Current crisis exposes weakness in China's economic system

08/28/2012 8:21 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Building infrastructure at breath-taking speed. Creating the world’s factory. Stringing together quarter after quarter of 7%, 8%, 9%, and even 10% growth.

These are some of the strengths of China’s economic system. And sometimes, as we watch the global economy struggle with the fall out from a financial crisis that started in the United States or the economies of Europe sink again into recession, it can seem as if China’s system has only strengths.

But no economic system is good at everything. And right now China is delivering a very painful lesson in exactly what its economic system is bad at.

China, and this shouldn’t come as a surprise given the history of other centrally controlled economies, is really, really bad at diminishing supply when demand falls. (Or at what economist Joseph Schumpeter called “creative destruction,” the process in which an economy destroys the old to give the new room to grow.) The current supply-side disaster is so bad, in fact, that the Chinese government has been forced to obviously falsify economic data to hide the extent of the problem. (And the extent of the problem is one reason I think that the People’s Bank of China will move relatively soon to cut interest rates and step up its efforts to stimulate the Chinese economy.)

The current obvious fakery is degrees of magnitude different from the usual distortion in Chinese economic data. So, for example, the Public Safety Bureau has simply stopped publishing data on new car registrations because the numbers show such a big drop in new car sales that they can’t simply be fudged. Data on the steel industry has been revised and revised again because the government can’t come up with a methodology that disguises the drop in steel sales and yet isn’t completely unbelievable. And, of course, the government hasn’t published data on the number of vacant apartments in China—a reflection of the country’s real estate boom and bust—since 2008.

Take a look at the auto industry as an example of China’s supply-side problem. Auto sales rose 8.2% in July from July 2011, according to the China Association of Automobile Manufacturers. That follows on year over year growth of 9.9% in June and 16% in May (when car sales jumped after new model introductions at the April Beijing auto show.) However, that brought growth in the first seven months of the year to just 3.6% from the same period in 2011. (The number itself needs to be taken with a pinch of salt since it includes cars pushed out of factories and now sitting, unsold, on dealer lots. Inventories of unsold cars climbed to 2.2 million as of the end of June from 1.3 million at the beginning of 2012, according to the general manager of General Motor’s Chinese car operation.)

At the current pace 2012 looks like another bad year for China’s auto industry. In 2011 total vehicle sales climbed by just 2.5% and passenger car sales rose by just 5.2%. That’s quite a tumble from the 32% growth in total vehicle sales in 2010. Except for the 2008 global financial crisis year, China vehicles sales had grown at a double digit pace in every year since 1999. Even in 2008 sales rose by 6.7%.

And how have China’s 70—that’s right 70—domestic automakers responded to the slowdown in demand? A KMPG report in January 2012 estimated that China’s auto industry finished 2011 with 6 million units of unused capacity—that’s equivalent to the entire German auto industry. Things have only gotten worse since then. With the industry currently running at 65% of capacity, way below the 80% range needed for profitability, you might expect the industry to be cutting back by cutting capacity, delaying new plants, and shuttering older factories.

Not at all.

China’s auto industry is still on track to increase capacity by 68.5% by 2016. (Contrast that to a projected 6% increase in capacity for the United States and Canada.) Capacity at China’s 30 largest carmakers is set to hit 31.2 million vehicles by 2015, according to the National Development and Reform Commission. Total vehicle sales in 2011 were 18.4 million in 2011.

There are lots of ways that any industry in any economic system can get itself into this kind of a mess. CEOs can simply refuse to believe that the slump won’t be over soon. As late as April 2012, for example, Zhang Fangyou, chairman of the Guangzhou Automobile Group could say “Auto demand in China is still huge and on an upward trend.” Overcapacity is a temporary problem, he added. And the first response of any Chinese industrial sector is always to believe it can export its way out of any slump in demand at home. China’s automakers certainly thought they could solve their industry’s over-capacity problem by exporting more cars to the world’s developing economies—until the slowdown in global growth made that solution untenable.

But part of the problem is peculiar to China’s economic system. No company in China goes bankrupt as long as it can find a lender willing to let it borrow. China’s state-owned banks have long been accustomed to granting loans to state-owned companies even if the company isn’t making a profit and even if the new loan is being used to fund money-losing operations and to pay the interest on old loans. Local government officials, accustomed to being evaluated on measures such as employment and growth, are more than willing to put the arm on banks and government affiliated lenders to keep sending good money after bad. Central government banking regulators play into this system by only reluctantly calling a bad loan a bad loan. Bad loans at Chinese banks did increase by $2.86 billion in the second quarter, for the third straight quarter, but because Chinese banks continue to make new loans at a relatively high rate, non-performing loans (loans overdue by at least three months) rose to just 0.9% of total bank loans as of June 30. That percentage was unchanged from March.

The strongest evidence that the problems in China’s auto industry sector are the result of the way China’s economy works is that the same problems of overcapacity, falling profits, and yet continued spending on building new capacity can be seen across China’s economy.

For example, profits at all of China’s industrial companies fell for a fourth straight month in July, the National Bureau of Statistics reported on August 26. Income at these companies was down 5.4% in the month from July 2011.  Profits at industrial companies are down 2.7% for the first seven months of 2012. In the first seven months of 2011 industrial companies reported a 28.3% gain in profits during the first seven months of 2011.

