China's Growth: Far Less than Meets the Eye

For those who, like me, are skeptical of the solidity of China’s economic growth and the basis for the commodity rally, this article is for you:

Copper’s 76 percent rally this year may soon end on signs that China has stockpiled more than it can use in new homes, cars and appliances.

Inventories monitored by the London Metal Exchange posted their first back-to-back weekly gains since February, increasing 8.3 percent from an eight-month low. Sumitomo Metal Mining Co., Japan’s second-largest smelter, said Chinese imports are slowing after record purchases boosted domestic supplies, and U.S. copper-scrap exporters report shipments to Asia are dropping.

. . . .

Refined copper imports by the Chinese more than doubled to 1.78 million metric tons in the first half and reached a monthly record of 378,943 tons in June, customs data show.

“China’s copper imports are likely to fall in the second half of this year because it bought so much in the first half, the government has stopped buying and demand from end-users may not be as big as people anticipated,” said Zhao Mingwang, manager of futures trading at Zhuji, China-based Zhejiang Honglei Copper Co., which produces about 100,000 tons of wire and rods a year. “The imports were so large it’s hard to fathom where it all went.”

Most of the gains in LME-monitored inventories during the past month reflect the eightfold jump in the volume of material in warehouses in Singapore and South Korea, the closest to China.

. . . .

Inventories monitored by the Shanghai Futures Exchange more than doubled this year, sparking concern the pace of consumption in China hasn’t kept up with imports.

. . . .

Imports may have exceeded manufacturing demand by as much as 1.3 million tons in the first half, Kaku said on July 24. “I don’t think copper prices climbed because of a dramatic improvement in supply-demand conditions,” he said. “I’m skeptical about a strong recovery in the market.”

. . . .

Chinese lenders responded to the economic slowdown by tripling loans in the first half of 2009 from a year earlier to 7.37 trillion yuan, according to the nation’s central bank.

The increased lending spurred demand for properties, helping home prices in 70 major Chinese cities rise for the first time in seven months in June. Passenger-vehicle sales climbed 26 percent to 4.53 million in the first half, while commercial-vehicle sales fell 0.5 percent to 1.57 million, the China Association of Automobile manufacturers said July 9.

Dollar Slide

Investment in fixed assets, including water and road projects, jumped 34 percent to 9.13 trillion yuan, the National Bureau of Statistics said. Spending on capital projects accounted for 87 percent of China’s economic growth in the period, according to Morgan Stanley Asia Ltd. Chairman Stephen Roach, who is based in Hong Kong.

China's answer: Make another bubble

This all suggests that the 8 percent (annualized) Chinese growth in the second quarter is far less than meets the eye. It is the result of unleashing a flood of credit to finance “capital projects,” the quality of which is highly dubious; tripling the quantity of loans, to an amount representing 40 percent of the loans already on bank balance sheets, inevitably means that a large fraction of these loans are financing uneconomic projects.

Think about it. Chinese banks are lending three times as much during the most severe world economic downturn since the depression as they did when the Chinese economy was booming last year. A tripling of lending would inevitably lead to the financing of numerous negative net present value projects even in normal times. In current circumstances, the waste of resources must be astounding.

As I’ve written before, massive government stimulus like that being undertaken in China and being funneled through the banks can lead to increases in measured output. But the return on the projects funded is usually negative, and substantially so. In other words, you pay people to dig holes, and buy cement to fill them in, the expenditure counts as economic “output,” but all you’ve got in the end is cement filled holes that will not do what capital is supposed to do: provide a stream of benefits into the future.

What’s more, when a large fraction of these projects come a cropper, this dramatic expansion of credit will leave the lending banks with a slug of bad debt, forcing the government to: (a) bail them out, or (b) watch them fail or turn into zombies, thereby constraining their ability to finance viable projects in the future.

In other words, the Chinese have responded to a financial crisis caused in large part by an excessive creation of credit in the US and Europe by engaging in their own excessive creation of credit. The great exporting nation has thus imported the Hair of the Dog theory of economic policy: Respond to one massive distortion by creating one’s own.

