-->Sino Bubble

The Daily Reckoning

Paris, France

Friday, 5 September 2003

-------------------

*** Keeping the system going! A lose, lose, lose affair...

*** Stocks rise. Gold falls...

*** Maximus debtus... Europe says NO... asking the IRS... and
more!

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No, dear reader, we're not changing our position. If the
rest of the world doesn't seem to be headed in the
direction we forecast... it will just have to change course!

Not that we know where stocks are going this week or the
next... not at all! That is asking too much from a free
email service. We will give you our guess: the current
rally will fizzle out sometime this fall. But what do we
know?

What we know is that the Fed, the Bank of Japan, the
People's Bank of China, the European Central Bank, even the
Bank of Nepal, for all we know, are desperately trying to
keep The System going. You understand the system better
than most people: it's the Dollar Standard system created,
by default, by the Nixon Administration.

Here's how it works: the U.S. spends as much as it wants
and settles its debts by issuing bonds or dollar credits.
Foreign companies end up with trillions of U.S.
dollars... which they use to build more factories; then they
recycle the rest back to the U.S., boosting prices of
stocks and bonds on Wall Street.

It's win, win, win for everyone!

U.S. consumers get SUVs and toaster ovens... foreigners are
kept busy producing them. And politicians and central
bankers get to continue mismanaging their economies.

If The System could go on forever, we would surely want to
get in on the fun along with everyone else. We could buy
some Krispy Kreme stock... or maybe Cisco... or even our old
friend, the great River-of-no-returns stock, Amazon.com. Or
we could buy small-cap stocks, because, as James Boric
suggested in yesterday's Daily Reckoning, they always lead
the way out of a bear market... or more real estate as Dr.
Sjuggerud recommends, because the boom in real estate has
yet to begin.

Or, maybe we should lend a little money to the great state
of California. At more than 5% yield, who can resist?

But, as we pointed out yesterday... there's the smart money,
the dumb money, and the money so hopeless you feel you
would be doing it a favor by smothering it with a pillow.
In a better world, we would be able to tell you which was
which right now. But the Creator did not set things out to
make it easy for us to make money. We will have to wait
until after the fact, along with everyone else.

Still, we have a hunch or two...

Our hunch is that people who lend to California will get
what they deserve. The state has no way of paying them
back. Unlike the Federal government, California has no
printing press with which to settle its accounts. It must
pony up, or go broke. Most likely, its bondholders will
receive only pennies on the dollar - as the bonds collapse
in value, or the dollar does.

Stock market buyers, too, will rue the day they heard the
expressions - 'buy the dips,' or 'investing for the long
term' - as the whole system becomes a lose, lose, lose
affair for almost everyone. More below...

Over to you, Eric:

------------

Eric Fry from lower Manhattan...

- The stock market continued rumbling along yesterday, as
the Dow gained 19 points to 9,588 and the Nasdaq advanced
16 points to 1,869. The resurgent Nasdaq Composite is
powering ahead like the days of old, as bellwethers of old
like Cisco Systems lead the way. The Nasdaq has racked up
seven straight winning sessions - a feat it had not
accomplished since the glory days of February 2000.

- So it seems that all is well with the stock
market... Right? And the economy is improving - more or less
- according to most of the recent economic reports.
Yesterday, for example, we learned that American workers
are increasingly productive. The bad news is that fewer of
them are producing.

- Productivity, which measures output per employee, grew at
a 6.8% annual rate in the April-June period, or triple the
first quarter's rate. Unfortunately, the glowing
'productivity' gains in the second quarter were largely the
result of falling employment, rather than rising
production. American companies eliminated a net total of
170,000 workers during the second quarter... and the job
losses continue. Initial jobless claims rose last week to
413,000, the highest weekly tally in more than a month.

- But Wall Street economists promise that better times are
a-comin' just around the corner."The economy is
improving," heralds the hopeful chorus, as it points to a
lengthening strand of positive economic reports. Yesterday,
the Institute for Supply Management announced that its
services index held steady at the six-year high it reached
last month. Meanwhile, factory orders increased for the
third straight month, which is the longest winning streak
for this manufacturing-sector indicator in nearly a decade.

- Even we must admit, therefore, that some aspects of the
U.S. economy are improving in some ways... But please don't
ask us to join the frenzy for richly priced common stocks.
Yesterday we observed that bond investors are hesitant to
buy the bonds of 'fiscally challenged' municipalities like
the state of California. They fear that lending money to
the Golden State is a risky proposition. Bond investors,
apparently, have read about California's $38 billion budget
shortfall and strongly suspect that this fact is not a good
thing.

