Flaws appear in the Middle Kingdom’s economic miracle

http://business.timesonline.co.uk/tol/business/markets/china/article4744096.ece
September 13, 2008

Flaws appear in the Middle Kingdom’s economic miracle
The storm clouds are gathering as the seemingly unstoppable juggernaut of double-digit Chinese growth starts to slow downLeo Lewis
If you picked up a cigarette lighter anywhere in the world, there is an 80 per cent chance that it was made in Wenzhou. And if your job was at a cigarette lighter factory in Wenzhou, there is an 80 per cent chance that you are now unemployed. Anywhere else, such a decline in a local industry would be considered catastrophic, but this sprawling industrial city has always taken a brutally capitalist view of life.

Seen from the gates of the 100 lighter factories in Wenzhou that are still running, the 600-odd that have fallen silent in the past 18 months were simply the unlucky ones. The people of Wenzhou realised that, beyond lighters, there are bigger, darker clouds gathering over the Middle Kingdom. The raging debate is: how big, how dark and how badly will they hit property prices?



Choosing the perfect proxy for Chinese growth has never been straightforward, but there are plenty of metrics to suggest that what was once a seemingly unstoppable generator of growth has begun to slow. Electricity production, for example, had risen at 12 per cent for the past two years, but it fell to single digits in July.

Evidence more recent and more striking came in the form of industrial production growth. It plunged to a six-year low in August. Of course, Glenn Maguire, Société Générale’s chief Asia economist, said, the Olympics and the forced closures of many factories and coal-fired power plants that were made while the Games were under way were behind that fall, but while industrial production is not collapsing, he said, it is tracking exports into softer territory.

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Other economists share the view that although the slowdown of the United States and Europe will do plenty of harm to China’s exports, its economy will not follow theirs into the abyss. Downturns in America and Europe will turn consumers towards cheaper, Chinese-made goods and even last year, when export growth was supercharged, net exports (exports minus imports) accounted for only 16 per cent of nominal GDP growth.

What will happen, though, is that last year’s 11.9 per cent GDP growth will probably be replaced by something around 9 per cent this year and 8 per cent next year. Although that would still leave the Chinese growth story looking impressive against most developed and developing economies, it will mark a psychological turning point. For both Chinese and many outside investors in China, double-digit growth has become something of an article of faith – “evidence” that the titanic Chinese numbers game is as good as it looks on paper.

The Beijing Olympics, and the organisers’ obsessive pursuit of records for size, expense and grandeur, was a key ritual of that faith. However, for both Chinese and international investors – and for the Communist Party policymakers 1,300 miles away in Beijing – Wenzhou’s lighter crisis encapsulates many of the doubts and worries now swirling around the country’s economic juggernaut. It also goes a long way, analysts say, to explaining the 65 per cent plunge in Shanghai-listed stocks since their peak last October and the marked absence of any rally before, during or after the Games.

It could also come to explain a vicious shakedown of property prices, which Nicole Wong, a CLSA analyst, believes may be in line for a 20 to 30 per cent correction. It is speculators from Wenzhou who have now begun to bale out of properties bought in Hong Kong and Shanghai. Having been among the first to feel the wealth effect of China’s growth, they are leading a flight from property because they cannot meet payments on what they bought at the top of the market.

Paul Cavey, Macquarie’s China economist, believes that any looming crisis in the property sector would trigger a response by the authorities in Beijing, given the central importance of construction to Chinese GDP.

There is much anecdotal evidence that China’s property market could turn very nasty, a misery that could rapidly transmit itself to the banking sector as a vast nonperforming loan build-up. Early buyers of apartments in Hangzhou trashed the offices of a developer because it had started to offer discounts to later buyers. In Hunan, 10,000 people rioted over an alleged property fraud scheme. There has already been a sharp rise in mortgage defaults in Shenzhen and Guangzhou provinces and other examples of people “walking away” from mortgages and forfeiting their deposits rather than watch their property fall into negative equity.

It all hinges, economists say, on how quickly unemployment emerges from any export-led downturn. Like so many facets of China’s export-emphasised, lower-tech industrial base, the Wenzhou lighter plants have been hit by rougher terms of trade and an unexpectedly fierce squeeze on margins. They also expose China’s still relatively low position on the so-called “value chain” of increasing technological prowess that Beijing is so desperate should propel industry along.

The zinc alloy and copper used to make lighters have doubled and tripled respectively in price since 2005. The combination of huge – some economists believe dangerously “malin-vested” – factory production capacity and ferocious competition means that the costs cannot be passed to customers. Profits of some lighter manufacturers in Wenzhou have taken 70 per cent maulings since last year.

Jim Walker, the managing director of Asianomics, believes that China’s potential downfall may lie in the extent to which it has too long allowed capital to be mispriced. It has done this, he argues, by regulating retail lending rates, manipulating the renminbi exchange rate and overt interference in market pricing mechanisms for key factors such as energy and food. When that is shaken down, the global effects will be far-reaching.

Although global commodity and energy prices are tumbling fast, their nearly vertical ascent earlier this year unravelled the mathematics of perhaps tens of billions of dollars of capital expenditure and capacity expansion. Business models that reaped bundles of cash with zinc at 8,000 yuan (£655) per tonne stop being viable at 20,000 yuan per tonne. The same appears to be true of energy. The cost of sending a container of goods from China to the West Coast of the United States is now about $8,000 (£4,475), 160 per cent higher than it was eight years ago when American manufacturers were making their decisions to outsource production to China.

To make matters worse, the factories of Wenzhou have had to respond, along with industry across China, to robust consumer price inflation. For the Government, the 6.3 per cent level reached over the summer was a politically unacceptable figure demanding policy response; for factory bosses, even the August rate of 4.9 per cent means wage rises and yet more pressure on already shrinking margins.

Added to that pressure is the effect of the new Employment Contract Law, which went into effect this year and was designed to offer greater government protection to workers. Most analysts believe that the impact so far has been negligible, especially in the sweatshops feeding the clothing industry. However, the knock-on effect, said Andy Rothman, of CLSA, has been significant: workers now fight for their rights in a way that they did not before.

According to lawyers in Shanghai, labour disputes there in the past eight months are up by 115 per cent on the same period last year. Only a quarter of those cases ended in victory for plaintiffs, but smaller companies – particularly export processors – are running scared. Many, fearing litigation under the new law, have moved to grant minimum wages that previously they might have got away without paying.

A more unsettling question on labour may be the future of Chinese labour productivity. Recently published research suggests that across manufacturing – private and state-owned – annual productivity grew at a huge 20.4 per cent a year between 1995 and 2003.

According to Pieter Bottelier, a China economist at Johns Hopkins University, the significance of that may have been missed by most analysts. It was this unprecedented and still unique productivity growth profile that allowed China’s manufacturers to reduce export prices, gain market share, increase profits and pay rapidly rising real wages – all at the same time. What is still not known is where productivity has gone since 2003. Professor Bottelier assumes that it will have slowed, placing yet more squeeze on margins.

If, as many suspect, the margin squeeze is hurting corporate China – some estimate that 67,000 companies have failed so far this year – how Beijing attacks this will be perhaps the biggest test it has faced in two decades.

Mr Walker said: “The capital mispricing mistakes are about to be exposed. They will turn out to be more extensive than the housing market debacle that characterises the US.”