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The dangers of piggybacking on China

July 20, 2009

NEWS FROM THE GLOBE AND MAIL

AVNER MANDELMAN

00:00 EDT Saturday, July 18, 2009

Avner Mandelman is president and chief investment officer of Giraffe
Capital Corp. and the author of The Sleuth Investor.

amandelman@giraffecapital.com

Risky countries are run like businesses, and risky businesses are run
like countries. That's why you can gain by analyzing most businesses'
internal politics, and by analyzing most countries' businesses.

And regarding the latter: What would you say about a business bulging
with cash, whose unions have become restive because of layoffs, and so
its management has decided to blow a lot of the cash to produce
inventories it can't sell, just to keep the unions from rioting?

This was the situation in China last year, as this column pointed out.
Several Canadian e-mailers objected then to the analogy, but more than a
dozen e-mailers from China wrote and provided corroborating information
about local conditions, suggesting that the forecast was likely correct.
And indeed, since that time, the Chinese stock market has halved in
value. It has regained some of its melted worth but is now teetering
again as riots have begun to spread.

Is this a buying opportunity? After all, China's coffers are still
bulging with cash - so much so that it keeps buying resources in
preparation (so say several brokerage reports) for the growth ahead and
to diversify away from the bad U.S. dollar.

Well, the argument that China is getting ready for future expansion can
make sense; ditto the argument that it is safer to hold copper, oil or
steel than U.S. dollars.

However, there is another way of looking at it: If China were a
business, you would say that its management has been speculating by
exchanging cash for raw materials, betting that the latter will go up in
price more than the cash.

There are two reasons I mention this: The first is the investment
implication; the second is the catalyst that makes such a mention
particularly timely.

First, I've seen a number of articles suggesting investors piggyback on
China. Because the massive Chinese purchases of resources are likely to
drive up their future price, you, too, should get in there for the
coming ride, these articles claim.

However, I'd propose that you take such advice with a big grain of salt
because recent information coming out of Stratfor, the private
intelligence service, suggests that China has been pushing its banks to
lend even more recklessly than before by relaxing the credit criteria
further to keep the economy growing by hook or by crook. Indeed, there
is almost a whiff of panic in such forced lending, especially in the
face of recent riots.

Although the lending is notionally comparable to the U.S. stimulus,
there is one major difference: Americans, living in a democracy, will
not riot when the economy tanks and unemployment rises to 12 per cent or
higher. American citizens would simply vote their leaders out. The
Chinese, however, might riot - and many have already done so.

Now, admittedly, the recent riots are by Uyghurs, who are an oppressed
Muslim minority, so a case can be made that their grievances are
cultural and not representative of the population as a whole. But the
same arguments were made last year, when this column was first
forecasting riots.

I think that what we are seeing now may be only the beginning -
especially if the Chinese economy weakens, as it must, when many of the
recent reckless loans are written off.

And since the main engine of growth for the world economy and for
resources prices is still China, any economic and political weakness in
China could create a mess comparable perhaps to Freddie and Fannie's
writeoffs. In which case, China, like a regular company burdened with
too many inventories of raw materials, may have to sell what it has
accumulated for speculation.

There are still individual resource companies providing value. But you
should buy them only for their own merit, after researching them
individually, not because you wish to speculate on China's resources
speculation.
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