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China's New Economic Challenges


History shows while the short effects of subsidies may be positive, the longer term results are not.

The following is the latest missive from Minyan Peter, author of such recent popular articles as Bank Earnings Post Mortem and A Closer Look At Mastercard's Earnings.

Last week's Wall Street Journal highlighted the challenges faced by both China and India as a result of government subsidies on retail oil prices. Having now achieved the economic growth they had hoped to foster through subsidies, both countries face the dilemma of choosing between fuel shortages and higher fuel prices.

History repeatedly shows that while the short effects of subsidies may be positive, the longer term results are not. And China, having elected to subsidize both its manufacturing and consumer sectors through commodity subsidies, now faces challenges across its economy.

Chinese manufacturers subsidized oil, encouraged an overbuilding of capacity because suppliers perceived the subsidy as a long lasting international competitive advantage. Similarly, for Chinese consumers, subsidized oil encouraged the demand for previously unaffordable products, such as automobiles. All of this worked like a charm until, as will always happen, the demand for a subsidized product exceeded supply at the subsidized price.

For China, it must slow everything down either through high commodity prices, slower economic growth, or some combination of the two. But to be clear, it must reduce demand.

If any of this feels vaguely familiar, I would suggest that America is now living through the unintended consequences of its own subsidized economy. In the US' case, the subsidy was low interest debt. Thanks to the post-9/11 Federal Reserve, interest rates in the US were too low for too long. Like China's oil subsidies, America's subsidized interest rates powerfully affected both the manufacturing and consumer sectors of its economy.

With cheap debt, builders could afford to build houses like there was no tomorrow, and, with cheap debt, more consumers than ever could afford to buy both more "house" and more houses than ever. But, as happens, ultimately house price inflation leveled the playing field, issues of affordability arose and, now that interest rate subsidies have expired (through higher short term interest rates), the clearing price for homes is falling fast, which takes me back to China.

I, for one, expect that like the US' subsidized economy experience, China's will end badly. Ultimately commodity supply and demand in China will meet. Whether it is the result of lower export product demand, higher domestic energy prices, higher domestic interest rates or a currency revaluation, or some combination of all of the above, balance will be restored.

But like America's experience, the restoration process will be painful. Chinese manufacturing capacity will exceed demand and with that unemployment will rise.

I for one, expect that when all is said and done, we will see lower commodity prices and, believe it or not, a higher dollar.

-Minyan Peter
No positions in stocks mentioned.
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