Before China, there was Japan.

From the 1960s to the 1980s, Japan was on a roll. They had one of the highest economic growth rates in the world, according to PBS. Their manufacturing prowess grew to be the envy of the world. Their stock market soared 373 percent between 1980 and its peak in 1989, according to Knowledge@Emory. And, like China today, there were predictions that Japan would overtake the United States as the largest economy in the world.

Oh, but times change.

Japan’s economic miracle came crashing down in the 1990s along with its stock market. By the end of 2010, the Japanese stock market, as measured by the Nikkei 225 index, was down an astounding 73 percent from its 21-year old 1989 high, according to data from Yahoo! Finance.

As happened in Japan, extrapolating past performance could be hazardous to your wealth. Will China suffer a similar fate? If it does, what will that do to the financial markets?

In this final installment of our series on China, we’ll look at three issues facing China that are an outgrowth of their strong economy and how these issues may affect you.

MANAGING THE ECONOMY
China has deftly managed its economy over the past three decades to produce spectacular growth and improved living standards for its people. In fact, economic growth has contributed to more than 500 million Chinese people rising out of poverty since 1981, according to The World Bank. But, growth has its price.

Strong economic growth can lead to problems such as inflation, social and economic inequality, and a growing pile of foreign exchange reserves. Let’s take a closer look at each of those three issues.

Inflation
Inflation is a major threat to China’s future success because if it gets out of control, the population may revolt. In August 2011, inflation rose by 6.2 percent from a year earlier – well above the government’s 4.0 percent target. Worse yet, food prices rose 13.4 percent from a year earlier and, for a country that needs to feed 1.3 billion people, that’s a problem.

Rising food prices is particularly difficult for China to stomach (pardon the pun) because the average Chinese household spends about a third of its disposable income on basic food, according to the Financial Times.

If you want to know why inflation is a threat to national stability, go back to 1989. The Financial Times said, “Inflation of nearly 20 percent is considered a key contributing factor to the 1989 student protests that culminated in the bloody military crackdown in and around Beijing’s Tiananmen Square.”

Social and Economic Inequality
While China’s economy has grown more than 90-fold in the past 30 years, the gains have left a widening gap between the “Haves” and “Have-Nots.” Chinese Premier Wen Jiabao said back in February 2011 that rising inequality is threatening social stability, according to a Bloomberg article.

Can you imagine what would happen if even a small percentage of China’s 1.3 billion people turned against the government?

Well, unrest has been on the rise in recent years. As Bloomberg reported in citing data from Sun Liping, a professor of sociology at Beijing’s Tsinghua University, “‘Mass incidents,’ everything from strikes to riots and demonstrations, doubled from 2006, rising to at least 180,000 cases in 2010.”

So, how do you keep 1.3 billion people “in check?” According to Nicholas Bequelin, a China researcher for Human Rights Watch in Hong Kong, China’s been doing it “through a combination of economic growth, social reforms, and political repression.” Time will tell how long that lasts.

Foreign Exchange Reserves
At $3.2 trillion, China has – by far – the largest foreign exchange reserves in the world, according to The Wall Street Journal.

These trillions were built over the years through China’s trade surplus, foreign direct investment, and capital inflows betting on yuan appreciation (the yuan is China’s currency). On the surface, large foreign exchange reserves sound like a good thing, and, in some ways, it is. The downside is that it exacerbates inflationary pressure, according to Bloomberg.

In an ironic twist, the U.S. has been a beneficiary of this massive reserves buildup. China had to park their cash somewhere so where did they turn? To the U.S. treasury market! At the end of June 2011, China was the largest foreign holder of U.S. Treasuries with more than $1.1 trillion filling their balance sheet, according to the Treasury Department.

Viewed another way, China has been a big reason why the U.S. has been able to run up trillion-dollar budget deficits while keeping interest rates low – we have China as a willing buyer of our paper.

