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Jubak's Journal
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| | Jubak's Journal
When China brakes, the world slows
Insatiable demand for raw materials and a huge, cheap labor force give a relatively small economy enormous influence. Heres how China affects us all.
By Jim Jubak
Heres a trend few investors would have predicted even a few short years ago: China just thinks about slowing its torrid economic growth, and the worlds financial markets go into a tailspin.
Case in point: On April 28, Chinese banks reported they would go on a three-day lending moratorium on government orders. The same day, the Reuters news service ran an interview with the premier of China, who promised very strong action to rein in excessive growth. In the United States, shares of companies selling iron ore, aluminum, nickel and copper to China tanked on fears that the Chinese were about to stop buying the raw materials that fuel their economy.
The damage didnt stop there, either. The next day, shares of shipping companies sank on fears that a cooling Chinese economy would have less need for the services of oil tankers, container ships and bulk freighters.
Thats a lot of global clout for an economy that is, after all, still only about a tenth the size of the U.S. economy. If you believe the official figures, not necessarily a good idea -- especially not in the case of China -- U.S. GDP is about $11.4 trillion in current dollars. Chinas GDP is about $1.4 trillion in U.S. dollars. How is it that were living in a world where the words of Wen Jiabao, the current Chinese premier and hardly a household name even in his own country, carry more weight in the financial markets than those of Federal Reserve Chairman Alan Greenspan?
The simplistic answer is sheer size. Youve probably got your own favorite tidbit about how even a minor shift in the individual behavior of Chinas estimated 1.3 billion people can change the global economy. Heres my current favorite from an estimate by the Chicago agricultural forecasting firm AgResource: If every person in China consumed one more tablespoon of soybean oil annually, world trade in soybean oil would double.
A make-or-break influence
So, how did China become the pivot point in the world economic and financial systems? The answer is leverage. The internal structure of the Chinese economy has combined with current global economic conditions to give China even more global impact than its huge population already warrants.
I can count five ways that leverage gives China a make-or-break influence over the global economy.
Chinas economy is labor light and commodity heavy. This might seen counterintuitive, since half of the stories you read these days are about the effect of Chinas cheap labor force on U.S. manufacturing. But precisely because Chinese labor is so cheap, it makes up a very small percentage of the cost of goods produced there compared with the cost of the commodities used to make those goods.
In the United States, raw materials might make up about 10% of the cost of the finished goods and services churned out by the U.S. economy. Labor accounts for as much as 65%.
Related news and commentary on MSN Money
Exactly the reverse is true in low-wage China. According to the South China Morning Post, the average wage for a worker in Shanghai at the end of 2002 was about $1.26 an hour (assuming a 40-hour week). In less-expensive Chongqing, it was about 55 cents an hour. With labor this cheap, the commodity inputs used to make a product -- the plastic, the copper, the iron, the aluminum -- add up to a bigger part of the whole.
This effect is exacerbated by the inefficiencies of the China factories. China used 30% of the worlds coal last year and still suffered energy shortages.
Leverage: The Chinese economy is far more weighted to commodities than the economies of the United States, Europe or Japan.
China has become the marginal consumer that sets global commodity prices. Blame this on tight worldwide commodity supplies. If key commodities were in excess supply worldwide, the huge growth in Chinese demand for commodities wouldnt have much effect on prices.
Thats not happening today. Take the worst case: the global supply/demand story for oil and natural gas. The International Energy Agency (IEA) estimates that global demand for oil will climb to 79 million barrels a day by the end of 2004. Supply will stay ahead of demand, climbing to 82.3 million barrels, but thats not much of a margin, only 3%.
That margin seems even smaller when you factor in the growing Chinese demand for crude oil. It was up 9% in 2003, In fact, the IEA says, China accounted for 35% of total global growth in oil demand in 2003 and will account for 30% of demand growth in 2004. (The drop isnt due to moderation in the Chinese appetite for oil. The real reason is increased oil demand in Japan, the United States and elsewhere.)
Chinas effect on prices is magnified further because its leaders know the country is poor in critical basic materials -- pretty much everything except coal -- that are essential to ensure continued growth. So, the Chinese have become aggressive bidders in deals that guarantee long-term access to oil and gas supplies.
Leverage: As the buyer at the margin, China sets key commodity prices.
China is now the worlds marginal producer and sets global inflation rates. This is the result of cheap labor and a glut of manufacturing capacity.
Nobody knows exactly how much excess manufacturing capacity still exists in China. We do know that political pressures to preserve jobs or keep a politically-connected factory owner happy have long kept inefficient factories in business. We also know that Chinas banks have kept pumping money into building new factories, among other things -- despite jawboning from Beijing to rein in lending growth to 8% from 9.1% in 2003. Commercial bank loans have been growing at 40% annualized rates recently.
