We posted a positive piece on China, but not everybody is convinced China is in such a great shape.. It’s low-cost manufacturing base in in danger.

The Great Crash of China
by Brian Klein Far East Economic Review
Posted October 1, 2008

• China is widely believed to be immune from the economic shock waves making their way around the world from the U.S. to Europe and Japan. Although it is relatively unaffected by subprime mortgages and the credit crunch, China’s economy is actually facing a fundamental structural adjustment that has arrived much earlier than expected.
• Decreasing foreign demand for inexpensive manufactured goods, the misallocation of vital investment, and product safety concerns are straining China’s manufacturing base and challenging the tenuous linkages between continued economic growth and a rising middle-class.
• Conventional wisdom holds that China’s domestic demand is increasingly responsible for driving growth, not exports, giving the Chinese economy a natural buffer against wild swings in the world economy. The new middle class, it is assumed, will continue buying television sets, computers, washing machines and cars – all domestically produced with cash derived from large reserves of personal savings. Domestic banks are healthy and the central government is now promoting growth through expansionary fiscal and monetary policies.
• At first glance the statistics look promising. Consumer spending is up 22%, inflationary pressures are receding as food prices drop, and strong foreign exchange reserves continue to accrue ($1.8 trillion as of July). Fixed asset investment is rising as well (up 27% in the first eight months of 2008) and China’s sovereign debt rating is improving (S&P has raised long term ratings to A+.)
• On closer examination, however, a vastly different story emerges. By the end of 2007 almost half of China’s GDP growth was attributed to exports and government consumption, a dramatic reversal from 2003 when growth was dominated by investment and private consumption.
• While savings rates have been traditionally high, immense wealth has been invested in the stock market and real estate. The Shanghai index lost two-thirds of its value since its peak in mid-October 2007 and the Hang Seng is down over 50% from its peak a year ago.
• While fixed asset investment may be rising, one-third is continuing to pour into the real-estate sector (up 29% year-on-year) despite vacant commercial floor space in China rising by 6.1% at the end of July (the latest month for available statistics). Real estate prices are experiencing their slowest growth in 18 months and new home prices in Guangzhou and Shenzhen have actually declined. Meanwhile growth in new car sales, while still robust, is slowing.
• Not surprisingly, consumer confidence, according to official Chinese statistics, is drifting downwards and Western ratings on Chinese commercial banks, the holders of unused commercial real estate, are being lowered. Those on the cusp of entering the middle class are faring poorly as tens of thousands of small and medium sized enterprises go bankrupt.
• Guangdong Province alone, the heart of China’s low-cost manufacturing base, has seen half of the shoe manufacturing industry close shop (over 2,200 factories) this year. These are some of the low-skill, low-wage jobs China wants to replace with high value-added manufacturing. However, there has been very little preparation for laying the foundations for such an economy. The largest destination for fixed asset investment has been manufacturing, much of which has been concentrated in low-end commodities.
• The expectation in Beijing earlier this year, teeming with cranes and construction workers, was for a post-Olympic surge in foreign companies opening offices in the capital. That was of course before the threat of recession hit the world’s major economies.
• Laid-off factory employees, along with millions of migrant construction workers likely to be left jobless as construction slows, will return to a countryside largely unchanged from when they left years before. It should come as no surprise then that demonstrations against local officials in smaller cities quickly escalate into “mass incidents.” Fixed investment in education, health, and social programs accounted for a paltry 2.3% of the total through July.
• Unless current expansionary monetary and fiscal policies are directed at skills development, an expanded intellectual property rights enforcement bureaucracy and research and development capacity, China may be running headlong into a great economic brick wall. Rising middle class expectations, shrinking manufacturing jobs, and a lack of qualified workers are more of a threat to continued economic growth than the People’s Bank of China’s exposure to U.S. Treasury bonds.
• Economic development has been the foundation of social stability and party legitimacy for the past several decades. Premier Wen, in his recent UN speech, reaffirmed China’s commitment to reform and opening. That entails some hard choices regarding China shifting away from its traditional focus on low-end production. As the world economy continues to flounder (and most expect a U.S. led turn around is at least a year away) China faces the fading memories of a successful Olympics and a wave of unemployed workers with very little to cheer about.

The good news is though, they do have the means to invest their way out (with a 2% budget surplus and just 16% public debt as a % of GDP), and this is already starting. Don’t count China out yet.

For a very interesting perspective on China by famous historian Niall Ferguson, for instance, the spectacular growth of Chongqing, the world’s fastest growing city, the almost Stalinist misallocation of resources (yet they might pull it off.. “build and they will come..”), the end of the symbiotic relation with the US (one half did the saving, the other half the borrowing). Very good read.