With China needing a large liquid market to park its reserves and the U.S. needing a big buyer of its paper, these countries have the ultimate “too big to fail” global relationship, said Andy Rothman, an analyst in Shanghai for the investment bank CLSA as quoted in The New York Times.

Conclusion
China is so large and growing so fast, that it will impact the world in major ways for the foreseeable future. Its success or failure, its twists and turns, will reverberate throughout the financial markets and affect everything from the level of interest rates to the price of soybeans to the volatility of the S&P 500 index.

Will China stumble at some point? Probably. The big question is how will their potential tumble cascade throughout the world? Yet, no matter what happens, we will continue doing our research. We will continue monitoring your investments. We will continue doing what is in your best interests.

We truly live in a globally interconnected world that is getting smaller and smaller by the day. One thing that does not get smaller is our commitment to you.

Like it or not, we’re all involved in running the “family business.” We worry that our parents might outlive their retirement savings. We’re comforted by the thought that family members would probably bail us out if we got into money trouble. We strive to help our children financially, and we’d like to bequeath them at least part of our nest egg.

In short, our family is our asset, liability, and legacy. Now here’s the contention: It’s time to build this notion into the way we manage our money.

Here are just some of the reasons why:

Raising Children: If your children grow up to be financial deadbeats, you may likely rise to the rescue. Indeed, your children could turn out to be your greatest financial liability.

Don’t want your adult children swimming in credit card debt, missing mortgage payments, and constantly asking you for money? Your best bet is to make sure problems never arise by raising money-savvy children.

That’s trickier than it seems. Children grow up spending their parent’s money, so it’s almost inevitable that they will have a skewed financial outlook. After all, for children, all purchases are free, so why should they fret about the price tag or control their desires?

Make your children feel like they’re spending their own money. Give them a candy allowance when they are younger and a clothing allowance when they are teenagers, and insist they live within this budget. This way, instead of you constantly saying “no” to your children, they will learn to say “no” to themselves.

Launching Adults: Once your children get into the work force, you want them to get into the “virtuous financial cycle” where they are steadily building wealth.

They will become able to own their home rather than renting, buy their cars rather than leasing, fully fund their 401(k) plan and their individual retirement accounts each year, and never carry a credit card balance.

The sooner your 20-something children get into this virtuous cycle, the easier it will be for them to meet their goals and less of a financial drain on you. To that end, encourage your children with your words and with your fine example.

A few financial incentives may also help. Tell your adult children if they scrounge together a house payment, you will lock in some additional dollars, or offer to subsidize their 401k contribution at 50 cents on the dollar.

This doesn’t mean you intend to fund their retirement instead of your own, but getting them started as investors sure seems like a smart idea.

Everybody was on the same side of the trade.

If you have not read Michael Lewis’ book, The Big Short, about the U.S. financial crisis, be sure to do so. It is enjoyable and instructive reading from a number of angles. One interesting, but disturbing chapter tells about how low-rated subprime bonds were packaged and magically transformed into AAA-rated bonds.

I’ve always thought bond ratings mattered, but now I pay even closer attention. A lot of AAA-rated corporate bonds had no business being rated that high in 2007-2008.

As government balance sheets in the West continue to deteriorate, is it possible that some of the current AAA-rated sovereign bonds will not belong in that category? What then will investors do? Will they demand higher interest rates to compensate for the additional risk they are assuming? Or will they make the final move to equities as they conclude that they are being asked to take equity-like risk in the government bond markets without the opportunity for equity-like returns? Why not buy a corporate security such as stock and, at least, have a shot?

One of the takeaways I had from the book is that the subprime collapse/credit rating failure, which caused the 2007-2009 crisis, was containable in the sense that taxpayers could back up the losses.

Essentially, that is what has happened as the U.S. government, backed by taxpayers, bailed out AIG, several investment banks, and commercial banks that had strayed into trading esoteric instruments. Next time, the taxpayer may not have sufficient capacity to do so.

