NEW YORK (Real Money) -- The Chinese economy is showing signs of rapid deceleration. Although much of this slowdown has yet to make its way into official government reports, some of it has, and it more of it will become apparent over the rest of this year.
The easiest way to envision China's current relationship with the rest of the world is as a giant manufacturing center. The world sends its raw material and money to China, and China produces shoes, consumer electronics and myriad other products that it ships all over the world. Foreign trade is the foundation of the Chinese economy and provides the capital, economic activity and revenue that it can invest in the growth of its domestic economy.
This is a macroeconomic version of what each person goes through in life -- work, earn, spend and save -- ultimately to the point that your assets' earnings can replace your labor. In terms of China, that means expanding its domestic economy to the point that it no longer relies upon foreign trade and capital.
Right now, though, that's not the case. As exports decline, the risks to the domestic economy increase as foreign investors slow their investment in the country, and the Chinese government must stimulate in order to make up for the revenue shortfall.
Ever since the Lehman Brothers crisis in the U.S. in 2008, analysts have been watchful for signs of a domestic economic crisis in China. Chinese foreign trade did indeed plunge in the 12 months following Lehman's collapse. The offset to this was massive fiscal and monetary stimulus in China -- at about three times as much as the U.S. government spent in the wake of the Lehman crisis, as a percentage of GDP.
The immediate result of that action was an infrastructure build-out that has now left the country with a multi-year excess of capacity that is reflected in ghost cities and idle factories.
The expectation by economists and government claims has been that eventually, exports would pick up and capacity utilization would rise. What was not expected was that the European debt and banking crisis, which is a residual effect of the 2008 U.S. banking crisis, would result in another round of export crashes.
In the simplest terms, for China, this is the equivalent of losing your job in late 2008, living on credit cards throughout 2009, getting a new job with lower pay in 2010, having that pay cut further in 2011, and now in 2012 having it cut even more.
China's predicament is that it needs more fiscal and monetary stimulus, but its debt levels are already inflated.
And this presents a real problem for Chinese authorities on multiple fronts. The three main areas of stimulus they can unilaterally and directly control are fiscal spending, currency depreciation and monetary/banking reserve policy.
All of these areas have the potential to both assuage and aggravate foreign investors, while simultaneously causing domestic price inflation, negatively affecting Chinese consumers. It's not a crisis yet, but it could become one if the rate of deceleration in exports and economic activity quickens, and that looks probable.
In the first four months of 2012 Chinese auto imports increased by 26.7%, even though end sales increased only 1.9% during the same time frame.
Distortions are also evident in the production of goods, and this is most pronounced in the industrial space. The cost of manufacturing steel has been rising with the increase in input costs for iron ore and coke. Those prices have been increasing, because the Chinese keep buying more of it to offset the decline of the productive value of what they had produced with it earlier.
The result is that profitability at steel manufacturing plants has plummeted, and this effect has been magnified by a slowdown in orders for steel to build ships and cars.
The response by the Chinese government, as reported today, is to embark on more government-funded infrastructure projects.
When I was in the Marine Corps, we referred to such actions as "painting rocks." It's an activity designed to keep Marines busy when peace breaks out, so that they aren't getting into trouble.
More infrastructure investment in China serves the same purpose: Providing the people something to do while the country waits for global demand to pick up again.
At the time of publication, Arnold xxxx.
Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.