China’s Economy in Peril

Forget the house price crash. That’ll be child’s play compared to the big crash that’s on the cards.

I’m talking about China.

As you may know, I’d been pretty bullish on the China story for several years, going back to my days as editor of the Australian version of The Daily Reckoning.

But that view started to change late last year.

I’ll be honest, your editor didn’t turn from a raging bull to a grizzly bear overnight. The change has been gradual.

We started off by pulling back on the number of stocks we tipped that were dependent on a booming Chinese economy. Then we started to look at ways of hedging portfolios against a Chinese economic crash.

Now we suggest only buying into the China story if you’re into high-risk, high-stakes punting. Otherwise, stay clear and hedge your portfolio against the inevitable bust.

That’s something Dan Denning is showing his readers in Australian Wealth Gameplan. If you haven’t seen his ‘Exit the Dragon‘ strategy yet, take a moment to read about it here…

Because believe me, a crashing Chinese economy could be much closer than the mainstream press could ever dare dream.

Just remember, the mainstream press arrived late on the scene with the China story. And they’re destined to exit the scene even later – probably just after the dust has settled is our guess.

So, what is it that’s caught your editor’s eye? What is it that has caused us to shift into an even higher state of alert on the Chinese economy?

Well, it was the news last week as reported by Businessweek that, “China Cuts Rare Earth Export Quota, May Cause Dispute.“

Diggers & Drillers editor Dr. Alex Cowie gave you the rundown on rare earths last week in this article, so I won’t go over all the details again.

But as a summary, simply put, without rare earths you wouldn’t be able to read today’s issue of Money Morning.

You probably wouldn’t be able to drive the car you drive, and you wouldn’t be able to watch the latest episode of Australia’s Next Top Super Master Chef Idol… or whatever the show’s called.

Because without rare earths, LCD and plasma screens aren’t possible. Mobile phones would be a distant dream or very weird looking, and even some of the new technology used in the automobile industry such as in hybrid cars couldn’t happen.

All of those things, plus many others – the Defence industry for example – rely on this bizarre group of elements called rare earths.

Incidentally, before I go on, I’ll openly state that rare earths is a pet topic. We’ve followed the industry for some time in Australian Small-Cap Investigator and wrote extensively on the subject in the April 2010 issue which we titled “The Coming Plasma Wars…“

In that issue we painted a grim picture of how China’s stranglehold on the rare earths industry – about 95% of global production – could ultimately lead to economic disaster for the rest of the world.

Unless that is, non-Chinese production ramps up to pick up more than just a 5% market share.

Again I won’t go into the full story as that’s for Australian Small-Cap Investigator subscribers only, but the gist of it is for how much longer can the Chinese authorities prop up their economy and prevent civil unrest?

Our guess is that like every other violent and oppressive regime in history it will ultimately meet an end. When that happens, the odds of the Chinese manufacturing industry continuing to run are minimal. And equally minimal are the chances of Chinese rare earths producers being able to export the minerals.

Remember, this is a situation where the Chinese control the export of a crucial resource. It’s not like the iron ore or copper industry where China is the buyer. For those industries, if China stops buying there are others that could eventually pick up the slack.

I’m not saying it would be seamless, but other buyers would gradually emerge.

But for rare earths it’s the Chinese, not the Australians or Brazilians or Canadians that is in control of the resource.

And that’s why the Businessweek article caught our eye. The story claims:

“China, the world’s largest rare- earths producer, cut export quotas for the minerals needed to make hybrid cars and televisions by 72 percent for the second half, raising the possibility of a trade dispute with the U.S.

“Shipments will be capped at 7,976 metric tons, down from 28,417 tons for the same period a year ago, according to data from the Ministry of Commerce yesterday.”

To show you exactly what this means, the company that I’ve tipped in Australian Small-Cap Investigator has produced the following table:

I’ve circled the two key numbers. Total exports for 2009 were 50,145 tonnes. In 2010, the total exports are predicted to be just 30,259 tonnes.

Make no mistake, that’s a massive difference. But why would the Chinese do such a thing?

According to Businessweek it’s because:

“Rising production of hybrid cars and music players such as Toyota Motor Corp.’s Prius and Apple Inc.’s iPod have driven up demand for rare earths even as China cut the quotas to shore up prices and ensure domestic supplies.”

In other words, because there’s such a demand for rare earths from overseas manufacturers such as Toyota and Apple, the Chinese apparently want to “shore up prices and ensure domestic supplies.”

Right. The second part of that we can accept. Even though in a moment we’ll argue it’s not the real reason for the cut to the export quota. Even so, the argument is that due to the demand from overseas, Chinese manufacturers are having to compete for rare earths and are perhaps having their supply of rare earths impacted.

But the first part of the argument, about shoring up prices, doesn’t make any sense at all. If there truly is such a huge demand from overseas and domestically, then that alone should shore the price up without the need for a cut to the quota.

So, could there be more to the story than meets the eye?

