By Bear Feller.

Over the last couple of months this column has been used as a forum to articulate my concerns over various risks to the economy and the markets, especially risks seen through a macroeconomic and geopolitical lens in an age where traditional methods of fundamental and technical analysis are proving to be less reliable.
The biggest geo/macro risk I see to the economy, especially to Australia where I’m based, is of course the collapse of the Chinese economy; a centrally-planned giant whose dabbling in capitalism over the past 20 years has bequeathed tremendous growth to the world since the end of the Cold War, yet which is increasingly being seen to be as mismanaged as it is demographically imperilled.
As mentioned by myself and also by another Australian blogger, Leith van Onselen,  hedge fund managers Hugh Hendry and Jim Chanos, analyst Vitaliy Katsenelson and now Société Générale strategist Albert Edwards, among many others before in recent time, China’s uneasy political system of high growth in exchange for low freedom is leading to all sorts of troubling situations.
First, a massive fixed asset overhang, where empty apartments, shopping malls and cities have been built to make work, create prestige and achieve GDP targets with little thought for utilisation; second, a wide-ranging housing bubble, where the means to nouveau riche affluence – the property ladder – has outpriced and ensnared a generation; third, a low-margin, export-dependent manufacturing sector, where the need for foreign earnings and stable employment levels on the eastern seaboard has dangerously usurped the need for purchasing power in a globalised age; and fourth, a mispriced Yuan, which has compounded the issue of trade imbalances, enraged the United States, imperilled China’s forex holdings and led to a currency war, which furthermore leads to the risk of a veritable trade war.
All these situations have been allowed to develop not just under the CCP’s post-Tiananmen regime, but under the aegis of America’s consumption-led economy, first in the pre-crash Greenspan era of leveraged US consumption and subsequently in the post-crash Bernanke era of monetary easing where central bankers, from Washington, to London, to Tokyo to Beijing, have injected money and credit in great dollops to keep doors open and shoppers shopping. And, notwithstanding the fact that the Republican-led House of Reps is now making noises about US debt and US debt ceilings, China is still, far and away, the most profligate manufacturer of M2 money supply, as Nietzschean -analyst/blogger “Zarathustra” of Hong Kong has pointed out before, thus making it almost morally imperative that America’s own profligacy continue:

And then consider, as SitkaPacific Capital advisor Mike Shedlock did in his blog last month, that China is not only pumping Yuan into the system, but is encouraging unsustainable credit growth as well, just to reach those ridiculous GDP growth targets. As Shedlock writes, China’s money supply growth has been over 20% most years since 2007, but latest credit growth figures are at 28% and that credit growth, not money supply growth, is the real factor behind inflation. Consider that private credit in China is at 148% of GDP and this is what we call a vicious cycle.
Too bad that the European PIIGS economies – who have most reason to pump money into their economies have been prevented from doing so – aren’t as brave, unencumbered, or politically manipulated, as China’s central bank.
And so we wonder why China is at the risk of supply-side price shocks, whether they come in the form of grains, vegetables, or energy. Returning to Shedlock, it is the latter which is most frightening and which has most potential for ruining the whole house of cards and, in turn, the fortunes of Australia (which according to ratings agency Fitch – via blogger van Onselen – is one of the most China and commodity-dependent economies on earth). Simply put, the more that China messes with its money supply and credit supply, notwithstanding token efforts like the token 25bps rate rise on Christmas Day, the more it makes itself vulnerable to inexorably rising commodity prices, many of which are of its own Ponzi-style making. With supply-side factors (particularly geo-political ones, as discussed in my last post of 2010) colluding for higher crude prices in 2010, a potential end-game for China looms. The scorpion, surrounded by a ring of fire, will only kill itself.
Looking closer at that theme – oil prices, not scorpions – we should turn to an interesting note by UBS economist Jonathan Anderson of January 5, which analysis potential effects of a supply-side oil shock on Chinese GDP. While admitting that commodity price inflation actually buoyed emerging market growth in 2008 (mainly because most commodities seem to be mined or grown in developing countries, I would add) Anderson cites the oil shock of the late 1970s and what that did to emerging markets as a risk factor to gravely consider. I’d also say you should consider the fact that China is now a net-importer of crude and food – the two bull commodities of 2011 – and that as a developing country its citizens, on a per capita basis, are going to be a lot more hurt by rises in these than anyone otherwise would in the West.
Despite US February crude’s 3% drop earlier in the week, a combination of factors are coalescing to almost guarantee that oil will be over $US100/bbl throughout the calendar year, and possibly more if The Bernank ignores positive signs like America’s recent job numbers and continues to print the US dollar down (cf: China and it’s game of race to the bottom). On one hand, we’ve got the former president of Shell, John Hofmeister, for instance, speculating that Americans will pay $US5 per gallon by 2012 due to a “de-facto moratorium” on Gulf of Mexico drilling, and elsewhere we have issues like recent flooding in central Queensland, which via the resulting effect on exports of another carbon – thermal coal – is likely to drive across-the-board commodity price inflation (especially in China) further.
But, once again, it’s in geopolitics where I see the real risks for a sharp spike in crude prices, rather than merely a momentum trade exacerbated by the malign and ever-present spectre of robo-traded derivatives. On that note, and as with late last year, the two countries I’m most worried about are Sudan and Belarus – two key yet vulnerable links in crude’s oily chain.