I don’t see how this can end well. I understand the tremendous social pressures that make the Chinese leadership feel compelled to engage in this policy, but they are, in my view, just deferring the day of reckoning–and arguably making it far worse.

And since the commodity rally is based in large part on Chinese purchases, this also means that the rally is considerably overdone. Indeed, another Bloomberg article suggests that the copper market (and arguably, other commodity markets as well) is the economic equivalent of a crack addict, dependent on a continuing supply of Chinese government largesse:

Copper climbed in Shanghai, after falling the most in two and a half months yesterday, as China’s central bank damped speculation it would curb lending, boosting the demand outlook for raw materials.

Futures tumbled yesterday as speculation the Chinese government would limit bank loans sent the country’s stock market plunging by the most in eight months, dragging base metals lower. Equities rallied today after the central bank said it will maintain a “moderately loose monetary policy,” aiming to consolidate the nation’s economic recovery.

“The tightening of bank lending has been the major fear in the minds of copper importers and dealers,” Lin Xu, analyst at China International Futures Co. in Shenzhen, said by phone today. “So the reiteration of a loose monetary policy from the central bank helped sentiment.”

Downside for commodities

Just further illustration that the Chinese are riding the tiger. It’s damn hard to get off. The problem is, you can’t ride it forever.

The statistics in the first article regarding the immense quantity of copper imports are truly staggering; perhaps the ChiComs have a special affinity for the Red Metal... Note that China’s imports during a worldwide recession are double what they were when the Chinese economy was booming in 2008. Stocks in LME warehouses are also beginning to increase even as prices are increasing. (The same is true for other metals.) Oil inventories are also increasing. And for the most part, these measured inventory increases do not include Chinese stocks. Thus, commodity prices have been supported by massive Chinese stocking. Chinese consumption, such as it is, and as indicated by the inventory build it is far less than their purchases, is driven by a massive stimulus that is not sustainable for an extended period. The signs of recovery in the U.S., Europe, and Japan are faint, at best. And even a recovery in manufacturing in the OECD, or an increase in OECD consumer demand that would give a jolt to Chinese output for export, would have to work through massive stocks in order before any price-supporting fundamental tightness occurs. Other measures of demand, such as ocean freight rates, have been flat.

Commodity prices and inventories can move together if there is a spike in economic uncertainty that leads people to increase their demand for precautionary inventories: the only way to accommodate the increased demand for inventories is to raise prices to discourage consumption and encourage production. But if anything, the main metrics of economic uncertainty–such as the VIX volatility index–have been declining while commodity prices have been increasing. Price volatility for oil and other commodities was at historic levels in December of last year. (Oil price volatility was higher during December than during the 1990-1991 Gulf War.) So, increases in uncertainty/risk cannot explain the co-movement of prices and inventories.

All of this suggests that there is considerable downside risk in commodities. The markets are supported by a Chinese stimulus program that even many Chinese officials recognize is not sustainable, and which is leading to sectoral distortions. The stimulus has encouraged a buildup of inventories that will weigh on the market for a long time. The signs of recovery in the U.S. and elsewhere in the OECD are very fragile. Even the slower-than-expected decline in U.S. GDP in the second quarter is somewhat misleading as it conceals weaker than expected consumption. Fundamentals remain very weak, and the market is dependent on extreme Chinese fiscal and monetary policy. That translates into serious risk of a big selloff in commodities.

Comments

[I am not a ...:]