Often, the market’s mispricing of some asset is so great, and therefore the profit potential so high, that waiting for a few years can be well worth it for investors. In the case of the subprime mortgage market of the mid-late 2000’s, the hedge fund managers betting against it knew they were going to be right eventually; they just weren’t sure if they could convince their investors to ride it out long enough to see the upside.

They all recognized the flaw in the market’s pricing was the assumption that housing prices never went down. Moody’s and S&P built an assumption into their ratings models, and Goldman, Bear Stearns, and Lehman all built it into their business structure and pricing models.

After all, housing prices in the recent past did have a tremendous track record of upward growth. Home prices rose steadily in all economic conditions. However, with analyzing the market we often have to go much farther back than the recent past if we are truly going to learn from history to avoid its mistakes.

History is cyclical. Modern generations easily lose the first-hand experience of bygone lessons. Therefore, they are prone to make the same emotional mistakes in reaction to traumatic events and logic flaws when trying to problem-solve.

The largest shocks to the system come when everyone is on the same side of the trade.

That seems to be an appropriate description of China’s economic growth model. Just one look at Shanghai’s waterfront or their high-speed train system is enough to make you believe China’s infrastructure can rival anything in the world.

Here’s a June 2011 picture of downtown Shanghai looking across the Huangpu River to the ultra-modern skyscrapers on the other side. That building with the rectangular hole at the top is one of the three tallest buildings in the world.

Just 21 years ago, none of the skyscrapers picture here existed, according to The Atlantic.

In part II of this series on China, we’ll look at the massive build out within China and see if this fixed investment boom is sustainable. If the building boom ends, it could cause a worldwide economic slowdown.
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Fixed Investment Versus Consumption Spending

A significant amount of China’s growth over the past 20 years has come from what’s called “fixed investment” as opposed to consumption spending. Fixed investment includes tangible things like roads, bridges, trains, buildings, and machinery. It accounted for 46 percent of China’s GDP in 2010, according to Financial Times. The June 30 launch of the Beijing to Shanghai high-speed train is a good example of fixed investment. It cost $33 billion to build, reaches a top speed of about 200 mph, and connects the two major cities in less than five hours, according to The Vancouver Sun.

Fixed investment is good from the standpoint that it equips a country with the tools and resources needed to grow and be productive. However, too much fixed investment can lead to overcapacity and strained budgets.

China has an amazing collection of world-class infrastructure. Their airports, high-speed train system, skyscrapers, and Olympic Village are very impressive. Clearly, China has built its infrastructure with future growth in mind. The big question is, “Have they built too much too quickly?”

The Chinese philosopher Confucius said, “Do not be desirous to have things done quickly. Desire to have things done quickly prevents their being done thoroughly.” The Chinese government learned that the hard way as a recent high-speed train crash in eastern China killed several dozen people and cast a pall on China’s breakneck pace of infrastructure growth.

The Wall Street Journal commented that the train crash, “has transformed a symbol of Beijing’s pride into an emblem of incompetence and imperious governance.” Ouch! Recurring problems on the new Beijing to Shanghai high-speed rail system have exposed additional vulnerabilities in China’s management of infrastructure projects and further soured the populace on governmental corruption and secrecy.

Making the Switch

Knowing the risks of an investment-led economy, the Chinese government has developed a plan to rebalance its economy from investment and manufacturing towards consumer consumption and services, according to Financial Times. Ironically, this would put China more in line with the U.S., where consumer spending accounts for about 70 percent of economic activity, according to The Wall Street Journal. In China, the comparable private consumption number is 34 percent, according to Financial Times.

One of the knocks on China is that the growth in fixed investment has risen faster than GDP and this could cause problems with too much capacity and too much debt to fund those investments.

