Wednesday, September 12, 2012

China’s New Stimulus Will Unleash Inflation

Contributed by Chriss Street. Specialist in corporate reorganizations and turnarounds, former Chairman of two NYSE listed companies.

We have been warning that China’s current economic slowdown signals that the country China has entered the “Middle Income Trap” that will mark the end of the nation’s 30 years of 10% compounded annual growth. With inflation having already driven Chinese wages up to uncompetitive levels, manufacturing and construction activities are plummeting. Desperate to try to stave off up a spectacular increase in unemployment, China just announced another massive public works stimulus program to try to revive to at least the 8% growth rate necessary to create enough jobs for the millions of young people entering the workforce each year. Although shoveling cash at the problem might have delayed a recession after 2008, new stimulus cash will ignite a vicious round of inflation and fail to drive sustained economic growth.

China’s gross domestic product (GDP) growth has fallen from 8% to 3% over the last year according to Xinhua News Agency. Consistent with a slowing economy, China’s reported consumer prices only rose by 2.7% for each of the last two years. But official inflation rates notoriously understate the inflation the people suffer, since the government subsidizes key goods and services such as utilities, energy and public transport that make up a big chunk of the consumer price index (CPI).

The actual inflation the Chinese people have been experiencing is on a tear. The rental price for an apartment in the southern China industrial city of Guangzhou rose 10% in the last year according to Centaline Property Research. Starbucks, which is opening one new store every four days, raised prices by 8% this year to an equivalent of $4.20 for a “tall latte”. Food prices are just beginning to accelerate as “official food prices index” rose in August at a 12% annualized rate. Over the last year, private-sector wages have risen by 18.3%, many provinces have granted workers double-digit compensation increases, and a survey of 4,242 employers by Manpower Group reports labor conditions remain tight.

The Central Publicity Department of the Communist Party of China recently disclosed that from 2005 to 2010, urban residents’ income surged to 137% higher than rural dwellers and continues growing 10 times faster. With rural migrants comprising one third of the 665 million people living in Chinese cities; any economic decline would cause massive unemployment for these “temporary” workers.

The 2008-2009 Great Recession caused exports to shrink over 50%. China’s leaders panicked that 100 million migrants might become unemployed and ordered an epic $586 billion of stimulus spending on state owned enterprises (SOEs), driving new investment as a percentage of the economy from 42% to 50% of GDP last year.

The problem is that no country can be productive enough to reinvest 50% of GDP in new manufacturing plants, capital equipment and infrastructure without eventually creating immense overcapacity and a staggering level of non-performing loans. Chinese productivity has actually declined, since private sector companies have not been eligible to receive stimulus loans and grants.
A significant amount of the spending also was systematically squandered in kickbacks and outright theft. According to CNN, in 2011 four bridges collapsed from mudslides in the span of a week. At a bridge near Chongqing, a city of 32 million, 40 people fell 460 feet to their deaths. Investigations uncovered kickbacks, thefts and money used to build a hostess bar. Philosopher John Stuart Mill warned of crony capitalism 150 years ago:

"A government with all this mass of favors to give or to withhold, however free in name, wields a power of bribery scarcely surpassed by an avowed autocracy, rendering it master of the elections in almost any circumstances but those of rare and extraordinary public excitement."

The last stimulus was so big it funded a 50% increase in crude steel capacity, doubled aluminum capacity and tripled cement capacity. China now dominates the world with 46% of steel, 41% of aluminum and 60% of cement production capability. This new industrial might furnished the materials to build dozens of sleek empty airports, with 45 more planed; a new bullet-train system, wracked lately with financial, corruption and safety scandals; hundreds of highways, to nowhere; thousands of colossal government buildings and numerous residential ghost towns, that will never be inhabited.

Institutional investors have not been fooled by China’s stimulus spending. China’s Shanghai stock market has plunged by -86% since 2008, and it remains the only major stock market in the world that is down this year. The last Chinese stimulus program delayed a Chinese recession for the last three years, but it made China less competitive by destroying the private sector, creating massive over-capacity of state-owned-enterprises and inflating away Chin’s historic wage advantages.

The new “Five-Year Plan” stimulus promises to increase the consumer share of the economy; but a close inspection reveals China continues to try to grow their economy on export-led industrialization and an under-valued currency. In the short run, the investment boom will fuel inflation misery for the population, but price inflation and overcapacity will inevitably lead to a deflationary cycle.

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