China’s economy is out of control (and that’s not a good thing)

I love how everyone says “China is gonna be the next superpower” without actually sitting down, beer in hand, and crunching some numbers. Yes, they do have a million-man standing army. Yes, they do hold a massive amount of the US’ import debt. Yes, they do have nukes. But is that enough to ensure a 21st-century USA-style global domination? Maybe. Then again, probably not.Why not, you ask? Here are some reasons:

1. “Chinese people” don’t all speak “the same language”. They can read the same language – but that doesn’t quite come off the same when you want to pull off a Nuremberg rally. A recent poll showed that only around 50% of people had learned Standard Mandarin, the official government-sanctioned second language, despite a recent massive ad-blitz advocating proficiency.

2. There are reputedly 10’s of thousands of protests in China every year regarding environmental, spiritual, cultural, historical, economic, et. al. issues. This means TPTB [define] in China are losing grasp as it is – even with the massive propaganda campaign of economic growth.
3. MAD
NWO/PTB monkey wrench: if TPTB (groups and think-tanks such as the Bilderbergers, the Carlyle group, CFR, PNAC, Trilateral Commission, Bohemian Grovers, Skull and Bones, Free Masons, Illuminati et. al.) are indeed exclusively Euro-centric (as most of their roots would suggest), the Chinese would most likely be no. 2 or more in the quest for world power. Besides, refer to above points.

[off-note: sorry about the delay in posting, people. I’m making an attempt to write an editorial about the “Post-Peak Pro-Prosperity Movement” (my coinage) in an effort to stay away from simply re-posting articles and adding in comments. Very unoriginal, I know. Hey at least it’s non-profit, right?]

So, without further ado, here’s an MSN (of all places) article addressing some of issues behind the ragged state of China’s economy.

http://tinyurl.com/m8bz2

China is growing so fast — using cheap money to build steel mills, highways and textile factories it doesn’t need – that the coming crash grows uglier by the day. By Jim Jubak
In a train wreck, there comes the moment when it’s no longer possible to avert disaster. Pull the brakes as hard as you can, the momentum of the train is so great that disaster is unavoidable.

I fear that China’s economy passed that point of no return in the second quarter of 2006.

Today, I’m going to tell you why I think China’s economy is headed for a train wreck. Not tomorrow, but in the reasonably near future. I’d say 2009.

And in my next column, I’ll sketch out the likely effects of that train wreck on the rest of the global economy and the folks, like you and me, who invest in it.

If you’ve been following the debate in the U.S. about the likelihood that cheap money here has produced a bubble in housing prices, you’re already familiar with the basic scenario for a train wreck in China. Cheap money makes it easy to borrow to buy assets. That produces an asset bubble — in the United States, first in stocks and then in real estate. As the asset bubble grows, borrowers get in over their heads as their judgment is overwhelmed by the excitement of rising prices. And lenders under the influence of similar emotions make loans to unqualified borrowers.

When the asset bubble starts to deflate, overextended borrowers default on their loans, putting pressure on lenders, who respond by tightening their lending standards, reducing the amount of money available to all borrowers. That sends the economy into a slowdown or worse.

They’re borrowing to grow even more

China does add a few wrinkles of its own to that scenario. Since the Chinese economy is still very bad at allocating capital, corporate borrowing to build new plants itself becomes part of the asset bubble. I’ll start my sketch of China’s coming train wreck with the problems in that sector.

In the second quarter, China’s gross domestic product grew by an extraordinary 11.3%. That’s a significant speed-up from 9.9% growth in 2005, 10.1% growth in 2004 and 10% growth in 2003.

That’s a problem, because an economy can have too much growth. In China, it has led to massive overinvestment in manufacturing assets in sectors already suffering from oversupply. Investment in fixed assets — everything from steel mills to cement plants to oil refineries to highways — grew by 30% in the first half of 2006.

Although the reported profits of China’s largest industrial enterprises climbed 28% in the first half of 2006 over the same period in 2005, companies in some sectors have seen profits squeezed, sometimes to the vanishing point. According to government numbers, 80% of the profits in the Chinese economy went to companies in the oil, power, coal and nonferrous metals sectors. The other 30 sectors of the economy shared just 20% of corporate profits.

The iron and steel sector is the current poster child for the problem — and a worrying sign of things to come in other sectors. Profits in the sector dropped by 20% in the first half of the year. The problem is overcapacity. Too many steel companies have added too much capacity, driving down the price they can charge for their product.

That’s not exactly a surprise to the government in Beijing. At the end of 2005, steel production capacity stood at 470 million metric tons. (A metric ton is about 2,200 pounds.) Concerned about the issue, China’s National Development and Reform Commission announced a plan to remove 100 million tons of steel capacity from the market by 2007 by gradually phasing out small blast furnaces and converters. Removing that production capacity from the market would be key to restoring profitability to the sector.

That was the plan. Instead, steel companies have broken ground on 70 million tons of new capacity and put an additional 80 million tons into the construction pipeline. Thanks to opposition from local authorities, the National Development and Reform Commission said it would be able to close just 55 million tons of capacity by 2007, and that it was pushing back its deadline for the full 100 tons to 2010.

If the iron and steel sector is unprofitable, why are companies rushing to build new capacity? Three reasons:

  • First, by adding new, modern capacity, smaller and less-efficient producers can avoid the government regulations that would force them to shut.
  • Second, local officials have big incentives to keep mills open, even if they’re losing money: Officials are judged on metrics such as local job growth, and they often have a financial stake in local companies.
  • Third, money is cheap in China. How cheap? The People’s Bank of China recently raised its benchmark one-year rate to just under 6%. But with inflation at the wholesale level running at about 2.4%, that leaves the real cost of a one-year loan at about 3.5%.

