Fast forward three years and you find a very different story: the biggest mall in the world – the South China mall, with space for fifteen hundred stores, only has a dozen stores open for business – it is empty. Shoppers never materialized. Billions of dollars have been wasted.

Analyzing the Chinese economy while it is growing at superfast rates is like analyzing a credit card company or a mortgage originator during an economic expansion – all you see is reward – the growth. But the defaults – the risk – are masked by a healthy economy and constantly increasing new business that is profitable at first. The true colors of that growth only appear after the economy slows down and new accounts mature. (In fact, the banks or credit card companies in the U.S. that showed the lowest loan growth during last expansionary cycle have a lot fewer credit problems than those that did – U.S. Bank Co comes to mind here.)

The consequences of LSGO are likely to be very painful for China. As of today we don’t know how much of the recent growth came from wasteful, unproductive growth. Only after a slowdown will the true problems surface.

The Speed. What makes things even worse is that China cannot afford a slow down. I discussed this in the past but it is worth repeating. The Chinese economy is like the bus from the movie “Speed”. In the movie the bus is wired by a villain (played by Dennis Hopper) with explosives, and will explode if its speed drops below 50 miles per hour. The Chinese economy has 1.3 billion unsuspecting people on board. It could blow if economic growth drops below its historical pace.

A combination of high financial and operation leverage sprinkled with past high growth rates will send this economy into a severe recession if growth rates slow down. Let me explain:

High operational leverage. China has become a de facto manufacturer for the world. With the exception of food products, it is difficult finding a product that was not, at least in part, manufactured in China. Industrial production accounts for 49% of GDP, double the rate of most developed nations (i.e. industrial production for the United States is 20.5 % of GDP, UK 18.2% , and Japan 26.5%).

Chinese miracle growth is largely driven by the manufacturing sector; historically its industrial production grew at a faster rate than GDP. The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. High commodity prices and rapid wage inflation has driven those costs up. Once a factory is built the costs of running it are to a large degree independent of the utilization level – they are fixed – a classical definition of operational leverage. On top of these factors, laying-off workers is a politically sensitive process in China, which creates another layer of fixed costs.

High financial leverage. Debt is the instrument of choice in China. Due to a lack of equity-fund- raising alternatives (their stock market is very young), bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China – this generates a great degree of financial leverage. (Though according to my friend Bill Mann, The Motley Fool’s advisor of Global Gains newsletter, a frequent visitor to China, state owned enterprises are much more leveraged than private enterprises.)

Total operational leverage. Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage.

Total operational leverage in China is elevated further as factories are built to accommodate future demand – this is a classical byproduct of LGSO. It is a human tendency to draw straight lines and thus making linear projections from the past into the future. During the fast growth period the angle of the straight lines is tilted upward, causing an over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. (Fear of over investment is overrun by fear of losing customers.)

This type of thinking results in tremendous overcapacity when demand cools. Here is an example: let’s say a company saw demand for its widgets rise 10% year after year. It builds a new factory to accommodate future demand, let’s say five years. It will likely model a 10% annual increase in demand as well. But what if demand comes in at 6% a year over the next five years? This will translate into overcapacity – not 4% but 20% (4% per year times five years). Suddenly you don’t need to build factories or add capacity for awhile.

This greatly leveraged growth is terrific as long as the economy continues to grow at a fast pace: sales rise, costs rise at a slower rate (in large they are fixed) – margins expand – the beauty of leverage. However, leverage is not so sweet and soft when sales decline. Overcapacity is a death sentence in the manufacturing (fixed costs) world. As companies face overcapacity or slowdown in demand, they try to stimulate sales by cutting prices, which in part lead to price wars (similar to what we observed in the U.S. between Sprint (NYSE:S), MCI (NYSE:MCI) and AT&T (NYSE:T) in the long distance business during the mid 90s) and to a fatal deflation. Sales decline, costs remain the same – margins collapse.

The weakness in the US and European economies will temper demand for Chinese made goods. China is already showing first signs of slow down – inflation is increasing and rate of real growth is decreasing.

It gets worse: high commodity prices

Chinese demand for stuff (oil, metals, machinery etc…) has a tremendous impact on commodities, driving their prices many fold. High (and rising) commodity prices are negative for developed world economies but they are catastrophic to developing economies – they bring comparatively higher inflation and often stagflation. Here is why:

Inflation is sourced from two broad categories: commodities (stuff) and wages. Emerging markets are twice as cursed when it comes to inflation:

1. Commodity prices (less shipping costs and government controls – the Chinese government limits price increases on certain commodities, but we know that doesn’t work in the long-term) are the same around the world. Thus the U.S. and China will see a similar increase in commodity prices (at least in dollar terms). But the commodity component represents a larger portion of the total product cost in China than in the U.S., as wages in China are a less significant component of a total cost. For instance, bread baked in the U.S. and China will require the same amount of wheat and wheat will cost as much. But baker wages will be significantly larger in the U.S. than in China and will result in a much higher cost of the finished product. Therefore, a spike in wheat prices will have a larger impact on the loaf of bread in China than in the US.
2. Wage inflation: the US and Europe have little wage inflation, as rising unemployment has diminished the already weak bargaining power of the labor force, keeping wages in check. Economic expansion has put significant upward pressure on wages inflation in China (and India as well).

In combination, these two factors were responsible for inflation in high single digits in China, double the rate of inflation in the U.S.

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