I have read through the comments here and all appear to be of the view that China (as a whole) is very good at business. My experience is that I tend towards the opposite view. Business in China is an area fraught with difficulty as one attempts to conduct an honest role while being approached at all levels for bribes in order to do one thing or another.
If ,when doing business with a big concern,which will be owned by the Chicom you run the risk of being arrested if the deal doesn't go their way.
There have been several examples of Australian manufacturers being blatantly robbed by government officials blind with greed.
So when I hear of the alleged stock piling of copper,I am not surprised. China did the same to the world wool market in the early 1990's by driving the wholesale price for raw wool up to $3000AUD per kilo(!) then suddenly ,overnight,stopped buying and totally refused to pay for stock already delivered.
To illustrate another point,A certain James Pen was arrested and spent several years in Chinese Prison because he wouldn't pay bribes at a local level ,even though he was an Australian citizen.
Lately ,Rio tinto's head of China operations was arrested and has been held for some weeks under torture ,without charge while being accused of spying...,because Chinalco was refused permission to to take over Rio's mining assets in Australia. A childish act of vengence ,yet entirely the chinese way of doing business.
So,again when I hear rumours of an impending financial bubble because of bad fiscal policy,I understand entirely what is happening .
We can but sit back and watch to see what happens over the next few years, but as for what happened 2000 years ago,those who say that forget that China was several different countries and only lately has it become one,one which will not last 5000 years if they carry on as they are now.

Aug 04 09:53 AM

[FloridaBoy2:]

Wind is the best and cheapest way to bring electricty to rural areas in China. It may not be the answer for us...we use too much electricity.


On Aug 04 09:10 AM wind4me wrote:

> look at China Wind Power, China is SPENDING on Wind Energy and USA
> talks alot , ie Pickens Plan
>
> China is the play , one may as well JOIN the party or be left on
> the sidelines!

Aug 04 10:31 AM

[Dave Dorgan:]

Sir, you make an important point. Self-preservation of the communist party/government is ultimately the key factor in any decision the government makes. That can - and sometimes does - come before the best interests of the economy, the people, and the country as a whole.


On Aug 03 07:32 PM Zhang Fei wrote:
>
> Western governments can lose elections and go back into the private
> sector. If the Chinese government falls, Hu Jintao & Co. could
> end up being beaten to death, much like the steel company executive
> several days ago.

Aug 04 10:53 AM

[NormK:]

I'm actually pleasantly surprised that there are dissenting opinions on both sides of the copper issue here. From my observation, some copper mining stocks have more than tripled since the Oct/Nov lows but are still much lower than their 2 year highs (or even averages). Although I'd love to see them double again, as WD216 predicts, I'm happy to have taken my 200% profit already and either move on to other sectors and buy back either with extreme caution or only on a significant dip. Copper for me is one of just a few examples that have helped my 401K 40% drop recover to 20%.

Aug 04 11:06 AM

[swaps:]

China is now the fourth largest economy in the world, just behind Japan.
Having come from a low base so quickly, and with a huge rural labor pool to convert to producer - consumers, China still has room to run.
The country is so vast in terms of population we read that China is booming and growing even as millions are deemed redundant workers and idled at the same time. China is shrinking and expanding at the same time, like an amoeba moving through time.
So one can look at one part or another and not get the bigger picture.

Aug 04 11:14 AM

[bobbobwhite:]

For you mature readers and informed others..... remember all the junk that came from Japan after WW2, and how it turned it around to become one of the two top quality producers in the world(Germany is the other, not the USA)?

China is now just emerging from that "junk" product status, and I can finally state that I bought a Chinese product that could be judged as "good quality", and not the previous junk. When the overall quality standard there improves to the point where it becomes dominent, as it is in Japan and Germany now, be prepared for truly explosive growth. Where China now has the global volume-of- goods advantage over all exporting countries, it may then have quality-of-goods equality if not superiority.

In its speed-of-improvement favor, China has many advantages over the emergence of Japan, as China has computers exactly like those in the rest of the world, and build materials globally available today are far superior than they were 60 years ago in Japan. Its giant worker pool is eagerly seeking global lifestyle equality, so when the Chinese worker/social commitment aspect rises to meet the high quality standards of those computers and materials, and it is rapidly doing so, China will surely be the runaway success story of the 21st century.

As the old timey jazz singer Al Jolson used to say, "you ain't seen nothing yet". Prepare yourselves for it.

Aug 04 12:03 PM

[lazzybum:]

I was traveling on a two lane highway in China ten years ago. The workers were working to add thee lanes on each side. The high way didn't have a lot of traffic then. I traveled the same road two years ago. The 5 lane highway was full of traffic. They may be digging holes and filled them with cement today. I would not doubt the growth in China.