Now, the excess factories werent always particularly efficient, and they may have had problems meeting quality standards. But their very existence has kept constant pressure on manufacturers everywhere to cut costs and prices, and inflations been low. Offshore companies have grown accustomed to shopping around their business on a regular schedule, looking for the best price. So, they regularly compare costs and quality in China with costs and quality at home. Result: a lot of companies have moved manufacturing from, say, Chicago to Shanghai.
There are signs, however, that China may be about to start exporting not deflation but inflation. Inflation in China picked up to 3.2% in the 12 months ending in December and 2.8% in the first quarter. So far, much of that increase has been in the cost of food. Heres where the commodity-heavy nature of the Chinese economy could become a real problem. As commodity prices rise, Chinese manufacturers have to pass on much of that increase to their customers.
Leverage: As the supplier at the margin, any uptick in inflation in China quickly travels around the globe.
Local political pressure and realities make it hard for Chinas central government to engineer a soft economic landing. Hard talk from Beijing has been remarkably ineffective at slowing runaway bank lending, slowing growth or shutting bankrupt companies. Local officials have a long and honored tradition in China of ignoring edicts from the center.
Exercising effective economic control from Beijing remains one of the biggest problems facing a Communist party that still believes in a large measure of central economic planning.
Beijing cant simply step back and let the free market allocate capital and resources. Remember, local politics -- not economic efficiency -- more often than not control the market. If a local governing body wants a new factory to create jobs, the local bank will be under intense pressure to deliver the cash. This helps explain why the economy grew by 9.9% in the fourth quarter of 2003, above the 9.1% average for the year. And this despite central government pressure to hold growth down.
The end result: The central government may be forced to take stronger and stronger measures to reach its goals. If banks wont slow lending voluntarily, Beijing will impose a lending moratorium. If raising capital requirements for banks doesnt slow lending, Beijing will raise interest rates. The danger here is that these measures will wind up overshooting their targets. Rather than slow things down, they could actually stall the economy. That was the pattern in the early 1990s.
Leverage: The governments effort to slow the economy produces a bust instead of a soft landing.
While China is a global manufacturing juggernaut, its financial sector remains underdeveloped. Theres a race on in China between the central governments efforts to improve the financial condition of the banks by injecting capital and reducing bad loans and the next economic downturn. If the downturn is severe enough, it could send one or more big banks to the brink of default.
Default is unlikely in the Chinese system, but even the likely government bailout could raise investor doubts about the Chinese financial system and force interest rates higher. That might put the big hurt on Chinese equities. If the increase were big enough, it might cut the legs out from under the Chinese consumer, who has of late increasingly used debt for purchases such as cars. Any decline in Chinese stocks could send international investors to the sidelines. And the decline would feed back into the banking system as well by lowering the price of equities held by the banks and the value of collateral for many of their loans.
Leverage: The Chinese financial sector is weak enough to turn a nasty short-term dip into a long term problem.
Is China the engine of global economic reorganization?
Theres another form of leverage that I havent mentioned here because it would take a whole column on its own.
China is really just the shorthand for a complete reorganization of the global economy that has woven manufacturers from China, design houses from Taiwan, subassemblers from Malaysia and retailers such as Wal-Mart Stores (WMT, news, msgs) from the U.S. into a new global economic fabric.
In my next column, Ill take a look at how the China story is really the tale of the reorganization of the global economy.
Changes to Jubak's Picks
Sell Lamar Advertising
Lamar Advertising (LAMR, news, msgs) reports earnings after the market close on May 6. I think theres a good likelihood that the company will report further improvement in the outdoor advertising market, with billboard occupancy inching up another 3 percentage points to 80% from the current 77%. (That comes on top of the improvement to 77% from 74% last quarter.) But that starts to push Lamars occupancy numbers near historical averages, and I have trouble justifying an increase to my current price target of $45. That leaves me waiting around for a last 10% gain from recent price levels. I find the current market, worried as it is about a likely interest rate hike in June, just too risky for that. So Im selling Lamar Advertising with this column with a 2% loss since I added the shares on March 12, 2002. That 2% loss masks a lot of volatility, though. In July 2002, this position was almost 36% under water. In the last six months, the stock is up 17%. (Full disclosure: I will be selling my shares of Lamar Advertising three days after this column is posted.)
New developments on past columns
Clean enough for Buffett, clean enough for me
During the trading day on April 30, The Washington Post Co. (WPO, news, msgs) announced first-quarter earnings of $6.15 a share, well ahead of the $5.91 a share Wall Street consensus. The quarter saw the company operating on all cylinders. Newspaper revenues grew 7% from the same quarter of 2003; television revenues grew 8%; magazine revenues were up 9%; and cable revenues increased by 10%. But continuing the pattern of recent quarters, it was the companys Kaplan education division that provided the real power. Revenue in that division jumped 45%, or 21% if you exclude the effect of acquisitions. With the Federal Reserve primed to raise interest rates, Im not inclined to up my target price right now. As of May 4, my target price stays at $990 a share by September 2004. (Full disclosure: I own shares of The Washington Post Co.)
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: Lamar Advertising and The Washington Post Company. He does not own short positions in any stock mentioned in this column.
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