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Financial Madness

Justice Litle
for The Daily Reckoning
May 16th, 2005

The Daily Reckoning PRESENTS: There are two ways to think about China: you can take the optimistic standpoint, and view it as a rapidly growing country filled with opportunity... or you can see it as a ticking time-bomb, just waiting to destroy itself. Justice Litle explores both avenues of thought...

China presents two stories at once. In the long run, the dragon's rise seems inexorable. It's hard to imagine anything that could thwart it. In the short run, however, China must deal with dangerous internal weakness, namely a rotten banking system, poor internal controls and a dangerous torrent of "hot money" - speculative capital in pursuit of aggressive returns - that threatens to boil over the economy and unleash massive instability down the road when it withdraws, similar to the Asian currency crisis of the late '90s.

A divergence of opinion is slowly building as to whether China will make the full transition to free-market capitalism with its current political system intact. Naysayers believe that a top-down, statist approach to governance will never mix with free markets and that the conflicts inherent in China's uneasy arrangement will eventually tear the leadership apart... or bring about a violent end to free-market reforms... or both at the same time.

In contrast, optimists point to thriving countries like Singapore, where capitalism has flourished under the benign authoritarianism of Lee Kuan Yew and his protégées. (By the way, it's technically not illegal to chew gum in Singapore; you simply can't import or sell it legally.) They point out that an arrangement that appears statist and authoritarian is actually more democratic than it looks, because the people willingly endorse the arrangement. The tradeoff is stability for prosperity, and as long as prosperity is delivered, stability in the form of quasi-democracy will be accepted. The optimists see China's authoritarianism slipping away gradually - just as China's communism has transitioned from policy to rhetoric - and they see no reason why the transition cannot be carried further without a major dislocation.

Only hindsight will prove who is correct, but the stakes are high because of the global turmoil that would follow any political uprising. As of year-end 2004, China had more than $600 billion in U.S. dollar reserves. That is a sum that could effectively tear the financial plumbing system apart, if it were unceremoniously dumped on the markets with such massive pressure in a compressed period of time the pipes would surely burst. Of course, this would be fiscal suicide for the dumpers as well, which is precisely why such a move is not feared. China's own economy would be sucked into the vortex too, so why would the Chinese put a gun to their own heads?

The theme that applies here is the doctrine of mutually assured destruction, or MAD - but of the financial sort, rather than the nuclear.

A product of the 1950s, the doctrine of MAD essentially states that two parties with the capacity to destroy each other will recognize the folly of hostilities. We liquidate the Soviet Union, they liquidate us and nobody wins. So peace is assured, right? Wrong. The flaw in the theory comes in the form of a question: What happens if one side or the other is thrown into political turmoil, or if the reins are taken over by madmen with nothing to lose?

A Communist Party leadership on the edge of collapse would make a last-ditch bid for stability by any means necessary, which in turn would make it willing to contemplate the financial-Armageddon option, as a form of extreme blackmail, if its hand were forced. If the mandarins feared implosion, they would have the means to not just ask for extraordinary coordination from the United States and Japan, but to demand it... on pain of catastrophic consequences if they were allowed to fall.

But is this a point in favor of the optimists or the pessimists? Obviously, it's not a pleasant thought to imagine a breakdown in China's economy sparking massive civil unrest, in turn leading to a "hot war" with Taiwan as a means of distraction and a catalyst for unifying nationalism, which by extension draws in the United States and sets the stage for the grand finale: the financial equivalent of a hydrogen bomb going off as hostilities escalate out of control.

As a silver lining to this dark cloud, we have a built-in bias for stability on the part of global leaders such as Japan and the United States.

As MAD wisdom dictates, everyone loses if the mandarins lose, and thus everyone has strong incentive to ensure things go smoothly. In this sense, financial MADness works in favor of China's current political system, rather than against it. As fans of functional plumbing in the global financial system, you and I have a vested interest in the mandarins' success.

