Money and Markets: Investing Insights

China on the Verge of Volcanic Eruption

Martin D. Weiss, Ph.D. | Monday, May 9, 2016 at 7:30 am

If you were shocked by the extreme wealth inequality in America (see What could be worse than the Great Depression?), the extreme polarization in U.S. politics (Is the GOP collapsing?) and the potentially disastrous consequences globally (Five Black Swans) …
Then brace yourself for the inescapable truths I will reveal next: These same trends are even more extreme and dangerous in the world’s second-largest economy — China.
And no matter how distant China may seem in this topsy-turvy political season, never underestimate its impact on the global economy, U.S. corporate profits, or your own investments.

My Forecast

Reaching this conclusion has not been an easy journey. It has taken me several decades and many thousands of miles.
I learned Chinese in 1967. I specialized in Asian studies for my Ph.D. I have traveled to Asia repeatedly since 1979. I have pored over thousands of pages of documents on China from the International Monetary Fund (IMF), the U.S. Congress, major research think-tanks, plus the Chinese Government, itself. And I can make this forecast with confidence:

China today is a volcano ready to erupt. The longer the eruption is delayed, the greater its impact will be on the global economy. And of all the countries in the world, it’s the United States, China’s largest trading partner, that could feel some of the greatest economic shock waves.

The likely scenario: A recession in China triggers political and labor unrest, followed by an even deeper economic decline. Beijing responds with a combination of economic stimulus and brutal crackdowns. But it’s too little, too late. China’s ascendant middle classes and entrenched elites tolerated the central government’s tough-fisted controls and corruption only as long as they could continue to reap the material benefits of a growing economy. As those benefits disappear, tolerance turns to turmoil.
Hard to believe? Then consider the hard-nosed realities …

The IMF Highlights China’s Income Inequality

Until around 1990, the IMF reports, Asian economies grew strongly and evenly. Hundreds of millions of people from all strata of society participated in the economic "miracles" of China and the Asian Tigers. Middle classes grew by leaps and bounds. Poverty plunged.
But in the early 1990s, Asia reached a monumental fork in the road. Its growth trajectory made a sharp turn. And it has not changed course ever since.
Yes, the growth continued. But it was far more imbalanced, tilted heavily toward the rich. And yes, Asia gave global GDP a huge boost. But it did so with ever greater vulnerability to political instability.
The Gini Index, a widely accepted measure of bad income distribution, rose in Indonesia, Hong Kong, India and even in supposedly mature economies like New Zealand, Australia, Japan, Taiwan and Singapore.

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But the worst and most dramatic changes took place in China, where income inequality rose far more than in any other country in Asia.
While India’s Gini index rose by about 7 points and Indonesia’s by 10, China’s rose by nearly 20.
And even this measure greatly understates the huge regional discrepancies in China – between the impoverished countryside and the industrial megalopolises; between the small coastal provinces (see blue in map) and the giant Western regions (brown).
No matter how you slice the numbers, China has clearly suffered the most radical shift from equality to inequality among all large countries and across all regions of the world.
Since 1990, inequality in China has surged over ten times faster than it has in the advanced OECD countries, in the world’s Newly Industrialized Countries (NICs), and in Asia’s Low Income Countries (LICs).

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Meanwhile, even regions like Sub-Saharan Africa and Latin America have made improvements during this period.
These numbers don’t lie, and I have seen it with my own eyes: When Elisabeth and I walk down Wangfujing Avenue in Beijing or stroll in the Pudong district of Shanghai, for instance, we see scenes that bring the stats to life in dazzling color.
We see China’s super-rich lining up for diamond-set coats at Cartier. We see them inspecting Phantom Coupes at the Rolls-Royce dealership. And at almost the same time, we’re beset by the wretched ultra-poor, peddling counterfeit Rolexes, refilled mineral water bottles, or Mao’s Little Red Book.
Everywhere, the most-widely revered gods in urban China today are the god of wealth and the god of power.
In the long march toward conspicuous consumption, even Confucian traditions — respect for elders, parents and those of lower social status — have largely fallen by the wayside.
Of course virtually no one — inside or outside China — advocates for a return of the forced (and oft contrived) equality of the Maoist era. But this rapid shift to the opposite extreme has shocking consequences …

Protests, Revolts and Chaos in the Making

I cannot predict when or how the tautly stretched fabric of Chinese society and politics will snap. But I don’t have to. Because it’s already beginning to happen:

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Revolts. The 1989 Tiananmen Square uprising may have been the most widely known to the outside world. But it was not the last nor the most widespread.
In terms of the number of provinces impacted, the protests by the Falun Gong religious movement a decade later was broader. Ten years after that, the riots in Urumchi, the capital of the minority Uyghur region of Northwest China, were still larger. And the more recent Pro-Democracy protests were the biggest of all.
Year-by-year, province-by-province, protests in China are growing progressively more impactful.

