What will be first sign of an impending Chinese economic correction?

April 30th, 2008

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In our previous article, Can China really ?de-couple? from a US recession?, we mentioned our theory that China’s economy

may be an epic boom waiting to be a bust.

In that article, there are three major reasons why we have reservations (which may turn out to be unfounded, hopefully) on China’s economy:

  1. “A severe recession in the US economy will crimp US consumption significantly. This will translate into a disproportionate contraction in the higher stages of production, which is China?s job. This in turn will result in yet another disproportionate contraction in yet another higher stage of production- for example, Australian resource production.”
  2. “Does China have enough capital goods, labour and raw materials to continue the current trajectory of capital investment growth in China?”
  3. “To re-tool and re-configure the Chinese economy towards its domestic needs [and away from declining export market] requires a period of adjustment in which capitals are destroyed and built.”

Indeed, Marc Faber did wrote that

Let us assume that the unthinkable happens: China?s economy slows down sharply, or even contracts – and there are reasons why it could.

So, if this unthinkable happens, what will be the warning signs?  Today, we will attempt to answer this question.

Let’s take the above-mentioned reason (2) as an example. Suppose the Chinese economy cannot be supplied with enough raw materials and skilled labour fast enough to maintain the trajectory of economic growth. How will this situation be manifested in real life? Rising and persistent price inflation is a sign that the Chinese economy is running low on ‘fuel’ to keep the economy running at the current speed. During inflationary times, input cost of production rises. For producers of consumer goods, this may mean that their profit margins get squeezed. Some may even go out of business. For major capital projects, rising costs may render them into mal-investments. For example, for the builder of a skyscraper, cost overruns may result in the project being unprofitable. Banks may not be willing to extend further credit for such projects.

For reasons (1) and (3), it is obvious that a lot of businesses will fail.

So, imagine what will happen if all these business and project failures happen en masse? A lot of bad debts will build up in the economy. If there are enough of them, the banking system will be severely threatened. Then the economy will go into a slump.

Therefore, rising levels of bad debts will precede an impending Chinese economic correction. This does not mean that such a correction is imminent. It may possible take a while for that stage to arrive, but we believe that if such breakneck economic growth continues, it is only a matter of time for a bust to arrive.

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