The giant production engine that is China excels at making more and more stuff. But it's not good at slowing down, and when demand falls, that's a profit killer, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Building infrastructure at breathtaking 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 US and global economy struggle with the fallout 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 painful lesson in exactly what its economic system is bad at.

China—and this should come as no surprise, given the history of other centrally controlled economies—is really, really bad at shrinking supply when demand falls. The current supply-side disaster is so bad, in fact, that the Chinese government has been obviously falsifying 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.

Case in Point: The Auto Industry
The current obvious fakery is degrees of magnitude different from the usual distortion in Chinese economic data. 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 simply can't be fudged.

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).

That brought growth in the first seven months of the year to just 3.6% compared with the same period in 2011. (The number 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 the year, according to the general manager of General Motors' (GM) Chinese car operations.)

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 vehicle sales had grown at a double-digit pace in every year since 1999. Even in 2008, sales rose 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 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. 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 with 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.

There are lots of ways that any industry in any economic system can get itself into this kind of a mess. One is that CEOs can simply refuse to believe that the slump won't be over soon. As recently as April, 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 overcapacity 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 willing lender.

China's state-owned banks have long been accustomed to granting loans to state-owned companies, even if the companies aren't making a profit, and even if the new loans are 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, nonperforming 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.

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An Economy-Wide Problem
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 its 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. Income at these companies was down 5.4% 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.

Data on the steel industry have 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.

What's stunning about this 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 industrial companies in the first seven months of the year. It looks as if we've got a lot of unprofitable growth in China right now.

(The situation is probably even worse than the statistics show, because 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 steelmakers have seen profits plunge by 96% in the first half of 2012 versus the same period last year. 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 problems 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 figures from Pimco, after climbing by 23 million metric tons in 2001, 30 million metric tons in 2002, 40 million in 2003 and—drumroll, 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.

That was a problem even before this year. In 2011, demand fell to 683 million tons (of which 52 million went into inventory). And now it's a huge problem, with demand for this year forecast at less than 600 million metric tons.

And how has the industry responded? In July, China's steel mills produced a record monthly output. In the first ten 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 it's no wonder that LDK Solar (LDK), China's fourth-biggest solar manufacturer, reported a $588 million loss in the first quarter of 2012. Industry analysts peg LDK Solar and Suntech Power (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 US standards. The company has already defaulted on payments of $85 billion to suppliers, 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.

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When the Crunch Hits
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 history shows it does move eventually. What will happen, almost certainly, is that "failing" companies will either be:

  • recapitalized and restructured by the government
  • folded into one of the stronger companies in the sector by the government

Unfortunately for the health of these individual sectors, neither action will reduce capacity as quickly or as radically as US-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 demand picks up.

Part of the government response to any attempt to reorganize these sectors is likely to be an effort to stimulate demand. So, for example, the government is likely to push ahead as quickly as it can with the ambitious goals in the most recent 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.)

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, 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.

For sustained gains, I'd look at Chinese domestic-growth companies such as Tencent Holdings (TCEHY), noodle giant Tingyi (TCYMY), Ping An Insurance (PNGAY), or Home Inns and Hotels Management (HMIN).

If you want to play the rebound in the industrial sector and export sector, 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 options. (I'll take a look at whether Yingli Green Energy is cheap enough in an upcoming blog post.)

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 pick as survivors. If you want to play the aggressive stimulus odds, I'd rather go with real-estate development companies (most of which trade only in Shanghai or Hong Kong) or pure industrial commodity plays such as Aluminum Corporation 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, may or may not now own positions in any stock mentioned in this post. The fund did own shares of 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 here.