As prices start to break, hoarded commodities suddenly become available for sale by highly leveraged owners. Copper in China was so abundant that bonded warehouses were full. In January and February, extra copper was sold abroad as Chinese exports were eight times the year-earlier total.
Falling Copper Prices
London Metal Exchange bonded warehouses saw copper inventories leap 17 percent in the first quarter. Furthermore, to circumvent tight bank lending in China, borrowers are relying more on available letters of credit to finance copper arbitrage trading and otherwise have the use of the borrowed money with copper purchases as their collateral. If copper prices continue to fall, those borrowers will have to sell their copper on the market to prevent further losses, resulting in still-lower prices.
Meanwhile, sugar topped out in February, and cotton in March. I pointed this out in a speech to an investor conference in April, and several people in the audience questioned my facts. I compared those who hadn’t noticed this peak to Wile E. Coyote of the “Road Runner” cartoons, who runs off the cliff and finds himself suspended in air before dropping to the valley floor.
Further confirmation came May 2, when silver prices, which had skyrocketed earlier, started to collapse and virtually all other commodities followed: crude oil, cotton, copper, grains and even gold.
Moving in Lockstep
As I noted earlier, there is so much leverage money floating around the world that regardless of how it’s managed -- by fundamental, momentum or technical strategies -- it tends to end up on the same side of the same trades at the same time. So, when one of these positions reverses, the effects spread rapidly as speculators bail out of their positions to reduce risk and preserve their capital. Keep in mind that the prices of the wide variety of commodities continue to move in lockstep.
Many commodity bulls see this trend as a short-lived midcourse price correction and have maintained their long positions in copper, crude oil, corn and even silver. But markets anticipate, and it now appears the declines in commodities are foreshadowing a hard landing in China, with the effects spreading globally.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the last of a five-part series.)
Past performance, in China’s case, may be indicative of future results.
In late 2007, the Chinese government was scrambling to control acapital-spending boom. The central bank was concerned about 11 percent growth in gross domestic product, far above its official target of 8 percent, and about money flooding in from exports and direct foreign investment.
By Nov. 1, the People’s Bank of China had raised its one- year lending rate five times and reserve requirements eight times to soak up excess liquidity.
My firm’s research predicted then that the government would curb capital spending and excess liquidity just as exports weakened. Then, as excess capacity mounted, direct foreign investment would disappear and deflation would reign.
That’s essentially what happened in 2008 and 2009, as the effects of China’s fiscal and monetary restraint coincided with the worldwide economic slump. The growth rate dropped to 6 percent, which in China constituted a major recession.
Don’t be surprised if history repeats itself in the next few years.
This time around, some signs of cooling are already apparent. Besides dampened housing demand, the HSBC Flash China Manufacturing Purchasing Managers Index in June fell to 50.1, its lowest level in 11 months. Passenger-vehicle sales grew 33 percent in 2010, when the government subsidized small-car purchases, but only 3 percent this April over a year earlier.
Money, Banks, Stocks
Growth in the broadest measure of China’s money supply has declined from 30 percent year-over-year in December 2009 to 15 percent year-over-year at the end of May. Bank loans fell 25 percent in May from April. Excavator sales fell 10 percent in May from a year earlier, possibly foreshadowing a construction bust. The 14.3 percent decline in the Shanghai Composite Index last year and the 10 percent drop since mid-April also don’t bode well for growth.
Despite all these negatives, with recent data showing first-quarter GDP expanding by a still-healthy 9.7 percent, and consumer inflation at its highest levels since July 2008, China has continued to tighten its economic policy. The government raised banks’ reserve requirements to 21.5 percent in June, the ninth such increase since November. And it will probably continue to tighten until it sees decisive results -- that is, a hard landing.
What will happen next?
No Floating Yuan
For one thing, even though a hard landing could cause hot money to flee the country and weaken the yuan, China will not float its currency. Many Western governments argue that if China allowed the tightly controlled yuan to float freely, it would rise against the dollar and other major currencies. That, the thinking goes, would discourage exports, encourage imports and quickly eliminate China’s chronic trade surplus.
The Chinese have repeatedly told Western officials that they will not be pushed into floating the yuan. They worry that a jump in the currency’s value would wreak havoc on Chinese exporters and force them to move production to cheaper venues. A stronger yuan would also reduce the value of China’s foreign- currency reserves.
Furthermore, exchange rates have only limited effects on import or export prices and, therefore, imports and exports themselves. The key determinant of a country’s exports is the economic health of its trading partners. If their economies are robust, they buy more of everything, including imports.
The dammed-up zeal to own the Chinese currency would dissipate quickly if all barriers were removed and it became clear that a more expensive yuan was not ending China’s trade surplus. Pressure from foreign governments for a stronger yuan would then evaporate, as would interest in owning more Chinese currency in anticipation of higher values. And the removal of restrictions that prevent Chinese from diversifying their investments abroad might actually depress the yuan by encouraging money to flow out of China.
Holding Treasuries
China also won’t be selling its $1 trillion in reserves of U.S. Treasuries in great amounts, as some have feared. The Chinese are well aware that doing so would be disastrous for their economy, because the resulting nosedive in Treasury prices and the dollar would decimate the value of China’s remaining holdings of U.S. debt and other assets. A global depression might well ensue, with China and other export-dependent countries as the biggest losers.
Excess Capacity
Instead, China’s most likely reaction -- to focus still more on exports -- will exacerbate its hard landing. If consumer spending doesn’t increase substantially in the next few years, China will have a serious problem using all the industrial capacity it has built, partly to keep people employed. Capacity is mushrooming so rapidly that even in China’s booming economy, most manufacturers are still seeing flat or falling utilization rates.
This unused capacity portends weak profits and trouble for the loans that financed it. My judgment is that it will once again be used for exports aimed at the U.S. and Europe. And once again, this will add to global excess supply and put downward pressure on prices.
Then China, along with other export-dependent emerging economies, will be competing fiercely in a world of slow growth and deflation.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the fourth in a five-part series.)
