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.

Four-Step Guide to Small-Cap Success. Download your free report now.

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, 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

Free Report: How Aussie investors could potentially win big when China takes on Silicon Valley — Download your free report now.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

Money Morning Australia