Thursday, November 21, 2013

China Drowning In Overcapacity And Debt

Chinese Communist Party officials have announced they will pursue significant reforms under the new president and premier during the coming decade. The devil will be in the details as to how these reforms will be implemented. And those are lacking. So far, allowing the market to play a "decisive" role in the economy has emerged as a message in the state media. The details of their new economic policies are lacking but in the coming weeks and months the official media is expected to divulge more of what is planned by the Chinese leaders. They must quickly address the issue of a glut of new factories recently built but sitting empty for lack of demand

Fast growth tends to mask flaws and weakness within a system, and China has been growing like a weed for years. To make things worse many of the investment decisions were driven by politics and often influenced by corruption. This has created massive overcapacity. Money has been poorly allocated and often shoveled into deep holes like ghost cities and bridges to nowhere. Premier Li Keqiang has pledged to open the economy to market forces and strip power from the government in a process he conceded would be “very painful.” In July, he vowed to curb the overcapacity which the government blames for driving down prices, eroding profits and generating pollution.

The introduction of market forces into the economy by Chinese leaders would be key to achieving necessary "breakthrough" reforms. These involve reforming capital markets, labor in the form of improving social welfare, and land. Basically, the factors of production all need reform and much of it requires raising productivity in order to support growth. This will be no easy task for any economy, much less one where powerful state-owned enterprises dominate the financial sector and key parts of the economy. This is a hard change in direction, for years many of these companies have operated on razor thin margins and been focused on expansion with the goal of creating jobs.

Currently a 6.6 trillion dollar spending spree used as stimulus to combat global economic slowdown is coming back to haunt China. This has greatly expanded credit and created huge overcapacity during the past five years. A massive debt crisis now looms in the offing. At stake are trillions of yuan in bank loans that companies producing everything from ships to steel to solar power are struggling to repay as the world’s second-largest economy in in the mist of a major slowdown and the weakest annual growth since 1999. An example of the problems and overcapacity this has created is a company many Americans have never heard of named Rongsheng. This company is seeking a government bailout after accumulating 25 billion yuan ($4.1 billion) in unpaid loans as of June.

Rongsheng has been crushed by over-investment gone bust. After watching its assets jump sevenfold between 2007 and 2012 when government-directed lending led to a shipbuilding boom it is now drowning in debt with loans outstanding to the Export-Import Bank of China and China Development Bank Corp, which is a government owned bank set up to provide financial support at a low cost to companies and industries endorsed by the state. Rongsheng may post a second consecutive loss of 2 billion yuan this year and a 1.1 billion yuan loss in 2014. The company has let go 38,000 employees, almost 80 percent of its workers over the past two years.

Rongsheng now relies on its remaining 8,000 workers to build the world’s biggest cargo ships for a Brazilian iron-ore producer and Oman Shipping Co., as well as smaller vessels and oil tankers. Workers in its shipyards as well as the office staff in its Shanghai office have had their salaries delayed by as much as two months recently. The company and the banks involved are both are tight lipped about the situation. The problem is Rongsheng is one of many shipbuilders in this situation. The same is true in much of the economy, China has built like demand was unlimited. Industries such as steel and cement also stand out and have been named by the State Council as facing a “serious” glut. China’s economic planners have sought to rein in the steel industry since at least 2004

Gordon Chang, author of "The Coming Collapse of China," said China may only be growing 2 or 3 percent and if you strip out all the construction going into ghost cities and "high-speed rail lines to nowhere," the economy may not be growing at all. China claimed 7.7 percent growth for the first quarter but when you look at electricity, by far the most reliable economic indicator of Chinese economic activity, that grew 2.9 percent in Q1. When you consider that the growth of GDP is historically 85 percent of the growth of electricity, you're talking 2.5 percent (growth)." Many of those loans used to finance the construction of those ghost cities and idle train lines may never get repaid. Instead, banks continue to roll over these loans-many made to state-owned companies.

A huge issue is the risk and wild card China poses going forward, If they were to use foreign exchange reserves to recapitalize the banks this could have nasty unintended consequences. By converting their U.S. Treasury holdings to yuan they could "explosively increase the money supply" and at the same time torpedo their currency. This could unleash inflation creating a major crisis. For some international investors, China uncertainty has been reason to avoid the country's equities altogether. One thing is certain and that is the level of credit growth in China is unsustainable. There is bound to be a significant contraction in credit and most likely in growth. Of course not all China watchers are bearish as I and many expect China to muddle through.


 Footnote; Please feel free to explore the blog archives and as always you comments are encouraged. For more on China see any of the four post below,
                                      http://brucewilds.blogspot.com/2014/03/china-and-great-credit-trap.html
                                      http://brucewilds.blogspot.com/2013/04/china-and-corruption.html
                                      http://brucewilds.blogspot.com/2013/02/china-bubble-yes-it-is.html
                                      http://brucewilds.blogspot.com/2012/09/china-made-by-america.html

Footnote #2; Please note you can thank the problems in China for keeping import prices low and all many of the "bargain" prices in stores this holiday season. This has tamped down inflation but for how long?

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