Is There More Trouble Brewing in China?

by: Andrew Mickey November 27, 2008 | about stocks: CAF / FXI / PGJ    

Andrew Mickey

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Almost every day, the U.S. government releases some new tidbit of economic data. It never fails that there is always someone out there to question the validity of it. They say how manipulated or plain wrong the data may be. In most cases, the scrutiny is certainly justified.

There, however, seems to be no scrutiny of the occasional bit of economic data released from China, and the “next thing to go wrong” could very well be in China.

China’s $585 billion bailout sparked a renewed sense of confidence, which will likely be short-lived. After all, that’s about 17% of China’s GDP (the equivalent in the U.S. would be more than a $2 trillion stimulus package).

The markets were quite excited with the spending plan (although not much different from what the world was expecting the country to do anyways). However, the excitement is probably not going to last.

China’s current economy is built for boom times. As a result, when times are good for the world, they’re great for China. When times are bad for the world, it’ll get downright ugly in China.

That’s why China has taken very drastic measures to ensure the economy keeps growing. On Wednesday, the country announced its biggest interest rate cut in 11 years. The 1.08% cut was a big one, but it was the fourth interest rate cut in the past three months.

Remember back in February when the Fed slashed interest rates by 1.25% in about a month’s time? Well, the impact was quite limited. It was too little, too late, and now, China is playing catch up. However, aggressive rate cuts will probably end up being another case of too little, too late. Of course, those are just short-term interest rates, which take a while to work their way through the economy.

China, however, made an even more aggressive move on Wednesday when it cut the reserve requirement for its banks. Before Wednesday, China’s reserve requirement for all banks was 16.5%, and starting December 5, the reserve requirement will be 15.5% for larger banks and 14.5% for smaller banks. I consider this the most drastic move of all. The multiplier effect of reducing bank reserve requirements can have a truly massive impact on money supply. Just a simple 1% or 2% tweak will be multiplied many times over in new money created by a fractional reserve lending system.

Clearly, China is facing drastic times. So far, though, they’re being met with drastic measures, but there’s a very real risk that these measures might not be enough. The cracks in China’s economic engine have already started to show. Massive amounts of factory shutdowns (and the accompanying rioting Chinese factory workers) are just the start. Unemployment is on the rise and the World Bank has lowered its estimates for China GDP growth to 9% and 7.5% in 2008 and 2009, respectively.

From a medium and long-term perspective, China stocks are as cheap as they have been in a long while. The country needs a lot of infrastructure (roads, bridges, water distribution systems, etc.) and has the money to spend. Most importantly though, it has a work force made up of people willing to work. That’s probably going to be the big difference-maker over the long run. Factory workers who can (and are willing) to make the move from making steel to build roads are key to a successful economy.

There are potential structural issues that could easily spell more short-term pain for the economy that has been built to thrive off very high growth. Basically, China is highly leveraged to the world economy, as it has a massive capital base of steel mills, mines, and factories, which are all highly cyclical industries.

In addition, 37% of China’s GDP comes from exports, which are already in decline, and 37% of China’s economy is used to build stuff to build more stuff. For instance, a big part of China’s economic growth came from building factories and machinery to build more things. That’s where the big problem lies. You can't be building new toy factories while other ones are being shut down.

All of this is why there are still a lot of risks left in China that most investors just haven’t considered, yet. As unemployment continues to rise in the U.S. and the rest of the high-consumption, importing Western world and consumers watch their dollars more closely, China’s economy will be going through a lot of very rough patches. So far, the Chinese government has been able to keep confidence high, but the country’s actions show the structural issues of the economy may be far bigger than most investors are expecting.

There are still a lot of reasons to like China. There are, however, a lot more reasons to be very skeptical of China’s near-term prospects. That’s why it’s best to continue to take a very conservative investing approach when buying shares in Chinese companies and ensure you’re still in a position to pick up more shares in the likely case these truly historic economic stimulation efforts don’t pan out as well as the market is currently expecting.

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This article has 12 comments:

  •  
    Nov 27 09:54 AM
    Good realistic analysis of the situation in contrast to many who simply says China will save the world because of its usd2 trillion reserves, double digit gdp growth, 1.3bn population etc.
    Reply | Link to Comment
  •  
    Nov 27 10:02 AM
    ANDREW, I AGREE WITH MUCH OF YOUR ANALYSIS .

