The IMF has released a nearly 300 page report on prospects for world economic growth that raises some of the same questions we wrote about the other day, including whether the de-coupling of the developing world from the US and Europe is real this time around. No one knows the answer to that question. Here are some excerpts from the IMF Report:

Although Chapter 3 shows that the particular dynamics of the housing market in the United States are not matched by those in other countries, it also shows that housing may now play a more marked role in the business cycle more broadly — as the nature of mortgage financing has changed and as valuations have increased almost everywhere over the past 10 years.

The second potential vulnerability is, of course, commodity prices. Chapter 5 examines the role of commodity prices in contributing to the strong performance of many emerging and developing economies in recent years. It is striking how the surging tide of commodity prices over the past five years has lifted almost all commodity-based boats around the world. Although there is some reason to believe that the countries exporting commodities are now better able than in the past to withstand a serious downturn, we continue to urge caution: commodity prices have fallen, on average, by 30 percent during significant global slowdowns over the past 30 years.

All eyes now turn to the world’s leading emerging economies. They have come of economic age in the past half-decade— diversifying their exports, strengthening their domestic economies, and improving their policy frameworks. It is conceivable that their strong momentum, together with some timely policy adjustments, can sustain both their domestic demand and the global economy. At this moment, however, these emerging economies find themselves beset not by impending recession, but rather by inflation pressures. In particular, the financial dynamics of dollar depreciation and increasing financial market uncertainty have combined with continuing strong demand growth in the emerging economies and sluggish supply responses by commodity producers in such a way as to keep upward pressure on food and energy prices despite the darkening clouds over the global economy. Therefore, at the very time when preparations for countercyclical measures would seem to be warranted, leading emerging economies find themselves trying hard to take the edge off inflation…

The overall balance of risks to the short-term global growth outlook remains tilted to the downside. The IMF staff now sees a 25 percent chance that global growth will drop to 3 percent or less in 2008 and 2009 — equivalent to a global recession…

What explains the resilience of the emerging and developing economies? Will they be able to effectively decouple from the substantial slowdown — and possible recession — in the advanced economies in 2008? There are two main sources of support for these economies: strong growth momentum from the productivity gains from their continuing integration into the global economy and stabilization gains from improved macroeconomic policy frameworks. What is important is not just how these factors have evolved in individual countries, but also how they have interacted across countries to change the dynamics of global growth.

there have been two important shifts in the growth dynamic of the global economy. The first is that growth in global activity over the past five years has been dominated by the emerging and developing economies — China has accounted for about one-quarter of global growth; Brazil, China, India, and Russia for almost one-half; and all the emerging and developing economies together for about two-thirds, compared with about one-half in the 1970s. Growth in these economies also is more resource-intensive, given their patterns of production and consumption (see Chapter 5 of the September 2006 World Economic Outlook). One consequence of these trends is that the increasing demand for key commodities such as oil, metals, and foodstuffs is now driven by growth in these economies — they account for more than 90 percent of the rise in consumption of oil products and metals and 80 percent of the rise in consumption of grains since 2002 (with biofuels representing most of the remainder).

This has contributed to the sustained strong increase in commodity prices observed over the past year, despite moderating growth in the advanced economies, and has been an important factor behind the strong recent performance of commodity-exporting countries in Africa and Latin America, as well as oil exporters in the Middle East. The second, related shift is the growing importance of emerging and developing economies in the structure of global trade. These economies now account for about one-third of global trade and more than one-half of the total increase in import volumes since 2000. Moreover, the pattern of trade has changed. Almost one-half of exports from emerging and developing economies is now directed toward other such economies, with rising intraregional trade within emerging Asia most notable…As a result, the advanced economy business cycle may play a less-dominant role in driving swings in activity for the emerging and developing economies,

We have a couple of takeaways from this excerpt of the report. First, if China (and the BRIC-like countries) have not achieved the decoupling that the IMF clearly hopes has happened, there are nasty implications for world GDP growth. As the report says: “China has accounted for about one-quarter of global growth; Brazil, China, India, and Russia for almost one-half; and all the emerging and developing economies together for about two-thirds.”

Second, what will happen to commodity prices this time around? The IMF warns: “commodity prices have fallen, on average, by 30 percent during significant global slowdowns over the past 30 years.” Will it happen again this time?

How self-sustaining has developing nation growth become? This is one of the most interesting economic and political questions of our times. We’re going to find out the answer (or answers) pretty soon.

The US is more or less in a recession. Europe isn’t far behind in growth dropping to de minimis levels — and that’s without factoring in the strains, sure to increase, between the Club Med countries and Germany and others regarding monetary and fiscal policies in the Eurozone. The Middle East can of course continue its outsized expansion as long as the oil bubble remains intact, but its history and traditions have not to date demonstrated that that region has developed the attributes to sustain indigenous economic growth, including innovation, labor force participation, or other characteristics that are typical among affluent economies.

It is unknown, as of this writing, whether the BRIC countries, and in particular China, can sustain their phenomenal growth rates in the current global environment. (We tend to believe not, as you know, and some of the evidence is beginning to point our way.) No less an official source than the Peoples Daily has said that China is 70% dependent on foreign trade for its growth, so we shall soon see just how self-sustaining the Chinese economy has become during its remarkable transformation of recent years.

