How China’s Massive Automotive Malinvestments Will Affect the World

This Bloomberg article features a fantastic narrative of the boom bust cycle of China’s automotive industry (bold added)

The boom…

For much of the past decade, China’s auto industry seemed to be a perpetual growth machine. Annual vehicle sales on the mainland surged to 23 million units in 2014 from about 5 million in 2004. That provided a welcome bounce to Western carmakers such as Volkswagen and General Motors and fueled the rapid expansion of locally based manufacturers including BYD and Great Wall Motor. Best of all, those new Chinese buyers weren’t as price-sensitive as those in many mature markets, allowing fat profit margins along with the fast growth.

No more. Automakers in China have gone from adding extra factory shifts six years ago to running some plants at half-pace today—even as they continue to spend billions of dollars to bring online even more plants that were started during the good times. The construction spree has added about 17 million units of annual production capacity since 2009, compared with an increase of 10.6 million units in annual sales, according to estimates by Bloomberg Intelligence. New Chinese factories are forecast to add a further 10 percent in capacity in 2016—despite projections that sales will continue to be challenged.

 

Easy money AND government subsidies….

The carmaking binge in China has its roots in the aftermath of the global financial crisis, when China unleashed a stimulus program that bolstered auto sales. That provided a lifeline for U.S. and European carmakers, then struggling with a collapse in consumer demand in their home markets. Passenger vehicle sales in China increased 53 percent in 2009 and 33 percent in 2010 after the stimulus policy was put in place. But the flood of cars led to worsening traffic gridlock and air pollution that triggered restrictions on vehicle registrations in major cities including Beijing and Shanghai.

The frantic race to build supply hounded by diminishing marginal productivity/ diminishing returns…

Worse, the combination of too many new factories and slowing demand has dragged down the industry’s average plant utilization rate, a measure of profitability and efficiency. The industrywide average plunged from more than 100 percent six years ago (the result of adding work hours or shifts) to about 70 percent today, leaving it below the 80 percent level generally considered healthy. Some local carmakers are averaging about 50 percent utilization, according to the China Passenger Car Association.

Excess capacity is raising the pressure on carmakers to step up margin-destroying discounts to goose sales and keep production lines busy, according to Boston Consulting Group. The markdowns can be huge. Motorists can buy an iEV4 car made by Anhui Jianghuai Automobile for 61,100 yuan ($9,642), 60 percent off its sticker price, according to Autohome, a popular car pricing portal in China. Western models aren’t immune to the price slashing. The offering price of Audi’s A1 is being cut by up to 35 percent, to 194,900 yuan, in some Chinese cities, according to Autohome. And with capacity growth expected to continue outpacing demand, the industry’s return on invested capital in China will decline from 19.1 percent in 2014 to 10.5 percent by 2018, Sanford C. Bernstein estimates.

 Yet more subsidies…

Carmakers recently got help when China’s government, prompted by the sharp slowdown in auto sales in this year’s first three quarters, announced a tax cut on vehicle purchases from Oct. 1 through the end of 2016. China’s purchase tax on vehicles with efficient engines 1.6 liters or smaller has been cut in half, to 5 percent. Buyers have responded, with retail auto sales in the first three weeks after the tax cut rising 11 percent from the same period last year, according to the China Passenger Car Association.

The tax break could postpone the day of reckoning for the industry, especially for smaller manufacturers of cheaper models. But analysts worry that even if small or weak players survive, they won’t make enough money to support the investments needed to meet stricter safety and emission standards that China has scheduled for the next few years. The government is requiring auto makers to lower the average fuel consumption of their vehicles to 5 liters per 100 kilometers (1.3 gallons per 62 miles) by 2020, from the current 6.9l/100km. Companies have been developing electric vehicles or adding complex fuel-saving features to meet the tougher standard. But all that takes technical expertise and money—things foreign joint ventures have, but that many small domestic carmakers don’t.

