Confessions of a China Contrarian

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Anyone who is interested in investing or who follows world economic news can testify to the fact that the single dominant story of our times is the mania concerning the "Chinese economic miracle." Conversations with finance industry professionals, or even amateur investors, tend to revolve around the passionate belief that China is the pot of gold at the end of the rainbow. I’ve lost count of the number of times that learned friends have waxed zealously about the need to "hop on the China train before it leaves the station."

Being of a somewhat cautious nature, my skepticism has led me to investigate the matter more thoroughly. My fear is that we are in the grips of yet another obsession that may end badly, akin to the tech stock bubble of the late 90’s.

While China is probably destined to one day be a leading, if not dominant, economic powerhouse, this does not mean that it will happen in a timeframe that is relevant to the typical American investor. A century or so is meaningless in such an ancient land, but it is an eternity for someone who is saving for his retirement in a decade or two.

I base my concern on several issues that are often overlooked by the China cheerleaders:

Concern #1: China’s industrialization is being stimulated by a massive misallocation of capital

One of the major evils of government manipulation of money is that it distorts the marketplace and sends misleading signals to producers. Specifically, the American government and the US Federal Reserve have embarked on a hideously irresponsible policy of interest rate and money supply manipulation. The net effect of this policy has been to promote consumption based on debt. Americans essentially now save nothing. They are purchasing consumer goods using credit cards and risky home refinancing schemes. These policies are being implemented to "stimulate the economy" by providing a demand stimulus over and above the actual purchasing power of the citizenry.

From China’s perspective, this has stimulated a massive buildup of factories and industries whose primary purpose is to produce gadgets for American consumers. The unfortunate thing about using debt to purchase consumer goods is that it has to be paid back — with interest. While Americans are currently able to live beyond their means through such spending, what will happen when the wolf finally arrives at the door? The American people cannot run up their credit cards forever. Sooner or later, the real estate bubble will deflate. When that happens, the American people will be forced to live on less than their actual income while they service their massive debt load.

What will happen to all of these Chinese factories when this occurs? Who will buy all of the gadgets and widgets then?

The only answer that I foresee is that many of these factories will close for lack of customers.

What, then, will happen to all of the investors who have put their money into these firms?

Concern #2: China still has a huge base of hideously inefficient state-owned enterprises that make our social security system look solvent by comparison

Not so long ago, China was a typical communist nation. Specifically, the Chinese government owned and operated a myriad of factories, mines, and farms. These industries were predictably inefficient, corrupt, and required constant infusions of cash to keep running.

And herein is the problem, as noted in a recent article at

Long bereft of any ideological underpinnings, the government’s legitimacy is now wholly based on its ability to grant its citizens a gradually increasing standard of living. It does this in large part by guaranteeing cradle-to-grave employment for more than half of the Chinese workforce via its titanic — but majestically inefficient — state-owned enterprises (SOEs).

But those SOEs have put the Chinese state in a double bind. Since the SOEs were designed as social ballast as opposed to functioning firms, they cannot be reformed in the traditional sense to face international competition without massive layoffs.

Those shiny new capitalist enterprises which produce gadgets for Wal-Mart are only a small fraction of the total Chinese economy. A much greater portion is comprised of these bloated state-run concerns. The government can’t cut its losses and close them down for fear of a massive uprising among the workers. Thus, it is left with no alternative but to continue to shovel good money after bad. This gigantic black hole is growing.

Concern #3: China still has a repressive political system.

Since Tiananmen Square, China has managed to slam the lid on calls for political reform. But the underlying issues which bubbled to the surface at that time have not been addressed. China still does not have a representative government or guarantees of basic individual rights.

This situation will, someday, rear its ugly head again. As the Chinese people become more familiar with the workings of the rest of the world via TV, internet, and foreign travel, the call for political change will return. While no one can predict exactly when or where, it is safe to say that it will happen eventually.

I believe that long-term economic prosperity goes hand in hand with individual rights and the respect for life, liberty, and property. As such, I am doubtful that China will be able to continue on its current trajectory of economic growth without addressing these fundamental issues. I hope, of course, that they are resolved in a peaceful manner which allows for the continued rise in living standards for the Chinese people. But there is no guarantee that this will be the case. It is just as possible that the situation will implode and take the "economic El Dorado" down with it.


My admittedly amateur opinion is that investing in China is much more risky than most people are being led to believe. I seriously doubt that most investment professionals are taking these issues into account when advising clients to hop into the China boom.

As "exhibit A", I offer the following additional commentary by

In December 2006, five years after China gained WTO membership, foreign banks will be allowed to fully compete in the Chinese banking sector. Currently, foreign access to China’s financial world is thin, restricted as it is to local currency transactions in 18 cities. But even this limited access has led to the formation of some 220 foreign bank offices in China and total business worth 108.3 billion yuan ($13 billion) at the end of 2004. These foreign banks already hold 12 percent of all lending business in Shanghai, a rate of increase that Shi calls “unexpectedly [read: disturbingly] fast.”

Full-scale competition will mean the full-scale evisceration of Chinese banks. Since they subsidize their primary clients — the SOEs — the state banks grant little to no interest to their depositors. Full competition would send Chinese money to the foreign banks in droves, and once foreign currency [read: U.S. dollar] operations are allowed, capital flight will reach mountainous proportions.

In other words, the Chinese government is balking at its WTO commitment to allow foreign banks full access to the Chinese market. It is doing this because it fears a massive capital flight out of the country by Chinese investors.

Here, we see an interesting contradiction. At a time when every internet day-trader from Hoboken to Sacramento is salivating at the prospect of investing his money in China, the Chinese people are champing at the bit to get their money out of China.

Who is right?

Which group is more informed as to the actual realities on the ground?

My vote is with the Chinese.

That ancient land may be a nice place to visit, but I wouldn’t want my money to live there.

Steven LaTulippe [send him mail] is a physician currently practicing in Ohio. He was an officer in the United States Air Force for 13 years.

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