We think so. Not that the mainstream press has bothered to pay much attention to it. The best the Fairfax papers could come up with was a cut and paste job from the Businessweek article.

We’re yet to find any commentary from any of Australia’s mainstream know-it-alls who are usually so keen to jump on to any China related story. If it’s good news then they’ll say “I told you so”, and if it’s bad news they’ll say, “Fuhgeddaboutit, China’s gonna grow for thirty years, Ken Henry said so…”

You see, the real reason for the quota cut is likely to be much more sinister than the boys and girls at Businessweek would have you believe.

It’s not so much the price of rare earths, or even the concern about maintaining domestic supplies that the Chinese are worried about. What’s more likely to be their real concern is the demand for Chinese finished products.

What this decision tells you is that the bureaucrats are seeing a slowing demand for Chinese produced goods. Remember, for all the mainstream guff about China having a market-based economy, the fact is that China has a command economy.

It’s industries produce goods based on what it’s told to produce, not on what the market demands. And as anyone will tell you about command economies, the bureaucrats dishing out the orders aren’t usually the quickest to recognise a glut in production.

Why do you think you hear the stories about Chinese companies dumping products in foreign markets for below cost? They don’t do it in order to win market share, that’s just a furphy the vested interests like to claim.

The real reason is because the bureaucrats have set production levels too high and then they’ve been too slow to cut back.

Odds are that this is what’s happening across the board in Chinese industries. Manufacturers are producing goods under orders from centralised bureaucrats, goods for which there isn’t the demand.

What can the government do about that? Well, if you rule by fear the last thing you’ll want to do is order businesses to slash production and slash jobs. Not when millions of rural workers have been moving to the big new cities to work for these manufacturers.

Can it really be expected that these people would just say, “Ho hum, back to the country then.”

Of course not. Cutting production to real levels of demand would mean millions – and I mean millions – thrown out of work and literally onto the streets. No oppressive and violent regime wants to risk having millions of angry people on the streets with pitchforks and torches.

So the only other option is for the Chinese authorities to try and attract more demand. What better way of doing that than cutting the supply of perhaps the world’s most strategic resource – rare earths.

And if you think that’s drawing a long bow, think again. We’re talking about a resource that’s required for the production of items most people use every day. For instance flat screen televisions and mobile phones.

To prove the point, take this article from yesterday’s Sydney Morning Herald:

“Televisions will soon start to outnumber the number of people in the average Australian household as the cost of flat-screens declines and viewing habits change, experts say.

“Sales of televisions larger than 40 inches recorded 75 per cent growth in the past year, with 140,000 sold in the six weeks before the Socceroos’ opening round World Cup match against Germany on June 13, according to analysis by the industry research group, GfK.”

The article goes on:

“Last year Australians bought 2.7 million televisions…”

Now multiply that number globally. Now consider the number of mobile phone handsets that are bought every year here and overseas.

We’re talking huge numbers.

And it’s a huge number the Chinese want to gain an even bigger control over. That along with every other industry that uses rare earths.

Think about the numbers in the chart I pointed out above. The Chinese export quota is forecast to be nearly 40% lower in 2010 than in 2009.

It’s not as though non-Chinese manufacturers can simply sign a deal with non-Chinese rare earths producers to fill the gap. Well they can – such as the stock we’ve tipped in Australian Small-Cap Investigator – but it will be nowhere near enough to meet what global industry requires.

And as we pointed out in the April issue of Australian Small-Cap Investigator, “industry insiders believe it will take Mountain Pass fifteen years to get the full supply chain going.”

By the way, Mountain Pass is the large US rare earths deposit that used to be the largest source of rare earths until the 1970s. That was before the Chinese took over the industry. Production was finally halted at Mountain Pass in 2002!

So mark my words, this announcement by the Chinese authorities on rare earth production should be much bigger news than it has been so far. Largely because it tells you more about the real state of the Chinese economy than any government manipulated statistic will ever tell you.

The headlines in the mainstream press tell you about the booming Chinese economy, about the insatiable appetite for Australia’s resources and how the Chinese are creating a new breed of middle class citizens.

What the headlines don’t tell you is what the rare earth quota cut implies – that China is desperate to do anything to prop up a manufacturing sector that is producing more goods than it can sell.

And the only solution it has to prevent – or at least postpone – a catastrophic economic meltdown and civil unrest is to manipulate the market to try and gain control of more manufacturing from overseas.

One way of doing this is to slash exports for the one natural resource that China has supreme control over – rare earths.

So far the mainstream media has let this one slip through to the keeper. In our opinion that’s criminal considering the potentially huge impact this measure could have.

However, because we believe this event is so important, it’s one that we’ll follow very closely over the coming months.

The first cracks in the Chinese economy are starting to appear, but so far, very few people seem to have noticed.

Cheers,
Kris Sayce
For Money Morning Australia

China's Economy in Peril, 8.7 out of 10 based on 19 ratings

Tagged as: china, Chinese, economy, industry, market, peril, Rare Earths