Spend it quickly.

Baruch was pondering the apparent excesses of the Chinese stimulus package today, and stumbled on what may be a most interesting hypothesis. Possibly, if he is right, the most important investing insight for the next 10 years.

The Chinese stimulus quite incredibly big; $600 billion is 15% of Chinese GDP. But it is being more than matched by “private investment”; for every dollar spent by the government on a project, 3 are being lent by the banks, either willingly or unwillingly. So unlike the US trillion dollar package, it is hugely leveraged. Did you know they will be spending $146 billion over 3 years on their 3G wireless rollout? Bet you didn’t. That’s a lot of money. But it was a dry, contextless datapoint until today, when Baruch found out what that level of network spend actually means: just 1 of the 3 wireless operators there, China Unicom, will be building 125,000 base stations in year one of the rollout. This might bore you but hear me out. That’s more 3G base stations than all the operators in Western Europe have rolled out in the 9 years since the 3G wireless standard has been in existence.

The majority of phones sold in the past 3 years in Europe have been 3G enabled, and Baruch imagines that 60%-70% of EU wireless subscribers are at least partly on 3G networks. That must be like 150-200 million people, and it isn’t like you get a weak signal over here. OK not all of them are heavy data users but this is changing rapidly. That’s more network capacity than Unicom 3G subscribers could possibly want until like, 2014-15, given the rosiest takeup scenario; true, there may be many more Chinese people than there are Western Europeans, but right now there are precisely zero “proper” 3G subscribers in China, ie those that aren’t on operator sponsored trials. This is future-proofing a network taken to an absurd degree. There is no way that this can possibly make any financial sense, in the way we currently understand capital budgeting.

And it struck Baruch; these guys are in a hurry.

Think about it. China and the US are locked in an embrace I discussed here a couple of months ago. China Inc owns the biggest pool of USD assets outside the US that the world has ever seen. It is their nest egg stored away for a rainy day, the reward of 10-15 years of saving and hardscrabble labour, making widgets and assembling them into finished goods for largely American consumers. For their part, American consumers desperately needed someone to backstop their addiction to buying stuff, someone who would lend them the money. It was vendor financing on a epic scale. And while the US consumer junkies needed their fix, their Chinese “pusher man” formed an economy dedicated to supplying it.

This created a mutual co-dependency, which is sadly no longer viable. The Americans now are desperate to reflate their currency and thereby their economy, while the Chinese are equally keen to diversify out of their dollar assets into something else. The problem, the prisoner’s dilemma, is that in doing so each would hurt the other. The US, on losing its lender of penultimate resort, would see their bond yields balloon, potentially choking off any recovery, whereas if the US successfully inflated their debt away, the Chinese would see their nest egg devalued; they would be the neighbours beggared. The more vulnerable partner in the embrace has to be China, however. Inflation is the time honoured tool of the borrower state to weasel out of paying debts; the temptation is eventually irresistible. The US economy is likely more flexible than the Chinese, and likely to better withstand the shock of the breakup better. Finally, the chinese government fears unrest and revolution more than any US administration; there’s many a precedent of the officials deemed responsible losing more than their jobs when things go wrong.

So the Chinese know they have the weak hand. They have a lot of money right now that may well be worth less, far less, in possibly an undefined period of time. It’s a version of the problem faced by Richard Pryor in Brewster’s Millions, but on a galactic scale. Baruch will call it the “Brewster’s Trillions” dilemma (OK, it only bears a very vague similarity to the movie, but I love the clip). And like Brewster, like any sane person would do, Chinese are going to spend it before it goes away, but unlike Brewster, they hope they’ll end up with at least something of value at the end of it.

That’s why they are investing more than they could conceivably need, for example, on a 3G network which under current plans will be simply the very best in the world, and the most under-utilised — a 6 lane superhighway to every town in a country currently without cars (if you see what I mean). That’s why the previously successful rural subsidy for electronic goods, ostensibly in the name of rural development, is now being duplicated in the big cities where there isn’t any developmental need for it except to goose demand. It’s why the latest plan for renewable energy involved a 2000% increase in the production of solar energy in China from 1-2 gigawatts today, to like, 20 in I forget howevermany number of years (or is it 20 to 200? I don’t remember, but a gigawatt is a lot, I think), a plan that dwarves any other national energy proposal in any other country, on technology that for most people just isn’t efficient enough to justify without subsidy. It isn’t a waste, in their mind; it would be a waste not to use it while they have it, to try and turn it into something worthwhile and lasting.

Money just became very cheap in China; their inflation expectations have clearly skyrocketed and it is about to shift from the global lender of last resort to the global consumer of last resort. And as we all know, its consumer expectations of inflation that matter more than the actual expansion of the money supply in an inflationary environment. Previously a deflationist, Baruch wasn’t sure about where he stood on the inflation-deflation debate, but given all of this he may have just become a radical inflationista.

11 responses to “Spend it quickly.

  1. Alan Murdock

    What if accounting gimmicks were regarded as incidental, and the objective was to acquire resources required for the nation to determine its own destiny?

    Is Baruch AKA Tom Friedman?

  2. No, Tom Friedman and Baruch are different in too many ways to count. Baruch’s moustache is waxed and curly at the ends. Friedman’s is more of a beer strainer.

    You could view China’s accumulation of natural resources as a push for national greatness or independence at least. But one could also view it as a preparation for a coming global inflation they know to be inevitable. After all, commodities and real assets are very good inflation hedges.

    Inflation and devaluation are not accounting gimmicks, but you may not be referring to that, Alan. Can you elaborate?

  3. yorksranter

    And they’re buying those Node-Bs from….ALCATEL-LUCENT AND ERICSSON. Not Huawei or ZTE and certainly not Motorola or Nortel. We weren’t expecting that.

