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When Monte Burnham, the president of Birmingham, Ala.-based Foundry Manufacturing Solutions, recently visited Tianjin, China, he was pleasantly surprised to find its air more breathable than during his previous stay.
“Then I realized, the smelters weren’t running,” recalled Mr. Burnham, referring to the northern port city’s giant steel plants, which until recently had been delivering economic growth rates as high as 16% to Tianjin province.
The downturn in steelmaking activity in places like Tianjin is a direct cause of a 30% year-to-date decline in the international iron-ore price, a matter of concern for miners in ore-rich nations such as Australia and Brazil following a similar price drop in the prior year. It also suggests that multinational companies and others should temper their enthusiasm over recent improvements in economic data.
China’s second-quarter growth came in at a 7.5% annual rate, up from 7.4% in the first quarter, bringing it in line with the government’s full-year target. That, along with reports such as Thursday’s stronger-than-expected preliminary purchasing managers index from HSBC, has fueled talk of China’s “stabilization,” an apparent end to the unsettling slowdown of the past year.
Such optimism is premature, and not only because of the perpetual suspicion surrounding the accuracy of China’s statistics. The economy still has to work through tens of millions of square feet of unoccupied apartment space— symbolized by the notorious “ghost cities” in places like Inner Mongolia—and hundreds of billions of dollars of unused factory capacity, most of it debt-financed.
Already, data outside of China are flashing warning signals. Urging caution for investors who have revived bets on the Australian dollar, Mitsubishi UFJ economist Brendan Brown points to the Baltic Dry Index of bulk shipping costs for raw materials, which is down 35% from a year earlier and at its lowest level in 18 months. While that in part reflects a glut of shipping capacity left over from the 2008 global crisis, it is also a sign of weak Chinese demand for commodities.
So, how is China achieving 7.5% growth if it is powering down steel plants and letting copper stockpiles build up? With debt.
Despite official instructions to banks to curtail lending to overstretched developers and municipalities, loans are still increasing at rates twice as fast as the economy—and those numbers exclude a so-called shadow-banking lending system estimated at more than $5 trillion, or 80% of gross domestic product.
“That doesn’t make sense,” says PNC Financial economist Bill Adams. “Eventually, sustainability concerns will either cause Chinese policy makers to slow credit growth or investor risk aversion will cause less credit to flow through the trust companies” that manage the shadow lending programs.
A big question is what happens to bad debts when the treadmill comes to a halt. Despite rhetoric about opening up the financial system to market pressures, there is clearly reluctance in Beijing to let lenders suffer losses.
On Wednesday, construction company Huatong Road & Bridge Co. somehow found the funds to make a bond payment that it had earlier warned it would miss. With China’s second-ever corporate default averted, investors could for now set aside fears of a wave of bankruptcies. But any student of finance knows that postponing defaults will build up bigger problems in the future.
PNC’s Mr. Adams believes the government will find resources to restructure banks’ nonperforming loans once those problems can no longer be postponed, though this inevitably means the financial sector’s much-ballyhooed liberalization will have to wait. The real pain will be felt in economic, rather than financial, terms, he says.
Essentially, an end to credit flows will compound the economic effect from companies’ curtailing their use of retained earnings to fund capital expenditure, a category of investment financing that is now proportionally less than a quarter what it was during 2010 and 2011. Together, this could drive China’s economic growth rate down to 6% by 2016, says Mr. Adams, who blames such data for his recent conversion from bull to bear.
“It used to be that the China bears mostly cited anecdotes and bulls mostly cited statistics,” Mr. Adams says. “Now a bear doesn’t need 100 photos of ghost cities—the outlook from the statistics has weakened.”
Chinese Data Don?t Add Up - MoneyBeat - WSJ
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