Industrial Production Is Growing but Where Are All the Products Going?

Last week’s release of U.K. industrial production showed an increase in output. This finally brings the U.K. in line with the rest of the world making it about the last industrialized country to bottom in output. As I pointed out in my article two weeks ago, this lag in industrial output was the likely reason the U.K. economy failed to grow in Q3 while most other economies did (albeit stimulus-led in some cases).

Many other economies returned to growth much earlier in the year and a few, notably China, never stopped growing. Yet, as global trade remains flat, the question becomes: where are all the products going?

Even though the economy in the United Kingdom, similar to that in the United States, is predominantly services oriented, industrial production can drive key measures of the economy like GDP and unemployment figures. Output growth in an economy is a signal to companies to invest and hire. If it holds for the U.K., this signal becomes a key indicator that the global economy is on the mend even if the strength of the rebound is still up for debate.

Many other G-8 nations have recovered in output growth. Japan and Germany, two of the largest and most export-oriented economies among industrialized nations, rebounded much earlier in the year than the U.K. or even the U.S. Their drops in industrial production were particularly pronounced. As a result, the IMF forecasts their economies shrank in 2009 at a rate of 5.4% and 5.3% respectively. Most other advanced economies are expected to decline considerably less than 5% and in some cases just half that amount (the U.S. is forecasted to decline just 2.7% from 2008 to 2009).

It seems those with the sharpest decline were the ones rebounding the earliest and most strongly. The automotive sector in North America and Europe is a significant factor in this dynamic. With demand for new cars declining more than a third from the middle of 2008 to the middle of 2009, governments around the world went subsidizing auto purchases in one form of stimulus or another. While these programs failed to bring the market back to its 2008 highs, it did succeed in halting the drops in production and layoffs in this sector.

Chinese auto production continues to climb. One notable exception to this near calamity scenario is China. While ‘cash for clunkers’ programs in the U.S. and Germany got much of the attention, I would argue the most successful stimulus for the auto sector came in China. Early in 2009 the Chinese government directed that bank lending be increased substantially. This led to an increase in loans and money supply in China far in excess of 20% growth. It has been widely reported that the Chinese government has worked since the end of the summer to rein in this phenomenal credit expansion yet surprisingly Chinese auto production took another step up in September.

Chinese industrial production returns to strong growth. For much of the year I have been writing about Chinese industrial production, tracking four categories in particular. As of September, the growth in these four categories is back above 20%, a level that might be considered “normal growth” for Chinese factory output.

It is true that factory and store inventories have been at depleted levels and some restocking is in order. Through the third quarter, beyond autos though, there is scant evidence that commercial inventories are being built back up in the U.S. or anywhere else that reports such data. So where is it all going? Is it being consumed by the Chinese domestic market, possibly the only healthy consumer market on the planet right now.

Retail sales have grown 15% throughout the year in China. Chinese consumer confidence began to decline in middle 2007 and declined for almost two years before bottoming out in March of this year. During this period of decline in confidence, retail sales for China continued to grow at double digit rates. If you look past a distinct season pattern (sales spike in December and January ahead of Chinese New Year), retail sales delivered 22% growth each month in 2008 and 15% growth in 2009 to date.

Retail sales growth in China never dropped below 10%. While the level of growth declined from 22% last year to 15% this year, the consistency on a monthly basis was amazing. Each month China reports sales for the month and cumulative YTD numbers as well as growth in those numbers from the same period the year prior. After a couple-month period of adjustment from late 2008 to early 2009, the readings for growth have been remarkably consistent at a time (March ’09) when the rest of the world was worried that we were headed for another Great Depression.

Many skeptics have accused the Chinese government of fabricating economic data. Where the industrial production growth figures swing wildly from month to month and year to year, the consumer spending numbers have a remarkable consistency. To me they do not particularly exude a sense of fabrication so much as management. They remind me of a control chart on an assembly line where a target is assigned and data collected. Each time data is collected it is analyzed and inputs to the process modified until the result approaches targeted levels. The irony here is that it is data on consumer behavior not factory output that looks to be conforming to a target.

Let’s get back to the original question, what is happening to all this factory output? We know that factories outside of China are beginning to grow again; Chinese factories are returning to “normal” double digit growth rates; yet trade (a good proxy for global consumption) is flat after having dropped 20-30%.

The answer is important because the broadly deployed “risk trade” that has been driving world markets since the summer is to borrow cheaply in U.S. dollars and invest in almost anything else, particularly oil, other commodities, and emerging markets. This implies a weak economy in America and other industrialized nations but that demand is sufficient in the rest of the world to make commodities scarce. As we have seen above the data out of China implies this might be plausible but is it real?

Of course, data fabrication is one possible explanation. However, to me it is too convenient. Life is rarely that simple. An alternative explanation is that incentives for Chinese production and consumption have been successful enough to drive consumption growth (in the face of declining consumer confidence) while at the same time letting inventories (which we can’t see) build above normal levels waiting for the global consumer to return. Is Chinese consumer consumption large enough for this to work? The answer is possibly but only for a little while.

