China Changes Direction

John Mauldin puts out a very good newsletter/blog.  He occasionally guest blogs from other sources.  He recently passed on a China Visit Report from Simon Hunt.  Simon's observations are worth contemplating, as it means China is now in a five-year transition that is fraught with risk.  The Yelnick View has been that the 2008 Olympics are to China what Y2K was to the US - a defining event that the government will make work, whatever the cost.  Post the Olympics, all bets are off.  Will China make it that far?  Let's take a look at the China Report and its implications.

Historical Context. A decade ago China went for rapid growth. China goes through periods of central power or regional power, often with violence at the turn points. China's one-child policy has left the rural parts full of men with few options for career - or marriage. Letting them migrate to the cities, unemployed and unmarried, is a prescription for unrest. The breakneck growth has absorbed the migration of a hundred million or more.  A major achievement!  Cheap credit, low exchange rate, minimal environmental restrictions, and open markets worldwide, have created the Chinese Miracle.

Yet at some point the piper has to be paid. The core lessen of economic history is TANSTAAFL: Their Ain't No Such Thing As A Free Lunch. The distortion in China is manifested in bad debt. China has massive over-investment in manufacturing, supported by scads of credit. A representative example is that it has a 1000 or so ball bearings plants where 2 or 3 would do. This pattern is replicated across all sectors of production. Overcapacity results in extreme price competition, where these plants drive down prices to the marginal cost of production, or sometimes even below that, to the cost of debt service. How much Chinese value-add is there in a product such as a DVD player, with a Chinese-made drive at its guts? At one point, anecdotally I was told $3 out of a $99 retail product. This overcapacity has to be rationalized, or the banks will carry too much unperforming debt.

In addition, there is no incentive to conserve energy, protect the environment, or worry about excessive use of resources (water, metals). Consequently, the Socialist Paradise of China is not 'one with the land', a belief that the few remaining Marxists hopeless cling to, but a rapacious and wasteful exploiter. Energy is overused, resources are wasted, and the environment is trashed. With energy and commodity prices rising, the bad debt risks are being exposed - the squeeze is on. Maintaining a low exchange rate but having to pay more for imports (oil, metals) in Dollars puts pressure throughout the banking system. What to do?

China Report. Simon reports that the old growth policy of the former Premier, Jiang Zemin, has been replaced by the new Premier, Wen Jiabao. Quantitative growth is now replaced by qualitative growth. More emphasis is put on energy intensity and improving air and land pollution. Most critically, overcapacity is being dealt with. As Simon says: "A start will be made this year, the first year of the new 5-Year Plan. The main thrust will be to stop the continued development of duplicated capacity. It will be achieved by banks denying credit to all but their most credit worthy customers; manufacturing, especially in the private sector, will be hardest hit. This has started, as we have heard from friends." There will also be "a structural move away from energy and natural resource intensive industries towards the services sectors and IT industries." A 10% tax has been put on copper, and this may presage taxes on other commodities, discouraging their use and driving firms to high-levels of value-added.

Implications. 
Slower Growth. A bit of a balancing act, as this could spur political unrest if the banks come down too hard on underperforming companies. The regional powers have all built duplicated operations, and if the axe falls to much on certain areas, the losers will be a bit rebellious. Every shogun needs his ball bearing plant!

Real Estate Bubble Burst.  Shanghai has sprawled far out, and both commercial and residential values are reported as already is off peak values.  This new policy should drive them down farther. 

Up the Food Chain. Time for China to move beyond commodity manufacturing into more advanced development. Threat to the US? More a problem for Wal-Mart than a reason for concern in Silicon Valley.

Rising Wages. With high value-add comes higher pay for advanced workers. This would be very welcome, as it empowers the middle class, and provides a stabilization against the polluted and far-behind rural areas, which want a piece of the pie.

Rising Imports. The newly gentrified workers will want to participate in the world economy. From the goofy Marxist phrase, "From each according to his means, to each according to his needs," the socialist worker has learned that wants are needs - and needs can grow infinitely to fill available disposable income. Surely a newly empowered worker needs his new Lexus, and she needs her new Prada accessories. The miracle of the capitalist paradise!

Watch the next few years in China to see how this is pulled off. Of course, if China slows down and suffers increased regional unrest at the same time that the US goes into a recession, the whole global economy could spiral out of control. We have a very big stake in China managing its way through this necessary transition.

Comments

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