General Electric has a large exposure to GDP growth rates in the developing world. (BTW, it only covers 63% of its CP with bank lines.) Its orders were up 8% in the quarter, though earnings disappointed. Its “infrastructure” segment, the company’s largest, had $15 billion in sales was 23% higher than a year ago, principally due to orders from Asia and Latin America. The company would appear to be a good window into trends in the developing countries, so from now on, we’ll be watching it a little more closely to see if it sheds any light on the question of just how self-sustaining developing nations growth has become — when the consumers of the US and Europe slow down their spending.

China’s exports to the US are up only 5% this year, marking a sharp departure from their 25%+ recent growth rate. This astonishing bit of news is buried within this WSJ report on China’s economy and exports (which topped $1 trillion last year and grew at a 25% clip last year):

China’s quarterly trade surplus shrank for the first time in three years…The trade surplus in goods, the amount by which exports exceed imports, was $41.42 billion for the first three months of 2008, China’s Customs agency said Friday. That’s roughly 11% smaller than the $46.44 billion surplus for the same period of 2007. Imports for the three-month period surged 28.6% to $264.48 billion, while exports grew a less rapid 21.4% to $305.9 billion — with growth in exports to the U.S. especially slow…

Shipments to the U.S. are up just 5.4% so far this year, reflecting both weaker demand there and the rise in the Chinese yuan against the dollar. The yuan has however continued to depreciate against the euro – making Chinese goods cheaper for Europeans – and exports to the European Union are up 24.2%.

The US accounts for almost a third of China’s exports ($322 billion in 2007). That’s up from $50 billion in 1997, a growth rate of 22% over the period, which accelerated to 26% in the last five years. The abrupt slowdown in Chinese exports to the US is quite significant in our view, and heralds a likely slowdown in China’s growth within the next year that is greater than most observers currently foresee.

We should also add that the still robust growth in China’s exports to the EU are likely to show a slowdown in the next year or so, as growth in Eurozone GDP retreats from its relatively healthy 2.8% and 2.6% levels of the last two years to the forecast growth of 1.4% and 1.2% this year and next.

Long cycle expenditures such as infrastructure project spending and the like tend to lag the cycle in spending on consumer goods, so just maybe we are not so wrong after all about the economic problems in China that may lie just over the horizon. (There is no reason to build new factories in anticipation of 25% growth if growth becomes modest, after all — and the bank loans to such projects would have their own problems, etc.) Furthermore, in such an environment, the insane bubble that has enveloped commodity prices — in part due to the development projects of the BRIC countries — seems a fragile thing indeed.

China’s A share market, which has had some spectacular results until recently, and includes large US investment banks among its successful fund managers, has been said to be in a “bubble.” (We have discussed elements of this previously.) Indeed, according to this piece in the FT, 70% of its investors apparently believe they have invested in a bubble, but according to the author, Jake Lynch of Macquarie, they are wrong:

A recent survey of Chinese A-share investors found that 70 per cent believed they were investing in a bubble, matching the perception of most foreign observers. The A-share market has been cited, according to a standard calculation, as trading at a price/earning ratios of 70 times. Even worse, 30 per cent of earnings are alleged to come from investment income (that is, stock trading) – in effect, a giant Ponzi scheme.

Combine the above with a reputation for questionable accounting practices and the threat of $1,300bn of previously non-tradable shares becoming unlocked in the next two years, and it is no wonder that the A-share market is now off about 36 per cent away from its highs.

So is this correction just the first leg of the great unwinding? Not likely. In fact, it is hard to find evidence of a bubble at all. Take valuations: the benchmark CSI 300 index is now trading at 23 times 2008 consensus earnings forecasts. This is not cheap, but it is far from what we think of as bubble valuations and below its 10 year average of 30 times…

consensus forecasts predict 32 per cent earnings growth this year. While 32 per cent seems like an aggressive number given the global slowdown, 7 percentage points come from a one-off tax break and a 25 per cent pre-tax growth rate may be achievable with a mid-teens nominal GDP growth rate – particularly when banks, oil and commodities are the main drivers…

a quick glance at the A shares that have been unlocked since 2006 show that only 10 per cent were actually sold into the market In fact, over 75 per cent of the shares being unlocked belong to the government. That they would be sold down en masse is highly unlikely. A much more likely scenario is the one that the government itself gives – that it will control the issuance of supply to continue to foster a healthily developing market.

Indeed, the increase of share supply is critical for a sustainable market. A-shares have historically traded at high valuations because China’s ratio of free-float market capitalisation to both GDP and savings remains far below other emerging and developed countries. In other words, there is not enough ‘supply’ of shares relative to high ‘demand’ from savers…

Time will tell if China’s “banks, oil and commodities” are the place to be in 2008, and whether the old argument of “not enough supply” of common stock to meet investors’ demands has any merit this time around. We have our opinion, but as we’ve said, we’re probably wrong.

We’re probably wrong. We’ve been wrong often and for a long time about a serious hiccup in China’s amazing growth story. But something seems different this time. The slowing of American consumption of Chinese goods, the appreciation of the yuan, China’s high domestic inflation, and the crash of the Shanghai market, all point towards a significantly slower growth environment in China, and at reduced margins for businesses. It is also an environment in which inflation takes the traditional stimulatory measure of loose monetary policy off the table. So options for correcting the decline in growth are somewhat limited in the short term.

