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In a train wreck, there comes the moment when it's no longer possible to avert disaster. Pull the brakes as hard as you can, the momentum of the train is so great that disaster is unavoidable.
I fear that China's economy passed that point of no return in the second quarter of 2006.
Today, I'm going to tell you why I think China's economy is headed for a train wreck. Not tomorrow, but in the reasonably near future. I'd say 2009.
And in my next column, I'll sketch out the likely effects of that train wreck on the rest of the global economy and the folks, like you and me, who invest in it.
If you've been following the debate in the U.S. about the likelihood that cheap money here has produced a bubble in housing prices, you're already familiar with the basic scenario for a train wreck in China. Cheap money makes it easy to borrow to buy assets. That produces an asset bubble -- in the United States, first in stocks and then in real estate. As the asset bubble grows, borrowers get in over their heads as their judgment is overwhelmed by the excitement of rising prices. And lenders under the influence of similar emotions make loans to unqualified borrowers.
When the asset bubble starts to deflate, overextended borrowers default on their loans, putting pressure on lenders, who respond by tightening their lending standards, reducing the amount of money available to all borrowers. That sends the economy into a slowdown or worse.
They're borrowing to grow even more
China does add a few wrinkles of its own to that scenario. Since the Chinese economy is still very bad at allocating capital, corporate borrowing to build new plants itself becomes part of the asset bubble. I'll start my sketch of China's coming train wreck with the problems in that sector.In the second quarter, China's gross domestic product grew by an extraordinary 11.3%. That's a significant speed-up from 9.9% growth in 2005, 10.1% growth in 2004 and 10% growth in 2003.
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That's a problem, because an economy can have too much growth. In China, it has led to massive overinvestment in manufacturing assets in sectors already suffering from oversupply. Investment in fixed assets -- everything from steel mills to cement plants to oil refineries to highways -- grew by 30% in the first half of 2006.
Although the reported profits of China's largest industrial enterprises climbed 28% in the first half of 2006 over the same period in 2005, companies in some sectors have seen profits squeezed, sometimes to the vanishing point. According to government numbers, 80% of the profits in the Chinese economy went to companies in the oil, power, coal and nonferrous metals sectors. The other 30 sectors of the economy shared just 20% of corporate profits.
The iron and steel sector is the current poster child for the problem -- and a worrying sign of things to come in other sectors. Profits in the sector dropped by 20% in the first half of the year. The problem is overcapacity. Too many steel companies have added too much capacity, driving down the price they can charge for their product.
That's not exactly a surprise to the government in Beijing. At the end of 2005, steel production capacity stood at 470 million metric tons. (A metric ton is about 2,200 pounds.) Concerned about the issue, China's National Development and Reform Commission announced a plan to remove 100 million tons of steel capacity from the market by 2007 by gradually phasing out small blast furnaces and converters. Removing that production capacity from the market would be key to restoring profitability to the sector.
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