China's Overcapacity Bubble

TAIPEI ( TheStreet) -- If we say anything contrary about China's expansive and expanding economy, we normally point to slow export demand in major Western markets and the awkward rebalancing of economic policy that is supposed to replace industrial investment with consumer spending.

The whole sundae of tasty common explanations came up on Monday when China's premier gave an annual political convention his forecast for 7.5% economic growth in 2013, down from 9%-10% levels for most of the past decade.

A less-discussed yet more crucial explanation lies in the 20-year-old crisis of manufacturing overcapacity. Some call this problem the core threat to China's $7.4 trillion GDP, which is No. 2 in the world and an economic engine affecting every continent. The threat, on its face, should add to GDP growth. But eventually it will force today's expansion at least to melt.

Overcapacity in some of the country's anchor industries is already chafing at global trade relations by putting more stuff on the market. If the bloated banana boat finally bursts, foreign companies that have invested in the overwrought makers of steel, copper and aluminum -- three culprit industries -- will find themselves without a life raft. Overseas firms that sell orders to these companies for expansion would obviously need a new source of income.

Utilization rates for six of the most suspect industries ranged from 67% in aluminum to 85% in refining, according to a European Chamber of Commerce-Roland Berger study done in 2009. The other industries were cement, steel, wind power and ethylene chemicals. More recent reports say the problem that began in the 1990s has hardly abated since 2009.

A lot of these companies are just deeper in debt now and less profitable. Often pushed by local governments to boost employment, the manufacturers take out loans for new capacity. Rates are low and state-run companies easily qualify, though some are reluctant to go along with the local government campaigns as profits fall.

"A company will refuse to take on this mandate and say 'our balance sheets are weaker and not making money,'" notes Helen Lau, senior metals and mining analyst with Singapore-based securities firm UOB Kay Hian.

So at least industry is onto its own hard-edged problem. In another sign that things are bad enough to stir up a rethink, China's central government is looking at new recipes. It has banned new turbines as wind power loses gale force (if it ever had any) and moved to control steel input, among other largely ineffective measures.

Also on the eve of the annual political convention this week, President Xi Jinping sounded an alarm through the official Xinhua news agency. The alarm didn't mention debt or overcapacity, but let's not read too little into it:

"The world's second-largest economy now stands at a crossroad after 30 years of fast development, in want of a more qualified growth and a fairer system," Xinhua says. "China's growth, for one thing, is still plagued, to some extent, by an inefficient growth model of high investment and low return."

Central officials, however, tend to run hot on policy ideas but cold on any idea how much of a grip local authorities already have over day-to-day reality. Overcapacity is likely to linger for a while, touching investment in various forms.

Sino-foreign joint ventures that once looked attractive -- possibly because the Chinese partner got a cheap loan for the project -- will cool quickly if capacity spills too far over.

New York-based Alcoa ( AA), for example, signed a deal last year with China Power Investment Corp. to work together on a range of aluminum and energy projects, worth a total of $7.5 billion. They set up a company in Shanghai to make aluminum products for aerospace, consumer electronics and commercial transportation in China.

Even if China Power Investment Corp. runs at ideal capacity, Alcoa may get caught in a downturn in the aluminum industry as a whole as Chinese official media have hinted at a coming slump of up to five years.

Suppliers to China's target industries, such as factory equipment maker Hitachi Plant Technologies ( HTHIY), will also see orders ease if Chinese manufacturers cut back.

On the brighter side for overseas firms, China's trade relations will change if overcapacity worsens. Indebted, unprofitable companies would, in theory, push (dump?) less stuff on nations such as the United States to relieve capacity, meaning less-crowded home markets. Weaker pressure from Chinese metal imports should boost business, and share prices, for non-Chinese resource giants such as BHP Billiton ( BHP) and Rio Tinto ( RIO).

But if overcapacity suddenly flattens Chinese GDP growth, global markets won't like that at all because they look to China for global economic direction. Markets from Hong Kong to New York would slide until an equivalently heavy piece of good news comes along.

At the time of publication the author had no position in any of the stocks mentioned.

Ralph Jennings is on LinkedIn.

This article was written by an independent contributor, separate from TheStreet's regular news coverage. The author has no positions in the shares of companies named in this column.

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