  4. Lots of things don’t make financial sense, like clean water, clean air, rural electrification, R&D…

    Cell phones and internet access have entered the category of economic need. Technology road maps and standards for the next decade indicate a long life for 3G UMTS WCDMA and LTE. While this level of ramp-up is overkill, this is a better use of money than causing stock and real estate bubbles or paying financial industry bonuses.

  5. yorks, you might think that. I couldn’t possibly comment; while Baruch may own those names, UB is not a dodgy tipsheet for stock plungers. You are right of course, though I think the Chinese guys are also getting a fair share.

    LY you make my point. But there are other benefits to the Brewster’s Trillion gambit too, notably a reversal of the trade imbalance as you buy up equipment from overseas (see yorks above on who is actually benefitting).

  6. decoupling deja vu etc etc

    This story is the same as last year , when the immense potential of the Chinese domestic demand was supposed to save the world:This didn’t happen of course.
    Now the new story is that they will replace paper wealth with physical stuff.
    Nice idea , but if physical stuff will be left to rust then that’s not a great trade either.

    Hence your insight on the current trade by the Chinese is essentially based on the latent assumption that all this stuff ( 3G, coal an copper inventories at highest levels ever, solar power) will be used up by the domestic Chinese demand: So we are back to June 2008 , with oil above $100, and people with wild eyes looking at China.

    A final point to make is the assumption that “China” is one monolithic thing out there.
    But think of this : If the 3G network stays underutilised for 2, 3 or even 10 years, while the $ collapses , how will the reserve manager that “avoided ” the $ collapse and therefore benefited in terms of money and prestige pay the 3G investor that will have suffered horrible returns for all these years?
    Moreover, how you convince ex ante the 3G investor to built this super duper network just to hedge the risk that the $ collapses.
    I don’t think that anybody , even a Chinese semi-state entity makes investment decisions in such a way.

    Expected Chinese demand drives investment , and investors have to gauge if this demand will materialise and if profits will be made.

  7. “While this level of ramp-up is overkill, this is a better use of money than causing stock and real estate bubbles or paying financial industry bonuses.”

    There’s no hard law on this. Over-investment is over-investment, and a bubble is a bubble. One case may see more efficient use of capital within a narrow range, but in the end you’ve still got a bubble. Besides, your comment seems more to be a swipe at America’s use of capital, and it’s hardly the case that China is not in the process of creating its own real estate bubble (or numerous other bubbles) with its policies, or that the Chinese are not in myriad other ways throwing money at people – individuals and groups of individuals – who are in reality drains on a market economy.

  8. Hi,

    I am openly ignorant of the finer details of economics but pose the following thoughts –
    1. The population of Europe is around 591 million, the population of China is around 1.31 billion (Wolfram Alpha). Given that China’s population is 2.2 times that of Europe, and they are trying very hard to rapidly become a (if not the) leading world economy then this sort of spend does not look so silly. I grant you that their wealth distribution is ridiculously skewed and that vast (major proportion) numbers of the population still live in agrarian poverty but the Chinese are doing all they can to move their economy through 100 years of development in as short as time as possible. One way to do this is to spend on core infrastructure required for the 21st Century, and IT and the ‘knowledge economy’ that goes with it is critical for a move away from manufacturing to higher value added competitiveness.

    2. My comments above make me think of the opening up of the US, and the building of railroads. Sure – possibly far too many were built; many companies went bust, but that infrastructure risk and leap was critical for opening up frontiers and provided an infrastructure that still exists today.

    3. The Chinese are ‘in a hurry’ because their economy that has garnered some considerable wealth from the folly of the West and they know they need to pull themselves up by the bootstraps to ensure that this no flash in the pan. In my view, they know they are in a very precarious position, and need basic infrastructures of health, education, roads, social security and technology etc because their people have tasted success and like it.

    4. IMHO – Issues like the promotion of clean energy, and of high tech infrastructure – all of which are being promoted in the West, makes eminent sense, because, unlike the in the West, you do not have to rip out or replace old infrastructures – you just leap frog to the newest one – which is far cheaper.

    5. Currently China appears to be very pragmatic, which constantly surprises me, but we have yet to see how the Chinese population or their masters deal with this transition as it gathers pace. Paraphrasing the reputed Chinese proverb – “We live in interesting times”!

  9. MPO, why do you think I am taking a swipe at the use of capital in the US? I am not making any value judgements at all, merely trying to think in ways that might make me money. re China, you are right about over-investment possibly causing a bubble, I think.

    Decoupling, actually I think that in many ways in industrial policy in general, China can act “monolithically”. Also note that the Chinese operators in many cases lease their networks; they don’t own them outright. The actual owner of the network is another, more shadowy entity.

    Essentially the return on capital of any project depends on the opportunity cost of that capital which is what we encapsulate in the discount rate for that project. China is going to lose a lot of that money through inflation if it just leaves it there; the opportunity cost for spending it is very low, therefore the threshold for investing it is too. Money is cheap in China!

  10. Willo, I think I agree with every single one of your points, except I have learned to not be surprised at how pragmatic the Chinese can be. I am really very impressed with how they have played the last 10 years.

  11. Comrade de Chaos

    I am still in neither inflation or deflation camp. There are just too many variables at the play right now. However, there might be one weak spot in your analysis. Can you trust the information that comes out of the “Politburo” statistical office? Do majority of Chinese people have any substantial savings by the western standards? And given the huge uncertainty of tomorrow, will they spend money now? Besides it seems that Chinese are doing everything wrong with their bailout. They are putting money into the supply side rather than demand side, which in turns could make overproduction threat all too real.