- But stock market investors - if they read anything at all
- don't seem to read the same newspapers that bond
investors do. (Then again, most stock market investors
don't seem to read at all. Why should they?... CNBC runs
continuously during market hours.) Stock investors do not
seem troubled in the least that states and municipalities
are struggling to make ends meet.

- If they were troubled about such matters, they would not
be scooping up the shares of companies like Maximus Inc.
that rely upon contracts with state and municipal
governments. Maybe the eager buyers of Maximus shares are
looking ahead to the day when municipal coffers will run
over once again. Or maybe they are buying the stock, merely
because it is going up. We do not know. What we do know,
however, is that investors are not buying the stock because
business is booming.

-"Hardly a day goes by without headline news detailing the
dismal budgetary situation of state and local governments,"
observes Robert Tracy of Apogee Research."So why, then,
have the shares of Maximus Inc., which derives about 89% of
its revenues from contracts with state and local
governments more than doubled since April? The answer
cannot possibly be that business is improving. It most
certainly is not.

-"Maximus' operating margin has been shrinking steadily
since the boom days of the late 1990s," says Tracy."and
conditions for the company are getting worse, not better,
as Maximus itself openly admits."

- Tracy is referring to a passage from the company's first-
quarter report that reads:"Financial results for the three
months ended March 31, 2003 were impacted by delays in
contract signings, work start delays, and some program
scope reductions. These factors are primarily reflective of
continued state budgetary pressures, which trend is
expected to continue in the short term."

- Needless to say, Maximus'"short term" difficulties may
be somewhat longer term than expected if rising tax
revenues don't begin flowing into the nation's statehouses.

- MBIA shares are another stock market curiosity. The stock
of this municipal bond insurer has soared 60% since March.
It's true that business is booming, but that's a mixed
blessing. Business is strong, primarily because the
finances of so many municipalities are weak. Many
municipalities are in such terrible financial shape that
they must insure their bonds against default in order to
sell them to the public.

- That's the good news for MBIA. The credit insurer
reported a whopping 53% jump in second-quarter profits,
thanks in large part to a 136% surge in new insurance
policies written on municipal bonds. The bad news is that
the company is on the hook whenever a cash-strapped
municipality defaults on one of the billions of dollars
worth of bond issues that MBIA has insured.

-"Examining MBIA's insurance exposure," observes the
Prudent Bear's Doug Noland,"it is worth noting that
California General Obligation (at $2.81 billion) ranked
number two in its list of Largest Public Finance Units. The
top eight exposures also include California Housing Finance
Agency at $2.2 billion and Los Angeles Unified School
District General Obligation at $1.92 billion. California
jumped to 17% of net 2003 added exposure by geographical
region."

- Indicative of California's soaring indebtedness, the
state must pay higher interest rates than many comparably
rated issuers. Isn't it curious that bond investors are
balking at buying many of the same issues that MBIA is
insuring?

- Note to stock market investors: Read the newspaper... or
ask a literate friend to read it to you.

------------

William Bonner, back in Paris...

*** Gold fell $1 yesterday. It is still up $29 in the last
4 weeks.

*** 'Why is gold in a bull market?' people are beginning to
ask. Because the situation in the mid-East is going
badly... because China is buying... because investors are
losing faith in the dollar... because Indians are
buying... because U.S. householders aren't refinancing their
homes they way they used to... because George W. Bush is in
the White House... because Hillary Clinton might one day be
in the White House... because California is courting
bankruptcy... because the world is already saturated with
dollars and debt... and because more and more debt is being
added every day... because... because... because... because...
because...

***"Chirac and Shroeder say No to U.S.," says the headline
in today's Figaro."You got yourself into this mess," was
the gist of their message, referring to the Iraq situation,
"you can get yourself out."

*** A report from the Detroit Free Press tells us that IRS
Help Centers give taxpayers the wrong answer almost every
second time they pick up the phone. What astonishes us is
not that they are so ignorant - we expect that - but that
anyone would call them in the first place. We had our last
courteous correspondence with the IRS back in 1974, when we
sent a note:"Please take me off your mailing list." We got
no response.

*** We heard recently of a taxpayer who won a case against
the IRS, arguing that no law had ever been passed requiring
individuals to pay income taxes. According to the email
account, the taxpayer sent a polite letter asking the
agency to show her the law. She wasn't contesting the
issue, said she, she just wanted to know. She sent several
letters, never got a direct answer, and concluded that she
really didn't have to pay. A jury apparently refused to
convict her.

*** Well, it is the end of the week. The children are all
back in school. Everyone has returned to work after the
summer holidays. The dead, victims of the heat wave, have
been collected and interred. The strikes begin next week.
It is life as usual under a gray Paris sky.

