The Domino Effect: Is China Next?

China has seen phenomenal growth in the last ten years. All we ever read about is the price of (insert any chosen commodity here) is up because of Chinese demand. From steel to soybeans, copper to corn it's all down to Chinese growth.

Since 1998 China's GDP has grown at about a 10% annual real growth rate, and it's economy more than tripled in size (in real terms). There were no recessions, just expansion. The origins of China's tremendous growth are well known: large population migrating from low (farming) to higher productivity (manufacturing) activity, cheap labour, a capitalism-friendlier communist government, and insatiable demand from the US, the EU and the rest of the developed world for cheap goods.

The Chinese model has been driven by three things - investment, exports and consumption.


Investment growth has weakened because banks are less willing to lend due to the credit crisis.

Chinese growth has largely been driven by the manufacturing sector; historically its industrial production grew at a faster rate than GDP. The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. High commodity prices and rapid wage inflation has driven those costs up. Once a factory is built the costs of running it are to a large degree independent of the utilization level - they are fixed.

Bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China. Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage.

Total operational leverage in China is elevated further as factories are built to accommodate (percieved) future demand. This type of thinking results in tremendous overcapacity when demand cools.


In 2005 NY Times ran an article entitled China, New Land of Shoppers, Builds Malls on Gigantic Scale, it talked about the biggest shopping mall in the world that happened to be in Dongguan, China. The article said:

"Not long ago, shopping in China consisted mostly of lining up to entreat surly clerks to accept cash in exchange for ugly merchandise that did not fit. But now, Chinese have started to embrace America's modern "shop till you drop" ethos and are in the midst of a buy-at-the-mall frenzy.... by 2010, China is expected to be home to at least 7 of the world's 10 largest malls... Already, four shopping malls in China are larger than the Mall of America. Two, including the South China Mall, are bigger than the West Edmonton Mall in Alberta, which just surrendered its status as the world's largest to an enormous retail center in Beijing."

Fast forward three years and you find a very different story: the biggest mall in the world - the South China mall, with space for fifteen hundred stores, only has a dozen stores open for business - it is empty. Shoppers never materialized, much like the spectators at the current Olympic Games.


The weakness in the US and European economies will temper demand for Chinese made goods. China is already showing first signs of slow down - inflation is increasing and rate of real growth is decreasing.


Rising commodity prices, such as we have seen over the last couple of years, are starting to have a tremendous impact on Chinese inflation. The average American family spends 15% of their household budget on food, whereas the Chinese spend 37%. It is obvious therefore that an increase in the price of wheat or rice or soybeans will have a greater impact in Chinese consumption (and inflation) than it will in the US.

If food inflation is having an effect on consumption in the West (and it is), imagine the effect in China where they spend more than double the amount of household income on food than we do.

The US and Europe can cope with energy and food inflation a lot better than China and other developing nations, as we spend a lot less on food and energy as a percent of our income and have a lot more discretionary income.


One economist likens the Chinese economy to the bus from the movie "Speed". In the movie the bus is wired by a villain (played by Dennis Hopper) with explosives, and will explode if its speed drops below 50 miles per hour. The Chinese economy has 1.3 billion unsuspecting people on board. It could blow if economic growth drops below its historical pace.

The current situation raises political risk in China and also the chances that government (social) intervention will rise. This also puts in doubt the significant development of a Chinese middle class, at least in the near future.