China’s Bubble Coming To An End Stimuls led to over capacity. Too many steel mills, while unoccupied buildings indicate that the construction boom is over

WASHINGTON – Here is the latest news from China. In the North West, several companies are going bankrupt. Some of them are victims of sharply lower demand. Others were run by corrupt managers who tried to cover up bad numbers. This is how the Chinese magazine Caixin reports these developments.

Bad loans

“Some of the bad loans in Inner Mongolia were the result of the country’s 4 trillion yuan stimulus plan in 2009, a banking regulatory official in the Yangtze region said. Companies borrowed too much and now cannot repay the money, the official said.

Industrial Bank Co. Ltd. arranged for its managers to tour Shanxi recently to study the situation there. The risks in the province were mainly linked to private coal and steel companies, one Bank of China employee said.

Several inquiries into corrupt officials have made the situation for some companies more difficult, one source said. Seven provincial-level officials in Shanxi have come under investigation for graft this year.

Xing Libin, chairman of the private coal firm Shanxi Liansheng Energy Co., was detained in March. His detention meant he could not deal with Liansheng’s problems, and the company’s 30 billion yuan in loans might go bad, the source said.”

Not just a slow down

The economic problems are not limited to this region. Reports about bad loans, bankruptcy, and managers suddenly “disappearing” are becoming frequent. And there is more. The seemingly endless construction boom is over. Across China, several new apartment complexes and shopping malls sit empty or almost empty. State banks are trying to give money away, hoping to stoke economic fires. But it will be hard.

This is not just a slow down, an inevitable phase of the familiar business cycle. This is probably the end of a mad race that led to massive overbuilding and the creation of over capacity in almost any sector. For instance, there is no way that China, (or the world, for that matter), will be able to absorb the massive steel overcapacity that was created at the time of a fantastic, break neck construction boom that could not possibly be sustained. (More on this below).

Well, what do we make of this news? Quite frankly these look like indications of a bubble economy coming to an abrupt end, even though the Beijing Government and the Central Bank are trying to create a counter trend via stimulus spending and easy lending.

End of the miracle?

So, bye-bye to China’s miracle? But, wait a minute. Wasn’t China supposed to be the never-ending economic phenomenon, the country that would prove that there is indeed something far better and more effective than old-fashioned, crisis prone, Western capitalism?

Well, China demonstrated that it is possible to have an exceptionally good run on the basis of what are in fact old-fashioned but workable mercantilist policies. China managed to become the world’s workshop on the basis of its ability to bring literally tens of millions of truly poor rural Chinese men and women into new factories built in urban areas.

The Chinese formula for success

The poor peasants turned into factory workers would earn a fraction of their Western counterparts. But their wages would still be much more than whatever they were making working the land.

With this bargain in place, the brand new Chinese factories could charge ridiculously low prices, mostly because of their ridiculously low labor costs. Add to this enormous advantage the fact that these millions of migrant workers lack resident permits in the cities where they have moved,  and so they do not have access to many social services. Given their status, the migrant workers cost less to the state. And finally consider the deliberate state policy aimed at keeping the Chinese currency undervalued in order to make already cheap Chinese goods even more competitive.

And so here the secret to the success of China’s manufacturing sector: cheap labor performed by exploited migrant workers, and an artificially under valued currency.

Move up the value chain?

But this over now. Not that China’s factories are going to close down. However, the ability to add indefinitely to productive capacity is over, simply because most export markets have been saturated. Besides, slowly but surely, China’s labor costs are rising, this way eroding the cheap labor key competitive advantage.

The best way forward for China would be to move up the value chain. And this means the ability to compete on quality, and not just on price. However, here I do not see any self-evident advantage. The Chinese have proven to be hard-working people. But innovation requires a different set of skills. It requires imagination, and venture capital willing to bet on smart people pursuing different paths.

As China’s growth model is based on exporting generic goods, given current trends, expect to see less and less capacity utilization. There is no way that China can keep producing millions of toasters, hair dryers, sport clothing for an ever-expanding export market eager to buy cheap Chinese stuff.

Massive over capacity

And this is only half the story. The other half is the construction boom which led to a gigantic expansion of all the industrial sectors that supply and feed construction. Here is how David Stockman put in a recent piece (Commodity Prices Are Cliff-Diving Due To The Fracturing Monetary Supernova–The Case Of Iron Ore) in his ContraCorner:

“Nowhere is this [bubble] more evident than in China’s vastly overbuilt steel industry, where capacity has soared from about 100 million tons in 1995 to upwards of 1.2 billion tons today. Again, this 12X growth in less than two decades is not just red capitalism getting rambunctious; it’s actually an economically cancerous deformation that will eventually dislocate the entire global economy.  Stated differently, the 1 billion ton growth of China’s steel industry since 1995 represents 2X the entire capacity of the global steel industry at the time; 7X the size of Japan’s then world champion steel industry; and 10X the then size of the US industry.”

“Already, the evidence of a thundering break-down of China’s steel industry is gathering momentum. Capacity utilization has fallen from 95% in 2001 to 75% last year, and will eventually plunge toward 60%, resulting in upwards of a half billion tons of excess capacity. Likewise, even the manipulated and massaged financial results from China big steel companies have begun to sharply deteriorate. Profits have dropped from $80-100 billion RMB annually to 20 billion in 2013, and are now in the red; and the reported aggregate leverage ratio of the industry has soared to in excess of 70%.”

“But these are just mild intimations of what is coming. The hidden truth of the matter is that China would be lucky to have even 500 million tons of annual “sell-through” demand for steel to be used in production of cars, appliances, industrial machinery and for normal replacement cycles of long-lived capital assets like office towers, ships, shopping malls, highways, airports and rails.  Stated differently, upwards of 50% of the 800 million tons of steel produced by China in 2013 likely went into one-time demand from the frenzy in infrastructure spending.”

A real problem

Here we go. We are talking about an extravagant level of over capacity that is bound to lead to plant closures and unemployment. Of course the Chinese Government will do its best to mask all this.

Chinese state banks will continue to extend credit to State Owned Enterprises that will be kept artificially afloat even when virtually bankrupt. But this means more bad loans on top of the existing ones, in a country whose economy is already quite leveraged.

Is China going to crash? Probably not. The state has a lot of tools, first and foremost a gigantic cash pile accumulated during the fantastic 30 year expansion. But I do not see the foundations for the continuation of the sustained growth that we have become so used to.

Can China become an “innovation hub”?

As I indicated above, ideally China should develop innovation hubs, real centers of excellence. But, while some sectors hold promise, the Chinese are not great innovators. They are mostly excellent imitators.

And if you want a reason why it is difficult to innovate in China, here is one. Innovation thrives in a decentralized, free economy where different actors can compete, collaborate, share. It requires flexible laws that allow flexible business arrangements. It requires rules of the road that guarantee contracts enforcement and a modicum of transparency. And, more than anything else, it requires people free to look around, poke, explore, probe, challenge, test, try.

In a word, innovation thrives in a free society.


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