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January’s PMI data for China’s manufacturing sector, as released by Markit Economics and HSBC, showed a marked decline in production activity. More disturbing, however, is their analysis on the individual sectors of the manufacturing economy. 

According to the report, firms cut their staffing levels at the quickest pace since March 2009, and, more importantly, “average production costs declined at a marked rate, while firms lowered their output charges for the second successive month.”

This last part is especially important as it indicates the high probability of the beginnings of a major market correction, as the major monetary inflation that China has been utilizing to stimulate its economy for the past several years is now coming back to haunt it.

In particular, money printing that, typically, enters the economy through the loan markets, tends to stimulate growth in the higher-order manufacturing industries, a result that is very politically popular. However, this growth tends to be all out of proportion to the actual demand for the goods that are to be produced, a fact that often isn’t realized until many of the projects are well under way.

The situation then presents itself as one of overproduction in industrial and capital goods combined with underproduction in consumer goods, the exact situation that China finds itself facing right now.

For the past year, China has been struggling with production surplus problems in just about every one of its industrial markets. Iron ore, steel, concrete, wool, cotton, textiles, copper, solar panels, LEDs, and, most recently, rubber. Even housing, which is still in its boom-level heyday, has been determined to be an asset bubble problem by the Chinese government.

All of their money production has resulted in problems of overcapacity that has spread economy-wide, and they have been combating these problems with more stimulus, trying to siphon off excess inventories into various public works projects, such as bridges and dams around the globe, and with buy up programs, which put inventory surpluses into government storage.

This has led them to where they are now, with excessive production and massive stockpiles relentlessly driving down global commodity prices. Profits have been shrinking for the past several years, and bankruptcies are imminent, situations which have further driven companies to expand so as to not be the last player without a chair.

Adding another nail in the coffin, the Chinese government has enacted several directives so as to cool down its economy, directives which are only going to make things worse. One directive is cutting funding back for housing, in order to quench the heat in the construction market. Another is a set of rules intent on reining in the shadow-banking loan market. Policy-makers think they will be able to control the decline in the markets, but they won’t be able to. These funds are what are keeping many businesses alive, helping them to finance and refinance their outstanding debts. Removing these funding sources will only precipitate a scramble for liquidity which will result in catastrophic collapse.

Once businesses hit the panic point, they will begin to liquidate in any way they can. Prices will moderate, and then decline, as companies try to get what they can for their stocks, even if at no profit or at a loss. This will aggravate the situation, as, to retain market share, companies will begin a race to the bottom in order to stay ahead of their competition. They already have too much leverage, and they have insufficient reserves to simply outlast the crisis.

Which brings us to the present. Global commodity gluts are contributing to the biggest bear markets that have been seen in some time. Spurred on by government policy, instead of declining, production is accelerating, which is resulting in a further destabilization of world markets. The PBOC is taking the contradictory stance of tougher monetary controls and injecting banking liquidity in order to stave off a banking crisis. The controls will eventually become dominant and precipitate a monetary contraction, which is considered the bellwether of economic correction.

Already, prices for production inputs are declining. But, more importantly, output prices are also beginning to decline. Which means that both the highest order and the next highest order levels of production are facing pressures to drop profits in order to keep in business.

Demand is beginning to show signs of weakening, as indicated by slowing growth of new orders, and with job shedding at its quickest pace in nearly 5 years, there are signs that businesses feel that this is not a holiday-driven decline, but a long-term trend.

The Chinese economy has become so top-heavy in industry that a simple decline can quickly turn into a major rout. Too many sectors have overextended themselves and are, individually, risking a major decline. Interconnected as they are, they threaten a major crisis of falling dominoes once the first one is tipped. Unfortunately, there is no way for any particular industry to avoid crisis in order to correct its imbalances, and the economy has been pushed beyond its limits to avoid anything but a hard landing.

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Categories: Finance & Economy

Tags: China, Economics, Economy of the People's Republic of China, Finance, Manufacturing, People's Bank of China, Purchasing Managers Index