Jubak's Journal Recent articles: • 5 infrastructure boom bets, 7/13/2005 • Let China buy Unocal, 7/12/2005 • 6 stocks for a second-half growth rally, 7/8/2005 More... | Jubak's Journal China: the dragon that isnt China just isn't the economic threat many think it is. In fact, it faces a double-barreled economic crisis in coming decades. Here's why. By Jim Jubak In my last column, "Let China buy Unocal," I had the temerity to say that I'd let the free market -- rather than ranting U.S. politicians -- decide whether California-based ChevronTexaco As I expected, my e-mail was filled with abuse. I was called naive, wrongheaded, weak-minded, foolish, a pinko, a commie and a traitor to the United States. "You are forgetting," one reader scolded, "China is still ruled by a communist government. Much of the money for this deal comes from the government and communist doctrine still calls for world domination." Can I suggest that everyone take a deep breath or two? Stop hyperventilating. Pop a Valium or meditate. Whatever it takes. Not the juggernaut we think it is China is not as big an economic threat to the United States as some of you seem to think. In fact, I think China is looking at a horrific double-barreled economic crisis over the next 30 years. The real danger to the United States is that the Chinese won't figure out how to solve this crisis and will resort to domestic and international violence, the last resort of all failing regimes. (Or that we'll fail to solve our own economic and demographic crisis over that same period.) China's still-developing economy is far more inefficient than the juggernaut of our nightmares. And those inefficiencies will, over time, take a bite out of Chinese economic growth.
That may already be happening. The Chinese government recently lowered its forecast for 2005 economic growth to 8%. That's a rate most countries in the world envy, but for China it's a slowdown from the 9.5% growth in the first quarter of 2005 and from 9.4% for all of 2004. And some analysts are projecting that growth could slow to 6% or 7% in 2006. The problem seems to be a developing profit squeeze -- ironic, no? -- now hitting Chinese companies. The costs of raw materials such as oil and iron ore are up, but Chinese companies can't raise prices. Remember how mega-retailers such as Wal-Mart Stores The Chinese profit squeeze The profit squeeze is widespread. It's hit the petrochemical sector, where Jinzhou Petrochemical on July 13 forecast a loss of $70 million for the first half of 2005. That's 10 times higher than the loss the company predicted for the same period back in April. Profits in China's auto industry are projected to decline by 50% in the first half of 2005, and profits actually have already declined 60% in the first four months of 2005, according to the Chinese Ministry of Commerce. TCL, one of the country's largest companies, will lose enough money in its mobile-phone business to throw the whole company into the red for the year. Related China news and commentary on MSN Money
Press releases from individual Chinese companies and Chinese government ministries reel off a list of reasons for the profit squeeze. The standard causes are sluggish sales growth, fierce price competition and rising prices for raw materials. Not surprisingly, though, no one in Beijing ever adds to the list the inefficiencies of a Chinese economy that's still relatively primitive and shockingly bad at allocating capital. The result is massive over-investment in sectors already bloated with excess capacity. Take a look at the steel industry. Steel production in China grew by 23% in 2004 to 273 million tons. It is on trend to grow by another 50 million tons, or about 20%, in 2005, and it is projected to increase by yet another 50 million tons, or about 15%, in 2006. Considering that major steel-consuming companies are growing at much lower rates -- auto-industry production grew by just 1.5% in the first four months of 2005, for example -- is it any wonder that steel prices are falling? And yet, it's still remarkably easy to raise massive amounts of money in China to build a new steel plant. On July 12, Wuyang Steel announced a plan to invest $700 million to build an iron ore and steel-plate plant in central China. Politics drives capital allocation Why? Because capital in China is still largely allocated by politics. You can raise money to build a steel mill if national politicos, who want to develop the slowly growing inland provinces, put the muscle on national banks to make the loan. (And, of course, you get the loan if you've dressed up your board with the sons and daughters of high-ranking party officials who can put the muscle on just about everyone.) Any investor in the United States watching the judge hand down a 25-year prison sentence to former WorldCom CEO Bernie Ebbers knows our own capital markets don't do a perfect job of allocating capital. But our markets are still much more efficient than the Chinese system. After misallocating capital, the Chinese system then requires a top-down plan from the officials in Beijing to fix the mess. For example, a day after the announcement of a new steel plant from Wuyang Steel, China's State Council announced a policy to consolidate the steel industry by driving smaller steel mills out of business. The goal is to put 70% of