The Biggest Sign of a China Bubble


Fed Chairman Ben Bernanke has taken a lot of heat for printing money, even being dubbed "Helicopter Ben" by his critics, a metaphorical reference to showering the U.S. economy with money. But if Bernanke's making it rain from a helicopter, China's been bombarding its economy from multiple stealth bombers. Money supply rose markedly in May and recent years' credit growth has surpassed even that of the U.S. in the period leading to the Lehman collapse.

Unfortunately, instead of being put to good use, much of that money has ended up in the hands of wasteful state-owned enterprises, or SOEs. Meanwhile, cash-starved private entrepreneurs have watched quietly from the sidelines, unable to participate in Beijing's ragin', capital-misallocatin', credit-fueled investment boom. Is this another sign of the unsustainability of Chinese growth?

It's raining yuan
The SOEs are like the profligate Real Housewives of Beijing. They get tons of money to splurge on fancy, wasteful items, get wined and dined by the country's most powerful figures, yet contribute relatively little to the economy. In many cases, they're profitable solely because they're the only players allowed in strategically important industries.

Meanwhile, the small and medium-sized businesses (SMEs) do the grunt work, contributing two-thirds to taxes and total industrial output, and employing more than 75% of the Chinese workforce. Yet they get no love. Despite the surge in bank credit, many are either denied access altogether or charged absurdly high rates on loans.

SOEs before bros
Of course, the nation's four largest banks -- themselves majority state-owned -- have a tremendous bias in lending to SOEs. And the government's vested interest in protecting the status quo has led to major restrictions on multinational banks looking to expand within China. Tellingly, JPMorgan Chase (NYS: JPM) , Wells Fargo (NYS: WFC) , and Bank of America (NYS: BAC) have decided to avoid retail banking in the region altogether.

As a result of their intimate connections with China's authorities, SOEs enjoy a number of remarkable advantages that private firms would kill for. They get huge government subsidies in the form of significantly lower tax rates, have access to much cheaper basic inputs like water, land, and energy, and enjoy barriers to entry in key industries.

But despite their edge, SOEs are much less efficient than their private counterparts, and have become increasingly inefficient over the past decade. In fact, many are loss-makers and there's mounting evidence they've misallocated capital on a tremendous scale. But thanks to the "wonders" of state capitalism, they keep getting funded -- accounting for more than 75% of all bank loans -- and continue to expand.

No demand for steel? Try raising pigs
A recent piece in the Financial Times outlined how several state-controlled steel companies, faced with falling demand, are branching out beyond their core lines of business. Baosteel Group, the world's third-biggest steel producer, derived half its net profit last year from non-steel related businesses, which ran the gamut from real estate to telecommunications to manufacturing.

The example that struck me as most peculiar was that of Wuhan Iron & Steel, the country's fourth-largest steel producer. It's investing $4.7 billion over the next five years in pig, fish, and organic vegetable farming, as well as logistics and chemicals. Yep, that's right. They went from steel to pigs.

More worryingly, this trend isn't just confined to steelmakers. Cofco, a state-controlled grains company, is now building luxury hotels in Beijing, and Tongling, the nation's second-largest copper producer, is diversifying into timber.

So instead of reducing capacity in response to falling demand, China's SOEs forge onward with their grand schemes, lured by potentially higher profits and encouraged by preferential access to cheap loans. After all, if the cheap money keeps flowing, you gotta invest it, right? Just like when the music was playing, you had to get up and dance. Haven't they learned anything about the perils of excessive and cheap credit from that recent little blip we call the Great Recession?

But China is different...
Despite growing evidence of huge capital misallocations in the state-run sector, many investors remain indifferent, citing their faith in the effectiveness of central planning. They say China is a special case and that an authoritarian government can more easily control the economy. I find this hard to believe, given the abundance of historical evidence suggesting exactly the opposite. As Societe Generale's Dylan Grice points out: Just because an authoritarian regime has tight control of the levers of the economy doesn't mean it has the faintest idea how to use them.

Unless there's a meaningful rebalancing of the economy that involves severely curtailing lending to the SOEs, China will not prosper. To grow sustainably, it needs a large transfer from the state sector back to households, whose savings have subsidized government profligacy -- and even outright theft -- for too long.

Only through policies that raise households' disposable incomes and their purchasing power might we finally see the Chinese start to spend, a godsend not just for China, but also for the hundreds of multinationals, like Yum! Brands (NYS: YUM) and Starbucks (NYS: SBUX) , that are banking on the tremendous promise of Chinese consumers.

Maybe I'm just a naive outsider and maybe I'm wrong. Maybe I don't fully grasp the benefits of state capitalism. Maybe all the historical evidence against central planning doesn't apply to China. Maybe this time is different. And those pigs Wuhan is raising? Yeah, maybe they'll fly someday.

At the time thisarticle was published Fool contributorArjun Sreekumardoes not own shares of any companies listed above. The Motley Fool owns shares of Starbucks, JPMorgan Chase, and Bank of America. The Fool owns shares of and has created a covered strangle position in Wells Fargo.Motley Fool newsletter serviceshave recommended buying shares of Starbucks and Wells Fargo.Motley Fool newsletter serviceshave recommended writing covered calls on Starbucks. The Motley Fool has adisclosure policy.

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