More Trouble Brewing in China

Almost every day, the U.S. government releases some new tidbit of economic data. It never fails there is always someone out there to question the validity of it. They say how manipulated or plain wrong the data may be. In most cases, the scrutiny is certainly justified.

There, however, seems to be no scrutiny of the occasional bit of economic data released from China. And the “next thing to go wrong” could very well be in China.

China’s $585 billion bailout sparked a renewed sense of confidence which will likely be short-lived. After all, that’s about 17% of China’s GDP (the equivalent in the U.S. would be more than a $2 trillion stimulus package).

The markets were quite excited with the spending plan (although not much different from what the world was expecting the country to do anyways). However, the excitement is probably not going to last.

China’s current economy is built for boom times. As a result, when times are good for the world, they’re great for China. When times are bad for the world, it’ll get downright ugly in China.

That’s why China has taken very drastic measures to ensure the economy keeps growing. Earlier today, the country announced its biggest interest rate cut in 11 years. The 1.08% cut was a big one, but it was the fourth interest rate cut in the past three months.

Remember back in February when the Fed slashed interest rates by 1.25% in about a month’s time? The impact was quite limited. It was too little, too late. Now, China is playing catch up. But aggressive rate cuts will probably end up being another case of too little, too late.

Of course, those are just short-term interest rates which take a while to work their way through the economy.

China, however, made an even more aggressive move today when it cut the reserve requirement for its banks. Before today, China’s reserve requirement for all banks was 16.5%. Starting December 5th, the reserve requirement will be 15.5% for larger banks and 14.5% for smaller banks.

I consider this the most drastic move of all. The multiplier effect of reducing bank reserve requirements can have a truly massive impact on money supply. Just a simple 1% or 2% tweak will be multiplied many times over in new money created by a fractional reserve lending system.

Clearly, China is facing drastic times. So far though, they’re being met with drastic measures. But there’s a very real risk that these measures might not be enough.

The cracks in China’s economic engine have already started to show. Massive amounts of factory shutdowns (and the accompanying rioting Chinese factory workers) are just the start. Unemployment is on the rise and the World Bank has lowered its estimates for China GDP growth to 9% and 7.5% in 2008 and 2009, respectively.

From a medium and long-term perspective, China stocks are as cheap as they have been in a long while. The country needs a lot of infrastructure (roads, bridges, water distribution systems, etc.)and has the money to spend. Most importantly though, it has a work force made up of people willing to work. That’s probably going to be the big difference-maker over the long run. Factory workers who can (and are willing) to make the move from making steel to build roads are key to a successful economy.

But there are potential structural issues that could easily spell more short-term pain for the economy that has been built to thrive off very high growth. Basically, China is highly leveraged to the world economy. It has a massive capital base of steel mills, mines, and factories. Those are all highly cyclical industries.

Also, 37% of China’s GDP comes from exports which are already in decline. And 37% of China’s economy is used to build stuff to build more stuff. For instance, a big part of China’s economic growth came from building factories and machinery to build more things. That’s where the big problem lies. You can be building new toy factories while other ones are being shut down.

All that is why there are still a lot of risks left in China most investors just haven’t considered yet. As unemployment continues to rise in the U.S. and the rest of the high-consumption, importing western world and consumers watch their dollars more closely, China’s economy will be going through a lot of very rough patches.

So far, the Chinese government has been able to keep confidence high, but the country’s actions show the structural issues of the economy may be far bigger than most investors are expecting.

There are still a lot of reasons to like China. There are, however, a lot more reasons to be very skeptical of China’s near-term prospects. That’s why it’s best to continue to take a very conservative investing approach when buying shares in Chinese companies and ensure you’re still in position to pick up more shares in the likely case these truly historic economic stimulation efforts don’t pan out as well as the market is currently expecting.

By Andrew Mickey

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