The Biggest Sign of a China Bubble

Fed Chairman Ben Bernanke has taken a lot of heat for printing money, even being dubbed "Helicopter Ben" by his critics, a metaphorical reference to showering the U.S. economy with money. But if Bernanke's making it rain from a helicopter, China's been bombarding its economy from multiple stealth bombers. Money supply rose markedly in May and recent years' credit growth has surpassed even that of the U.S. in the period leading to the Lehman collapse.

Unfortunately, instead of being put to good use, much of that money has ended up in the hands of wasteful state-owned enterprises, or SOEs. Meanwhile, cash-starved private entrepreneurs have watched quietly from the sidelines, unable to participate in Beijing's ragin', capital-misallocatin', credit-fueled investment boom. Is this another sign of the unsustainability of Chinese growth?

It's raining yuan
The SOEs are like the profligate Real Housewives of Beijing. They get tons of money to splurge on fancy, wasteful items, get wined and dined by the country's most powerful figures, yet contribute relatively little to the economy. In many cases, they're profitable solely because they're the only players allowed in strategically important industries.

Meanwhile, the small and medium-sized businesses (SMEs) do the grunt work, contributing two-thirds to taxes and total industrial output, and employing more than 75% of the Chinese workforce. Yet they get no love. Despite the surge in bank credit, many are either denied access altogether or charged absurdly high rates on loans.

SOEs before bros
Of course, the nation's four largest banks -- themselves majority state-owned -- have a tremendous bias in lending to SOEs. And the government's vested interest in protecting the status quo has led to major restrictions on multinational banks looking to expand within China. Tellingly, JPMorgan Chase (NYSE: JPM  ) , Wells Fargo (NYSE: WFC  ) , and Bank of America (NYSE: BAC  ) have decided to avoid retail banking in the region altogether.

As a result of their intimate connections with China's authorities, SOEs enjoy a number of remarkable advantages that private firms would kill for. They get huge government subsidies in the form of significantly lower tax rates, have access to much cheaper basic inputs like water, land, and energy, and enjoy barriers to entry in key industries.

But despite their edge, SOEs are much less efficient than their private counterparts, and have become increasingly inefficient over the past decade. In fact, many are loss-makers and there's mounting evidence they've misallocated capital on a tremendous scale. But thanks to the "wonders" of state capitalism, they keep getting funded -- accounting for more than 75% of all bank loans -- and continue to expand.

No demand for steel? Try raising pigs
A recent piece in the Financial Times outlined how several state-controlled steel companies, faced with falling demand, are branching out beyond their core lines of business. Baosteel Group, the world's third-biggest steel producer, derived half its net profit last year from non-steel related businesses, which ran the gamut from real estate to telecommunications to manufacturing.

The example that struck me as most peculiar was that of Wuhan Iron & Steel, the country's fourth-largest steel producer. It's investing $4.7 billion over the next five years in pig, fish, and organic vegetable farming, as well as logistics and chemicals. Yep, that's right. They went from steel to pigs.

More worryingly, this trend isn't just confined to steelmakers. Cofco, a state-controlled grains company, is now building luxury hotels in Beijing, and Tongling, the nation's second-largest copper producer, is diversifying into timber.

So instead of reducing capacity in response to falling demand, China's SOEs forge onward with their grand schemes, lured by potentially higher profits and encouraged by preferential access to cheap loans. After all, if the cheap money keeps flowing, you gotta invest it, right? Just like when the music was playing, you had to get up and dance. Haven't they learned anything about the perils of excessive and cheap credit from that recent little blip we call the Great Recession?

But China is different...
Despite growing evidence of huge capital misallocations in the state-run sector, many investors remain indifferent, citing their faith in the effectiveness of central planning. They say China is a special case and that an authoritarian government can more easily control the economy. I find this hard to believe, given the abundance of historical evidence suggesting exactly the opposite. As Societe Generale's Dylan Grice points out: Just because an authoritarian regime has tight control of the levers of the economy doesn't mean it has the faintest idea how to use them.

Unless there's a meaningful rebalancing of the economy that involves severely curtailing lending to the SOEs, China will not prosper. To grow sustainably, it needs a large transfer from the state sector back to households, whose savings have subsidized government profligacy -- and even outright theft -- for too long.

Only through policies that raise households' disposable incomes and their purchasing power might we finally see the Chinese start to spend, a godsend not just for China, but also for the hundreds of multinationals, like Yum! Brands (NYSE: YUM  ) and Starbucks (NYSE: SBUX  ) , that are banking on the tremendous promise of Chinese consumers.

Maybe I'm just a naive outsider and maybe I'm wrong. Maybe I don't fully grasp the benefits of state capitalism. Maybe all the historical evidence against central planning doesn't apply to China. Maybe this time is different. And those pigs Wuhan is raising? Yeah, maybe they'll fly someday.

