China Speed - Running into the Great Wall?

June 22, 2005 - Minyanville.com / Bloomberg According to the Economist, the Chinese economy grew 9.4% in the first quarter in 2005 with industrial production being up an astounding 16%. Surprisingly most of that growth was real, as inflation was only 1.8%. It is impossible to say how accurate these numbers are, since they are put out by a very political and secretive entity – the Chinese government. In my view, the government would not hesitate to interrogate the data until it confesses to the party line numbers. These government produced numbers have little use if one is looking for inflection points of economic growth. However, it is hard to argue with the fact that the Chinese economy is growing at a very fast rate by any modern standard. The Chinese economy reminds me of the movie "Speed" (the flick that arguably sent Keanu Reeves to stardom status). In the movie, a bad guy with a grudge, masterfully played by Dennis Hopper, rigs a transit bus with multiple explosives, one of which is triggered if the bus goes slower than 50 miles per hour. How does that apply to China? The Chinese economy is akin to a bus with 1.2 billion people on board, where massive financial and operation leverage are the explosives that would likely blow up if the economic growth falls below its current pace. Even a small speed bump is likely to send this monstrous economy into a severe recession. Here is why: Chinese economic growth is largely driven by the manufacturing sector - industrial production growing at the double rate of GDP supports this argument. China has become a de facto manufacturer for the world. With exception of food products, it is very difficult to find a product that was not, at least in part, manufactured in China. The manufacturing industry is very capital intensive. To build a factory a large upfront investment is required (with commodity costs on the rise, the required investment has increased over the years) and once it’s built there is a fixed cost associated with running a factory that is somewhat independent of utilization level – a classical definition of operational leverage. Debt is the instrument of choice to finance ever-growing factories in China. A June 20th Financial Times article highlights the point: “In the first quarter of this year Chinese businesses relied on banks for 99% percent of their official fundraising, the highest rate in at least decade…. The lack of fund raising alternatives means that many private companies – the motors of growth in the modern Chinese economy – borrow money from start-up finance ‘underground’ banks that charge high interest rates.” Debt (financial leverage) coupled with high fixed costs (operational leverage) create total operational leverage. Total operational leverage in China is elevated further as factories are built to accommodate a future demand, which has been rising in the past and thus automatically projected to climb in the future. This highly leveraged growth formula works fine as long as the economy is growing at super fast rates. As sales are growing, costs are not growing as fast as they are largely fixed (due to operational leverage) leading to expansion of operating margins (the beauty of leverage). Unfortunately leverage works both ways, as sales growth slows down the opposite takes place. The airline industry in the U.S. is the poster-child for a high degree of total leverage, as planes costs over a hundred million dollars and most of the time are financed with debt (yes, leases are just another off balance sheet form of debt). Add to that a very unionized, overpaid, difficult to lay off labor and the deep cyclicality of the industry and you have a recipe for disaster. That’s a fair description of the airline industry. Arguably Chinese labor is not as grossly over-compensated as United Airline’s flight attendants or pilots, but laying-off workers in China is a politically sensitive process (according to FT) thus creating another layer of fixed costs. I can think of many reasons that could cause the fatal slow down in Chinese economic growth: Slow down of the U.S. economy, the biggest trading ‘partner’ with China. China is financing its biggest customer – the U.S. consumer. Not unlike Lucent while it was inducing its sales growth by financing its dot.com customers. China is financing U.S. consumers by buying U.S. Treasuries as if they were going out of style (pushing prices higher), thus keeping the U.S. interest rates at very low levels and creating what Mr. Greenspan calls a ‘conundrum’. At some point, either because of the higher interest rates or simply due to debt overdose, U.S. consumer spending will temper, lowering demand for Chinese produced goods. A mounting pile of politically motivated bad loans may bring the Chinese banking system to a halt. Though China is trying to move closer to Western lending practices, a combination of semi-market economy and a government controlled banks is very dangerous. Loans are often made not on the merit of investment but based on political connection. Overcapacity - It is a human tendency to draw straight lines and direct projections from past into the future. During the fast growth times the angle of the straight lines is usually tilted upward, causing over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. In the height of the dot.com mania, telecom equipment companies often could not keep up with ever-rising demand, and therefore constantly increased capacity. Overcapacity is a death sentence in the manufacturing (fixed costs) world since it leads to price wars – a fatal deflation. Currency float – there is a good reason why the Chinese don’t want the renminbi to float (appreciate). As it would chip away some of the comparatively low-cost producer advantage, it would likely reduce the U.S. demand for its products. In addition, renminbi appreciation will devalue the Chinese stock pile of U.S. Treasuries. Most companies stress their China strategy on their conference calls, in a similar fashion as companies were stressing their internet strategies in the late 90s. I don’t foresee companies re-naming themselves to incorporate China into their names though (as many did with dot.com in the late stages of internet bubble). It is very apparent that many are making large investments in China – B of A’s $3 billion investment into the Chinese bank comes to mind here. As usually happens after the bubble pops, the past asset turns into today’s liability. Thus, Chinese exposure that is looked upon as a source of revenue growth today, may turn into a written-off investment tomorrow. It is not a question of ‘if’ but more of a question of ‘when’ the Chinese economy will cross that metaphorical 50 miles per hour mark and fall into the deep abyss of prolonged recession in my view. China is living through one of the greatest historical bubbles. Dozens of books will likely be written to describe how it happened and how it imploded, but as always, they’ll be written after the fact. I even have suggestions for the book titles: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2”. But, as with any bubble timing, the pop is very difficult. Bears are usually too early to call it and bulls are usually too late to see it. As government published numbers of economic growth cannot be trusted, investors should look for anecdotal clues for the inflection point. Conference calls of U.S. companies doing business in China are probably the best source of information. The risk of the Chinese bubble is real, thus it may be wise to prepare by immunizing portfolios from that risk. Though being completely rid of the China risk is impossible and impractical, it is very important to stress-test a portfolio against that risk, one stock at a time. Vitaliy N. Katsenelson, CFA Copyright Minyanville.com