David White's  Instablog

China grew its industrial production by 12.3% last month. That is good or great in any environment. When the world is in a recession it is undoubtedly great. China’s retail sales grew right along with it by 15+%. Could the economic world look any rosier for China?

 

The answer is apparently “yes”. People are questioning China. They are suspect of its banks. They are suspect of the numbers the government is providing. Why do they doubt it economic numbers? The answer would seem to be that the numbers just seem too good to be true. Are they?

 

My belief is that the numbers are a mixture of good and bad. There may be some number juggling by the government, but the US government has often been accused of that too. I believe the numbers are largely true. At the same time the numbers give me doubts about the Chinese economy. How can that be?

 

The answer is in the fine print mixed with a little common sense. China has been growing in the high single digits to low double digits for about ten years now. They have been making incredible numbers of loans in order to sustain this high growth rate. As they have continuously grown quickly the “questionable” loans have not really come back to haunt them. If everything is going up, you don’t have to worry about real estate that is under water (or not for long). If China keeps growing its production, the extra money from the extra production keeps stoking the Chinese furnace. The whole thing would seem to feed on itself. So what is the problem?

 

The problem is that sooner or later the Chinese economy will grow beyond the demand levels of the importing countries (buyers). The demand growth rate in the other countries does not begin to approach the production growth rate in China. China is one of the most populous countries in the world. It cannot rely on the idea that the greater number of importing countries will prevent it from outgrowing the demand levels of its foreign customer base.

 

Just the opposite is true. In the current environment, we have seen China’s exports shrink in a consistent down trend for many months. Last month China’s exports were down 23% y-o-y. China’s trade surplus shrank 45%. With numbers like these how can China’s GDP continue to grow, especially at the rate it has been?

 

A possible/partial explanation may be that the Retail Sales were up 15+% last month. However, a lot of this has been stimulus driven. The government has given out vouchers, etc. The government has also funded many projects which needed materials (for example, steel products produced from iron ore). The stimulus part of the demand picture will disappear relatively soon. What will China do without stimulus demand? The inherent character of the Chinese consumer has not changed (Roubini).

China will increase production even more as more months go by in order to pull itself out of its slowdown (which posed the threat of exposing China’s banking woes). Yet China's markets will have shrunk. The Chinese export market is clearly trending downward. The US and Europe are slated to grow slowly if at all for the next two years. Unemployment in those countries is predicted to worsen before it gets better. US and European Unemployment is predicted to stay high well into 2011. China's stimulus won't last that long. If China finds there is virtually no growth in the US and European markets over the next two years, where will it sell its ever increasing production? It cannot sell it to Europe and the US without serious dumping. This would bring retaliatory measures. In fact the US has imposed tire tariffs and the UK aluminum tariffs recently. China cannot sell its production completely internally because the Chinese are not going to change their spending habits that quickly. This means there will be a lot of left over production. This means deflation. It means a Chinese slowdown or recession. It means a lot of commercial loans are going to be at risk. It means a lot of residential loans will be at risk.  How can it mean anything else?

 

China has benefitted from being financed by western money via the Chinese trade surplus. If that surplus is reduced (or removed entirely), how will the Chinese growth continue to be funded? Will the Chinese even want to continue to try to grow that quickly without bigger markets for their products? Certainly there are nouveau riche Chinese as well as a growing middle class who will all spend more. However, China is still worker driven, and the workers are not likely to change their habits easily. They work too hard for what little they get.

Stop to admire what China has accomplished in the last ten years. The growth and development of the economy has been phenomenal. Then stop to consider where China is likely to go. China moving into slower industrial growth is tantamount to sending a child on a long journey alone. The child may survive, but there will be mistakes aplenty. There will be troubles all along the way.

 

China faces a slow down and/or recession. It faces deflation. It faces a possible high unemployment problem. In fact there are grumblings about this already. There will be trade wars if the Chinese decide to dump their excess production in the US and Europe. There may be civil unrest if the Chinese banking system develops problems similar to the ones the US banking system has recently experienced. There may be civil unrest upon a slowdown/recession or high unemployment. Some factory workers are already going back to farms.

The numbers for a continued Chinese expansion in the near term just do not add up. Barring some really insane behavior by US, European, and Japanese consumers, the Chinese economy will falter. It is currently standing on the precipice of a cliff! It is leaning out too far! I can see it falling easily. What could possibly stop it? The Chinese worker may be the only one with the power. My bet is that worker is not going to help. That worker is going to save for a rainy day -- not consume maniacally. My bet is the Chinese banks will reap the disasters of too rapid expansion. They will reap the disasters of relying on 10+% GDP growth rate every year. Exactly when the Chinese system will begin to falter seems the only real question. The latest numbers are ominous.

One can no longer simply be awed by the industrial production growth number. One now has to ask, where is that production going? The answer seems to be no where (or I don't know). With the stimulus package, the Chinese have forestalled this problem for the near term. However, this problem is coming. A second Chinese stimulus would forestall it a bit further. The growth / demand disaster is still coming. It was going to happen even without the worldwide recession. The Chinese have been expanding faster than the rest of the world's demand for their products. With the recession, the Chinese industrial production has in a single moment passed world demand for Chinese products.

China will survive. It is the same country that has grown phenomenally for ten years. However, the pain in the near future will be plain for all to see. China may well not be the best place to invest your money. Admittedly it has been in the immediate past. It may continue to be for an uncertain amount of time into the future. However, China seems likely to take some hard knocks. Some high flying stocks will likely crash. There are other geographical areas that would provide safer and larger returns on your money. I would pick your China stocks carefully. I am sure there will still be some great ones, but I think the days of investing in “anything China” for great returns may be over for some time to come.

I am sure you are now asking where should I put my money instead? I have not really investigated this thoroughly. However, I am inclined to think Brazil may be a good place. Vietnam with the mega US interest due to US vets familiarity with the country may be another. Perhaps I will write another such article on this subject after some much needed research.