China: Excess Capacity Recognized

Official Chinese news is reporting that the State Council is studying curbs on industries that are plagued with over-capacity, including steel and cement. Separately, the Aluminum Corp of China, warned Chinese smelters, traders and warehouses hold as much as 600k metric tons of inventories because of excess production. The Shanghai Futures Exchange warehouse holdings are about a third of that. And the problem is being aggravated by Chinese smelters coming back on line to take advantage of a 30% increase in prices.

Up until now the focus has been on the surge of bank loans in H1 and the government's efforts, largely through moral suasion, to bring the loan growth to more reasonable levels. While some of the loans apparently helped fuel the stock market rise and real estate speculation, some of the loans financed investment.

Investment accounted for around 30% of GDP in H1 09, up from 25% last year. It has reached the point of diminishing returns. Minxin Pei of the Carnegie Endowment finds that in the first half of the 1990s, CNY100 mln investment boosts GDP by CNY66.2 mln and created 400 jobs. Last year, that same CNY100 mln investment lifts GDP by a mere CNY28.6 mln and creates only 170 jobs.

The way China calculates its economic data confuses the issue and conceals some of the excesses. Consider that China counts as retail sales, for example, when the good gets shipped to the retailer, not when it is bought by the end-user, as is the case for most countries.

China's over-investment and over-production is a deflationary force in the world economy and in China in particular. Its developmental strategy of relying on investment and exports is approaching important limits. The cost of avoiding a steeper downturn now simply brings forward China's own day of reckoning.

Lastly, the fact that China's own domestic situation--the deluge of new lows, potential bubbles in the equity and real estate market, and over-investment--reinforces our assessment that China is toning down its push--seen beginning prior to the last G20 meeting--for international monetary regime change, while the US administration also seems less vocal about the need for China to allow its currency to appreciate.