Suppose growth slows in China beyond the modest decreases currently forecast. Will the world start caring about China’s allegedly cooked books and its “dodgy” Foreign Direct Investment numbers? Could there be a new bad debt banking crisis of the severity that some have foreseen? Could there become more stories about foreclosures and bankruptcies than about tales of amazing growth and prosperity? What would be the impact, if any, of these unpleasant developments after the Beijing Olympics? We’re probably wrong about China’s economic situation and all these other matters as well. But just suppose…

Wei Gu of Reuters writes in the IHT that “China banks could face credit crisis of their own,” a topic that has been pretty quiet since the big Chinese bank bailouts of a couple of years ago, in response to a mountain of bad debt that had accumulated by 2006:

risks are growing of a credit crisis with Chinese characteristics. A crisis like that could rock global markets, because China has been one of the few bright spots in the world economy. With memories still fresh of Beijing’s having injected more than $260 billion into its banks while shifting bad loans off their books, another huge bailout may become necessary if loose lending practices are not halted.

What could trigger such a turnaround in the Chinese credit market? A sudden sharp slowing of the Chinese economy. That’s not as far-fetched as it might seem. Weaker overseas demand and the bursting of an asset bubble in China could result in defaults by droves of companies. Sudden deflation of a bubble can lead to fast-deteriorating asset quality, cascading in a chain reaction through the financial system…

The nonperforming loan ratio for major Chinese banks rose for the first time in two years, to 6.72 percent in the fourth quarter from 6.63 percent in the previous quarter. That level is dwarfed by the 20 percent to 50 percent nonperforming loan ratios six years ago, but the trend is worrisome. “History shows even the worst banking systems can appear decent during periods of robust GDP growth,” said Charlene Chu, a senior director at Fitch Ratings. “Fitch remains concerned Chinese banks could well be underestimating potential future credit losses.”…

The World Bank expects China to grow this year at its slowest pace since 2002. And with inflation hitting 11-year highs, the central bank needs to clamp down on lending…Caught between an appreciating yuan, weaker global demand and rising costs at home, exporters are facing the toughest time in 20 years. In the Guangdong area near Hong Kong, about 12,000 exporters are likely to go bankrupt early this year, according to the Shenzhen OEM Association, an industry group. Signs are also suggesting that loans to real estate developers may go awry. After investors got used to rising housing prices, they are suddenly falling by double digits in certain cities.

The recent sell-off in the Chinese stock market — down 25 percent in the past four months — could also hobble banks because a big chunk of their business comes from equity-related products. A fair amount of corporate lending found its way into the stock markets, and that money might have evaporated already.

China’s banks have very high stock market valuations for their size, and of course the central government is flush with foreign exchange reserves, both of which factors could mitigate a new set of debt problems for China’s banks, even if those problems were as large as the largest estimates of a couple of years ago.

But, as noted in an AP story from the middle of last year: “’The banking system is still based on collateral and the collateral is all overvalued,’ says Andy Xie, an independent economist based in Shanghai and Hong Kong. ‘If the bubble bursts, then you will have a banking crisis like Japan in 1990…The question is how China can manage after the bubble’.”

The WSJ reports that journalists who covered the unrest in Tibet have been getting death threats via visitors to a “military themed Internet bulletin board”:

Some Chinese nationalists have undertaken a campaign of harassment, including violent threats, against foreign reporters who took part in a recent trip to Lhasa, for alleged bias in their coverage of unrest in Tibet. The intimidation efforts have included hundreds of calls and text messages to the cellphones of reporters who took part in the government-arranged Lhasa trip late last month, including correspondents from The Wall Street Journal, USA Today, and the Associated Press.

The flood of threats began this past week after the cellphone numbers, Chinese names, and brief descriptions of several of the correspondents were published on a military-themed Internet bulletin board. Contributors to that site have boasted of making harassing phone calls, and posted their own violent threats. “Beat to death these unjust, conscienceless criminals,” wrote one.

The campaign is the latest escalation in a nationalist backlash against Western news coverage of the March 14 antigovernment riots in Tibet and their aftermath. The precise basis for the complaints isn’t clear, although critics have circulated a few photographs published on news Web sites that they argue were misleadingly cropped or captioned. More broadly, the anger reflects deep-seated resentment among many Chinese — fostered by decades of government propaganda — at perceived interference in China’s internal affairs by foreign governments and groups. The phone calls and text messages in recent days have ranged from relatively mundane denouncements to profane attacks on the reporters and their families to numerous threats of violence and death. (”You damned American devil, God will punish you. Tomorrow you will be hit by a car and killed.”)

Robert Kagan and Bruce Kesler have more about disturbing and somewhat surprising developments in China in this year of the Beijing Olympics, a year in which the Communist government of China might better have opted for a friendlier public relations façade. (Is gunning down monks an Olympic sport?) Better to see the truth, however.

As Kagan notes, China is “a 19th-century power, filled with nationalist pride, ambitions and resentments; consumed with questions of territorial sovereignty; hanging on repressively to old conquered lands in its interior; and threatening war against a small island country off its coast. It is also an authoritarian dictatorship.” No kidding.