Aug 04 12:35 PM

[MSimon:]

If they are buying zinc as well I'd keep an eye out for an external war or internal insurrection.

Aug 04 01:25 PM

[Glen L.:]

If it's true, as it seems, that the Chinese have abandoned mercantilism (trade proctectionism and export dominance) in favor of Keynesianism (stimulus to avoid deflation/recession), they will fail as surely as we have. In any case, the one thing I'm certain of is that no central planner of any stripe or shade is smart enough to predict the needs and desires of billions of consumers, and therefore they will always make gross mistakes as to what to produce, what commodities to hoard, etc. The damage that they do will be enormous.

Aug 04 01:34 PM

[Tony Daltorio:]

The author is one of those right-leaning, one-note tune singers. From reading his articles it seems that the only tune he knows is the tune that says everything is ALWAYS great in the US and everything is ALWAYS lousy in China.

Following that sort of rubbish "advice" would have made you how much money in the past decade? Oh that's right - you would have lost a bundle. I suspect the same will hold true for the next decade.

Aug 04 01:56 PM

[stojan nena...:]

China gives loan to own population but this loan must not be returned. This loan is in fact a non-credit money (as Marshal's Plan to Europa).

Aug 04 03:00 PM

[Doug Roberts:]

I enjoyed this article by Craig Pirrong very much. I found much cross-confirmation with my own - less objective - analysis. Thank you very much.

Aug 04 03:40 PM

[a5fung:]

The problem I see here is that most people are arguing with different time frames in mind. Those that are negative on china seems to see an immediate bubble forming (and eventually popping). I don't necessary disagree with this, certain parts of the economy can and will overheat, certain industries will stumble and we will likely see several crisis come and go. In the short to medium term, China will have some troubles, no doubt. However, those are are pro the China story, seems to be looking at the long term and over a long period of time, say the 21st century. To see China continue her growth and become an economic power house (more so than now) during the next few decades is not exactly a pipe dream, to say the least. This is the China story; what she will do over the decades, not what will happen over the short term. Of course, this is not to say there will be no problems over the long term either, quite the contrary. But over a long stretch, I am bullish on China.

Aug 05 01:30 AM

[Michael Clark:]

Very insightful post. Today's China IS NOT the China of Lao-Tse and Confucius. Today's China is a bunch of bandits -- from the top to the bottom of the society -- looking for bribes so they can build or buy another house, add another floor on their parents' house. Cheating at business is not unethical because business IS cheating. You're a fool if you don't cheat or take bribes.

China is no more the China of Confusius than Romans today are the Romans of the glorious Empire (as Hitler quickly found out).


On Aug 04 09:53 AM I am not a number.. wrote:

> I have read through the comments here and all appear to be of the
> view that China (as a whole) is very good at business. My experience
> is that I tend towards the opposite view. Business in China is an
> area fraught with difficulty as one attempts to conduct an honest
> role while being approached at all levels for bribes in order to
> do one thing or another.
> If ,when doing business with a big concern,which will be owned by
> the Chicom you run the risk of being arrested if the deal doesn't
> go their way.
> There have been several examples of Australian manufacturers being
> blatantly robbed by government officials blind with greed.
> So when I hear of the alleged stock piling of copper,I am not surprised.
> China did the same to the world wool market in the early 1990's by
> driving the wholesale price for raw wool up to $3000AUD per kilo(!)
> then suddenly ,overnight,stopped buying and totally refused to pay
> for stock already delivered.
> To illustrate another point,A certain James Pen was arrested and
> spent several years in Chinese Prison because he wouldn't pay bribes
> at a local level ,even though he was an Australian citizen.
> Lately ,Rio tinto's head of China operations was arrested and has
> been held for some weeks under torture ,without charge while being
> accused of spying...,because Chinalco was refused permission to to
> take over Rio's mining assets in Australia. A childish act of vengence
> ,yet entirely the chinese way of doing business.
> So,again when I hear rumours of an impending financial bubble because
> of bad fiscal policy,I understand entirely what is happening . <br/>We
> can but sit back and watch to see what happens over the next few
> years, but as for what happened 2000 years ago,those who say that
> forget that China was several different countries and only lately
> has it become one,one which will not last 5000 years if they carry
> on as they are now.

