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The China Doomsday Scenario that everybody long oil wants to ignore

February 2, 2011

Lots of people think China is in a bubble. Hugh Hendy of Eclectica is a big china bear, but he isn’t the only one.  Just google “China Bubble” and you’ll have a few days of interesting reading. But few are really considering what would happen if that China bubble actually popped.

We know at least one very important fact – China has significant inflation.  And people are well aware that significant inflation has some chance of causing a massive popular uprising that ousts the current regime.  But people haven’t put together the doomsday chain of events that very high inflation brings to China – and to the commodity markets.

Real GDP is calculated as the nominal amount of goods moved through the economy, adjusted for the inflation rate. This relationship can be estimated as:

Nominal GDP = Inflation rate + Real GDP

It is common knowledge that China’s inflation rate is most likely massively understated.  Officially, Chinese inflation is in the 5% range, but many people think it is double that, at 10%.  This implies a much lower growth rate, if the Chinese nominal numbers can be trusted at all

15% nominal GDP = 10% inflation + 5% Real GDP

or

15% nominal GDP = 5% inflation + 10% Real GDP

So if they think inflation is higher, this dials down the growth rate in China.  Many people think that China’s real GDP growth rate is much, much lower than stated.  Instead of the official 10% growth rate, some reasonable people think that it is closer to 5%.

One of the great mysteries of China has been its reluctance to let its currency gain in value despite its incredible growth.  With growth at 10%, taking a bit of pressure off the inflation rate in your country by letting the currency gain in value is a no brainer.

But if China is only growing at 5%, their currency market actions become more comprehensible. If they are growing by only 5% instead of the stated 10%, then letting the currency gain by just a bit would be devestating to their economy.

What does this mean for commodities?  Lots of people on the Commodity side say things like “if China were to slow to 5% growth, commodity price would fall by 20%”.  It appears that China is only growing by 5%.  I suspect that people who are short China are also long commodities.

But it seems to me that Commodities are treading on thin ice here, if China growth is only 5%.  Because if the China bubble pops, then China might actually have some negative GDP numbers. Negative GDP tends to push down commodity prices quickly.

We’ve seen that China is very willing to manipulate their currency to take export driven growth and jobs from the U.S.

If a bubble pops in China, we’re likely to see China push the Yuan even weaker to stimulate growth.  This would do two things simultaneously.   First it would expose Chinas growth numbers as a sham – pushing down commodity prices.  Then, it would strengthen the U.S. Dollar as China pushes the Yuan weaker by purchasing boatloads of USD.  Both of these actions are massively bearish for commodities and U.S. inflation in general.

We’re already below target on inflation by any reasonable measure. This may be why the Fed is speculating on QE III.

But these actions are not bearish for Chinese food prices!! These actions will keep food prices high for Chinese people!  Right as a huge economic bubble is bursting for China, they will be taking actions that keep food prices very high.

And we’ve seen the results of high food prices.  High food prices make people downright revolutionary….

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