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Labor protests. Even if you accept the government’s official count, the number of major labor protest incidents in China has been surging.
Workers are demanding higher wages, better benefits or simply an end to outrageously abusive working conditions.
Crackdowns. Under President Xi Jinping, the Chinese government is cracking down on popular dissent with growing impunity, audacity and ferocity.
And the U.S. Congress has taken notice. In its latest annual report, the Congressional-Executive Commission on China pulls no punches, declaring that:

1. Human rights and rule of law conditions in China have deteriorated sharply, especially since Xi Jinping came to power in November 2012.
2. The Chinese government has broadly silenced dissent, suppressed human rights advocates, and taken control over civil society. They have targeted journalists, human rights lawyers, ethnic minorities, religious groups, non-governmental organizations, intellectuals, democracy advocates, petitioners and peaceful protesters.
3. Without an independent judiciary, citizens across China have little legal recourse, most notably to redress appropriations of their land or homes by local officials for development projects. Even those making modest calls for reform have faced harassment, detention and arrest.
4. The government has dramatically stepped up its rhetoric against ‘‘foreign” ideals, values, and influence. Specifically, the Communist Party’s Document No. 30 purges ‘‘Western-inspired liberal ideas” from universities and prohibits teaching and research on a number of topics, including judicial independence, media freedom, human rights and objective analysis of the Communist Party’s history.
5. In official pronouncements, the Chinese government says it’s committed to yifa zhiguo (the rule of law). But anyone who thinks that means "rule of law for the people" is bound to be disappointed. What it really means is precisely the opposite. According to the Congressional Commission, Beijing is "further entrenching a system in which they utilize statutes to strengthen and maintain its leading role and power over the country."

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This is not based just on theory or analysis. It’s based on fact:

• Community Party documents expressly state their intent to use the law to strengthen their control over legislatures, local governments, and the courts.
• Many of China’s religious and political prisoners are subject to harsh and lengthy prison sentences, often thrown into extralegal ‘‘black jails” and ‘‘education centers.”
• Reports of torture in detention are routine — not to mention other human rights abuses, including denial of medical treatment and the use of forced hospitalization in psychiatric facilities.
• Prominent public interest lawyer Pu Zhiqiang recently faced charges of ‘‘picking quarrels and provoking trouble” and ‘‘inciting ethnic hatred.” His so-called "crime": Social media posts that mocked several government officials and that criticized China’s ethnic policy. Liu Xia, wife of imprisoned Nobel Peace Prize laureate Liu Xiaobo, was isolated under extralegal detention at her home in Beijing municipality despite her poor health. All told, the Congressional Commission has information on approximately 1,300 cases of political and religious prisoners detained or imprisoned, though the actual number is certain to be much higher.
• Lawyers who accept politically sensitive cases face disbarment, physical violence, and the closure of their law firms. In July 2015, for example, Chinese authorities took into custody more than 250 individuals in an unprecedented nationwide sweep.

A rash of new, police-state laws. Suddenly and without warning, the Chinese government has issued a series of far-reaching new laws with the cumulative effect of gutting relations with the West. Just in the last 18 months, for example, they’ve issued or drafted …

• The People’s Republic of China National Security Law, which identifies cyberspace, outer space, the oceans, and the Arctic as parts of China’s national security interests. The law stressed the need not only to maintain territorial integrity but also to ‘‘guard against negative cultural influences” and ‘‘dominate the ideological sphere."
• The PRC Overseas NGO Management Law, which impacts more than 7,000 foreign non-governmental organizations (NGOs) operating in China. All will have to find a domestic sponsor (if they can). All will have to register with the police and be subject to random raids or inspections (if they dare).
• The PRC Counterterrorism Law, which grants authorities the legal power to cut Internet access in order to ‘‘safeguard national security and social public order,” while also stipulating that user data from Internet companies must be stored in China.

These and other laws add up to an even broader, more severe crackdown on critics, protesters and ethnic minorities. They are poison for U.S. companies that do business in China. And ultimately, they could sink U.S. trade with China.
The big dilemma, according to the Congressional Commission on China: America’s business and trade interests in China depend on the Chinese government’s willingness to comply with international law, enforce its own laws, allow the free flow of news and information, and fulfill its obligations under the World Trade Organization (WTO). But with these laws and crackdowns, China is moving swiftly in precisely the opposite direction.
And here’s where the Commission fears the ongoing changes in China could impact the United States directly:
Impact #1. It could hurt the safety of our personal information in cyberspace.
Impact #2. It could threaten the safety of our food and drug supplies.
Impact #3. It threatens the protection of our intellectual property.
Impact #4. It will destabilize the entire Pacific region.
Impact #5. It will reduce trade.
Impact #6. It could sabotage U.S. business interests.
Needless to say, all this could dig a hole in the portfolios of mutual funds, hedge funds or any individual investor with a big stake in China.
And all these impacts are based exclusively on currently observed trends — before the vicious cycle of recession and political turmoil begins in earnest, before the volcanic forces in China erupt.

My advice …

First, if you have a lot of money tied up in mainland Chinese companies, greatly reduce your exposure.
Second, beware of U.S.-based multinationals that derive a large portion of their revenues from China.
Third, continue to invest cautiously overall. That means a focus on extreme high quality stocks, an oversized cash position in your portfolio and solid hedges against market declines.
Good luck and God bless!
Martin

Dr. Weiss founded Weiss Research in 1971 and has dedicated his entire career to helping millions of average investors find truly safe havens and investments. He is Chairman of the Weiss Group, which includes Weiss Research and Weiss Ratings, the nation’s leading independent rating agency accepting no fees from rated companies. His last three books have all been New York Times Bestsellers and his most recent title is The Ultimate Money Guide for Bubbles, Busts, Recesssion and Depression.