What’s stunning about that profit decline is that China’s economy is still growing at better than 7%--7.6% in the second quarter—and that led to a 10.6% increase in revenue at these companies in the first seven months of the year. It looks like we’ve got a lot of unprofitable growth in China right now. (The situation is probably even worse than the statistics show since the government changed the threshold for including companies in this report to 20 million yuan in annual sales from 5 million. That had the effect of excluding China’s smaller companies at a time when many of these companies, lacking the clout of the big state-owned enterprises, are struggling to find loans to keep their operations running.)

Move from national statistics to individual industries and the pattern is the same. For example, China’s iron and steel makers have seen profits plunge by 96% in the first half of 2012 versus the first six months of 2011. Sales margins fell to 0.13% in the sector from last year’s not terribly robust 3.06%. Net losses across the industry hit more than 1 billion yuan in the first half of 2012, according to the China Iron and Steel Association.

The steel industry suffers from the same problem as the auto sector—too much capacity at a time of stagnant demand and a reluctance to curtail production. Production capacity in China’s steel industry reached 850 million metric tons in 2011, according to calculations by investment manager Pimco, after climbing by 23 million metric tons in 2001, 30 million metric tons in 2002, 40 million in 2003 and, drum roll please, 75 million metric tons in 2005. In that period China was adding the equivalent of the entire steel production of Japan every two years.

Which was a problem even before 2012. In 2011 demand fell to 683 million tons (of which 52 million went into inventory) when capacity hit 850 million tons. And now it’s an even bigger problem with demand in 2012 forecast at under 600 million metric tons.

And how has the industry responded? In July China’s steel mills produced record monthly output. In the first 10 days of August, the China Iron and Steel Association reported a further rise in production. This increase comes in the face of a campaign announced this year by China’s National Development and Reform Commission to end what it called the “reckless expansion” of the steel industry.

And lest you think this is a problem plaguing only older-line industries in China, the solar sector shows exactly the same pattern. Faced with collapsing demand from European markets, companies kept adding capacity resulting in a price war that saw industry gross profit margins fall from 30% in 2010 to 10% in 2011. Profit margins are forecast to fall even further in 2012, according to the China Photovoltaic Industry Alliance. At anything less than a 10% gross margin, the China Renewable Energy Society says, China’s solar manufacturers lose money. So no wonder that LDK Solar, China’s fourth biggest solar manufacturer, reported a $588 million loss in the first quarter of 2012. Industry analysts peg LDK Solar (LDK) and SunTech Power Holdings (STP), the world’s largest solar company by manufacturing capacity, as the two Chinese companies most likely to go bankrupt.

But will they?

LDK is probably already bankrupt by U.S. standards. The company has already defaulted on payments to suppliers of $85 billion and the company is $3.8 billion in debt, but LDK continues to tap the loan market from state-owned banks thanks to local government leaders who see the company as an important source of jobs and local economic growth.

That doesn’t mean LDK or SunTech or all 70 of China’s automakers or every steel company will be able to put off the day of reckoning forever. China’s economic system may be slow to move to reduce unneeded capacity but on the historical record it does move eventually. What will happen, almost certainly is that “failing” companies will either be 1) recapitalized and restructured by the government or 2) folded into one of the stronger companies in the sector by the government.

Unfortunately for the health of these individual sectors, neither of those actions will reduce capacity as quickly or as radically as U.S. style bankruptcies would. Factories will largely stay open and workers will largely keep their jobs. That will certainly reduce social turmoil and worker suffering, but it will mean that loss-making sectors will continue to make losses until domestic and global demand picks up. Part of the government response to any steps to reorganize these sectors is likely to be an effort to stimulate demand. So, for example, the government is likely to push as quickly ahead as quickly as it can with the ambitious goals in the last Five-Year Plan to increase China’s installed solar generating capacity. And the People’s Bank is likely to move to stimulate the general economy.

Where does that leave an investor who is looking at prices for China’s industrial giants that are, in historical terms, bargains—or who might own shares in one of these sectors? (Yingli Green Energy (YGE), one of the five largest solar manufacturers in China is a member of my Jubak’s Picks portfolio http://jubakpicks.com/  . I’ll have a more detailed individual run-down on the stock in a post later today.)

Because it is going to take a while to bring demand and supply back into something like balance for China’s industrial sectors and because in that effort these sectors will largely have to wait for the slow return of global demand to show significant improvement, I think investors will be better off looking at other sectors of China’s economy for bargains. If China does pursue more aggressive stimulus policies, these industrial exporters will certainly bounce, but their near-term future is closely tied to any global economic recovery. Instead for more sustained gains, I’d look at Chinese domestic-growth companies such as Tencent Holdings (TCEHY in New York or 700.HK in Hong Kong) or noodle giant Tingyi Holding (TCYMY in New York or 322.HK) or Ping An Insurance (PNGAY in New York or 2318.HK in Hong Kong) or Home Inns and Hotels Management (HMIN).

If you want to play the rebound in the industrial sector and export sector that might result from anther interest rat reduction, I’d still look to avoid the sectors with the worst overcapacity problems—unless the stocks in question are so cheap that they’re essentially trading like an option. (I’ll take a look at whether Yingli Green Energy is cheap enough in my post this afternoon.) Investors won’t know how badly existing investors will be savaged in any reorganization plans and they don’t know which companies the government will decide to pick as survivors.  If you want to play the aggressive stimulus odds, I’d suggest going with real estate development companies (most of these only trade in Shanghai or Hong Kong) or pure industrial commodity plays such as Aluminum Corp. of China (ACH.)

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares Home Inns and Hotels Management, Ping An Insurance Tencent Holdings, and Tingyi Holding as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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