Before the tax cut, China’s auto regulators had repeatedly urged smaller auto companies to merge or be acquired as part of a strategy to pool resources and nurture a handful of manufacturers that can compete internationally. “The tax cut delays the process of eliminating outdated extra production capacity and clouds the judgment of automakers of the market and capacity expansion,” says Xu Gang, a managing director at Boston Consulting Group in Beijing. “Instead of trying their best to become more competitive, some local carmakers are getting used to the idea that the government will help them out when the going gets tough.”

 The seminal bust…

Even big automakers are tapping the brakes. BMW says it cut production in China in the first seven months of the year by 16,000 vehicles. And Toyota Motor, despite seeing an 11.5 percent increase in China sales in the first nine months of 2015, is treading carefully. It’s scheduled to begin production of an assembly line in Tianjin by mid-2018, which will allow it to make an additional 100,000 vehicles a year. But Toyota says that output will be mostly offset by ending production on an existing assembly line elsewhere on the mainland. That kind of caution is fast becoming the new normal for carmakers in China.

Through the years, China's automotive industry’s growth model has been heavily RELIANT on easy money and government subsidies. Said differently, the industry depended on DEBT financed car purchasing (DEMAND), and most importantly, debt financed race to build capacity (SUPPLY)

Apparently, excess capacity has reared its ugly head. It’s a symptom of boom-turned-bust. And basically this comes from two things: supply has grown faster than demand, and second, slowing demand reinforces and magnifies overcapacity.

As with the strains on the stock market or the property market, the Chinese government’s response has been to apply more subsidies or the bailout of the industry. Yet these will merely “postpone the day of reckoning”

However with the immense outgrowth of supply, the initial industry reaction has been to dive selling prices through “margin-destroying discounts”. In short, price deflation of autos.

The second feedback mechanism has been, and will be, the “tapping the brakes”. Insufficient sales and profits will lead first to the suspension of capacity expansion. Eventually losses will translate to capacity destruction. In short, the markets will clear on these excesses.

China’s boom bust cycle in the automotive industry also means that it will “export deflation” around the world.

Perhaps “margin-destroying discounts” will be pushed to markets abroad. That’s if there will be demand enough to absorb it or even just a portion of it to partially allay the overcapacity troubles.

And that’s if the government’s of her trading partners abroad won’t erect trade barriers to prevent China’s auto exports from affecting their domestic producers. 

You see, inflationism runs opposite to free trade. Instead, inflationism raises the spectre of protectionism. Hardly any free trade agreement will offset the inherent protectionist proclivities and impulses brought about with tampering with credit and money prices.

Alternatively, China’s automotive industry can also export deflation INDIRECTLY.

Suspension of capacity expansion, and worst, capacity destruction entails of jobs and output slowdown or losses, and similarly, financial stresses to sectors attached to these industries or the non-linear supply chain and credit networks depending on and have been related to the industry.

Think the current annihilation of commodity prices. Palladium, for instance, supply over half of catalytic converters mostly used by automotive industry. 

China’s mammoth oversupply dilemma has been contributing to the ongoing collapse of palladium prices.

Yet since the Chinese government keeps throwing obstacles to prevent markets from clearing, then such process will only get extended and will even be more painful.

And as for the Philippine version where "STRONG MARKETING and varied financing options helped drive vehicle sales to reach 28,667 units in October, 29% more than the tally a year ago, and 5.9% up from September, according to latest figures from the country’s two biggest auto industry groups."

Understand that this has hardly been about G-R-O-W-T-H, but about INFLATIONISM.

Current events in China should serve as a blueprint.

   

International Currency Swap Markets Reveals of a Developing Credit Crunch!

Big trouble for risk asset bulls. US dollar shortages have been emerging all over.

From the Bloomberg: (bold mine)

A crunch is developing in international funding markets.

The cost to convert local currency payments in the euro area, U.K. and Japan into dollars has jumped amid speculation the Federal Reserve will raise interest rates in December. With other major central banks set to hold, or even loosen, monetary policy, the projected policy divergence is supercharging the usual year-end uptick in demand for dollar funding….

The one-year cross-currency basis swap rate between euros and dollars reached negative 39 basis points Wednesday, the largest effective premium for dollar borrowing since September 2012, according to data compiled by Bloomberg. The rate was at negative 37 basis points as of 11:31 a.m. London time.