the country's steel production in the hand of the country's 10 largest steel makers by 2020. (China's top 15 steel makers now produce about 45% of the country's steel.) I'd give this piece of industrial planning an "F" on capital efficiency: First the banks fund new steel mills, and then the government shuts them down. And an "F" on industrial efficiency: The government is going to pick winners and losers on size. That just exacerbates one of the biggest flaws in the Chinese economy: According to Western managers at joint ventures in China, it's almost impossible to make a decent profit because Chinese companies are fixated on size and market share. They will cut prices to the point of sacrificing profits to gain that share. China needs fast growth This would be just a normal cyclical economic problem in the United States, but it is something like a crisis for China, where anything less than 7% economic growth has huge consequences. That 7% growth rate is a rough measure of economic break-even in China. If the economy grows at better than that rate, it creates enough jobs to match population growth and reduce China's huge population of the jobless and underemployed. At anything less than 7%, the Chinese economy isn't producing enough jobs and unemployment rises. But that's just the start of the problem. China's government needs better than 7% growth if it hopes to do anything about the horrific inequalities that have been produced by China's recent economic growth. In the three-and-a-half years since China got full membership in the global economy with its entry into the World Trade Organization, incomes among the rural Chinese who make up most of the country's population have actually declined, according to the World Bank. Because of an average income of just $318 a year, this 70% of China's population accounts for just 40% of domestic consumption. Shockingly, and perhaps most shockingly to the Chinese themselves, the divide in China between rich and poor is now greater than before the Communists came to power in 1949. The richest 10% of the population control 45% of the country's wealth, according to government figures, and the poorest 10% hold about 1%. On the GINI Index, a measure of economic inequality, Communist China now rates a 45. The bad ol' running dog capitalist U.S. of A is only slightly worse at 46.5. Which is quite a problem for the current Chinese regime. The great economic experiment launched by Deng Xiaoping scrapped the Iron Rice Bowl guarantees of an earlier generation in exchange for a promise that, eventually, everyone would be better off -- even if that required that some people would get rich first. The boom leaves most behind For a sizeable portion of the population -- those that live in the rural areas of the interior provinces -- that promise hasn't been kept, even as the country's economy as a whole grew by nearly 10% a year. Lower growth, even the 6% to 7% growth some now forecast for 2006, will make it harder, if not impossible, to deliver on that promise. Delivering on this promise will be made much harder by the demographic crisis that the country now clearly will face somewhere between 2025 and 2040. China, unlike the United States or Europe or Japan, will become old before it becomes rich. In 2000, the median age was 36 in the United States and just 30 in China. By 2025, however, because of Chinese population controls and U.S. immigration, the two countries will be about equally old, according to the United Nations. The median age will be 39.3 in the United States and 39 in China. By 2040, 26% of the U.S. population will be at least 60, up from just 16% in 2000, according to a study by the Center for Strategic & International Studies. But 28% of China's population will be at least 60. And that population will be staring at old age without anything like the system of pensions, retirement accounts, Social Security and Medicare that support the aging population of the United States. Why we should want China to succeed That gives the current Chinese regime a relatively narrow window of 30 years or so to deliver on the promises of Deng Xiaoping of a better life for those who have so far been left out of the Chinese economic boom, and to figure out how to provide for a rapidly aging population. I hope they do. And I think it's in the best interests of those who live in the United States that they succeed. Moving China toward a consumer economy (and away from an export-driven emphasis on industrial development) would, in my opinion, be the best way to raise living standards for rural Chinese. It would also be good for workers in U.S. businesses who would have millions of new customers. The alternative is to hope for Chinese failure. That would eliminate what I think are largely imaginary fears of Chinese world domination. But it would throw more than a billion people in China into violence and chaos. I don't wish that on anyone. New developments on past columns 8 stocks to watch in a wandering market On July 12 PepsiCo Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday. E-mail Jim Jubak at jjmail@microsoft.com. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: PepsiCo. He doesn't own short positions in any stock mentioned in this column. | |||||||||||||||||||||||||||||||
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