Manufacturing is Dragging Down China’s Economy

The US-China trade war is taking effect.

The Middle Kingdom has already shown signs of falling. In hindsight, it makes perfect sense.

China is an export-led economy. That means they excel at making stuff and selling it to the world. Their advantage is built atop of cheap labour, a cheap exchange rate and conducive policies.

If you needed any more proof that China is hurting, the red nation is about to flood their economy with cash.

According to South China Morning Post (SCMP), China’s central bank is going to cut required reserves. This is the level of cash which banks are mandated to hold.

The idea behind these reserves is to make sure banks have enough cash when times get tough. Playing with this ratio can also be a relatively quick way to increase or reduce the amount of cash circulating in an economy.

Lower reserves are very similar to lower interest rates. Lenders are encouraged to lend. More money circulates the economy. And China hopes it will lead to the creation of new goods and services: growth.

But here’s the problem with that plan…

There is one thing dragging China’s economy down: Manufacturing.

The industrial and manufacturing sectors account for 40% of China’s economy output. But if they want to be a super power, they’ve got to wean themselves off it, fast!

Manufacturing is a dying industry. I believe producing nations like China, Japan and South Korea need to make drastic changes.

They all have the herculean task of moving labour and capital from manufacturing over to the service sector. And it’s here, in the service sector, that countries like China, Japan and South Korea can prosper.

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Why is manufacturing a dying industry?

But first, why is manufacturing dying?

Simple. We’re all getting super-efficient at producing things. These efficiency gains are outstripping demand for goods year-after-year. What you get is a market crowded with producers making things people aren’t buying.

It’s why China is so big on trade. Domestically, they make way too much stuff. So, they export those cheap goods to countries like the US.

And with more money in their economy, potentially US$210 billion, I know some of that is going to go into propping up dying manufacturers.

Back to services…

While Chinese manufacturers had it rough last year, the service sector did pretty well. From SCMP:

Growth in the Chinese service sector accelerated to a six-month high in December, according to a private gauge released on Friday, demonstrating some resilience in the world’s second largest economy.

The service sector purchasing managers’ index (PMI), compiled by Markit and published by Chinese financial news outlet Caixin, rose to 53.9 in December. The measurement is well above 50.0, the point between expansion and contraction, showing services were performing strongly in the last month of 2018.

The pickup in the Caixin reading, which is based on a survey of over 400 companies, is a rare good news story for the Chinese economy, the prospects of which are clouded by a trade war with the United States.

Despite the US-China trade war, new export orders in the Chinese service sector also rose to a six-month high last month, with export companies stepping up their overseas sales and marketing.

Why is China’s service sector so reliant, even as the trade war kicks off in the background? It’s because the service sector is immune to global competition.

The local banks dominate the local areas they’re in. The local power companies dominate the local areas they’re in. And the local couriers dominate the route they own.

There’s a lesson here.

Local is important. You should try to find companies that dominate locally, whether that’s for a single product or a single geographic region.

If you can, they won’t just be immune to global events. They might even be immune to the likes of Amazon.com, Inc. [NASDAQ:AMZN]

Like Amazon, China can’t afford to compete

Did you know you could make close to AU$422,000 delivering packages?

That’s what Amazon promises. From Businessweek:

Amazon is so dependent on people that it’s copying FedEx Corp., building a network of independent couriers around the U.S. Bezos this summer promised mom and pop franchisee types a chance to earn $300,000 [USD] a year delivering for Amazon, all for as little as $10,000 [USD] up front.

…In return, the moms and pops have to handle the tough part: finding drivers willing to meet Amazon’s high standards while making much less than other delivery people, even with plenty of jobs available elsewhere.

While that could be a road block (finding willing workers), what I believe could be much tougher is competition for routes where established couriers already exist.

Think about it…

Say an Amazon delivery franchisee tries to set up shop in an area dominated by an established FedEx franchisee. Who do you think has the upper hand?

The FedEx franchisee, of course. They already have the volume, workers and routes set up. These are all the fixed costs the Amazon franchisee still needs to fork out.

And they’ll have to do it upfront, when they have no volume at all.

With a lower average cost per package, the FedEx franchisee can lower their price, forcing businesses to choose: the higher priced Amazon franchise or the lower cost FedEx courier.

But Amazon has a lot of cash, you say. They can afford to make losses until their network is being built.

Maybe that’s true.

But no matter how much cash you have behind you, it’s never smart to compete at a competitive disadvantage.

Hopefully the Chinese understand this and funnels as little new cash into their manufacturing sector as possible.

Your friend,

Harje Ronngard,
Editor, Money Morning

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Harje Ronngard is the lead Editor at Money Morning. He’s also the Editor of Wealth Eruption and Gold & Commodities Stock Trader, and co-Editor of the Third Wave Portfolio.

The aim of both Wealth Eruption and the Third Wave Portfolio is to find misunderstood opportunities. These are the type of investments that multiply small amounts of money five- to 10-times in size.

Harje has an academic background in investments and valuation. He’s had experience across a range of asset classes, from futures to equities.

For any investment, Harje believes you only need to ask two questions. What is it worth? And how much does it cost? These two questions alone open up a world of opportunities, which Harje shares with Money Morning readers five days a week.


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