Shanghai Daily in May 2007:

The world’s fourth-largest economy has expanded by at least 10 percent for each of the past four years. Foreign direct investment in China rose 4.5 percent last year to a record of US$63 billion…Foreign direct investment has surpassed US$700 billion since China began accepting overseas’ investors money, Commerce Minister Bo Xilai said in March…

T C A Srinivasa-Raghavan in India’s Rediff News:

It has always been something of a mystery to me as to how China attracts such huge volumes of FDI, especially when the rate of return there isn’t very exceptional. I have, therefore, always believed that the data is dodgy. For example, when China tells you how much FDI came in a particular year, it counts the entire project cost, not just the FDI part of it.

Does this disparity between China and India, as reported by A.T. Kearney, make any sense: “China’s FDI flows are larger ($53.5 billion) and primarily capital-intensive, while Indian FDI flows are smaller ($4.3 billion) and skill-intensive, concentrated in information and technology areas.” Moreover, India’s efficiency of its invested capital is much higher than that of China. Given these factors, is it likely that FDI in China is 12x greater than that in India?

Japan Times says that Japanese investment in China is on the wane:

Japanese investment in China, which dropped in the first half of 2007, is unlikely to pick up in the near future as manufacturers scale down investments in the country, a Japanese trade organization said Thursday.

Even as overall overseas Japanese investment more than doubled in the January-June period, that to China dropped 11.2 percent from a year earlier to ¥342.8 billion in the same period, a report by the Japan External Trade Organization’s Beijing office says.

The drop comes after a sharp rise in Japanese investment in China in the first half of this decade, particularly after the country’s entry into the World Trade Organization in 2001. “Manufacturers’ initial investments to China have been all but completed, and those in the future will be for enlarging existing facilities or for sales, so a major increase in the near future is not expected,” the report says…

In contrast to the drop in Japanese investment in China, that in Southeast Asia from January to June shot up 72.8 percent from a year earlier to ¥427.5 billion, while that in India quadrupled to ¥107.3 billion…

Meanwhile, the Peoples Daily has quite a different spin: “Over the years, Japan has invested up to 39,000 projects and as much as 60.8 billion US dollars of promised capital in China, making it the second largest source of foreign capital for China. Japanese companies have flourished in various sectors, all with highly complementary industries, sound management, and significant return…Since the 1980s, Japan’s investment in China has reached three heights. Currently, it is riding its third high tide.” Somebody’s fibbing, or some important facts have been left out.

Near the beginning of this decade Foreign Direct Investment in China ran about $50 billion a year. By 2005 FDI was over $70 billion, or perhaps even more. Lee Branstetter of Carnegie Mellon and Fritz Foley of Harvard take a look at US FDI in China and find the numbers to be surprisingly small:

Many otherwise well-informed experts on international economics believe that US FDI in China is large, that US multinational enterprises (MNEs) have significantly enlarged the US-China trade deficit by shifting production aimed at the US market to Chinese affiliates, and that this production shift has undermined investment at home and in other countries. Current conventional wisdom also suggests that US MNEs are moving cutting edge R&D to China, in order to take advantage of vast legions of low cost technologically skilled workers. Our recent research, based on comprehensive surveys of US multinational activity in China, suggests that each one of these suppositions is largely false.

First, US FDI in China is surprisingly small relative to nearly any relevant benchmark. US firms account for a small component of total FDI inflows into China. US affiliates have contributed very little to Chinese fixed asset investment or employment growth. Moreover, in 2004 the Chinese operations of US firms accounted for only 1.9% of total foreign affiliate sales and 0.7% of total foreign affiliate assets. These small numbers reflect China’s poverty, its distance from the US market, and, to a lesser extent, its imperfect institutions. As the Chinese economy grows and Chinese consumers become richer, investment will increase. But it is likely to be many years before American firms conduct a sizable fraction of their activity in China. We believe that European MNEs are similar in this regard.

Second, US affiliates in China have played very little role in China’s export growth. While foreign firms are currently responsible for nearly 60% of China’s total exports, US firms account for only a very small portion. Foreign firms based in other Asian countries are the dominant force behind China’s export surge. US affiliates are overwhelmingly focused on sales to the domestic market. The notion that US MNEs significantly contribute to America’s large trade deficit with China by moving production of goods intended for the US market to their Chinese affiliates is simply not born out by the data. It appears that this same generalization largely applies to European multinationals.

Third, there is little evidence that increased US MNE investment in China is associated with less investment elsewhere. If investment in China is not that large and primarily focused on the domestic market, there is no reason to think that recent or future growth in FDI in China will crowd out significant amounts of investment at home or in most other host countries. Again, we think this is probably also true of European MNEs.

Finally, our review of US multinational R&D data and US patent data convinces us that China has not yet emerged as a major technological power, nor is the level of US R&D activity in that country large enough to contribute significantly to such an emergence…In between 2000-2006, China-based inventors obtained 3,447 patents in the United States. This is not large relative to more advanced Asian countries. Over the same time period, inventors in Japan received nearly 241,000 patents, and inventors in Taiwan received over 39,000

In 2004, US firms spent $622 million on R&D in China; an amount that was about 0.3% of the total R&D undertaken globally by these firms. China even accounted for less than 13% of total R&D undertaken by US firms within the Asian region.

China has just changed its FDI rules by 180 degrees in many cases (外商投资产业指导目录（2007 年修订), moving away from low value commodities and export-driven industries and trying to move swiftly up the food chain, as a recent NYT article noted. We doubt that the change can be made very quickly, given labor and infrastructure issues.