    YES, CHINA'S GROWTH IS SLOWING.
    YES, THE GOVERNMENT IS CUTTING INTEREST RATES.
    YES, THE GOVERNMENT IS INSTITUTING FISCAL STIMULUS.
    YES, A BUNCH OF TOY COMPANIES HAVE SHUT DOWN.
    AND YES,.... THE CHINESE PEOPLE ARE WILLING TO WORK, AND THAT'S THE #1 DIFFERENCE BETWEEN CHINA AND MUCH OF THE REST OF THE WORLD.

    THE CHINESE HAVE STUDIED THE WESTERN NATIONS ECONOMIES.
    THEY'VE LEARNED WHAT WORKS, AND WHAT DOESN'T WORK GOING WAY BACK TO THE DEPRESSION ERA.

    I FIND IT QUITE AMAZING THAT CHINA, OPERATING UNDER A COMMUNIST SYSTEM, IS ABLE TO ACT AS TIMELY AND DECISEVELY IN THEIR FISCAL AND MONETARY RESPONSES AS SHOWN.

    30-40 YEARS AGO, THE CHINESE PEOPLE WERE BASICALLY AN AGRARIAN SOCIETY, THEY'RE NOW THE FOURTH LARGEST ECONOMY IN THE WORLD. IN ONE WORD..."WOW"...

    Reply | Link to Comment
  •  
    Nov 27 10:40 AM
    whoever predicts 7-8% growth for china is either a complete liar or a moron.
    as we all know china's still in the process of industrialization. we only need to look at the output of iron and steel to find out how much the economy is growing. car sales are down, real estate sales are down, export is down, consumption is down. nothing is growing.

    i expect a negative 5-0% growth for china in 09.
    Reply | Link to Comment
  •  
    Nov 27 11:10 AM
    Jim Rogers is buying chinese stocks, maybe its time to get in

    www.jimrogers-investme...
    Reply | Link to Comment
  •  
    Nov 27 11:10 AM
    i suspect the main reason that the Chinese 'stimulus' plan is now being discounted is that it was already in the works long before the world's economies started crashing. it was in response to the earth quakes, you do remember them right? the biggest problem China has is that %37 of their economy is based on the rest of us. and when they fails (and it is) they have a big hole to dig out of. its like the US had %37 of its economy just gone. That would be what, about 5 trillion in a 14 to 15 trillion dollar economy that was just gone? Think we could recover from that?
    Reply | Link to Comment
  •  
    Nov 27 05:53 PM
    judejin is on target. watch what happens, not what the chinese government says. their economy is cooling off rapidly. they do not have a developed middle class. logically, they will collapse like the usa did in the great depression if this economic cycle is long term.
    Reply | Link to Comment
  •  
    Nov 27 06:50 PM
    There's always trouble brewing in China, given the potential for unrest in Xinjiang and Tibet. China's system of state control has been quite effective in keeping a lid on that.

    "The hand's" contention that lack of a middle class is a downer applied up until the announcement of the stimulus. That coming spending wave will be a shot in the arm for the middle class's development.
    Reply | Link to Comment
  •  
    Nov 27 10:16 PM
    Growth is slowing, unrest is rising, corruption is rampant, and so-called efforts to combat it are reversing years of reform. Yes, there is trouble brewing.
    Reply | Link to Comment
  •  
    Nov 28 05:28 AM
    I think you're getting your multiplier wrong because you assume that minimum reserve levels in the US and China are similar. Cutting the reserve from 6% to 5% increases the multiplier from 16.7 to 20. Cutting it from 18% to 17% increases it from 5.6 to 5.9. In the end it probably doesn't matter anyway. The contraint on lending now isn't the minimum reserve requirment but rather bank unwillingness to lend, so the multiplier effect will be even lower.
    Reply | Link to Comment
  •  
    Nov 28 10:32 AM
    <<China’s current economy is built for boom times. As a result, when times are good for the world, they’re great for China. When times are bad for the world, it’ll get downright ugly in China>>

    The writer must be using different figures than the rest of the world. He needs to cite the 1996-1997 or the 2001-2003 data to prove his point, which is not possible. This is a caution to the unsophisticated from a private equity investor -- not everything you read is true.

    Reply | Link to Comment
  •  
    Nov 28 11:48 AM
    Jude Jin

    Was the number you used (-5%) just a rhetorical statment or do you have information that the rest of us do not have or have seen?



    Reply | Link to Comment
  •  
    Nov 28 05:43 PM
    "You can't be building new toy factories while other ones are being shut down."

    Which is why new investment will be focused on infrastructure and housing. This article is big on generalities and opinion but sorely lacking in rigorous analysis.
    Reply | Link to Comment
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