Outlook Bleak for China & the Rest of Us

by Hugh

One part of the recent economic picture has been the too-cheap credit that has kept us all feeling really rich for the past decade. In the most famous story about this problem, cheap credit meant many people bought houses they couldn’t afford, and we all know what happened there. When the bad mortgage market collapsed – as it had to do, since it was built on fantasy demand – the housing market went with it, wiping out apparent wealth people had invested in their homes. Initially people here talked as if it was a problem specific to the USA, and that the Canadian real estate market and economy would be fine, since our banking and real estate sectors are significantly more conservative. The fundamentals of the Canadian economy were fine (whenever you hear that, you can assume the opposite).

The problem is that while our banking and mortgage systems might have been in better shape, the underlying demand for real estate is driven by the health of the overall economy. 30% of our GDP is generated by direct exports (not counting the significant spinoff economic activity that comes with those exports). 81% of our exports go to the ravenous USA. So, with a little bit of math you can conclude that if the US stops buying, Canada’s economy is up the creak.

And the problem is that the “cheap credit” problem was hardly confined to the real estate market. It’s in every bit of the economy. Credit was sloshing around everywhere, and that means spending everywhere: corporate mergers and acquisitions, new business, expansions, small business loans and student loans, car financing, luxury good purchases, lots of jobs for lawyers, accountants, and every kind of supplier to the big and little companies you can imagine, including web designers. Credit sloshing means we all feel rich, since there’s lots of cheap money to invest in new projects, lots of money and work to spread around.

But starting with the mortgage crisis, credit started drying up. All of a sudden the the rosy prospects for the whole economy contracted greatly. With credit expected to be no longer cheap, all the big spending ways of companies and governments and individuals, and all the VC money starts to tighten.

Imagine you have a platinum card, $100,000, and you spend accordingly, assuming you’ll be able to pay it off later. Then all of a sudden your card gets cut to a $1,000 limit. You’re going to spend less money: fewer trips, fewer gold necklaces, fewer iPhones. And each company that used to benefit from your largesse will feel the pinch too.

That’s why the stock markets have plunged. Because as each company’s credit has dried up, they are likely to buy less (services, materials etc). And since each company is likely to buy less, each supplier sees drops in their orders across the board. So everything is going down down down.

Since the stock market has long been a proxy for “health of the economy,” at least in the media, a shudder of terror went through just about everyone as the Dow, Footsie and TSX (and the rest of them) started to tank. But in some sense I get the feeling that people still think this is an abstract problem, with impacts on their RRSP statements, mutual fund holdings and stock portfolios, robbing them of significant paper wealth, but not quite linked to the day to day of life.

Of course it is: the result will be job losses across the board.

And then there is another problem: China.

While cheap credit was one reason we’ve all felt so rich the last decade or so, the other part of the equation is China’s manufacturing sector. Ever notice how cheap things are these days? You look at an item, say a BarBQ at Costco, and you just can’t figure out how something with so many components, materials, weighing tens of kilos, could have been assembled, built and shipped to you for such a low price. It often doesn’t make any sense, but we haven’t really bothered to care about that, we’ve just happily bought and bought more.

I worked for an environmental tech R&D company for a while, and one of our main products was a power inverter for alternative energy sources. A major part of the inverter was printed circuit boards. To get prototypes built here in Canada cost about $350 a piece, and took several weeks. To get the same thing from China too several days, including shipping, and cost $35 a piece.

That’s 10% of the Canadian price, and while I’m sure workers are paid poorly in China, I had trouble squaring such a price difference.

And the problem is that our whole economy is built on Chinese imports – of consumer goods sure, but just about everything now has Chinese components somewhere or other, especially anything in the hightech sector.

So if there is a problem in Chinese pricing, and if there is a real readjustment, then we’re all going to face the consequences. Here’s what Avner Mandelman has to say in today’s Globe:

You see, China, like Nortel and Japan and Soviet Russia, has been selling most things below true cost – which is the direct cost of production plus the cost of capital – and thus lost money on much of what it produced, and so destroyed much of its capital. A company that does so must eventually lay off workers and go bust. China, in my opinion, now faces similar risks, which Mr. Wen finally admitted.

Why does China sell below true cost? Because it is a dictatorship that wants to keep its restive people employed, and so, like (democratic) Japan before it, it keeps throwing good savings at bogus products. I say bogus because if you sell below true cost you create fictitious demand that otherwise wouldn’t be there had the product been priced realistically. Thus the large factory you built to satisfy the goosed-up demand cannot be rebuilt once it wears out because you didn’t include depreciation in the product’s price.

What this means is that we’ve been rich based on two simultaneous fantasies: cheap credit and cheap goods from China. But cheap credit eventually dries up, and the cheap goods from China have essentially been sold at below cost, meaning China’s whole economy could come tumbling down.

It’s hard to figure out how all of this will play out. After all, China owns much of the US’s debt, and China can only keep it’s economy going if the US keeps buying. So everyone has an interest in keeping the fantasy going, but the laws of physics, I fear, are going to get in the way eventually.

All that to say, things might be much worse than we think they are. I hope not.