The FDI changes do not lift the Chinese government’s tight control on media and academic or other social research. As the China Law Blog noted: “Continued restriction and prohibition of participation in publishing, media, market research and social research. In recognition of the influence of the Internet as an alternative publishing source, various Internet based businesses have been added to the prohibited category. This denial of access for media and publishing is a hot button for the United States and the Chinese do not seem willing to budge a bit on this.” Maybe they have something to hide.

Shang-Jin Wei of Columbia questions the efficiency of the huge amount of capital investment in China that is made by state-owned firms, which account for something less than a third of China’s output, but more than half the corporate lending in China (and how many of their bad loans?).

Is it really possible to invest wisely four out of every ten RMB earned? This concern is especially relevant when it comes to investment by state-owned enterprises. If the investment is not efficient, then the same output could be achieved with less capital, thus freeing resources for other uses, such as raising household consumption or improving profitability and/or the balance sheets of the banks that fund them.

There are a number of a priori reasons for believing that state-owned enterprises may be investing less efficiently than domestic private firms. They are burdened with more administrative interference in terms of restrictions on hiring and firing and on switching product lines in response to changing market conditions. Despite some progress over the years in linking executive pay to performance, managers in these firms often still do not have compensation schemes that encourage efficiency, or discourage overinvestment and “empire building.” Some state-owned enterprises also have weak corporate governance.

The Chinese financial system is dominated by majority or wholly state-owned banks as the figure shows. Such banks may favour lending to state-owned enterprises despite efforts by the authorities to increase the commercial orientation of these banks. For example, while state-owned firms represent a declining share of output (it was about a third in 2005), their borrowing from domestic banks accounts for more than half of the total lending by these banks. Majority state-owned firms also take up the lion’s share of all publicly-traded companies in China’s two stock exchanges…

To see whether state-owned enterprises are systematically less efficient investors, David Dollar and I analysed a data set based on a 2005 survey of 12,400 firms in 120 cities located throughout China. What we found was that ownership did indeed have an impact on the productivity of investments even after more than two decades of corporate reforms. As the chart shows, state-owned firms had the lowest marginal product of capital as measured by the marginal revenue product of capital.

It is perhaps no coincidence that something like 90% of China’s richest people are the children of Communist Party members. As Carsten Holz wrote in the Far East Economic Review and elsewhere: “of the 3,220 Chinese citizens with a personal wealth of 100 million yuan ($13 million) or more, 2,932 are children of high-level cadres. Of the key positions in the five industrial sectors — finance, foreign trade, land development, large-scale engineering and securities — 85% to 90% are held by children of high-level cadres.”

The China Economics blog, among others, predicted the decline of the Shanghai market that has taken place in the last six months. There have been a lot of shenanigans in the Shanghai market, that is true, but markets also fundamentally look ahead to future economic performance, perhaps six to nine months down the road. The NYT has more on the shenanigans:

the government fears that angry investors can be a social problem. And so while the state-run media report on the ups and downs of the market, and even warn investors of the risks and pitfalls of investing, the press does not usually report on investors’ anger. “Actually there are a lot of complaints, but the Chinese media can’t report this,” says Mr. Guan, the former real estate company owner.

Now, in the brokerage house corridors — corridors of pain — one can hear complaints about all the market flaws: the government doesn’t regulate the stock market and it participates in it by allowing mostly big state-owned companies to go public. There are also complaints about insider trading, stock manipulation, and big investors with government connections, pumping and dumping stocks on small investors…

“It’s a deformed market, an unhealthy market,” Mr. Guan says. “We’ve always had long bear markets and short bull markets…Look,” he said, “it took two years to go from 1,000 to 6,000 but two months to go from 6,000 to 3,500.”

Clearly there has been some crazy speculation at Shanghai 4000, and 5000, and 6000. And there’s clearly been monkey business going on, with the pump and dump operations and no doubt much worse. But we are beginning to see a good many signs, mostly anecdotal and suggestive thus far, of a coming significant slowdown in China’s economy.

If that should come to pass, with the cascading effects of increased scrutiny on the details of China’s economy, caution is in order. (Investors Business Daily has editorialized that China’s basic economic statistics are a scam.) In such an environment, some of the commodities related to growth, like oil, which have been on speculative steroids for some time (and giving off classic warning signs), may experience a reversal that seems largely unanticipated by markets at this time. Can’t happen, you say? Perhaps. But how many people understood the magnitude and impact of the subprime problem at the beginning of last year? Recessions happen, bubbles burst, discontinuities develop — and so many times they seem to appear as a great surprise.

In China, interest rates are up, so is inflation, bad debts are already high, the yuan has been revalued from 8.3 to about 7.0, exporters are facing lower sales increases (in a country 70% dependent on exports for growth) plus squeezed profit margins, some factories are closing, and these things translate into lower real FDI, itself a powerful engine of China’s growth. Add to that a limited range of monetary options (with inflation 7-10% and M2 growth 16+%) to spur growth, and China’s slowdown might be more serious than the world anticipates at this time. We’ll see.

Chi Mak was a Chinese sleeper agent in the US for over 20 years. Two decades is quite a nap. But he’s awake now. WaPo:

Prosecutors called Chi Mak the “perfect sleeper agent,” though he hardly looked the part. For two decades, the bespectacled Chinese-born engineer lived quietly with his wife in a Los Angeles suburb, buying a house and holding a steady job with a U.S. defense contractor, which rewarded him with promotions and a security clearance. Colleagues remembered him as a hard worker who often took paperwork home at night.

