Wednesday, November 12, 2008
nascent deflationary collapse in china?
In all the hoopla about the fiscal package, two economic numbers slipped out almost unremarked. Yesterday the National Bureau of Statistics announced that PPI inflation had declined from 9.1% year on year in September to 6.6% in October. Today they announced that CPI inflation declined from 4.6% year on year in September to 4.0% in October.
I am going to be accused of unrelenting pessimism, but I will explain nonetheless why even this “good news” worries me. As regular readers of my blog know, I tend to have a very monetary view of inflation, and I was convinced until two or three months ago that China’s furious money expansion of the past few years was going to lead inevitably to rising inflation. As I see it, when money growth outpaces the needs of the economy for a sustained period of time there are only three ways to adjust. The most benign way is that over a period of time the central bank engineers slower-than-warranted growth in money so that, in exchange for a temporary slowdown in economic growth, money supply and the real economy can get back into line.
The less benign ways consist either of a surge in inflation that causes the nominal value of the economy to rise sufficiently to meet the money supply (which is what I was expecting), or of a rapid and unexpected contraction in the money supply, which usually takes place in the form of a collapse in credit and in asset prices. If the former isn’t happening, then my model says that the latter must be happening, especially since the decline in inflation isn’t just because of food prices. Non-food inflation dropped from 2.0% in September to 1.6% in October.
We know that some of this contraction is indeed happening. Real estate and stock market prices are definitely falling. Loans in the banking system aren’t growing as fast as the government would like to see. But these aren’t new enough, or dramatic enough, to explain the rapid fall in inflation. Could it be that real credit growth is much lower than we think – that perhaps there has been a sharp contraction in off-balance sheet loans and in the informal banking sector? We don’t know, but we need seriously to consider that this indeed may be happening.
clearly things are not going well in china and haven't been for months. the question now is this:
was vitaliy katsenelson right when he put out this analysis of the "greatly leveraged" chinese growth miracle and diagnosed it with "late-stage growth obesity" (LSGO), predicting its collapse into a deleveraging deflation?
What makes things even worse is that China cannot afford a slow down. I discussed this in the past but it is worth repeating. The Chinese economy is like the bus from the movie "Speed". In the movie the bus is wired by a villain (played by Dennis Hopper) with explosives, and will explode if its speed drops below 50 miles per hour. The Chinese economy has 1.3 billion unsuspecting people on board. It could blow if economic growth drops below its historical pace.
A combination of high financial and operation leverage sprinkled with past high growth rates will send this economy into a severe recession if growth rates slow down. Let me explain:
High operational leverage. China has become a de facto manufacturer for the world. With the exception of food products, it is difficult finding a product that was not, at least in part, manufactured in China. Industrial production accounts for 49% of GDP, double the rate of most developed nations (i.e. industrial production for the United States is 20.5 % of GDP, UK 18.2% , and Japan 26.5%).
Chinese miracle growth is largely driven by the manufacturing sector; historically its industrial production grew at a faster rate than GDP. The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. High commodity prices and rapid wage inflation has driven those costs up. Once a factory is built the costs of running it are to a large degree independent of the utilization level - they are fixed - a classical definition of operational leverage. On top of these factors, laying-off workers is a politically sensitive process in China, which creates another layer of fixed costs.
High financial leverage. Debt is the instrument of choice in China. Due to a lack of equity-fund- raising alternatives (their stock market is very young), bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China - this generates a great degree of financial leverage. (Though according to my friend Bill Mann, The Motley Fool's advisor of Global Gains newsletter, a frequent visitor to China, state owned enterprises are much more leveraged than private enterprises.)
Total operational leverage. Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage.
Total operational leverage in China is elevated further as factories are built to accommodate future demand - this is a classical byproduct of LSGO. It is a human tendency to draw straight lines and thus making linear projections from the past into the future. During the fast growth period the angle of the straight lines is tilted upward, causing an over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. (Fear of over investment is overrun by fear of losing customers.)
This type of thinking results in tremendous overcapacity when demand cools. Here is an example: let's say a company saw demand for its widgets rise 10% year after year. It builds a new factory to accommodate future demand, let's say five years. It will likely model a 10% annual increase in demand as well. But what if demand comes in at 6% a year over the next five years? This will translate into overcapacity - not 4% but 20% (4% per year times five years). Suddenly you don't need to build factories or add capacity for awhile.
This greatly leveraged growth is terrific as long as the economy continues to grow at a fast pace: sales rise, costs rise at a slower rate (in large they are fixed) - margins expand - the beauty of leverage. However, leverage is not so sweet and soft when sales decline. Overcapacity is a death sentence in the manufacturing (fixed costs) world. As companies face overcapacity or slowdown in demand, they try to stimulate sales by cutting prices, which in part lead to price wars (similar to what we observed in the U.S. between Sprint, MCI and AT&T in the long distance business during the mid 90s) and to a fatal deflation. Sales decline, costs remain the same - margins collapse.
... In the past "stuff" stocks were cyclical, their margins played a very predictable foxtrot of bouncing together with the whims of the US economy. Today they are behaving if as Google is their middle name - their sales are climbing in double digits, margins keep expanding and now they are called "growth" stocks. They are not. It is just Chinese late stage growth obesity, which has disproportionately impacted the demand for stuff, creating an expectation that the "growth story" will continue forever. Nothing is forever. Starbucks discovered that and so will China. China is likely to have a bright future, but it doesn't consist of straight to the sky growth trajectories.
more from katsenelson here via seeking alpha.
UPDATE: katsenelson at minyanville:
I've said for a long time that one shouldn't trust economic statistics data coming from the Chinese government as it has the incentives, (and the power) to interrogate the data until it confesses to whatever the government wants to see.
Today, we learned that industrial production in China rose 8.2% in October, a slowdown from 11.4% growth in September, and below expectations of 10.8%. Even though industrial production growth wasn't great, it was still growth - and fairly decent growth by "developed" world standards.
But there was another bit of news (in the same article) that really bothered me: The volume of electricity generation dropped 4% in October. Yes, a drop. So which number would you trust?
UPDATE: clusterstock picks up on the electricity generation drop. how can they be growing? the answer probably is that they are not -- that official statistics have been inflated for some time now.