It turns out that retail sales in China are on track to exceed $1.5 trillion (measured in USD). A 15% increase in consumption means that the Chinese domestic market can absorb $200-$250 billion more of products in 2009 than in 2008. According to the WTO, China’s exports for 2008 reached $1.4 trillion. With two-thirds of the year reported, exports to the U.S. are running about 15% behind last year’s pace. Exports to other destinations like Japan or Europe may be down even more. Assuming a 15% decline in exports out of China broadly, it means that the domestic market could, in theory, consume the $200 billion worth of goods not sent overseas. This assumes the factory output is exactly what the Chinese consumer wants to buy.

This, of course, only holds when factories are not increasing output and consumers in America and Europe are retrenching. The Chinese domestic market is large enough to offset declines in consumption in the West but not large enough to drive robust growth on top of that. If all the published data is to be believed, the best explanation is that government directed Chinese stimulus and incentives to date have coordinated a delicate balance of additional consumption and reduced factory output over the last year. This provides a possible explanation up until now.

At this point, something has to give. Factories in China and abroad revving back up. The Chinese government is reluctant to stimulate lending and the money supply any further. Without western consumers (America and EU in particular) growing their spending at a healthy clip, finished goods in China and elsewhere around the world are going to be piling up on the loading docks quickly, if they aren’t already.

Disclosure: No positions.

Comments

[DrBenway:]

Excellent analysis. Very long-term China may be a great story (or may not - just think of the demographics problem in 20 years from now).

Short-term, it is certainly in a nasty asset/inventory bubble and is due for a major shake-out any time now, unless the rest of the world does a V-shape recovery. The good thing that China overcapacity will hold inflation in check at least for a while.

Nov 09 03:16 PM

[Ricard:]

Excellent article. I got curious as to how much of the stimulus went to autos. This AP article cites a 72% yoy increase:

www.google.com/hostedn...

Nov 09 03:39 PM

[tripleblack:]

Good article, good analysis. Fits with other things I have seen. The huge expansion in money supply and credit is something others miss, and the bulging warehouses in China is another factor that, as DrBenway says, is likely to hold down inflation until big orders start to ease the pressure.

Watch Europe for signs of protectionism to match that already perking at a low level in the sparring between Washington and Beijing, of course. Many Chinese goods are already at or below the triplines for anti-dumping laws in the West, and the push to move more is likely to run into resistance...

Nov 09 03:45 PM

[Old Trader:]

I believe it was Bloomberg that carried an article a couple of weeks back, showing that, surprisingly, France led the way in economic growth for the month, within the EU.

As far as the Chinese consumer goes, I wonder if the Chinese government isn't realizing that there are limits as to how long they can grow their economy by flooding the rest of the world with cheap/inexpensive products, without suffering a backlash. Hence, a conscious decision on their part to stimulate the consumer side of their economy.

Nov 09 09:43 PM

[sethmcs:]

Industrial production growing where are all the products going? Most of the GDP growth is inventory reduction. Increased production is restocking depleted inventories. This effect is most pronounced in the auto industry.

Nov 09 10:44 PM

[Ben Gee:]

I always thought more is better than less, have is better than have not.
I do not know since when having too much is a bad thing. Is it that when I have nothing, when someone else have too much, it is a bad thing? But it is not bad for that someone that has too much.

Nov 09 10:52 PM

[john12345:]

Right or wrong I decided long ago to not get too attached to macro numbers. Suppose a Chinese made T-shirt is sold in the US for $20.00. Economy sours and shirt isn't shipped, it's purchased locally in China for $5.00. Is China better or worse off? I say it makes no difference to China as long as the same volume of shirts is sold. You can see the opposing arguments below.

Nov 09 11:38 PM

[cayman:]

Interesting, you wonder whats going on with China having a 75% increase in Auto sales. But i guess they decide to become consumers rather than rely on the US. If this holds and the US comes back then we have a vibrant world economy firing on all cylinders. US, Brasil, India and China consuming and producing as well at various levels of the production chain.

Long term 5 to 10 years it's a very bullish picture-

Nov 10 03:51 AM

[bottoms-up:]

Question: "Where are all the products going?"

Answer: There are no products.

Hasn't it ever occurred to you that the G-20 are in a "hang together or hang separately" mindset?

You are witness to one of the greatest frauds in the history of the world.

This is all about appearances, not real recovery.

Nov 10 09:57 AM

[Mike from NYC:]

Doesn't China subsidize oil prices making autos more 'economical'?

I think that the EU, USA, CN and other countries will need to fight China's effort to keep its currency from floating and being as undervalued as it is today and making all the above nation's products uncompetitive as compared to China's.

China is now the T-Rex of the Industrialized World and until it is brought under control the rest of the developed world will suffer along with its citizens.

While I am not a believer in tariffs, something must be done to 'level the playing field' with China. China is 'rigging' the game and no one except China can win.

Nov 10 11:37 AM