China: Continued Boom or Epic Bust?

By Jim Quinn Oct 12, 2011 12:15 pm

There's no question that China's progress has been remarkable. The question is whether that growth is sustainable and built upon a solid foundation.

In a recent article, "How China Ate America’s Lunch," Clif Carothers described what China has accomplished in the last 30 years:

In thirty short years, China was able to accelerate her GDP from $216 billion to $6 trillion. She amassed reserve capital of $3 trillion. She reversed America’s fortunes from the greatest creditor nation to the greatest debtor nation. She gutted America’s factories while creating the world’s largest manufacturing base in her own country. A measure of output that highly correlates to GDP is energy consumption. In June of this year, 2011, China surpassed the United States as the largest consumer of energy on the planet. While the U.S. consumes 19% of the world’s energy, China consumes 20.3%.

While China was growing its economy by a phenomenal 2,800%, the U.S. GDP grew from $2.3 trillion to $15 trillion – a mere 650% increase, of which 420% was due to inflation. There is no question that China’s progress has been remarkable. The question is whether that growth is sustainable and built upon a solid foundation.

In a February 2010 Casey Report article titled "Is China’s Recovery a Fraud?", my thesis was the $2.1 trillion stimulus package rolled out by Chinese authorities after the 2008/2009 financial crash was leading to enormous malinvestment.

The officially announced stimulus package in November 2008 totaled $586 billion and was to be invested in key areas such as housing, rural infrastructure, transportation, health and education, environment, industry, disaster rebuilding, income building, tax cuts, and finance. In reality, the central government pumped an additional $1.5 trillion into the economy in an effort to maintain social stability through the subsidization of its industrial base. Chinese banks funneled cheap loans to state-owned enterprises in order to manufacture artificial profit margins to keep Chinese goods competitive and employment maximized. In the short term, the stimulus produced the desired effect.

Specifically, the Shanghai Index -- which had topped out at 5,913 in October of 2007 and had fallen to a low of 1,678 by November 2008 -- responded to the stimulus by rebounding to 3,300 in January 2010, as the chart below shows.

As with all monetary and fiscal stimuli, however, the initial high is always followed by a hangover. Today the Shanghai Index stands at 2,350, down 29% from when I penned my article. China is also experiencing accelerating inflation, a real estate bubble of epic proportions, a looming banking crisis due to the billions in bad loans made by Chinese banks as commanded by the Chinese government, and growing social unrest due to rising food and energy prices.

There are few opinions in the middle regarding the China story. People are either convinced China is a juggernaut that can’t be stopped and will become the dominant world power (a recent global Pew Poll found that 47% of respondents think China is or will be the dominant global power), or they see a colossal bubble that will burst and cause worldwide mayhem. While some might think my world view has a negative slant, I tend toward what I think is healthy skepticism that causes me to view things in a more realistic manner.

Based on the facts as I understand them, the Chinese government has created a commercial and residential real estate bubble in an effort to keep people employed and not rioting in the streets. In the case of the U.S. subprime mortgage bubble, critical thinkers like Steve Eisman and Michael Burry figured out it was a bubble three years before it burst. Jim Chanos and Andy Xei have been warning about this Chinese bubble for over a year. They have been scorned by the same Wall Street shills who denied the U.S. housing bubble. As Eisman and Burry proved (reaping billions), just because you are early doesn’t mean you are wrong.

Inflated Dreams

The table below paints a troublesome picture of rising inflation and gigantic over-investment in real estate. And this takes into account the fact that, much like the Bureau of Labor Statistics (BLS) here in the U.S. massages data, the Chinese statistics are tortured by the Party to paint the best possible picture. Even still, the Chinese government’s own numbers show inflation escalating as economic growth is slowing.

And the trend is not improving: The latest data show year-over-year inflation surging by 6.4% in June and food prices skyrocketing by 14%. With annual disposable income of less than $2,500 in urban areas and just $600 in rural areas, food and energy account for a huge percentage of the average Chinese person’s daily living expenses. The Chinese authorities are terrified by the revolutions sweeping across the Middle East and are desperate to put out the inflationary fires.

To contain stubbornly high inflation, the Chinese central bank has raised the benchmark interest rate three times this year, including the latest rate hike of 25 basis points announced on July 6. In an attempt to rein in excess lending, it has also hiked the reserve requirement ratio six times, ordering banks to keep a record high of 21.5% of their deposits in reserve.

Even with inflation surging, the Manufacturing Output Index fell to 47.2 in July -- the lowest in 28 months, and indicating contraction. China’s automobile industry, which overtook the U.S. in 2010 with sales of 18 million autos, has experienced a dramatic slowdown, with growth of only 3% through June versus 32% growth last year. For all of 2011, the China Association of Automobile Manufacturers expects sales to decline versus 2010.