Why China is headed for a fall

November 10, 2011
Manila, Philippines

There’s a key concept in economics called the law of diminishing returns. It sounds complex, but it’s actually very easy to understand.

Imagine for a moment that there are two towns cut off from each other by a vast river. Communications and trade are infrequent at best. But if you build a bridge, you’ll get a tremendous boost to the possibilities for trade and commerce.  Economic activity rises dramatically.

Build another bridge a half-mile from the first one and you’ll ease congestion, speed up travel times, and create some further improvement in the region’s economy.  But the additional returns on investment for the second bridge pale in comparison with the first.

So on and so forth for the third, fourth, fifth bridge that you build. Each successive bridge provides less and less of a boost to the regional economy.

What China has been doing for years now, is the equivalent of having built thousands of bridges, each one providing diminishing returns to its economy. Even more concerning, China has been building these economic bridges, so to speak, even though when they weren’t necessary.

Consider that the share of fixed asset investment in China, at more than 65%, is the highest for any major economy in modern history. What’s more, China’s own electricity authority recently reported that there are 64.5 million dwellings in China where absolutely no electricity is being used. The investments they’re making are producing little return.

When I was back in Wuhan this summer, I saw exactly this phenomenon.  You may never have heard of it, but Wuhan is an important commercial city of more than 10 million.

Barreling along one side of an 8-lane highway towards the airport with hardly another vehicle in sight, we passed apartment block after apartment block, sitting empty like a construction graveyard.

Eventually we crossed a gigantic new bridge over the Yangtze River.  Barely half a mile downstream, another equally vast and expansive bridge was nearing completion… and others further down the river.

I was astounded. There was no traffic. No commercial activity. No people. No tolls. Just empty space, and a lot of ridiculously expensive bridges. It was something out of a bizarre zombie flick.

There are thousands of similar projects all over China, many funded by debt.  And, with no direct cash flows earned back and the ongoing maintenance required, these infrastructure projects have become huge liabilities on the Chinese government’s balance sheet.

The conventional wisdom is that China’s economy will continue to grow 8% or 9% per year indefinitely. And a lot of people are drinking this Kool-Aid. It sounds a lot to me like the other old songs that we’ve heard over the past few years, like “real estate always goes up in value.” Famous last words.

I live by another rule:  “All booms bust.  The only question is when.” And China has had one of the biggest economic booms in history over the past decades. In fact, per capita consumption of cement in China is at the same levels as Taiwan and Japan right before those infrastructure-boom economies hit a brick wall.

One of my favorite speculations right now is to short the stocks of companies whose business model is based on eternal Chinese growth.

To give you an idea, I’m researching an Australian company for Sovereign Confidential premium members. It ONLY sells iron ore, and it ONLY sells to China. They’re in the process of tripling capacity at a time when demand in China is slowing markedly and iron ore prices have fallen by nearly 25% in the last few months.

Granted, shorting companies is always a risky endeavor (though you can limit your exposure by buying put options instead of shorting the stock). Bottom line, though, I’d urge you to have some healthy skepticism the next time you’re thinking about investing in a company based on the “China growth story.”

About the author

Tim Staermose

About the author

Tim Staermose is Sovereign Research’s Chief Investment officer, based in the Asia-Pacific region. Born to a Danish father and British mother in Dar Es Salaam, Tanzania, Tim has led an international life since the day he was born. He has lived and worked throughout Asia, primarily focusing on equity research and emerging market opportunities.

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