Levelling Mountains in China for the Sake of Economic ‘Progress’


The risk trade, it seems, is back on. Global markets surged overnight, gold and oil sold off, the Aussie dollar was up…

Talking heads explained the bullish move on upbeat data from China’s economy and the prospect of a ‘delay’ in the escalating conflict in Syria. When the market gets excited about a delay to a potentially very messy conflict, you know the speculative juices are still flowing.

But keep in mind the ‘delay’ is just that. Russia (in a great chess move) caused the unexpected delay by suggesting the US back off its war rhetoric if Syria would just hand over and destroy all its chemical weapons. Syria promptly agreed to do this.

Russia’s move put the US on the back foot. President Obama and John Kerry were in the midst of a feverish sales pitch about chemical weapons and threats to national stability when Russia suddenly gave them what they supposedly wanted.

Except it was just a sales pitch for an increasingly suspicious US public, who know the conflict is not really about chemical weapons. As we pointed out yesterday, it’s about energy…and containing Russia and Iran. Not that the US can come out and say so.

Now the US has to respond to Russia’s move. This will take time…time that the market’s grabbing with both hands.

And add to that ‘good’ numbers out of China’s economy and the risk rally is gaining momentum. Industrial production numbers for August came in at 10.4% (annualised), up from a 9.7% rate in July. And retail sales growth hit 13.4%, up from 13.2% in the prior month.

Of course this mini growth rebound is on the back of the post-June credit crunch stimulus provided by the government. At the time it looked like the wheels were coming off China’s credit fuelled growth but ‘they’ managed to hold it together. The result is a little growth surge, which we expect will be followed by more talk of a slowdown in the coming months.

That’s the nature of credit bubbles. You need to keep supplying more and more credit to hold the maladjusted structure together. How long the government can keep doing this is the big question. Perhaps they can keep going until the bears like us are thoroughly discredited and everyone begins to believe in the wisdom of the ‘state hand’.

But the bulls should ask themselves if these numbers actually represent real end demand…or just more unprofitable, government provoked production for the sake of keeping factories humming and people employed churning out widgets.

China watcher Gordon Chang, writing at Forbes, gives this reality check to the latest China fuelled rally (my emphasis):

 ‘In China, the name of the game is market share, and state banks are willing to support the ambitions of brand owners to produce in excess of demand.  That means, among other things, that Beijing’s retail sales number does not reflect the state of consumerism in China.  In fact, the National Bureau of Statistics includes in this closely watched figure items when they are shipped from the factory, not when they are sold to end users.  That’s one of the reasons why NBS can claim that retail sales climbed a robust 13.2% in July from a year ago. (The article was written before the release of the latest August retail sales number – ed)

So in the Chinese economy, retail sales become sales not at the point of sale but at the point of production?  Brilliant. The question is, how long will it take for the inventory to pile up so much that it causes a slowdown at the factories?

Chang reckons about a year:

 ‘Unsold inventory counts as gross domestic product, so Chinese growth figures still look healthy.  Eventually, however, overproduction will take its toll on factory output.  In China, that takes about a year according to trend-spotter Stevenson-Yang, who cites the examples of construction equipment makers after the stimulus boom of 2009-2010 and sportswear companies after the 2008 Summer Olympics in Beijing.  The same is inevitably going to happen to other sectors, probably by around the end of this year if the pattern holds this time.

It’s September now. So within three months, you should start to see evidence of the Chinese economic miracle starting to evaporate. Which will then trigger calls for more government stimulus. We don’t know much, but we do know that capitalism operates on the basis of profit and price signals. When you ignore both you’re going to get trouble.

Focusing on market share and volume and ignoring profit for too long will eventually send any company bankrupt — or seeking a bailout from its owners, who would then demand the sacking of the board and a new strategy.

When a large portion of a nation’s capital stock focuses on market share and volume, with a secondary consideration on profits, then the value of the capital stock will diminish. It’s really as simple as that. You can keep things afloat by throwing more capital in but if the strategy doesn’t change, it will just destroy that capital as well.

We saw a good example of this on Dateline last night. Reporter Adrian Rollins did a tour of China’s ‘Ghost Cities’. He revisited the South China Mall to see how it had progressed from its ignominious title of the largest (empty) mall in the world in 2011. Turns out it hadn’t progressed much at all. It was still empty and the authorities were spending billions more to turn it into a theme park and tourist attraction.

Then there’s the empty replica city of Paris…and the levelling of around 700 mountain tops to build another city dreamt up by a corrupt local mayor.

Getting back to the mall, which they built but no one came…where did all this destroyed capital from the original construction go to? Well, it’s probably still sitting on the banks’ balance sheets, and is certainly not written down and acknowledged as wasted capital.

In a real economy though, the costs of such waste surface somewhere. And in China’s economy, it is the financially repressed household sector that is the de facto payer of China’s overinvestment. Which is why consumers in China are doing it tougher than the statistics tell us. Or as Chang says:

 Analysts, mostly relying on official data, think the Chinese economy is stabilizing.  The country’s consumers, however, are telling us something else.


Greg Canavan+
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From the Archives…

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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