If you're shaken by the doom-and-gloom analysis, take heart: There's no point in living in fear, and nowhere to go that can make fear profitable. Bonds are hardly safe in the teeth of rising interest rates, and we've seen how quickly cash can depreciate in an inflationary environment. A neutral currency with a physical store of value, gold is the bulwark against any meltdown of the financial system.

As investors in natural resources, we have to incorporate certain principles into our long-term assumptions. One of those assumptions is that the China growth story has a long way to go. China is far from the only market, of course; as the lead exporter and financial counterweight to the United States, it simply demands outsized attention as a key player and bellwether. We can fully expect the storm and gird up for it - but we must also have conviction that the storm will blow over in time and that the natural resource market is still in its early days.

Don't expect global growth (and thus global demand) to progress in a straight line. There will be setbacks and corrections along the way as China, Asia as a whole and emerging markets in general step back from their trajectories to consolidate and retrench. With this in mind, we want to bring the same attitude to our core positions that China brings to its strategic maneuvers for ensuring energy supply: conviction grounded in a long-term perspective.

China's leadership is particularly farsighted when it comes to energy. With the challenges that will face it in coming decades, it will have to be. China's population of cars and trucks on the road is estimated to balloon from 20 million now to 120 million by that time.

Given these monster trends, it only makes sense that China is spending billions on alternative-energy investments. Whether oil maintains recent peak prices or comes off in a temporary demand slowdown, the case for alternatives as part of our core position is rock solid.

As it is China's destiny to grow, it is also its destiny to import massive amounts of oil. It simply does not have enough petroleum reserves available to meet internal demand, and it never will. So China is turning to coal on a large scale... but not without a price. At the moment, coal meets about two-thirds of China's energy needs. It is also causing significant pollution and logistics problems: coal is dirty, inefficient and costly to transport, which is why they are turning to coal-liquefaction plants.

Coal is a solid organic material made up of large, complex molecules containing mostly carbon, plus small amounts of hydrogen, sulfur, nitrogen and oxygen. Raw coal also contains moisture and solid particles of mineral matter (ash). The aim of direct coal liquefaction is to break coal down into smaller component molecules, then to add hydrogen, creating lighter and more stable oil molecules. The process simultaneously removes sulfur, nitrogen and ash, resulting in a clean liquid-fuel product.

The advantages of a "clean coal" product are numerous. For one, less dependence on imported oil. While it's estimated that oil will need to remain above the $35-per-barrel range in the long term for this technology to be cost effective, that projection is hardly a stretch. Given conservative projections, permanent shifts in the structure of demand and gradual depletion of proven reserves, $35 is clearly a solid floor for oil, barring a deep global recession or depression.

Transforming coal from bulk to liquid will also improve the logistics of delivery. Rather than clogging the nation's transportation routes with railroad cars and flatbed trucks loaded down with bulky coal deposits, as China is forced to do now, direct transmission pipelines can be built. Less stress on the transport system, fewer logistical hurdles to overcome and smoother distribution over time will all contribute significantly to a much-needed efficiency boost, lowering China's capital-intensive cost of growth.

Last but not least, clean coal in liquid form will be easier on China's ravaged environment. Eight out of the top 10 most polluted cities in the world are in China. As the dragon grapples with severe water shortages, acid rain, toxic rivers and throat-burning smog - and all this with 20 million cars on the road, rather than the 120 million to come - environmentally friendly technologies will become paramount.

Regards,

Justice Litle
for The Daily Reckoning

Editor's Note: Liquid coal has huge appeal outside China, too. Over the last 12 months, energy companies in the United States announced plans to build over $100 billion worth of new coal-fired power plants. And U.S. coal production is about to hit a record 1.2 billion tons... with Peabody Energy Corp., America's biggest coal producer, promising to double its production by 2010.

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall, 2004). In addition, Justice Litle has been quoted in the Wall Street Journal and by multiple financial newswires, such as Dow Jones and Future Source.