naked capitalism

We’ve believed that China would have to hit a speed bump, or worse, at some point. To resort to cliche, trees do not grow to the sky and rapid GDP increases often wind up seeding their own undoing.

There are already signs of trouble. Exports are a big driver of Chinese growth (the other is domestic investment) and high fuel prices are wreaking havoc. Bloomberg reported last week that Hong Kong businesses may shutter 20,000 factories in the neighboring province Guangdong out of 70,000. Similarly, EconomPic argues (with charts) that:

Are commodities being driven up by Chinese demand or has China been powered by cheap commodities? The story goes as follows:

High growth in China increases the demand for commodities, such as oil
The increased demand increases the price of commodities
A spike in commodity prices hurts Chinese growth prospects
Slower growth decreases the price of commodities
Rinse, repeat…

Since Fall there has been a dramatic shift in the relationship between the two with it looking like China’s success may have indeed been enabled by cheap commodities (cheap labor is not enough when commodities spike).

More skepticism on the “China’s growth as manifest destiny” comes from a story by Edward Chancellor in BreakingViews($, free trial):

The Chinese economy has been sprinting towards the Olympics at a blistering pace. But what happens when this summer’s games draw to a close? Most observers seem to expect more of the same….

While this view of China’s prospects may prove correct in the long term, serious clouds are appearing on the horizon. That’s the view of Dr. Jim Walker, former chief economist of CLSA and founder of the Hong Kong-based consulting firm Asianomics. Walker adheres to the Austrian school of economics….

Austrians are obsessed with interest rates, and most particularly about what happens when central banks apply the wrong rates. When interest rates are too low, they argue, credit expands too rapidly. This stimulates investment and fosters asset price bubbles. Eventually, credit “inflation” shows up in rising consumer prices. But by then, it’s too late to stop the damage. The end of the boom reveals the misallocation of capital, or “malinvestment” as the Austrians insist on calling it. After which, there follows a painful process as the economy is forced to adjust back to equilibrium….

Walker believes that Beijing has allowed an Austrian-style bubble to inflate in China. In equilibrium, he argues, short-term interest rates should be roughly in line with the economy’s nominal GDP growth. But China has actually enjoyed interest rates well below the rate of inflation at a time when its economy has been expanding rapidly…

The result has been strong credit growth. This, in turn, has fuelled an extraordinary investment boom. Investment has been growing at 25% a year and constitutes around 40% of GDP. Most of the fruit of this new investment has been exported abroad. The trade surpluses generated by these exports have meant yet more intervention in the foreign exchange markets and further credit growth. For a while, this must have seemed like a virtuous cycle. Now it’s turning vicious.

Chinese export growth is set to fall sharply. Europeans initially took up the slack after the housing bust dented the appetite of American consumers for all things “Made in China.” But the credit crunch is wreaking havoc on both sides of the Atlantic. Recent data suggest that European export demand is slowing. Many claim that Chinese domestic consumption will take up the slack. This is unrealistic. As Walker points out, the UK alone consumes more than China and India combined….

There’s another problem. The credit boom has finally erupted in widespread inflation…The costs of commodities and wages of semi-skilled workers have been soaring. This leaves the authorities with little choice but to tighten monetary policy into a slowdown. Real credit growth has already slowed sharply to around 6%, which suggests the economy will be far weaker next year than is generally expected.

After falling for years, Chinese export prices to the US have started to climb. The combination of rising inflation and the revaluation of the RMB against the dollar means that China in some sectors is losing its position as the world’s low-cost producer. Stratfor recently reported that the textile industry, which accounts for half of China’s trade surplus, is under stress and clamouring for the reintroduction of export subsidies. As a result of rising costs, Chinese containerboard companies recently stopped shipping their products abroad, according to Fischer International. Newspaper reports relate that some American companies are moving their manufacturing from China back to the US.

There’s little doubt that many ill-conceived projects have been financed during China’s investment boom….

An Austrian analysis suggests that the outlook for Chinese companies looks bleak. Profits are set to be crushed by a combination of weak export growth and rising input costs at a time when a record amount of new investment comes on stream. China’s “malinvestment crisis,” as Walker calls it, will not damage the country’s long-term prospect… It….makes a revaluation of the RMB less certain. As economist Andrew Hunt points out, the Chinese business cycle normally ends in devaluations, not revaluations, of the currency. Yet in April some $50bn of hot money entered China in the belief that a revaluation was a sure bet. It’s difficult to think of a better way for Beijing to punish noisome speculators than by frustrating such expectations.