Dear SOH, this article was published in my newsletter this past weekend.  It is a bit long and some of it is not very relevant to your immediate trading needs.  Yet, it attempts to ferret out both the intermediate term and long term fate of China from a personal 'hands on' perspective, along with those of noted short seller Jim Chanos and even a couple of NFTRH subscribers, both financial pro's. 

Excerpted from the January 17th edition of Notes From the Rabbit Hole (NFTRH68)

As
a US manufacturing person, I have been aware of and had to deal with
globalization from day one. First it was Japan, with its revolutionary
efficiency, automation and constantly improving quality. There was no
use fighting it or complaining about it. The only options were
innovate, automate or die. We chose options 1 & 2. This dynamic,
with its inherent quality and productivity, is to the benefit of the
entire developed planet. Continuous improvement, it’s more than just a
corporate buzz phrase.

In
recent years, it seems that China is the new Japan… on steroids. What’s
more, Wall Street – through famous commodity gurus like Jim Rogers –
has got the bit in its mouth and commentators far and wide continually
weigh in on the global manufacturing behemoth. 

So
what do we have here, new global manufacturing superpower, destined
through continuous improvement and shear capacity to become THE one
stop shop for the world’s manufacturing needs (one happy side of the
Wall Street spin) or a gigantic bubble built of limited regulation,
massive pollution, exploitation of human ‘capital’ and a noxious Ponzi
scheme involving a late-stage consumerist society’s increasingly worth less treasury bonds? This is of course, the dark side of the spin.

I
would have to say that the answer involves all of the above. There are
many obvious negatives currently in play for a ‘China Story’ that is
promoted 24/7 by financial types who are selling abstractions as
opposed to boots on the ground knowledge. There are also many positives
that time should nurture to the forefront.

On the surface, we have the likes of ‘China’s Round-the-Clock Auto Factories Still Cannot Meet Demand’
http://tinyurl.com/nftrh68a,
as credit has continued to expand, despite pretense toward fiscal austerity
http://tinyurl.com/nftrh68d. 
Beneath the surface, we have noted short-seller Jim Chanos looking into the books
http://tinyurl.com/nftrh68b
of China, Inc. In addition, here is an interview in which he not only
looks at China, but also the commodity complex so vital and intertwined
with its growth http://tinyurl.com/nftrh68c.

Technicals

I decided to highlight China this week in light of the Chanos story and since it is a short position held by
NFTRH,
with short fund FXP still performing fairly well as its mirror image,
the FXI China 25 ETF continues to look toppy. FXI has pulled a full 50%
retrace of the crash from the highs, weekly MACD has remained
trigger-down and the setup remains in place for an important high to be
registered.

As a side note before continuing, I would remind
readers that FXI (along the Hong Kong Hang Seng and Nasdaq 100, among
others) was one of the leaders to the upside of Hope ’09 as it made its
‘higher low’ in March, and as long as it persists with the current
topping posture, it must be taken as a negative divergence leading the
broad rally.

Two Esteemed Observers, Differing Opinions

Last
week I received emails from two subscribers, one a former executive of
a major auditing firm and the other, a Vice President at a well-known
investment firm. Both emails centered on the ‘Chanos bearish on China’
story. The former knows how to ‘look into the books’ of enterprise and
is bearish and in agreement with the NFTRH view that
China may be leading the US and other global markets into a topping process. The latter is quoted as follows:

“Beware
of advice/opinion you receive on China from any [non-Asian] that has
not lived in that country for years. China is littered with the dead
bodies of Western business execs who thought they understood how that
place works.

I highly recommend you read the book “Mr. China” before you bet any significant capital against that country:
http://tinyurl.com/nftrh68e. 
My brother has made MILLIONS undoing the destruction Western business execs have caused their firms in China.”

‘Destruction’

I
have seen plenty of it, as American companies fall all over themselves
– even creating new executive positions like ‘VP of Global Sourcing’ to
gain access to the Chinese miracle (and pennies on the dollar savings).
Do you want to know what has been destroyed? Quality ethic. I cannot
tell you how many times I have seen customers try to come back to
companies like my own, hat in hand simply wishing to get the stuff made
right.

NFTRH
is about perspective, if nothing else. So this is not a ‘slam China’
piece. I have no doubt that China is setting up as one of the behemoths
of the 21st century. But there are growing pains – huge ones, centering
on quality, lack of regulation, human rights and its love/hate
relationship (of convenience) with the US. 

Meanwhile,
sometimes there are happy endings for those who have been burned by the
China outsource trade. In 2009 I experienced yet another one. 

