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Warning signs flashing for China

Monday, September 3, 2012

Slowing manufacturing, rising corruption, a string of concerning statistics and shaky wealth creation packages spark concern

SCOTT BARLOW

Signs of distress in China's economy have swelled from a trickle to a flood. While it's still too early to predict an end to the Chinese economic miracle, multiple indicators now suggest that investors should be worried about what lies ahead. Here are four areas of concern:

Land of excess

The slowdown in the Chinese economy is evident in the growing amount of slack in the country's factories.

The International Monetary Fund reports that China's capacity utilization - how much its factories are now producing compared to how much they could produce - has fallen to 60 per cent. More than a third of China's manufacturing capacity sits idle.

The China Daily newspaper reports that 83 per cent of steel companies are losing money at current prices. Governments, however, continue to encourage high levels of production.

"Local governments force many steel mills to keep producing, even when it is uneconomic, to maintain tax revenue, jobs and to show Beijing they are delivering on economic targets," Tim Murray, managing partner at China-focused J Capital Research, said in a recent interview with the Australian Financial review.

The Chinese government has the financial firepower to reaccelerate infrastructure development by easing credit conditions. But previous overbuilding raises questions as to what a new round of government stimulus can achieve.

"The expected returns to investment [on new projects] are so low that even cheap capital and socialized credit risk is not enough to tempt privileged borrowers into borrowing and investing," Michael Pettis, a management professor at Peking University, writes. "This fact alone should worry those of us who are still not yet convinced that China has a serious investment problem."

Consumer credit risk

The Chinese government has kept interest rates well below the rate of inflation to spur infrastructure investment. As a result, Chinese savers have seen a steady erosion of their spending power because the interest they receive on bank deposits has not kept up with the rising prices of goods.

To bridge the gap, savers have turned to wealth management products - pseudo-money market instruments, sold through banks, that hold out the promise of higher yields. Wealth management products now account for ¥10-trillion ($1.6-trillion), or 13 per cent of all Chinese bank deposits.

Many of these wealth management products are opaque and highly risky, with fears that some could be of a Ponzi-like nature. The danger, says Patrick Chovanec, an economics professor at Tsinghua University in Beijing, is that some high returns are being paid "not from the real returns being generated by the money invested, but from money coming in from new investors."

Bad statistics

The reliability of Chinese economic data has concerned investors for years and the questions are growing larger.

A recent report from the U.S. Federal Reserve noted that "some studies indicate that [China's] GDP growth was overstated during the 1998-99 Asian financial crisis, when official figures reported that China's GDP grew on average 7.7 per cent annually. Alternative estimates ... ranged from 2 per cent to 5 per cent."

Over the past few months, the measures of Chinese economic activity that are least susceptible to government manipulation - indicators such as electricity usage and rail traffic - are suggesting growth levels well below official reports.

The recent electricity consumption data show no year-over-year growth, casting doubt on the official report indicating a 7.6 per cent rate of GDP expansion.

China's National Bureau of Statistics released a report showing a 3.2 per cent decline in rail freight traffic during June - an ominous sign since freight traffic measures have historically been closely correlated with Chinese economic growth.

Corruption

Despite high profile arrests of mid-level officials suspected of accepting bribes, the people closest to the top appear to be cashing in on China's success to a degree that would not be tolerated in most developed countries. According to the Hurun Report, which tracks wealth in the country, the 70 wealthiest government officials in China have amassed assets of $90-billion (U.S.).

The seamier side of the country's commerce has found fruitful ground in the booming building trade. He Quinglian, a Chinese economist, writes that almost three thousand Beijing bureaucrats have been arrested for corruption since 2007 and "most of their crimes were related to construction projects, particularly in the bidding process."

Construction-related corruption has led to numerous incidents where shoddy materials and poor building practices have resulted in civilian deaths. The most notable example is the Wenzhou rail disaster in July, 2011, where at least 39 people died - and China's government moved quickly to suppress media coverage.

China's goal of dragging its enormous population out of poverty is laudable. But unintended consequences of the growth-at-all-costs strategy are becoming more apparent by the day.