Here's a trend few investors would have predicted even a few short years ago: China just thinks about slowing its torrid economic growth, and the world's financial markets go into a tailspin.
Case in point: On April 28, Chinese banks reported they would go on a three-day lending moratorium on government orders. The same day,
ran an interview with the premier of China, who promised very strong action to rein in excessive growth. In the U.S., shares of companies selling iron ore, aluminum, nickel and copper to China tanked on fears that the Chinese were about to stop buying the raw materials that fuel their economy.
The damage didn't stop there. The next day, shares of shipping companies sank on fears that a cooling Chinese economy would have less need for the services of oil tankers, container ships and bulk freighters.
That's a lot of global clout for an economy that is about one-tenth the size of the U.S. economy. If you believe the official figures, U.S. GDP is about $11.4 trillion in current dollars. China's GDP is about $1.4 trillion in U.S. dollars.
Why do the words of Wen Jiabao, the current Chinese premier and hardly a household name even in his own country, carry more weight in the financial markets than those of
Chairman Alan Greenspan?
The simplistic answer is sheer size. You probably have your own favorite tidbit about how even a minor shift in the individual behavior of China's estimated 1.3 billion people can change the global economy. Here's my current favorite from an estimate by Chicago agricultural forecasting firm AgResource: If every person in China consumed one more tablespoon of soybean oil annually, world trade in soybean oil would double.
A Make-or-Break Influence
So how did China become the pivot point in the world economic and financial systems? The answer is leverage. The internal structure of the Chinese economy has combined with current global economic conditions to give China even more global impact than its huge population already warrants.
I can count five ways that leverage gives China a make-or-break influence over the global economy.
China's economy is labor-light and commodity-heavy. This might seem counterintuitive, given that half of the stories you read these days are about the effect of China's cheap labor force on U.S. manufacturing. But precisely because Chinese labor is so cheap, it makes up a very small percentage of the cost of goods produced there compared with the cost of the commodities used to make those goods. In the U.S., raw materials might make up about 10% of the cost of the finished goods and services churned out by the U.S. economy. Labor accounts for as much as 65%.Exactly the reverse is true in low-wage China. According to the South China Morning Post, the average wage for a worker in Shanghai at the end of 2002 was about $1.26 an hour (assuming a 40-hour week). With labor this cheap, the commodity inputs used to make a product add up to a bigger part of the whole. Leverage: The Chinese economy is far more weighted to commodities than the economies of the U.S., Europe or Japan.
China has become the marginal consumer that sets global commodity prices. Blame this on tight worldwide commodity supplies. If key commodities were in excess supply worldwide, the huge growth in Chinese demand for commodities wouldn't have much effect on prices. That's not happening today. Take the worst case: the global supply/demand story for oil and natural gas. The International Energy Agency estimates that global demand for oil will climb to 79 million barrels a day by the end of 2004. Supply will stay ahead of demand, climbing to 82.3 million barrels, but that's not much of a margin -- only 3%. That margin seems even smaller when you factor in the growing Chinese demand for crude oil. It was up 9% in 2003. In fact, the IEA says, China accounted for 35% of total global growth in oil demand in 2003 and will account for 30% of demand growth in 2004. The drop isn't due to moderation in the Chinese appetite for oil. The real reason is increased oil demand in Japan, the U.S. and elsewhere.Leverage: As the buyer at the margin, China "sets" key commodity prices.
China is now the world's marginal producer and sets global inflation rates. This is the result of cheap labor and a glut of manufacturing capacity. Nobody knows exactly how much excess manufacturing capacity still exists in China. We do know that political pressures to preserve jobs or keep a politically connected factory owner happy have long kept inefficient factories in business. We also know that China's banks have kept pumping money into building new factories, among other things -- despite jawboning from Beijing to rein in lending growth to 8% from 9.1% in 2003. Commercial bank loans have been growing at 40% annualized rates recently. Now, the "excess" factories weren't always particularly efficient, and they may have had problems meeting quality standards. But their very existence has kept constant pressure on manufacturers everywhere to cut costs and prices, and inflation has been low. Offshore companies have grown accustomed to shopping around their business on a regular schedule, looking for the best price. So they regularly compare costs and quality in China with costs and quality at home. Result: A lot of companies have moved manufacturing from, say, Chicago to Shanghai. But there are signs that China may be ready to export inflation, not deflation. Inflation in China rose to 3.2% in the 12 months ending in December and 2.8% in the first quarter. So far, much of that increase has been in the cost of food. Here's where the commodity-heavy nature of the Chinese economy could become a real problem. As commodity prices rise, Chinese manufacturers must pass on much of that increase to their customers. Leverage: As the supplier at the margin, any uptick in inflation in China quickly travels around the globe.
Local political pressure and realities make it hard for China's central government to engineer a soft economic landing. Hard talk from Beijing has been remarkably ineffective at slowing runaway bank lending, slowing growth or shutting bankrupt companies. Local officials have a long tradition in China of ignoring edicts from the center. Exercising effective economic control from Beijing remains one of the biggest problems facing a Communist party that still believes in a large measure of central economic planning. Beijing can't simply step back and let the free market allocate capital and resources. Remember, local politics -- not economic efficiency -- control the market more often than not. If a local governing body wants a new factory to create jobs, the local bank will be under intense pressure to deliver the cash. This helps explain why the economy grew by 9.9% in the fourth quarter of 2003, above the 9.1% average for the year. And this despite central government pressure to hold growth down. The end result: The central government may be forced to take ever stronger measures to reach its goals. If banks won't slow lending voluntarily, Beijing will impose a lending moratorium. If raising capital requirements for banks doesn't slow lending, Beijing will raise interest rates. The danger here is that these measures will overshoot their targets. Rather than slow things down, they could actually stall the economy. That was the pattern in the early 1990s. Leverage: The government's effort to slow the economy produces a bust instead of a soft landing.
While China is a global manufacturing juggernaut, its financial sector remains underdeveloped. There's a race on in China between the central government's efforts to improve the financial condition of the banks by injecting capital and reducing bad loans and the next economic downturn. If the downturn is severe enough, it could send one or more big banks to the brink of default. Default is unlikely in the Chinese system, but even the likely government bailout could raise investor doubts about the Chinese financial system and force interest rates higher. That might put the big hurt on Chinese equities. If the increase were big enough, it might hamstring the Chinese consumer, who has of late increasingly used debt for purchases such as cars. Any decline in Chinese stocks could send international investors to the sidelines. And the decline would feed back into the banking system as well, by lowering the price of equities held by the banks and the value of collateral for many of their loans. Leverage: The Chinese financial sector is weak enough to turn a nasty short-term dip into a long-term problem.
Changes to Jubak's Picks
Sell Lamar Advertising.
After the close on May 6,
reports earnings. I think there's a good likelihood that the company will report further improvement in the outdoor advertising market, with billboard occupancy inching up another 3 percentage points to 80% from the current 77%. (That comes on top of the improvement to 77% from 74% last quarter.)
But that starts to push Lamar's occupancy numbers near historical averages, and I have trouble justifying an increase to my current price target of $45. That leaves me waiting around for a last 10% gain from recent price levels. I find the current market just too risky for that. So I'm selling Lamar Advertising with this column at a 2% loss since adding the shares on March 12, 2002. That 2% loss masks a lot of volatility, though. In July 2002, this position was almost 36% under water. In the last six months, the stock is up 17%. (Full disclosure: I will sell my shares of Lamar Advertising on May 7.)
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Lamar Advertising. He does not own short positions in any stock mentioned in this column. Email Jubak at