Eventually, Mak’s job gave him access to sensitive plans for Navy ships, submarines and weapons. These he secretly copied and sent via courier to China — fulfilling a mission that U.S. officials say he had been planning since the 1970s.

Mak was sentenced last week to 24 1/2 years in prison by a federal judge who described the lengthy term as a warning to China not to “send agents here to steal America’s military secrets.” But it may already be too late: According to U.S. intelligence and Justice Department officials, the Mak case represents only a small facet of an intelligence-gathering operation that has long been in place and is growing in size and sophistication.

The Chinese government, in an enterprise that one senior official likened to an “intellectual vacuum cleaner,” has deployed a diverse network of professional spies, students, scientists and others to systematically collect U.S. know-how, the officials said. Some are trained in modern electronic techniques for snooping on wireless computer transactions. Others, such as Mak, are technical experts who have been in place for years and have blended into their communities.

“Chi Mak acknowledged that he had been placed in the United States more than 20 years earlier, in order to burrow into the defense-industrial establishment to steal secrets,” Joel Brenner, the head of counterintelligence for the Office of the Director of National Intelligence, said in an interview. “It speaks of deep patience,” he said, and is part of a pattern.

The Chinese have been hacking into advisers to the Defense Secretary, and into all sorts of commercial enterprises in the Free World as well. Nasty piece of work.

IHT:

QINGDAO, China: Scores of South Korean-owned factories are closing surreptitiously in eastern China as their owners flee rising costs, leaving behind embittered workers like Li Hua. Li and more than 200 colleagues have been fighting for a year to get the six weeks’ wages they were owed when the owner of the toy factory where they worked fled during the 2007 Lunar New Year holidays…

Qingdao mirrors, on a smaller scale, what is happening in the Pearl River Delta near Hong Kong. There, thousands of factories, mostly run by Taiwan and Hong Kong companies, are moving inland or abroad or are simply closing as rising costs undermine the assumption that China is the world’s cheapest manufacturing location.

In Qingdao, Sung Jeung Han, manager of the Korean Society and Enterprise Association said 20 percent to 30 percent of the 6,000 South Korean firms in that eastern port city were losing money. “The wage rise, yuan appreciation and higher input prices are the main reasons,” he said by telephone. The minimum wage in Qingdao has risen 43 percent in the past three years…

That 43% represented an increase in wages to about $107 a month.

It’s different this time around, or so says the WSJ. This time around, countries that produce commodities or industrial goods won’t be much affected by a US recession, in important part because the BRIC countries and others continue to have robust growth. There won’t be a domino effect this time around:

Here’s a big lesson of the first international financial crisis of the 21st century: Some old-fashioned economies are weathering the storm better than those that borrowed big to spur growth or those that bet heavily on debt-strapped American consumers…

“The remarkable difference between this period of financial upheaval and those in the past is the performance of developed and developing countries,” World Bank President Robert Zoellick said in a speech on Wednesday at the Center for Global Development, a Washington, D.C., think tank. “Not only has the epicenter of the quake shifted [away from developing countries], but so far the tremors have shaken markets differently.”…the global economy looks well positioned to weather the turmoil, unless the U.S. falls into a deep, lingering recession. The global economy is expected to grow 3.8% this year, compared with 4.7% a year earlier…

Resource-rich countries — including Russia, Brazil and Australia — are poised to keep prospering. Vast appetites for raw materials in China, India and elsewhere give commodity producers alternatives to the U.S. market, and have lessened the chance of a commodities crash…

When the U.S. economy last tanked in 2001, machine-tool maker Mori Seiki, in Nagoya, Japan, showed a loss for the first time in years. But it has since diversified its customers and this time it expects to turn a profit, says its president, Masahiko Mori. About 25% of Mori’s world-wide sales are to the auto industry, which have already been affected by a downturn in U.S. consumer spending. But Mr. Mori thinks demand from other countries will make up for this. “Of course the U.S. market is still important,” he says. “But our increase of business from BRICs [Brazil, Russia, India and China] and Europe means we’ve diversified our risk.”

Of course it just might be different this time around. The US is a smaller part of the world than it used to be, after all. But the US is still over a quarter of world GDP, and supports the growth of many of the export driven countries — so we won’t be a bit surprised if it’s not terribly different this time around.

We’ll have to wait until mid-April for the official GDP statistics, but evidence is accumulating of a significant slowdown in China’s economy. WSJ:

The World Bank has just lowered its forecast for China in light of the deteriorating U.S. economy and now expects growth for all of 2008 to slow to 9.4%, down two full percentage points from 2007. That is, of course, extremely fast by the standards of any other economy but would still be an adjustment for China after five straight years of gains of 10% or more.

“A slowdown of growth to a single-digit rate will shock the markets, we believe, and may well trigger a retracement of prices for energy and industrial commodities,” said Carl Weinberg, chief economist for High Frequency Economics in the U.S., in a research note this week…

China’s economy could be slowing by more than official figures indicate. For instance, the benchmark measure of capital expenditure, called urban fixed-asset investment, grew 24.3% from a year earlier in the first two months of 2008. That is a very mild easing from last year’s 25.8% increase. But the headline numbers published by the National Bureau of Statistics aren’t adjusted for inflation, which has been accelerating. After accounting for those rising costs, investment grew by 18% or less early this year, compared with 23% to 25% for most of last year. Analysts blame weaker real-estate markets as well as reduced factory expansion from exporters who are seeing less demand from the U.S.