Fool contributor Arjun Sreekumar does not own shares of any companies listed above. The Motley Fool owns shares of Starbucks, JPMorgan Chase, and Bank of America. The Fool owns shares of and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Starbucks and Wells Fargo. Motley Fool newsletter services have recommended writing covered calls on Starbucks. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (56)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 15, 2012, at 6:19 PM, Bonsaiscrooge wrote:

    Politicians everywhere, be they as corrupt as in China or simply as economically incompetent as e. g. in Europe, have tried throughout history to control the economy of their country and, as history proves, have always failed by causing catastrophic fiascos in the long run (the latest example is the EU). Economic systems are inherently chaotic and there is no mathematical rule to understand them fully. Therefore, the conclusion from the impression that China's economy seems to boom (if you are naive enough to believe their official numbers, that is...) that their dictatorial system has the key to eternal success, is shortsighted at best. Time will prove that even there certain basic economical principles can not be overruled.

  • Report this Comment On June 16, 2012, at 12:34 PM, ynotc wrote:

    There are at least 3 ghost cities in China that will house 1 million people each. If there is any sign of a bubble in China that is it.

  • Report this Comment On June 16, 2012, at 3:49 PM, xetn wrote:

    And you believe the creation of several trillion new dollars by the Fed have been put to "good use"?

    What, pray tell would "good use" be? Inflation? Paying more for most everything? Rolling over the government's debt? Purchasing toxic debt from the likes of Fannie and Freddie?

  • Report this Comment On June 17, 2012, at 12:51 AM, bornboring wrote:

    There is nothing new about China in this essay. We all know the move is to save the SOEs. The party is supposed to have an overseer in each commercial entity. The most obvious missing news is the absence of mentioning M&A. This is time for the well heeled SOE to take over the struggling SME, utilizing the personnel to form successful businesses. This glaring hole suggests inadequacy of reliable (uncorrupted) com. party members.

    This is different from money printing in the Western world where the intention is to dilute the monetary value to match up with the losses due to Fannie and Freddie etc. I am afraid Eurozone will have to do the same, even under another name.

  • Report this Comment On June 19, 2012, at 10:41 AM, kspes wrote:

    Where did you get this info? That not the China I've been seeing on the news and reading about in most stories. How about a citation.

  • Report this Comment On June 19, 2012, at 10:44 AM, ryanalexanderson wrote:

    > And you believe the creation of several trillion new dollars by the Fed have been put to "good use"?

    The gist of the article is against central planning. This implicitly criticizes Bernanke and his attempts at central planning as well, but the author correctly points out that the scale of US central planning is much lower.

  • Report this Comment On June 19, 2012, at 12:13 PM, kspes wrote:

    It might be true but, instead of pulling numbers out of nowhere just provide your sources. Watch http://www.zeitgeistmovie.com/ the movie for another opinion on central planning in the US.

  • Report this Comment On June 19, 2012, at 4:05 PM, Hawmps wrote:

    I like this part "Just because an authoritarian regime has tight control of the levers of the economy doesn't mean it has the faintest idea how to use them."

  • Report this Comment On June 19, 2012, at 4:43 PM, devoish wrote:

    <<And the government's vested interest in protecting the status quo has led to major restrictions on multinational banks looking to expand within China. Tellingly, JPMorgan Chase (NYSE: JPM ) , Wells Fargo (NYSE: WFC ) , and Bank of America (NYSE: BAC ) have decided to avoid retail banking in the region altogether.>> Arjun Sreekumar

    That is a flat out win for the Chinese vs the USA.

    < <Haven't they learned anything about the perils of excessive and cheap credit from that recent little blip we call the Great Recession?>> Arjun Sreekumar

    They are handling this world wide recession better than any country that has allowed those banks in.

    <<Maybe all the historical evidence against central planning doesn't apply to China>> - Arjun Sreekumar

    Maybe all the historical evidence against central planning isn't as strong as the evidence against not planning.

    Best wishes,

    Steven

  • Report this Comment On June 19, 2012, at 4:47 PM, ejprzybylski wrote:

    I'm just glad we don't have any state-owned corporations here. I could image the inefficiency if the Government were to own, say, a behemoth like General Motors. Or how dangerous it would be if Government-Sponsored Enterprises blindly and cheaply insured even the riskiest of debt assets of private corporations--I mean, there'd be excessive risk taking and outsized leverage taken with very little thought to the consequences, because you always have a backer to absorb the losses and pass them on to the treasury. Sheesh...I just am glad that's only happening in China.

  • Report this Comment On June 19, 2012, at 4:54 PM, whereaminow wrote:

    @ devoish,

    You make me laugh.

    -----> "Maybe all the historical evidence against central planning isn't as strong as the evidence against not planning." <---------

    It reminds me of an eminent economist, Paul Samuelson. He once asked if the political oppression present in the Soviet Union was worth the increased output.

