Streetwise Professor

A spate of news out of China all points in one direction: a slowdown, and perhaps a severe one.  Whether it is stock prices, PMIs, or data from the banking sector, or capital flows, the signs are all quite bearish.  The perpetual China bulls are doing their best Alfred E. Newman “What? Me worry?” imitation, claiming that the omniscient and omnipotent Chinese government will order another stimulus splurge that will propel Chinese growth back to stratospheric levels.

Interestingly, the Chinese government seems to be reluctant to oblige.  And with good reason, IMO.  The economy is already wildly unbalanced, with investment representing an entirely disproportionate share of GDP.  What’s more, much of this investment has been malinvestment.  As Baldingsworld points out, the signs are everywhere, such as 50 percent vacancy rates in apartments and massive investments in wind electricity generation capacity that doesn’t actually generate, you know, any electricity.  (Another competition we should lose, Barry!)  I’ve already blogged about the appalling returns on Chinese investments in solar: that post has sparked a lot of comments on Seeking Alpha. Then there are the bridges that fall down.  Then too there is the accumulation of large quantities of inventory of stuff like copper, coal, and iron ore (that shows up as investment) that just sits there.

And the phenomenon is economy wide.  The IMF notes that China’s manufacturing capacity utilization is 60 percent-as compared to US utilization at about 80 percent (which is low by historical standards).  Capacity utilization began to decline with the onset of the crisis, but has continued to drop post-stimulus, suggesting that much of the capacity resulting from stimulus measures has been unutilized, or underutilized.

Now all of this investment, when made, contributed to GDP and represented a healthy fraction of Chinese GDP growth.  To those of you who actually consume (or get utility) from “aggregates”, this is wonderful news!  But the joke is on you. Paying people to dig holes (or eat the inedible) may contributes to GDP-but you end up with holes (or indigestion).

Investment involves a sacrifice of current consumption (including consumption of leisure), and makes sense only if it generates a sufficiently large increase in future consumption.  Empty apartments, collapsed bridges, idle factories, piles of inventory, and oversized pinwheels do not produce any consumption gain.  The resources used to create them were wasted.

Thinking from a real options perspective makes things look even worse.  Real options theory says that under conditions of uncertainty, it is better to wait to invest because information about the value of the investment is revealed over time: just as one should only exercise a call on a stock early if pays a dividend, one should exercise the option to invest only when the immediate flow of services/consumption from the investment-the dividend-is sufficiently large to offset the information-driven benefits of waiting.  Empty apartments and underutilized factories and disconnected windmills are not generating any flow of services/consumption/dividends.  Indeed, inasmuch as they depreciate and require maintenance, they are producing negative flows.  Thus, the investments in them are at best premature, and at worst a total waste: in the future, information may reveal that the resources should have been used to produce something else.

Investment for investment’s sake, or to produce some economic aggregate number that gets people to ooh and aah (based on the fiction that the increase in the aggregate corresponds to an actual increase in the production of, or the potential to produce, things people actually value) is a waste.  Moreover, it is typically a drag on future economic performance, in part because worthless assets funded by borrowing weakens the banking system making it more difficult to finance truly valuable investments, in part because worthless assets aren’t yielding income or enhancing the productivity of labor.

You get something like Japan, now in year 21 or so of its Lost Decade.  Or worse.  And in China, worse is a very real possibility.  Moribund economic performance is a conformist society like Japan’s doesn’t lead to social convulsions.  China’s history is one of  convulsions.  Which is no doubt why China’s government stimulated like crazy in 2009.  That bought time.  But reality eventually intrudes.  Malinvestment can only go on for so long.  The wealth it creates is chimerical, and people are not happy when the fantasy is revealed as such. And 1.3 billion unhappy Chinese is not a comforting thought.

I have lived through the time when first the USSR and then Japan were touted as economic titans that would leave the US in the dust.  Amazingly, the optimism about China has been even more extreme.  And, methinks, the comedown that China will experience will be just as extreme.