"Jules needs to do some extra-curricular activities," said
his mother yesterday.

"Why?" asked his father.

"Because he'll need them on his resume in order to get into
a good college... besides, he needs to find out what he
likes to do and what he's good at."

"Well, he stays up half the night playing the guitar, isn't
that enough?"

"He can't put that on his resume... or, I guess he can, but
it won't impress anyone... how come he doesn't at least do
any sports?"

"I don't like sports... I'm no good at them..." the boy
interrupted.

"He's like his father..." observed the old man.

"But you were on the basketball team," said his wife.

"I was terrible. I was only on the team because it was a
small school and I was tall."

"It still must have helped your college application... on
the other hand, you went to the University of New Mexico.
So there. Jules, don't pay any attention to your father..."

***"Oh Daddy," said Jules' older sister, breathless and
practically in tears,"I've got to get this figured out.
I'm just under so much pressure right now. I don't have
time for anything. I've got to get ready for my audition
and I don't know what to do. I couldn't sleep last night
worrying about it. I thought I was going to do Maggie in
Tennessee Williams' Cat on a Hot Tin Roof... but what do you
think? Isn't it a little too old for me? Isn't it a little
too... well... heavy and dramatic? Maybe I should do
something much lighter and more in keeping with my own
character. How about Liza Doolittle from Pygmalion?
Or... Or... Oh I'm so upset about this... I wish I knew what
to do."

"Why don't you do something from Gigi... something typically
Audrey Hepburnish..." suggested the père.

"Oh Daddy, that's exactly what I should do. Oh thank you so
much... I'll do Gigi... yes, Gigi... I'm going to run out
right now and get the text... great idea... I've got to get
right on it..."

"When's the audition..."

"In April..."

---------------------

The Daily Reckoning PRESENTS: Bill Bonner looking ahead to
the next great investment mania...


SINO BUBBLE
by Bill Bonner

"An appreciation of the Chinese currency is only a matter
of time."

- Marc Faber


How do you say 'bubble' in Chinese?

We ask because, looking ahead, it may be a good word to
know. For there is the latest... and perhaps the last... of
the Dollar Standard blow-ups.

China was in the news yesterday... and again today. Hardly a
day goes by without a mention of what has become one of the
largest economies in the world... and one of the most
interesting.

While the developed world grows at barely 1% or 2% per
year, China's economy races ahead 4 times as fast. Imports
to the U.S. alone are said to be up nearly 40% this year,
filling China's pearly chests with dollars, and U.S.
treasury bonds.

In 1985, only $2 billion went into China as foreign direct
investment. By 2001, the figure had risen to nearly $50
billion. In 1985, total foreign trade with China was just
$69 billion; in 2001 it was over $500 billion.

The U.S. has a GDP of about $11 trillion. China's GDP is
thought to be only about 1/10th as big. But in rural
societies, many transactions are not measured in currency.
And local prices are much lower, so that a Chinese meal
consumed in Shanghai might be recorded as worth $1... while
the equivalent in Manhattan would go for $20. Some
economists try to resolve these problems by measuring
economies on the basis of purchasing power. In these terms,
the U.S. has an annual production of $9.6 trillion, but
China's economy is much larger than otherwise thought, at
$4.9 trillion.

"You are so skeptical of everything else," began our friend
Michel at lunch on Wednesday,"but you seem to believe
every word about China. You seem to forget that the country
is run by communists who lie about everything. In
particular, they lie about economic statistics in order to
make themselves look good. That's what the Soviets did
right up until the whole system fell apart. And Western
economists believed them! And now they believe the Chinese.
Even you believe them!"

We do not really believe the Chinese numbers, dear reader.
Then again, we don't believe the American numbers either.
Instead, we take them all like dabs of paint on a Seurat or
Pissarro painting. No number is reliable in itself, but
stepping back, we're able to get an impression of something
we recognize.

And what we see developing in China is the familiar face of
Richard Nixon's Dollar Standard system: money floods into a
country; a boom results... asset prices get marked up to
absurd levels... factories and office buildings go up
everywhere... finally, overcapacity and overpricing creates
a bubble... that inevitably blows up.

But wait... we see something more: we also see - in broad
strokes - the end of the whole system.

As the U.S. consumes more and more products from China, the
Chinese accumulate more and more dollars. The average
Chinese saves 25% of his income, so savings in local
currency are building up, too - as much as 1 trillion
dollars' worth is in interest-bearing accounts already. The
money is lent out by commercial banks, and has triggered a
typical boom... followed by a typical, Dollar Standard era
bubble.