We
have made a high quality medical oxygen component for the last eight
years, never raising the price and employing ‘lights out’ automated
production. Our customer’s outsource czar found a Chinese company that
would do it for .60 on the dollar, but their quality was lacking. So
the customer jumped at our offer to compromise to .86 on the dollar.
But the game was not over yet; the customer redesigned the component
(we were not given the opportunity to quote the re-design) to make it
easier to produce and was rewarded with a .40 on the dollar price! Got
to love capitalism, and cheap medical components.

No
tears for me dear reader, we have more than replaced this business with
medical companies that understand quality is number one. But for all
those who need medical oxygen, if you use the fine ‘American’ brand
XXXXXXXXX, breathe easy. After all, they wouldn’t compromise quality in
the interest of saving a buck, would they? Would they?

NFTRH View

I
will distill the two subscriber’s opinions into my personal view that
China is leading the global rally in hope and denial into termination.
But as NFTRH
has noted from early on, China – along other developing situations – is
an area I would look to invest in at the appropriate time, for the
longer term. But first there is the sorting out of its intimate
relationship with the consumer of last resort, the USA, to deal with.

The
United States is in the impossible predicament of trying to convince
the world that its debased treasury still deserves the world’s
confidence, even as it attempts to live on the creation of more debt
and printing of Federal Reserve Notes, with no commensurate
productivity to back up said confidence.

China
on the other hand, is in a dangerous situation for the near term due to
its reliance on what is in essence a gigantic macro vendor-financing
scheme. Its foreign exchange reserves grew another 23% in 2009 http://tinyurl.com/nftrh68f. 
Is it any wonder that countries like China and India are buying gold in an increasingly systematic manner?

Hording
of vital resources remains a key component of the future for China,
even if it means ‘over’ paying by using increasingly worthless US
dollars to do so. One wonders to what degree this plays into the
current bubble in copper and inflated pricing in other commodities.
Back in 2004, I wrote an article addressing the situation, and today I
would say that the only thing that has changed is the level of urgency.
Now I Get It!:

“In
phase one, Americans have happily gone along with Roach's "new
paradigm", where China more and more controls the means of production,
and the US controls the means of production of a different kind; that
of the world's reserve currency. In essence the game goes like this:
"You keep making cheap stuff (wink wink) and we'll keep printing this
paper (wink wink) and pay you huge amounts of it. Sure, there will be
'economic girlie men' out there saying this can't be done, but LOOK at
us, we're DOING it!". I don't doubt there are legions of people taking
the attitude of "if it ain't broke, don't fix it", but that's just the
point, it is broke. The fallout is just not obvious to all yet.”

 “But
something tells me a strong hint of what's to come was just flashed for
all to see with the above acquisition announcements. China's planners
are not so dumb after all. They'll use an advantageous labor arbitrage
and currency peg to gain global industrial production market share,
ship en mass to the largest consumer engine in the world, receive
payment in the heretofore most trusted world currency, and for the
master stroke, turn around and recycle those dollars into the very
commodities, goods and resources that will be necessary for their
continued growth and climb to world power.”

The
essential theme is that the United States feasted off of the 20th
century, and for good reason; it was a country in ascension with a
relative freedom of industry and private endeavor, which became the hub
of global commerce and finance, anchored by the then-respected US
dollar, the world’s reserve currency. 

But
humans being subject to excess and hubris, the US transformed into an
economic vampire, consuming not only its own seed corn but by leading a
system of debt creation as funding mechanism (replacing the old
productivity), leading much of the rest of the industrialized world
into financially hazardous practices as well. 

If
the US goes down, China is going to go down with it. This could become
a major buying opportunity as the deck chairs get rearranged for the
21st century. China, like the US, is inflating to try to keep the
current arrangement in place, but this will ultimately fail, as all
major inflations and bubbles eventually do. But with its reserves and
status as creditor, at least it will have options when it comes time to
dig out from the rubble. 

The
US on the other hand, has nothing but confidence to fall back on. That
will not cut it when said confidence is lost. The US will need to begin
the long, hard process of revaluing its remaining productive resources.
That will not happen as long as the printing press keeps running in a
pathetic attempt to deny reality (and re-valuation).

Given
that I may not even be alive by the time America heads back up the
curve, I think I will await coming opportunities out on the horizon in
China, other developing regions and in commodities. Shorter term, NFTRH
will continue to focus heavily on the gold sector for the fundamental
reasons carried forward to date and reviewed again below; until/unless
said reasons change.

In
short, the China miracle is in progress and will not be stopped. But
just as the US dealt with the great depression along the way to 20th
century dominance, so too will China deal with a multitude of issues
along the way. Not least of which will be extricating itself from the
twisted and complex relationship it has going with the great consumer
of last resort.