Corn Is Chicken Feed, But The Losses From Chinese Malinvestment Aren't

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by: Craig Pirrong

The WSJ reports that China could face a $10 billion write-down on the huge corn stocks that it accumulated, as part of its efforts over the past years to prop up prices for farmers. Corn is chicken feed, but $10 billion ain't.

But I think that the moral of this story goes far beyond corn. Chinese agricultural price supports are just one example of the myriad policies that the country has adopted over recent years that distort prices, and lead to misallocations of resources. Indeed, the deadweight losses from ag price supports are probably chicken feed in comparison with the waste resulting from distortions in the capital and credit markets that have led to massive malinvestment in industrial capacity (note the huge overcapacity in industries like steel), infrastructure and housing.

Perhaps the main difference is that the corn inventories are being written down. The corn counted towards national income when it was produced, and writing down the inventories will reduce national income. Alas, the vast bulk of the malinvestments elsewhere will not be marked to market, and reported Chinese national income will be too high as a result.

What's particularly important is that although the Chinese are apparently recognizing that their agricultural policies were inefficient, they cannot wean themselves from the credit stimulus habit. About 2 years ago I gave talks where I said China faced three alternatives, two of which were bearish for commodities: hard landing, transition to a more market-based, consumer-oriented system, or continued reliance on credit stimulus to keep measured growth high. I further opined that the latter alternative would just defer the choice between the first two for some time.

I did not venture a strong opinion on which alternative would happen, because I believed (and believe) that the choice is ultimately political, and I am in no position to predict with confidence Chinese politics. My sense was (and is), however, that sustaining the status quo was (and is) the most likely outcome. This would involve cranking up the stimulus in the face of any slowdown.

Recent experience suggests that's the case:

China's economy slowed further in the beginning of the year, though Beijing's policies to revive growth with old-style tools such as lending and construction appeared to gain traction in March.

China's gross domestic product expanded by 6.7% year-over-year in the first quarter, down from a 6.8% gain in the previous quarter, the National Bureau of Statistics said Friday. The figure, the slowest quarterly growth for China since the height of the financial crisis in 2009, was in line with forecasts.

In the past month, some confidence has returned to the world's second-largest economy, fueled in part by sharp property-price rises in China's major cities as well as some lessening of currency volatility and capital outflows that spilled over onto global markets last year and early in 2016. In March, China's foreign-exchange reserves grew for the first time in five months.

Friday's data release provided signs that a host of stimulus measures put in place over the past 15 months are having some impact-or are at least delivering some short-term gains. Industrial output, retail sales and property investment rose more than expected in March after a weak performance in January and February. Fixed-asset investment also improved.

And lending soared. Chinese financial institutions issued 1.37 trillion yuan ($211.3 billion) in new yuan loans in March, rocketing well past economists' expectations of around 1.1 trillion yuan, and almost twice February's volume.

This means more new malinvestment, and more papering over (with credit) the write-down (and hence recognition) of past malinvestments.

This credit splurge helps explain the commodities rebound in recent months. But it also shows how tenuous the foundations of that rebound are. It is an artifact of artificially stimulated investment. Eventually, inevitably, the accumulated waste and distortions will bring the entire Chinese economy to a shuddering halt, and perhaps a crash. Eventually the accumulation of distortions becomes so great that a shakeout and rationalization are necessary, and inevitable. China is at best delaying the reckoning.

Corn is a small part of a much bigger picture. But it is a revealing part. It shows how perverse pricing policies lead to inefficient accumulations of capital that eventually become worth far less than the amount invested. Corn is relatively easy to value, and the cost of the malinvestment in corn stocks looks to be about $10 billion. When one considers how many other wasteful investments have been made in China as a result of its interventionist policies, and the imagination staggers at what the losses would be.

Put differently, China's performance would look far less stellar if national income accounting was accurate, and realistically marked its past investments to market. Of course, it is this very fact that induces the Chinese authorities to use every trick in the book to prevent that from happening. But there will come a day, because losses this large cannot be concealed forever.