2. China Taming the Dragon

3. A little History… China Proper was unified for the first time in 221 B.C. Once the king of Qin consolidated his power, he took the title Shi Huangdi (First Emperor)

4. A little History… To fend off barbarian intrusion from the north, fortification walls were connected to make a 5,000- kilometer-long great wall. (What is commonly referred to as the Great Wall is actually four great walls rebuilt or extended during the Western Han, Sui, Jin, and Ming periods)

5. A little History… Genghis Khan (1167?-1227) supreme leader of all Mongol tribes invades China in the mid 13 th century Kublai Khan, grandson of Genghis Khan establishes the first alien dynasty to rule all China--the Yuan (1279-1368).

6. A Little History… Marco Polo visits China in 1271

7. A little History… Emperor Tai Zu, founded the Ming Dynasty in 1368. He first applied himself to the task of expelling the Mongols. The Great Wall was rebuilt to the form that we know it today. The Ming dynasty ended upon the arrival of the Manchus, who were invited to end a domestic rebellion, but decided instead to stay and take over the country!

8. Arrival of the Europeans… There was increasing European demand for tea, silk, and porcelain from China, but the Chinese didn’t want anything the Europeans had to offer ….the problems was solved by including India Textiles Cotton Opium Tea, Silk The emperor tried to end the opium trade by seizing opium imports. The British responded by crushing the Chinese (the Opium War) – The British were awarded the island of Hong Kong

9. The Beginning of Modern China… Frequent uprisings and rebellions ultimately ended the dynastic system. The republican revolution broke out on October 10, 1911. On March 10, in Beijing, Yuan Shikai was sworn in as provisional president of the Republic of China

10. Leaning to one side… On October 1, 1949, the People's Republic of China was formally established, with its national capital at Beijing. The country was led by the Chinese Communist Party under the Chairmanship of Mao Zedong China adopted “Five Year Plans” to achieve industrialization and agricultural collectivism. The most noted of these plans was the “Great Leap Forward” which was a disaster!

11. Modern Day China… Hu Jintao became head of China's ruling Communist Party in late 2002  GDP (2004): $1.409T (#7)  Population: 1.288B (#1)  GDP per Capita: $1,100  Current Account Balance (% of GDP): 3.2  Annual FDI: $55B

12. China has become the world’s largest consumer China has accounted for 25-30% of the growth in total world consumption – most notable raw materials and energy  Oil prices have risen as high as $59  The index of metals prices is up 50% over last year  Shipping activity is double what it was last year Recently, China outspent the US in virtually every commodity!!

13. Modern Day China…

14. Economic Growth (% Annual)

16. Problem: Is growth measured correctly Many industries are still using 1980 as a base year for calculating prices. Due to a large drop in industrial prices, this will understate inflation (overstate real output) Most industrial sectors have incentives to overstate output. These two effects combined result in a 1.5- 2% overstatement of real output growth

17. The Chinese Economy Nominal GDP in China has averaged 9% real growth over the last 15 years Inflation is heading towards 6% Credit/GDP has almost doubled to 166% over the last year The one year lending rate is around 5%

18. Negative Real Interest Rates The real (inflation adjusted) interest rate is equal to the nominal interest rate minus the inflation rate.

19. Negative Real Interest Rates Destabilize the Economy A “Neutral” real interest rate should be approximately equal to the rate of productivity growth plus the rate of labor growth Official Output Growth: 9.7% Capital Growth: 5.5% Labor Growth: 1.1% TFP (Productivity Growth): 3% Inflation = 6% Implied “Neutral” Interest Rate: 9.1%

20. Negative Real Interest Rates Low or negative real interest rates promote borrowing and artificially inflate investment (including residential) – eventual oversupply, excess capacity and falling prices causes debt defaults Rapid investment creates supply bottlenecks that contribute to inflation – with wages unable to keep up, average purchasing power drops as wealth is redistributed to those few who borrow money. Why is China keeping interest rates so low?

21. Pegging the Yuan To keep the Yuan weak, the Chinese continue to buy US Treasuries. They currently own about $609B. (They increased their holdings by $100B in the last year! AssetsLiabilities $900B (Foreign Reserves2.3T Yuan (Currency) People’s Bank of China 3.3T Yuan (Reserve) 2.0T Yuan (Other) 7.8T Yuan (Total Liabilities) ($940 Billion) 8.28 Yuan = $1 $5B (Gold) 296B Yuan (Gov’t Bonds) 7.8T Yuan (Total Assets) ($940 Billion)

22. Is China Slowing Down? Second quarter GDP in China was reported to be 9.7% Industrial production is still growing at 12% (well above the long run trend of 8-10%) Fixed investment 25% - down from its peak of 53% Inflation is still around 5-6%

23. Is the Red Dragon Heading for Trouble? Year Total Factor Productivity Growth 1991AgricultureIndustryConstructionTransportationServices 1992-2%9%35%-16%10% 1993-1%8%30%-11%7% 19940%6%24%-5%4% 19951%4%18%1% 19963%2%13%6%-2% 19974%1%7%12%-5% 19985%-1%2%17%-8% Recent Productivity gains (with the exception of Telecommunications) is less than stellar!

24. The Red are in the Red! Government Deficit (% of GDP)

25. China’s Financial System is Extremely Fragile! The Chinese financial system is dominated by four state run banks  According to Beijing, the NPL ratio of the Big Four state banks is 30% of assets  More objective private financial analysts say NPLs represent 50% of the total assets of the Big Four banks  Fitch IBCA and Moody's say the Big Four state banks are technically insolvent.

26. Could China’s Trade Position Reverse itself? Entry into the WTO has forced China to slash trade barriers China operates as an “assembly line” economy. It imports components and puts them together to sell to the west as finished goods CountryTrade Deficit (B) Taiwan$31.5 Korea$13.1 ASEAN$7.6 Japan$5.0

27. Could China’s Trade Position Reverse itself? China’s trade surplus has shrunk since 1996

28. Is all this starting to sound familiar? Just the facts ma’am. Persistent inflation High Money Growth Low Economic Growth Large Deficits Public Private Political Events Natural Disasters Market Sentiment Bad Policy Bad Luck

29. China has an “Ace” up it’s sleeve! Most of China’s capital inflow is FDI (US companies setting up subsidiaries). IF economic conditions change, FDI is not easy to reverse quickly.