Cheap money will find an outlet

There’s lots and lots of money to go around, too. Despite efforts to rein them in, China’s banks made loans equal to 87% of the annual loan target set by the central bank in just the first six months of this year. The People’s Bank of China had planned to keep money supply (M2) growth to 16% for all of 2006. But by the end of June, money supply was up 18.4% year over year.

The problem here is that to keep the Chinese yuan from appreciating against the U.S. dollar, the bank has to buy U.S. dollars and sell yuan to offset the huge inflows of U.S. dollars from China’s trade surplus with the United States. Thanks to that buying of dollars for yuan, the yuan has appreciated just 1.4% against the dollar since it was revalued (by just 2.1%) in July 2005.

As we in the United States know, too much cheap money in circulation produces asset bubbles. In the United States, the results were the stock bubble that broke in 2000 and the real estate boom that is slowly (we hope it’s slowly) deflating now.

Cheap money in plentiful supply has produced a real estate boom in China, too. Housing prices in Shenzhen, an industrial city near Hong Kong, were up 14.6% over June 2005. In Beijing, the increase was 11.2%. In 70 large and medium-size cities in China, the prices of what the National Bureau of Statistics defines as “expensive” housing climbed 9.7%.

Higher prices pull more money into real estate, of course. In the first six months of 2006, real estate investment climbed 24.2% over the same period in 2005. According to the National Bureau of Statistics, 1.41 billion square meters of housing were built from January through June 2006, up 21% from 2006. And as the boom ages, prices soar and excesses multiply. Units in the Tomson Riviera luxury apartment complex in Shanghai, for example, are priced at as much as $20 million. (I love the complex’s slogan: “dedicated to the elites.” How things have changed in Communist China.)

The Chinese government, alarmed by runaway real estate prices because high housing prices have become a major political flashpoint for the majority of urban Chinese, has attempted to pour cold water on the real estate boom by issuing new regulations that raised taxes on real estate speculation.

Incentives to spend, not save

But the problem with an economy fueled by cheap money is that if you damp an asset bubble in one sector, the money will just create an asset bubble somewhere else. So, for example, wealthy Chinese — and the country had 320,000 (U.S. dollar) millionaires in 2005, up 7% from 2004, according to Merrill Lynch — worried about high taxes on real estate speculation have moved their speculation to the art market. China’s 4,000 auction houses sold 10 billion yuan of art last year, up from 800 million yuan in 2000, according to the China Association of Auctioneers. Sales at the autumn and spring auctions of contemporary Chinese art in Hong Kong more than doubled in 2005 from 2004, according to Christie’s International and Sotheby’s.

The government seems extremely reluctant to tackle the root causes of these bubbles. Despite the People’s Bank of China’s April increase in the benchmark one-year interest rates to 5.85% — the first rate increase in 18 months — interest rates for borrowing are still ridiculously low. Companies can borrow at an after-inflation rate of about 3.5%.

On the other hand, the People’s Bank left the one-year interest rate that depositors get paid at 2.25%. That worked to bolster the profits of the big Chinese banks that the government is interested in taking public with Western investors as major buyers. It also created a massive disincentive for companies to save their cash. Instead, companies are reinvesting their cash, adding to the growth of fixed assets and to capacity gluts in some industries. According to the World Bank, retained corporate earnings accounted for more than half of new investment last year. That’s about double the ratio in the United States.

Such corporate reinvestment has completely negated government efforts to shift more of China’s national economy from investment and exports to buying by consumers. In 2005, the investment and export share of the economy actually increased and the consumer share fell to an all-time low of just 38% of GDP, according to the Institute for International Economics. And this corporate investment in fixed assets is largely unaffected by any changes in banking regulations or bank interest rates.

An increase in the value of the yuan against the dollar would damp corporate profits, slow the speed of investment in fixed assets and reduce speculative inflows from overseas investors who anticipate a yuan appreciation. Hiking the one-year benchmark interest rate again and again, and raising the interest rates paid to depositors would have similar effects. But such actions would also slow the economy and reduce the number of jobs that the economy is creating. China needs GDP growth north of 7% a year just to stay even with the number of new job seekers thrown up by its massive population every year. Reducing unemployment and underemployment — categories that take in about 40% of the Chinese population by some counts — requires even faster growth.

A significant portion of China’s small ruling inner circle has fought efforts to attack the problem at the source to a standstill. Commerce Minister Bo Xilai, for example, has complained that any appreciation in the yuan will cripple profits in marginal industries such as textiles, where the profit margin is just 3%. A purely rational economic analysis would say that if Chinese textile makers can’t compete after the yuan is appropriately revalued, then the least-efficient companies in the sector should go out of business and the jobs should flow to countries, perhaps Vietnam, where lower labor costs would allow textile makers to make a profit.

That would mean shipping jobs out of China, however, and advocating that is political death in a country that needs to create 20 million jobs a year to keep the population governable by the Communist regime.

So China is rolling the dice. Cheap money creates jobs today. Tomorrow? Well, maybe somehow things will work out.

In my next column: What happens to China — and us — if things don’t somehow work out.

Editor’s Note: A new Jubak’s Journal is posted every Tuesday and Friday. Please note that Jubak’s Picks recommendations are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest-rate environment, see Jim’s new portfolio, Dividend stocks for income investors. For picks with a truly long-term perspective, see Jubak’s 50 best stocks in the world or Future Fantastic 50 Portfolio.

E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.

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