Rising raw-materials costs also are squeezing profit margins for many companies. The statistics bureau’s survey of industrial companies found total profits for the first two months of 2008 grew 16.5% from a year earlier, a marked slowdown from the 36.7% jump for the full year of 2007. Among publicly traded companies, bellwethers of both light and heavy industry are suffering.

Weiqiao Textile Co., a fabric and yarn producer with shares that trade in Hong Kong, this week reported a 20% decline in 2007 net profit. Company chairman Zhang Hongxia blamed a weaker dollar, adverse tax-policy changes in China and rising raw-materials costs. Baoshan Iron & Steel Co. also recently reported an unexpected 2.8% decline in net profit for the year. China’s biggest steelmaker has been raising prices for many products this year in an attempt to recoup higher costs for iron ore and energy.

We’ve been cataloguing the growth of China for a number of years now, and only recently have contrary signs emerged. We’ll see what the GDP numbers say later this month.

James Ceaser, who spends quite a bit of time thinking about ideology and political parties, has a number of interesting observations on the 2008 election. He notes that the candidates of each party may be tied to a tired ideology, but is doing nothing to alter it to the circumstances of today.

Since Ronald Reagan ran for the presidency 28 years ago, all of the presidential elections have been fought within the same ideological framework. Candidates have come and gone, party fortunes have risen and fallen, and the world order has undergone a complete transformation; but the basic structure of the debate between liberalism and conservatism has remained unchanged. During the past two elections, the two camps have dug in, solidifying and consolidating their positions. The result has been an era of strong polarization accompanied by the political equivalent of trench warfare.

Electoral analysts from across the political spectrum have begun to argue that this structure is ready to crumble–a prognosis that seems about half right. There is now strong evidence that significant segments of the electorate are no longer much concerned with the old liberal-conservative divide. In Michael Barone’s words, “we have entered a period of open-field politics” in which voters are moving around and “there are no familiar landmarks.” This diagnosis applies especially to younger and newer voters, for whom Ronald Reagan is a distant figure from another age. The change is sufficiently large that most campaign strategists, Karl Rove among them, have counseled abandoning the 2004 battle plan of appealing chiefly to a committed base, and adopting instead a strategy that tries to appeal to those at the margin who are less tightly moored. Nonetheless, it is not true that the ideological edifice inherited from the Reagan era is in immediate danger of collapse. It remains intact–no alternative ideological way of thinking having yet been offered as a viable replacement.

From this perspective, the most noteworthy aspect of the current campaign is surely something that has not taken place. Neither party will select a candidate who has campaigned on the basis of a call to alter or reconfigure the party’s ideological position…

The absence of new thematic thinking certainly does not mean that ideological controversy will disappear. Just the opposite may be true. In the general election, each party’s candidate will be pushed by the opposition to defend a version of the existing party philosophy, perhaps even more faithfully for not having a philosophical platform of his (or her) own. Much time, of course, still remains before the fall campaign to develop new themes, but leopards do not easily change their spots, and dramatic changes in the contenders’ ideological thinking are unlikely at this point.

If a new turn in thinking is not what the candidates bring to the table, there is something else they do offer: themselves. All three of the candidates stand out dramatically in relation to their party, especially as non-incumbents. (Elections involving a sitting president inevitably have a strong emphasis on him personally, if only because the opposition may focus obsessively, as in 1996 and 2004, on what it cannot abide in his mannerisms and character.) What experts dryly call the “personal factor,” meaning the voters’ evaluation of the candidates’ individual attributes and style, seems certain to play a much larger role than usual in the upcoming election. The choice of the person, as Alexander Hamilton envisaged, will loom large.

Let’s add Michael Barone to the mix and see what we get: “Most people’s views of the world are shaped by the times in which they came of age. That’s why we speak of a baby boom generation or a Generation X. But some people miss out on the formative experiences of most of their peers. That’s the case, I think, with the Republicans’ certain nominee and the front-runner for the Democratic nomination. John McCain missed the 1960s. Barack Obama missed the 1980s.”

Interestingly, America’s problems today are somewhat like the needs of the 60’s and the 80’s. We believe that there is a need for a new American optimism about the future, but the prerequisite for that is a renewed sense that Americans can be and are in control of more of their nation’s destiny. Our unnecessary overdependence on foreign oil is one issue that is not seriously confronted by the political establishment. As well, Americans want to shop at Wal-Mart, where almost everything comes from China, but they justifiably worry that their job may go overseas. Neither of these issues is solved by a deranged populism, but both of them should be confronted.

Moreover, the mission (never coherently stated nor put to a vote) that has formed “the heart of the Bush presidency” — reforming the alien politico-religious structure of far off foreign lands — has surely not contributed to a sense that America is in very good control of its destiny.

Finally, the US would appear to be in a somewhat different position than it was in the last century. When FDR was elected, Americans numbered 122 million and were over 6% of the planet’s relatively tiny population. Now the population of this crowded world is almost 7 billion, and the relative US share of its population has fallen by almost a third to the 4% range. Americans are awash in a sea of other humans, and, if they are not going to run this big world, they at least want to control what goes on within their own borders. From control of the country’s borders, to better control of economic sovereignty, there are data that show that a majority of Americans want sensible measures that enhance an American sense of better control of the country’s destiny. We’ll have to see who, if any of the above, can rise to these challenges.