"Bad loans looming as a big cloud over China," warns
today's International Herald Tribune. Visitors to China
report that there are skyscrapers going up everywhere. Yet,
17% of the new buildings are already empty... and rents are
slipping.

While the offices are empty, the factories hum with
activity, day and night. The more Americans buy from the
Chinese, the more the Chinese are encouraged to produce. As
time goes by, more and more goods reach the U.S. at lower
and lower prices. And so does the correction come into
view. For as prices fall, profit margins fall, too. Soon,
businesses - in the U.S. and in China - are no longer worth
the money invested in them. Then, capital values drop, too.

At the same time, on the other end of the exchange,
consumers cannot buy an infinite quantity of TV sets and
automobiles. In America, the income of the average person
rose only modestly in the last 30 years... and is presently
dropping in real terms. How can these people be expected to
buy more products? They have no more income; they have
less.

And thus does the whole abstraction of credit, reserve
currencies, debts, profits, and trade imbalances suddenly
come clear. Stepping back, we see a ghastly picture.

But stepping back from the rush of everyday life, we get
the impression that everything corrects sooner or later:
financial trends, reputations, the wealth and power of
nations. On this day in 1939, the Germans had already
advanced deep into Poland (they crossed the border on
September 1st, beginning WWII). Hitler must have thought
that nothing could stop him... because, for a long time,
nothing did. As he and Stalin subdued the Poles, the 'phony
war' with France and Britain began. It was no war at all,
because neither side wanted a fight. Later, he moved
against the French and drove the English into the sea at
Dunkirk. By 1942, Hitler controlled Europe. Had he stopped
there, things might have gone better for him. But
everything that swells up later shrinks down to about where
it began. The Reich that was meant to last 1,000 years
peaked out in early 1942.

It was almost as if the Fuhrer called together his generals
and asked them:"How can we make a mess of this?" They soon
had their answer; they found a way to do the almost-
impossible... turn a nearly impregnable position in Europe
into a losing situation... by sending troops to North Africa
where they could be cut off by the British Navy... by
picking a fight with his ally, Stalin... and by declaring
war on the U.S.!

Three years later, Hitler's reputation, his army, his
country, his finances... even his life itself... were fully
corrected.

And now we see the Dollar Standard correcting, too. Bill
Gross describes the scene:

"Since its monthly trade surplus of $10 billion+ with the
United States implies a $120 billion annual addition to its
dollar reserves, there will come a time when [China's]
hundreds of billions if not a half trillion or so in
holdings of U.S. notes and bonds look a tad too risky. In
turn, the hundreds of billions that the Japanese and other
Asian countries have been buying in order to keep their
currencies competitive with the Chinese Yuan (Renminbi) and
the U.S. dollar will be subject to a sanity check as well.

"The currency/bonds/stocks of a reflating economy engaged
in guns and butter, Hummer and Hummvee spending of near-
historical proportions are bad investments. Sooner, or
perhaps later, our Asian creditors will wake up and smell
the coffee. Perhaps their java will take the form of dollar
or Treasury Note sales. Perhaps the aroma will resemble a
revaluation of the Yuan and then the Yen. Either way we pay
the price: higher import costs, a cutback in spending on
cheap foreign goods, rising inflation, perhaps chaotic
financial markets, a lower standard of living.

"Mark these words well for what they're worth (not much,
some will say): China holds the keys to our kingdom, and
our Hummers. Their willingness to buy our bonds, their
philosophy of fixing their currency to the U.S. dollar will
one day be tested. And should their patience be found
wanting, all of their neighboring Asian China wannabes will
move in near unison. Reflation's second round will have
begun, U.S. interest rates will rise, our goods in the
malls and the showrooms will be less affordable, and the
process of national belt tightening and increased savings
will have begun."

As we write, of course, belts are not being tightened;
they're being loosened. Investors at the Krispy Kreme
franchise are still feeling fat and sassy. Exactly when
their attitudes will change, we cannot say. Nor can we say
when the Chinese bubble will blow up.

But while it is too late to safely profit from the U.S.
bubble (prices are too high), Marc Faber believes there are
still excellent opportunities in Chinese stocks. Some sell
for low P/Es - as low as 2 - with high dividend yields.
Even China Telecom still sells for only about 8.5 times
earnings. Beijing Datang - a large power company - has a
dividend yield over 4%. Shenzhen Expressway sells for less
than 10 times earnings. Tiny Wing Shing Chemical, by
contrast, sells for less than 2 times earnings. You could
buy the whole company for only about $15 million, says Andy
Mantel, writing in Faber's newsletter.

The simplest China play, according to Mantel, may be the
China Mantou Fund, with its offices in Hong Kong.


Bill Bonner