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.

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.

Financial professionals often follow two rules of thumb when providing clients with financial advice. First, they suggest clients save as much as possible in qualified retirement plan accounts, such as 401(k) plans and Individual Retirement Accounts (IRAs). Contributions to these plans generally are made with pre-tax dollars, and they have the opportunity to grow tax-deferred. Second, they advise that retirees delay taking distributions from qualified accounts for as long as possible because no taxes are owed on qualified accounts until distributions are taken.

As with many rules of thumb, these principles are not accurate or reliable in every situation. Consequently, it is important to work with an advisor to evaluate your specific circumstances and determine the best course of action. Here are some of the issues that should be considered:

• Should I save for retirement in taxable or tax-deferred accounts? From a financial planning perspective, it is beneficial to have a blend of qualified and non-qualified assets. This provides more opportunity to balance and potentially minimize income tax liability over time.

• Do you receive company matching contributions? If your company’s 401(k) plan offers matching contributions, it is providing an automatic return on your investment. A company match of 50 cents on the dollar represents a 50 percent return on investment from day one, assuming you are 100 percent vested in the plan. When a matching contribution is available, it may be a good idea to contribute enough to the plan to receive the maximum match every year.

• Should more qualified plan savings be set aside by an older spouse or a younger spouse? The answer to this question depends on the couples’ goals and expectations. In general, an older spouse will be able to access qualified plan savings sooner than a younger spouse; however, a younger spouse will have more years to invest tax-deferred, which may mean that he or she accumulates more savings. If the younger spouse saves and accumulates more, his or her Required Minimum Distributions (RMDs) may be greater at age 70½. Since RMDs are taxed at ordinary tax rates, the long-term tax consequences should be considered.

• Should I draw assets from a taxable or tax-deferred account first? Many people assume it is best to let qualified plan accounts grow tax-deferred for as long as possible; however, when you take a distribution from a qualified account, it will be taxed at your ordinary income tax rate. It may be advantageous to use a combination of non-qualified and qualified account assets to moderate taxable income over time. In addition, higher qualified plan distributions may affect the taxability of your Social Security benefits.

There are many considerations when structuring retirement savings and retirement income plans. When combined, Federal and State income tax rates often total 30 to 45 percent. It is essential to plan carefully and understand the tax implications of your decisions.

If you would like to review your retirement plans, give us a call at 832-631-6060.