Aug 05 04:35 AM

[Michael Clark:]

My criticism of China is NOT because of their politics. Fascist governments lie and communist governments lie. And democracies lie. But democracies have a more difficult time lying because the press is trying to catch them in their lies.

I'm surprised that western capitalists have fallen into line with the Chinese so readily, believing that China is going to 'save the Western democracies' through the engine of their own capitalism.

I think western capitalists who think the Chinese are going to lead us out of this economic depression should not be too naive. Why do governments enslave their press? Because they don't want to have to tell the truth when it isn't in their interest to do so. They want to be able to lie and get away with it.

Not much difference between Nazi Germany and Communist Germany in the way they manage their internal politics and business.

Aug 05 04:43 AM

[Michael Clark:]

Edit:
Not much difference between Nazi Germany and Communist CHINA in the way they manage their internal politics and business.


On Aug 05 04:43 AM Michael Clark wrote:

> My criticism of China is NOT because of their politics. Fascist
> governments lie and communist governments lie. And democracies lie.
> But democracies have a more difficult time lying because the press
> is trying to catch them in their lies.
>
> I'm surprised that western capitalists have fallen into line with
> the Chinese so readily, believing that China is going to 'save the
> Western democracies' through the engine of their own capitalism.
>
>
> I think western capitalists who think the Chinese are going to lead
> us out of this economic depression should not be too naive. Why
> do governments enslave their press? Because they don't want to have
> to tell the truth when it isn't in their interest to do so. They
> want to be able to lie and get away with it.
>
> Not much difference between Nazi Germany and Communist Germany in
> the way they manage their internal politics and business.

Aug 05 04:53 AM

[zenovia:]

Maybe this is a way to get rid of the extra dollars that China accumulated and has plenty? And China is pushing (the dollars) down. But they want to spend them before the fall.
Interesting are the people coming from China to live in North America and believing in the Chinese supremacy.

Aug 05 08:00 AM

[coreopsis:]

The yobs in America rule!


On Aug 04 01:56 PM Tony Daltorio wrote:

> The author is one of those right-leaning, one-note tune singers.
> From reading his articles it seems that the only tune he knows is
> the tune that says everything is ALWAYS great in the US and everything
> is ALWAYS lousy in China.
>
> Following that sort of rubbish "advice" would have made you how much
> money in the past decade? Oh that's right - you would have lost a
> bundle. I suspect the same will hold true for the next decade.

Aug 05 10:31 AM

[Locked Out:]

Crap Heap,
You've got to be one of the most self-loathing, depressed individuals I run across.


On Aug 05 10:31 AM coreopsis wrote:

> The yobs in America rule!

Aug 06 12:30 AM

[Tom B:]

Backwards. China is a bubble right now, but they'll burst like Japan. Except Japan is eventually coming back; they'll got a decent government and a lot of talent. China has nowhere to go long term: fractious ethnic wars; resource constraints. Historically, size is a killer; the bigger you grow, the harder you are to manage.


On Aug 05 01:30 AM a5fung wrote:

> The problem I see here is that most people are arguing with different
> time frames in mind. Those that are negative on china seems to see
> an immediate bubble forming (and eventually popping). I don't necessary
> disagree with this, certain parts of the economy can and will overheat,
> certain industries will stumble and we will likely see several crisis
> come and go. In the short to medium term, China will have some troubles,
> no doubt. However, those are are pro the China story, seems to be
> looking at the long term and over a long period of time, say the
> 21st century. To see China continue her growth and become an economic
> power house (more so than now) during the next few decades is not
> exactly a pipe dream, to say the least. This is the China story;
> what she will do over the decades, not what will happen over the
> short term. Of course, this is not to say there will be no problems
> over the long term either, quite the contrary. But over a long stretch,
> I am bullish on China.

Aug 06 09:21 AM