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By John Wilson

Just how overheated is the Chinese economy?

There has recently been much talk about the overheated Chinese economy and it seems as though the words Chinese and bubble have been heard together more and more frequently. With the Shanghai Composite Index at its lowest in 15 months, down a staggering 32% from its high in August 2009, it’s no surprise the analysts are talking. A number of leading indicators suggest that this slow down will continue at least until the end of this year. July’s weaker than expected growth in auto sales was considered the first ‘hard evidence’ that the Chinese economy is cooling but there have been a number of soft indicators that have been hinting at this slowdown for some time.

The Tiger Yawns

Recently the Purchasing Managers' Index (PMI), which is a leading indicator in strong manufacturing economies such as China, has declined for the second month in a row down from 53.9 in May to 52.1 in June. Further trouble lingers ahead for the export dependent state. Producer price inflation, which measures the increasing costs associated with the production of goods, rose 7.1% in June. For an economy that bases a large component of their GDP on exports this could lull the mighty Chinese tiger to sleep. Non-deliverable Yuan forwards suggest that the Chinese Yuan will climb 1.5% this year. This appreciation could further injure the limping dragon’s delicate export environment; as the Yuan appreciates so does the cost of importing Chinese products. Further, when considering the extent to which China is tied to global export demand it should come as no surprise that if the other world economies were to enter into a double dip recession China would feel the squeeze as demand for their products tapers off.

The Year of the Pig

It is not whether the Chinese economy will slow but rather the magnitude of the slowdown that analysts disagree about. The question is whether it will be a soft landing or a hard landing. That is whether China will be able avoid high interest rates and inflation as it slows its growth or if it will experience a sharp decline in growth that results in a recession. On the one side you have the free fallers believing the China story will come to a rather abrupt end. They argue that the Chinese banks have been making increasingly speculative loans. The free fallers aren’t without their justifications. In 2009 Chinese banks extended $1.4 trillion in new loans; this is equivalent to an almost doubling of the 2008 growth. They are also quick to point out that much of the Chinese stimulus package, which injected $585 billion into the economy, is said to have gone to the speculative real-estate investments. These investments have inflated the GDP and employment numbers in the short term but these band-aid results are expected to fade when the stimulus package is removed.

Bursting the ‘Bubble’ Myth

On the other side are the soft landings group. They agree that in the past the Chinese’s economy has largely depended on exports but that this trend has been reversing in recent years. As manufacturing companies enter into China the demand for workers increases and correspondingly the Chinese workers experience higher wage pricing power. This is evident by the recent wave of strikes that have rippled through China’s manufacturing industry.

At a Honda plant workers demanded the right to form labour unions; in the past it was rare to hear of striking workers demanding labour unions but this trend is becoming more common. As the wages of workers are increased so will their disposable income which in turn can be used to support the local economy. Ford and Nike have already reported accelerated sales growth coming from within China’s own walls. The soft landings group also advocates that the housing investments are not speculative plays and are nowhere near bubble proportions. They contend that there is sufficient demand to fill these housing units as a mass urbanization movement is occurring as farmers move to the city to work manufacturing jobs. Research conducted by UBS suggests that 40% of China’s labour force is in agricultural industries and that this number has been declining steadily since 1980.

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In most mature economies only 3-8% of the population work in the agricultural industry, this suggests that there is likely to be a continued migration of Chinese workers into the city as more workers switch to the manufacturing sector. To further negate the rumoured Chinese housing bubble the soft landings group points out that the Chinese government requires a 30% deposit on mortgages. This is a far cry from the minuscule deposits that were required during US’s subprime frenzy in 2007. Moreover the Chinese tend to not overburden themselves with debt, below is a chart of debt as a percent of disposable income for China and the US.

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It is evident that the American consumer was much more levered during the financial crisis then the Chinese currently are.

There are cases to be made for both groups but with current economic data it proves very difficult to reach a conclusive decision.

Turning off the Fountain

Whichever camp you subscribe to the slowing of China’s economy will have a significant impact on the world economies.

China is the world’s largest consumer of copper and makes up 29% of the world’s copper demand (2008). As this 29% of demand begins to weaken copper prices will be pushed to lower levels (Chinese copper imports are already down 9.1% MoM)

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Copper Spot price (White) vs. Shanghai Index (Orange); notice the strong correlation. Chart as of July 9th 2010

Cheaper copper will cut into the margins of companies that mine the malleable metal. The companies that will be most affected will be the ones that receive a significant amount of their copper business through China. These companies will experience both falling volume and price. Copper isn’t the only metal that will be affected by the China’s slower pace. Iron ore will also likely be hit hard as China has been propping up this market for the past several years; while the rest of the world has experienced a downward trend in ore imports since 2006 China’s ore imports have increased at double digit rates. This slow down will most likely suppress ore prices to lower levels.

Another victim of the sleeping dragon is China’s cooling energy sector. With 20% of China’s energy being derived from oil a slowdown in the economy will exert some downward pressure on oil prices in the short term as the tap is shut off. The overall extent to which oil will fall is hard to judge as it has already come off in recent months but it is noteworthy to reflect that China’s oil imports make up 10% of the global demand for oil. Coal prices should also be affected by the cooling economy as it proves to be the lifeblood of China, making up 70% of China’s energy needs.

Which path the Middle Kingdom ends up taking will have an effect on the world economy, Canada included. As explained in Bullish on the Canadian Dollar the Canadian economy and dollar have always been strongly tied to its commodities. With the recent developments in China one wonders where the tiger is readying itself to swallow the loon whole?

Disclosure: No positions

John Wilson is pursuing his Honours Bachelor of Business Administration at Wilfrid Laurier University. He is currently completing his business co-op term at the hedge fund JC Clark as an Equity Analyst.

Source: China: Free Fall or Soft Landing?