Why China’s growth model is in BIG TROUBLE, and so are the countries depending on it!

An interesting phenomenon seems to infect the human psyche in the field of investing and economics. It’s the idea that “this time it’s different.” Regarding China, we continue to hear the nonsensical mantra that the country displays capitalism with Chinese characteristics, therefore China will continue to grow uninterrupted.

I say to that, dream on! And I’m not the only one. Michael Pettis, a finance professor at Peking University’s Guanghua School of Management, offered this insight:

“There is no such thing as a different kind of economics, and even a very cursory glance at Chinese economic history should have made clear that if China really does exist in a different economic universe, with its own set of rules, then this has been a fairly new phenomenon. For most of its history the same old set of rules seemed to apply to China that applied everywhere else.”

It Seems We Should Never Let the Facts
Get in the Way of a Good Story

China is facing severe pressures, as every economy in world did and does when they overinvest, overheat, and create bubbles in key markets leading to over-leverage and over-speculation. The Austrian’s call it “malinvestment.” It’s no different in China. The only difference is the degree to which Chinese bulls defend it.

The recent GDP report from China shows how silly this idea of dependence on official numbers flowing from China can be. And although to a lesser degree Western governments play this game, no one has the ability to manipulate raw data as good as the communist Chinese.

For example, it was expected that China would report annualized GDP growth for the second-quarter of this year at 7.6 percent.

And presto, the number was 7.6 percent!

China hit its number, stocks rallied on reaction. All is good. Soft-landing insured. Strong growth in the third quarter guaranteed. But all is not good. Consider some other numbers reported by several independent news sources about what’s going on in and around China:

• Land sales decline — The Chinese Index Academy reported in early July that land sales in Beijing dropped by about 38 percent during the first half of 2012; Shanghai land sales fell close to 60 percent over the same period.
• Shipping getting killed — The head of Chinese State Shipbuilding said that up to half of the members of China’s shipbuilding industry could go bankrupt within the next two years given the 60 percent decline in gross tonnage of orders (90 percent of the firms have won no — zero — new orders this year). He went on to say that China may impose a rule to only ship on Chinese vessels, and those vessels must have been built in Chinese ship yards in an effort to shield the industry from the glut.
• Steel overcapacity is rampant — Global steel capacity outside of China has increased by 5-6 percent since the 2008 crisis. But Chinese capacity has increased 35 percent since then! Now, the average margin for the Chinese steel industry is a wafer-thin 0.1 percent, putting a third of the industry in the red.
• Cement production — Up around 5 percent through May 2012. But business profits for the industry are down around 50 percent.
• Growing commodity stockpiles — There are vast and growing stockpiles of coal, iron ore, and copper.
• Electrical usage is flat — The June electrical grid usage was flat relative to May 2012.
• Inflation is still a concern — 73 percent of Chinese citizens surveyed believe the cost of consumer goods is too high; suggesting inflation is still a concern for policymakers despite official reports it is contained.
• Liquid natural gas prices falling — Prices in Asia sunk a whopping 25 percent in June because of collapsing demand.
• Global investment banks are retreating from Asia — A real disappointment given the region was considered a huge growth opportunity not too long ago. The value of share trading in the Asia Pacific region fell 22 percent in the first half of 2012, outpacing declines not only in the Americas, but even in the basket case of Europe. Meantime, commissions have been squeezed, falling by as much as 30 percent. Equity proceeds in Asia Pacific (ex-Australia) dropped by 31 percent so far this year to $11.3 billion, according to Thomson Reuters. That’s double the rate of decline in the United States.
• Singapore’s economic growth falling — China’s neighbor Singapore reported that its GDP growth fell 1.1 percent during the second quarter of 2012 following a 9.4 percent gain during the first quarter. The country cited a decline in manufacturing (electronics and pharmaceuticals) as the main drag on the economy.
• Australia losing jobs — Australian employers surprised the market after reporting payrolls were trimmed by 27,000 in June; pushing the unemployment rate up to 5.2 percent from 5.1 percent in May. This news validates overall weakness in Asia and especially China.

But hold on …

China’s Property Prices Are on the Rise.
Growth Will Return Soon. It’s Nirvana Again!

It may be true we will see a short-term burst of growth again, but growth at what cost? If Chinese policymakers allow more real estate speculation, we will likely witness short-term benefits such as: More land sales by local governments, supporting more speculation by State Owned Industries, and keeping many speculators from slipping into the abyss of default.

How many of these buildings will never get finished?

But long term, this policy exacerbates the bubble and does nothing, and arguably makes it worse for the average Chinese citizen laboring under severe financial repression. The average Chinese citizen will not be happy seeing prices in cities moving further and further away from his ability to afford it or the corresponding increase in other prices so associated. Social unrest in China continues to rise in an important year of communist party transition.

We have seen a property bubble bust before, but this time it is different. It’s more dangerous for Chinese growth given the size of the property bubble and the associated debt.

The following is from Andy Xie, former chief Asia economist at Morgan Stanley and a board member of Rosetta Stone Advisors:

“Around the country, I see numerous property developments that are in the middle of nowhere and may never be sold. When the last property bubble burst in the mid-1990s, numerous buildings stood unfinished. The scale of unfinished buildings will be much bigger this time. Out of 4.5 billion square meters being built, 20 percent may never be finished.”

I’ve shared with you before (to the chagrin of many who see China as the world growth savior) that ultimately the Chinese growth model is in big trouble because they are highly geared for exports in a world in which demand is falling. China has launched massive investment projects in order to substitute for this fall in world demand on the expectations demand would rebound and China’s share of final goods sales would increase dramatically.

But, demand hasn’t rebounded. In fact we see the two major customers of China’s exports fading fast — the euro zone and the U.S. And without another export boom, China’s domestic problems are exposed.

Then if the government tries to stimulate the economy by increasing money supply, more inflation and declining efficiency will result because the stimulus money mostly ends up in the state sector and export revenue won’t rise sufficiently to pay for rising inefficiency.

In summary, despite the near-term market momentum and improved sentiment regarding China, the country is not immune from the market. Malinvestment will overwhelm all those virtuous “Chinese characteristics” sooner or later. Consequently, it will hurt Asian-block currencies and the Australian dollar over the longer term.

Best wishes,

Jack Crooks

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