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Why China is Twisting My Melon

‘Twisting my melon‘ is a British phrase to describe being confused to the point of annoyance. The reason I bring it up is because it describes how I feel about China – and particularly in recent weeks – as contrasting and contradictory news have been undermining my convictions about the leading emerging market. So in my quest to untwist said melon, I present henceforth some observations on the matter.

–After the onslaught of poor Chinese economic data in recent weeks, the latest manufacturing data not only beat consensus, but also highlighted ongoing expansion. This number was, however, at odds with HSBC’s data point, which is showing increasing contraction from the sector.

China Manufacturing PMI

–Signals of slowing demand in Commodityland™ in recent months have been waving a big red flag, laying claim that the ‘commodity supercycle‘ is over. China’s steel demand does nothing to dissuade this notion, with the country’s steel association forecasting in recent days that demand is to remain weak.

Related article: China’s Energy Policies Unsettle Neighbors Both East and West

–Jim O’Neill is one of my most admired economists (despite his love of Man Utd), and he said this week that China’s growth plan is pretty persuasive. He said that Chinese business owners and senior policymakers he met recently are willing to accept a slowdown in the near term to “improve the quality and long-term sustainability of growth.”

–This view jives with last week’s announcement that the Chinese government is ordering the closure of factories for 1400 companies across 19 industries to reduce overproduction and curb price wars. This will more than likely be a good thing in the medium term for the Chinese economy as it reduces overcapacity, but will have negative economic repercussions in the near-term, while also being detrimental to energy demand.

–On the flip-side, however, the government did announce the day prior to this revelation that it was taking small steps to support the economy. These were in the form of three measures - cutting taxes for small businesses, passing reforms to support trade, and announcing infrastructure projects.

–’The Lewis Turning Point‘ .This theory is based on how developing countries have a surplus of labor, and are able to keep wages low as there is an unlimited amount of agricultural workers willing to work for such a low wage. The Lewis turning point comes when cheap labor from the agricultural sector runs out, and wages have to rise.

And indeed, wages are finally rising in China – which is a good thing – but corresponding consumer spending is not rising at a commensurate enough pace to offset the fall in investment caused by rising labor costs. The result is lopsided growth, all the while growing bargaining power is stoking tension in the labor market.

–Should ultimate fears play out and China see economic growth fall to 3% (anything below 5% would be viewed as recessionary), then predictions equate this with a $70/barrel oil price. Worrisome? Yes. Likely? Not on your nelly.

Related article: Can Abe Revive Japan?

–Chinese power production is something we looked at earlier in the year here as it was giving reasons to be cheerful. However recently – like so many indicators – it is giving cause for concern. The below chart is doubly telling as weakness in power production is affirmed by rail freight traffic.

Power Production and Rail Freight Travel

All these points build a picture about the current state of China. And it is okay that some of the signals are mixed – this is evidence in itself that the country is going through a mottled period of slowing growth. But the key takeaway is that China is willing to accept a slowdown in the near term, dealing with its growing pains and promoting structural reform rather than trying to stimulate its way out of its current predicament. A novel idea indeed.

By. Matt Smith

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