Leading up to the 2008 Summer Olympics in Beijing, China spent furiously on infrastructure in an effort to present the country in a positive light to the rest of the world. Those investments, coupled with a $586 billion stimulus package launched in late 2008 to fend off the economic crisis, have fueled concerns that some of China’s investments will turn out to be “bridges to nowhere” and end up as bad debts.

China’s leadership is beginning to understand that “If you build it, they will come,” has its limits.

Now, moving from an investment-led to a consumer-led economy is no easy task in a sprawling country of 1.3 billion people. There is a huge gap between the “Haves” and the “Have-Nots” that could cause social problems if conspicuous consumption becomes popular. There’s the potential for inflation to get out of control if Chinese consumers start demanding higher wages and start spending more rapidly than the economy can churn out goods and services. And, there’s a demographic issue working against the economy as the country is rapidly aging due to the long-standing one child policy.

Should China falter in its effort to rebalance its economy, it could lead to domestic problems that ripple out to the rest of the world.

In Part III, we’ll wrap up with a discussion of three issues facing China that are an outgrowth of their strong economy – inflation, social and economic inequality, and a growing pile of foreign exchange reserves.

There’s an old saying that when the U.S. sneezes, the rest of the world catches a cold. Given China’s strong historical growth, massive size, and potential issues facing its economy and government, advisors should be concerned about China sneezing, too. How they manage the rebalancing of their economy over the next few years is one issue that bears close attention.

As always, we very much appreciate your business.

Spending isn’t the problem. Unsustainable spending is.

Our national debt continues to climb to new heights and recently reached the $15.2 trillion level. The only saving grace for America is the historically low level of the U.S. Treasury yield curve. Moreover, now that the congressional “super committee” failed to enact a plan to cut $1.2 trillion from the deficit over the next decade, automatic spending cuts will begin in January 2013. President Barack Obama has vowed to veto any attempt to undo those scheduled cuts, which include expiration of the Bush tax cuts. And, Democrats oppose reducing entitlement programs such as Medicare and Social Security unless the Republicans agree to larger tax revenue increases. Political gridlock remains very much alive in Washington.

Here’s a list of eye-opening facts courtesy of The American Dream web site article, “Debt Slavery: 30 Facts About Debts in America that Will Blow Your Mind”:

• Credit card debt: Today, 46 percent of all Americans carry credit card balances from month to month. Together, we are bearing $798 billion in credit card debt. For households with such debt, the average amount owed is nearly $16,000.

One out of every seven Americans has at least 10 credit cards. According to the Federal Reserve’s web site calculator, a $10,000 credit card balance with a 13.10 percent interest rate will take 27 years to pay off if you only make the minimum monthly payments. You will end up repaying a total $21,271.

• Auto loan debt: The length of auto loans in America keeps getting longer. Today, 45 percent of all new car loans are for more than six years. At some point, this will become a massive problem.

• Mortgage debt: Home mortgage debt in the United States today is about five times larger than it was 20 years ago.

Historically, the percentage of U.S. residential mortgages in foreclosure has hovered between 1 and 1.15 percent. Today, it’s up around 4.5 percent. According to MSNBC TV show host Dylan Ratigan, 46 percent of all mortgage properties in Florida, 50 percent in Arizona, and 63 percent in Nevada are underwater. Overall, nearly 29 percent of all U.S. homes with a mortgage are underwater.

• Medical debt: This is a major problem for a growing number of Americans. One study discovered that 41 percent of all working age Americans either have medical bill problems or are paying off medical debt.

Sadly, the number of Americans who are protected by health insurance continues to decline. An all-time record of 49.9 million Americans do not have health insurance right now, and the percentage of Americans covered by employer-based health plans has fallen for 11 years in a row.

• Student debt loan: The total today is rapidly approaching $1 trillion. About two-thirds of all college students today graduate with student loan debt averaging $25,000.

The key to sustaining the current level of debt in the intermediate term is to maintain low interest rates. Longer term, unsustainable spending is a problem.