The measure, which was closely watched by investors during the financial crisis as an indicator of stresses in the banking system, reached negative 138 basis points in 2008 following the collapse of Lehman Brothers Holdings Inc. While the increase this month is driven more by monetary-policy divergence it still has implications for global banks. It also means U.S. companies, which have been borrowing in euros to take advantage of historically low interest rates, must pay more to swap those proceeds back into dollars….

This rush for dollar fundraising across the globe this month pushed up the one-year cost for Japanese banks to the highest level since 2011. Meanwhile, the cost for U.K. banks has more than doubled in November. That’s unusual because the surge was mostly focused in the euro area and Japan the last two occasions that funding costs rose, according to George Saravelos, global co-head of foreign exchange research at Deutsche Bank AG in London.

Well, this seem more than just about the FED’s lift-off, although speculations about it have been exacerbating the current conditions.(see charts above)

This seems really more about those balance sheets overstuffed by debt as evidenced by the $9.6 trillion credit in US dollars to non-bank borrowers outside the United States at the end of Q1 2015 (BIS)

This excerpt from a study from the Bank for International Settlements illuminates on the current dynamic: (Global dollar credit: links to US monetary policy and leverage, BIS, Robert N McCauley, Patrick McGuire and Vladyslav Sushko January 2015)

First, evidence from 22 countries over the past 15 years shows that offshore dollar credit grows faster where local interest rates are higher than dollar yields, and this relationship has tightened since the global financial crisis. And the wider the gap between local 10-year yields and those on US Treasury bonds, the faster the next quarter growth in outstanding US dollar bonds issued by non-US resident borrowers. This finding is consistent with the observation that, since 2009, dollar credit has flowed to an unusual extent to emerging markets and to advanced economies that were not hit by the crisis, while it has grown at a slower pace in the euro area and the United Kingdom (UK). In sum, dollar credit has grown fastest outside the US where it has been relatively cheap.

Second, before the global financial crisis, banks extended the bulk of dollar credit to borrowers outside the US. Low volatility and easy wholesale financing enabled banks to leverage up to funnel dollar credit offshore. These findings are consistent with Bruno and Shin (2014b) and Rey (2013).

Third, since the crisis, non-bank investors have extended an unusual share of dollar credit to borrowers outside the US. Firms and governments outside the US have issued dollar bonds, and banks have stepped back as holders of such bonds. The compression of bond term premia associated with the Federal Reserve’s bond buying has induced investors to bid for bonds of borrowers outside the US, many rated BBB and thus offering a welcome spread over low-yielding US Treasury bonds. We also find that inflows into bond mutual funds offering a spread over US Treasuries played a significant role in spurring offshore dollar bond issuance. We interpret this as evidence of the portfolio rebalancing channel of the Federal Reserve’s large-scale asset purchases.

A key observation is that, following a brief spike in spreads in Q4 2008, spreads declined in the subsequent quarters even as the stock of offshore dollar bonds grew rapidly. Thus, while we cannot reject the “spare tire” argument of Erel et al (2012) and Adrian et al (2013) at the height of the crisis (ie firms substituting from supply-constrained bank financing to bonds, despite widening spreads), any such effect seems to have been short-lived. Instead, heavy bond issuance amid falling yields and narrowing spreads points to the importance of a largely policy-induced favourable supply of funds from bond investors beginning in early 2009.

We end with a discussion of the implications for policy. First, dollar debt outside the US serves to transmit US monetary easing into immediately easier financial conditions for borrowers around the world. Second, while policy in economies outside the US can raise the cost of dollar debt at home, the effect of such policy is limited by multinational firms’ ability to borrow dollars abroad through offshore affiliates. Third, the recent prominence of bond markets in supplying dollar credit introduces new risks to financial stability, and thus changes the way that we need to think about the policy challenges posed by offshore dollar credit growth.

Now a progressing feedback mechanism between onerous cross border debt levels AND a downshift in global economic performance has been increasing strains in the supply of US dollar. Combine these with Fed’s potential rate hike (policy asymmetry between US and the world), hence the brewing credit crunch storm.