    In other words, it used to be taken for granted among State worshiping quack economists that Slavery Gets Sh*t Done. The collapse of the Soviet Union coupled with the revelation that it was little more than Bangladesh with missiles (and that might be insulting to Bangladesh), should have put to rest once and for all the idea that "economic planning" (read: violence) solves problems.

    Now your my boy Steve. Despite knowing absolutely nothing about economic history or the current complexities of Chinese central planning or how it compares to American central planning, you jump on the blood thirsty bandwagon, cheering what you think is totalitarianism because it's worth the political oppression.

    The true irony of course, is that American political oppression and central economic planning (they go hand in hand) is quite comparable to the Chinese, and it's quite hard even for the most informed of us to really make a call on whose country is run by bigger pieces of sh*t!

    What we do know, is that no matter who wins this Bizarro Award, Steven will be there to cheer on every regulation, every person caged, every person fined, every property stolen, and every war waged on the citizenry. So long as they make some arbitrary GDP number that you can just push up anyway with funny money printing and thus skip all this stupid bloody cheerleading.

    David in Liberty

  • Report this Comment On June 19, 2012, at 5:19 PM, rhealth wrote:

    Yellow sports cars and fancy prostitutes are a poor use of resources?!? Now you tell me!

  • Report this Comment On June 19, 2012, at 5:27 PM, TrojanFan wrote:

    I would recommend rereading this article with a few word substitutions.

    In place of China, insert the words "United States" and in place of SOEs, insert the words "Goldman Sachs".

    We should worry more about cleaning our own house before criticizing the Chinese for their messy political entanglements with privileged enterprises.

  • Report this Comment On June 19, 2012, at 5:58 PM, devoish wrote:

    David in the USA where you found the Liberty you enjoy, for all your long winded talk you have no free market economy to put up that has outperformed the USA Democracy and its redistributive wealth policys.

    You have nothing better than the European "Socialist" States.

    You have nothing.

    Not one.

    TrojanFan,

    I almost agree. In place of China, insert Goldman Sachs. In place of SOE insert Congress.

    David and the Deregulators are among the fools that led us to let finance in charge of our Democracy and it is time to take it back.

    At least, thats how i see it.

    Best wishes,

    Steven

  • Report this Comment On June 19, 2012, at 10:19 PM, jmapes101 wrote:

    in a totalitarian government like China, I wonder where there is any room at all for "private"entrepreneurs.

  • Report this Comment On June 19, 2012, at 10:54 PM, andyzhu wrote:

    Am a European and right now on a business trip to Tangshan (Hebei province, metal industry). Have known Tangshan since 2009 and every other couple of months I will come at the factory which is our subcontractor for electrical power cable (copper and aluminium). What I am seeing now is downright creepy; building huge housing towers all over the place (I guess thousands) + a military system in disguise (government is eventually almighty and can strip a rich Chinese of his asset, a factory for example, if it decides to do so based upon a tax audit for example). Most Chinese are totally money-driven, and poorly educated (am not talking about a Shanghai MBA student). Lots of very stupid jobs like holding a towel in a hotel. Prostitution is rampant. And a society which will definitely impact the world as it continues to grow and to consume. Quite fascinating. And yes, everybody here in Tangshan agrees that there is a clear housing bubble. The large and luxurious hotel where I stay has few customers and is owned by a steel company...

  • Report this Comment On June 20, 2012, at 10:42 AM, troym72 wrote:

    Where did you find the picture of the girl with the Ferrari?

  • Report this Comment On June 20, 2012, at 10:51 AM, troym72 wrote:

    To ejprzybylski:

    We do have state-owned corporations in the United States.

    Except here they are called "social programs". Our elementary and secondary education is a Socialist (gasp) organization run by the United States goverment, its just not called that. Medicare is also a United States government owned corporation - except we call it a social program to provide health insurance to the poor and elderly. So, yeah, don't think the United States is any better. Our govenent is just better at making the state-owned corporations seem like something else.

    I guess one big difference is our state-owned corporations don't try to make a profit. Oh .. wait .. there is the Lottery, which makes a lot of money which our government then blows on stupid sh*t and says it is paying for education.

    Hmmm. Are we any better than the Chinese government? Probably not.

  • Report this Comment On June 20, 2012, at 7:42 PM, CatFoodMoney wrote:

    Nice article.

  • Report this Comment On July 02, 2012, at 3:58 PM, pensive69 wrote:

    some one noted that the bureaucrats had constructed three 1 million inhabitant capacity cities with few if anyone to live in them.

    my capitalist pig suggestion?

    issue a new edict from Bejing that any family wishing to have more than 1 child may live in these cities at half price (ie; houses would sell for half off the list.)

    that'd fill those suckers up really fast!

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