UPDATE

We’d support the Victor Davis Hanson 10 Point Platform as an excellent approach for the next administration. (HT: GS)

The sometimes excitable Ambrose Evans-Pritchard sees more doom and gloom ahead in the oddly titled piece in the Telegraph “Foreign investors veto Fed rescue”:

Asian, Mid East and European investors stood aside at last week’s auction of 10-year US Treasury notes. “It was a disaster,” said Ray Attrill from 4castweb. “We may be close to the point where the uglier consequences of benign neglect towards the currency are revealed.” The share of foreign buyers (”indirect bidders”) plummeted to 5.8pc, from an average 25pc…The US has come to depend on $800bn inflows of cheap foreign capital each year to cover shopping bills. They may have to pay a much stiffer rent.

As of June 2007, foreigners owned $6,007bn of long-term US debt. (Equal to 66pc of the entire US federal debt). The biggest holdings by country are, in billions: Japan (901), China (870), UK (475), Luxembourg (424), Cayman Islands (422), Belgium (369), Ireland (176), Germany (155), Switzerland (140), Bermuda (133), Netherlands (123), Korea (118), Russia (109), Taiwan (107), Canada (106), Brazil (103). Who is jumping ship?

The Chinese have quickened the pace of yuan appreciation to choke off 8.7pc inflation, slowing US bond purchases. Petrodollar funds, working through UK off-shore accounts, are clearly dumping dollars amid rumours that Gulf states - overheating wildly - are about to break their dollar pegs. But mostly likely, the twin crash in the dollar and US agency debt reflects a broad exodus by global wealth managers, afraid that America is spinning out of control. Sauve qui peut.

The bond debacle last week tallies with the crash in the dollar index to an all-time low of 71.58, down 14.6pc in a year. The greenback is nearing parity with the Swiss franc - shocking for those who remember when it was 4.375 francs in 1970. Against the euro it has hit $1.57, from $0.82 in 2000. Against the yen it has smashed through Y100. Spare a thought for Toyota. It loses $350m in revenues for every one yen move. That is an $8.75bn hit since June. Tokyo’s Nikkei index is crumbling. Less understood, it is also causing a self-reinforcing spiral of credit shrinkage throughout the global system. Japanese investors and foreign funds are having to close their yen “carry trade” positions. A chunk of the $1,400bn trade built up over six years has been viciously unwound in weeks.

Of course things might get considerably worse from here. It’s hard to say. However, there should come a time, perhaps soon, when shorting the dollar and making bullish bets on commodities and oil ceases the be the riskless strategy that the Fed’s dawdling has thus far made it. In such a scenario, we would not be surprised to see the large foreign investors capitalize on the low dollar and reduced stock prices to recycle some of their exaggerated surpluses into US equities. One way or another, those surpluses have to be recycled or the global financial system cannot function.

After many years of eye-popping increases in exports (to over $1 trillion), economic growth and foreign exchange reserves, China’s trade surplus has narrowed sharply — by 63% — in 2008. Meanwhile, domestic inflation continues to soar. AP:

China’s trade surplus in February totaled $8.6 billion, down from $23.7 billion in February 2007, the customs agency reported…The 63% drop in the trade gap from the year-earlier period reflected the impact of a U.S. slowdown while China’s own expansion has stayed robust, driving demand for imported energy, consumer goods and industrial equipment…

China’s imports in February surged 35% to $78.8 billion from the year-earlier period, according to the customs agency. Exports grew by 6.5% to US$87.4 billion — a much slower growth rate than January’s 26%…

Consumer inflation rose to 7.1% in January, its highest level in 11 years. Economists expect February’s inflation rate, due to be reported Tuesday, to rise as high as 8.5%…The cost of basic oil products jumped 37.5% jump in February while that for steel products was up 29.6 percent, the statistics bureau said. Food-related raw materials rose 11%…

State-set prices of gasoline, electric power and some other consumer necessities were frozen in September. In January, food producers were ordered to get official approval for any price increases. Fertilizer prices also have been frozen to protect farmers. But steel mills, factories and other producers must pay market prices for coal, iron ore and other raw materials. Economists have warned that leaving price controls in place too long could add to inflation pressures…

Meanwhile, fixed asset investment in China rose another 25% last year, continuing a string of such increases, while money supply increased 18%. If export growth continues to falter (due to economic conditions in the West) in a country which is 70% dependent on exports for its growth, China might well find itself with a case of stagflation, or other similar economic distress. In any event, the current slowdown in China’s trade surplus marks a decided change from many years of astounding growth statistics, and so this break in a long trendline certainly bears watching.

Alan Greenspan, via Reuters:

Greenspan also said a boom in oil prices, which hit a record of $101.32 on Wednesday, will “go on forever.”

Greenspan was speaking in Saudi Arabia, by the way. Why are we always reminded (and not in a good way) of Irving Fisher’s “permanently high plateau” in prices when we hear such things?

Addendum: Greenspan also predicted a “dramatic contraction” in the Chinese stock market in the middle of last year. After that prediction, the Shanghai exchange promptly soared to new heights, and, as of this writing, it is trading a little higher than when the former Fed chairman spoke.