It’s perhaps germane, albeit foolhardy, to write about Sudan now as we’re merely days away from that country’s referendum on southern secession. The southern region of the former Anglo-Egyptian condominium, and victim of poorly-conceived colonial demarcation, is not only the poorest part of Sudan, but it hosts the bulk of the country’s 500,000bpd oil bounty, a bounty that the China National Petroleum Company shares a significant amount.
To sum up the conundrum, let’s take a look at the following three maps, courtesy of the BBC:

I don’t know about you, but what those maps tell me is that the people of Sudan, the international community and anyone else who relies on Sudanese oil is likely to have a problem on its hands. Don’t believe the soothing words of Omar Al Bashir, Sudan’s murderous president, who recently assured the south of the north’s cooperation, come what may, but recall instead what happened the last time the south tried to split (or indeed the last time oil-poor Darfur attempted the same). The geopolitical reality looks worrying indeed.
Back to Belarus, I remain slightly confused what to think of the political situation in that inscrutable former Soviet republic (what did Churchill say again?), but I know that with the increasingly assertive influence of neighbouring overlord and crude exporter Russia it’s unlikely to be any good. While this has been discussed elsewhere, such as in recent editorials by the Washington Post and Asahi Shimbun, I’ll add that Russia has the tendency to be belligerent and illiberal whenever oil prices rise, as described in a fascinating analysis by Post commentator Anne Applebaum.
No wonder that China has been investing so heavily in oil supply, whether via the multitude of deals recently outlined in the Wall Street Journal, or in pipeline assets such as those mentioned earlier in this blog or the new Chinese off-ramp of Russia’s 4,000km under-construction Eastern Siberia-Pacific Ocean pipeline, an off-ramp which became fully operational over the New Year and which runs eerily close to the Stalinist Krasnokamensk gulag where former Yukos oil chief Mikhail Khodorkovsky has been returned, following a kangaroo court trial late last year.

And lest you think this is all some bearish pipe-dream of mine, to excuse the pun, the chaos that oil price rises can cause is already demonstrably alive and well, slightly to China’s west in the perennially instable countries of Iran and Pakistan. Iran, as is written in Business Monitor International blog Risk Watchdog, is facing rising political tensions as a result of Mahmoud Ahmadinejad’s December petrol subsidy reforms, which have so far costed Tehran billions of US dollars per year. Pakistan’s coalition government, meanwhile, has just lost its second-largest party, the Muttahida Qaumi Movement (MQM), due to the “anti-people policies” of rising petrol prices, or, as the party’s leader Faisal Sabzwari more colourfully puts it: the “petrol bomb”. Add to that the murder of ruling-party governor of Punjab, Salman Taseer, one day after the MQM left government in Islamabad, and you have the recipe for a different kind of petrol bomb.
As the dominoes of oil price inflation fall, I could go further and discuss the possible effects of food price inflation, which has already led to the first major food riot of 2011 in Algiers, where youths have torched government buildings shouting “Bring us sugar!” China is no doubt aware of the potential for similar scenes in its cities, where, as Taiwan-based Epoch Times has reported, the “top ten” riots of 2010 were 70% food or land-acquisition related. The challenge for China, however, is how to prevent food price inflation without resorting to the Mugabesque policies of price controls or risking a wave of hot money through traditional cash rate increases. As blogger Economic Assassin writes: China’s only choice is to “kill the dollar” (peg), but that could in turn kill China’s manufacturing pre-eminence.What rock will China choose as an alternative to its hard place?
I plan to go further into this multi-faceted issue of food security (and adjacencies like GM crops and climate phenomena in a period of La Nina weather patterns) sometime next week, and also discuss the parallel build-up of China’s security apparatus too. It is food, after all, which has been the major causal factor in the success or failure of China’s historic dynasties and it is war, soon after, that comes with dynastic demise. The Communist-run People’s Republic of China, even in this age of internet, oil and fiat currency, is surely no different. In the meantime, I leave you with this final set of freaky maps to ponder as I prepare my research into butter and guns.