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Why China Will Dump On the West

As Chinese planners try to maintain employment, China will continue to make goods for markets that are no longer there...

THE LATEST Chinese manufacturing data show the Chinese economy actually recovered slightly from last month, thanks to a renewed burst of bank lending and a directive from the top to fast track projects and 'build stuff'. But the devil is in the detail for China, writes Greg Canavan for the Daily Reckoning Australia.

The index reading is a composite number, meaning it's derived from a bunch of sub-indices. One of those is employment. And while the press release doesn't give the actual reading, it does say 'employment down at sharpest rate in 40 months.'

Chinese authorities try to engineer economic growth with the aim of achieving full employment and social stability. The Chinese ruling class have their snouts so deeply in the trough that maintaining a 'harmonious society' is their over-riding aim. They don't want their countrymen to become unemployed, restless and inquisitive as to how the 1% live.

In order to keep the dream alive, China looks like abandoning its efforts to try and rebalance its economy. Already you're hearing grandiose announcements about big infrastructure spending packages from cities like Changsha and Guizhou.

And as Ambrose Evans-Pritchard writes in the UK's Daily Telegraph:

'The Politburo has clearly decided to protect jobs whatever the other risks, steering the Yuan down 1.3% against the Dollar this year to protect the wafer-thin margins of exporters.

'Nomura said Beijing is preparing a 17% VAT rebate on exports by Chinese steelmakers to divert excess output abroad, exporting China's "over-capacity crisis" to the rest of the world.

'Albert Edwards, for Societe Generale, said this echoes the Asian crisis in the late 1990s when the region flooded the West with goods, transmitting a deflationary impulse through the global system. This time the Asian bloc is a bigger animal, and the West is more fragile.

'"The harder the landing in China, the more goods they are going to dump on us. It is political dynamite in the run-up to a US election," he said.'

As the global economy cools, political tensions will begin to boil. Against all economic common sense, China will continue to produce goods for a market that doesn't exist. It will then dump those goods on other markets, forcing retaliation.

China's trying to maintain some semblance of economic control. But we're running on the theory that control of post credit-bubble economies is an almost impossible task. Keep in mind we're still in the early stages of China's economic adjustment. This will take years to play out.

In a worrying development for the Middle Kingdom, balance of payments data for the second quarter, released yesterday, indicate that China is beginning to suffer from capital outflow. The data indicates that for the first time since 1998, the balance of payments was in deficit.

For many years, the standard for China's economy was to run a balance of payments surplus. That is, a trade surplus plus a financial and capital account surplus. To balance this inflow, you saw constantly increasing foreign exchange reserves. This was effectively just the trade and capital inflows sent back overseas in order to keep the Yuan pegged to the US Dollar at a competitive rate.

But in the first quarter of 2012, capital and financial outflows of $71.4 billion were greater than the current account surplus of $59.7 billion. This necessitated an $11.7 billion contraction in China's foreign exchange reserves.

This is not a big deal...yet. An $11.7 billion contraction in a $3.2 trillion pile of reserves is nothing to get too worried about. But if it's the start of a larger trend, it will be.

You see, China's (until recently) constantly growing foreign exchange reserves were the source of its domestic liquidity. The burgeoning pile of reserves provided the fuel for China's extraordinary rise in nominal GDP growth over the past decade (you know, the constant 9-10% growth rate everyone grew accustomed to)

Now that the pile is no longer growing, now that it's starting to contract, China's economy has an additional challenge to controlling its slowdown and bolstering growth.

The real risk is if capital flight starts to pick up from here. That shouldn't be too much of a problem in a country that has a closed capital account (meaning China controls inflows and outflows). But as FT Alphavillve reports, China watcher Victor Shih of Northwestern University says that US$1 trillion Dollars represents less than 30% of the wealth of China's top 1%.

If China's wealthy panic and look to move a third of their wealth out of the country (which they could probably do, as the rules don't apply to them) then China's banking system and economy would be in real trouble.

It's a classic positive feedback loop. Bad news on the economic front causes capital flight, which restricts liquidity in a credit dependent economy. That causes more economic weakness, which causes more capital flight.

As we said, we're nowhere near that situation at the moment. It's an extreme outcome. But in these times, extreme outcomes are the norm. It's something to keep in mind.

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Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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