Industrial Production Is Growing but Where Are All the Products Going?

Last week’s release of U.K. industrial production showed an increase in output. This finally brings the U.K. in line with the rest of the world making it about the last industrialized country to bottom in output. As I pointed out in my article two weeks ago, this lag in industrial output was the likely reason the U.K. economy failed to grow in Q3 while most other economies did (albeit stimulus-led in some cases).

Many other economies returned to growth much earlier in the year and a few, notably China, never stopped growing. Yet, as global trade remains flat, the question becomes: where are all the products going?

Even though the economy in the United Kingdom, similar to that in the United States, is predominantly services oriented, industrial production can drive key measures of the economy like GDP and unemployment figures. Output growth in an economy is a signal to companies to invest and hire. If it holds for the U.K., this signal becomes a key indicator that the global economy is on the mend even if the strength of the rebound is still up for debate.

 

Chinese auto production continues to climb. One notable exception to this near calamity scenario is China. While ‘cash for clunkers’ programs in the U.S. and Germany got much of the attention, I would argue the most successful stimulus for the auto sector came in China. Early in 2009 the Chinese government directed that bank lending be increased substantially. This led to an increase in loans and money supply in China far in excess of 20% growth. It has been widely reported that the Chinese government has worked since the end of the summer to rein in this phenomenal credit expansion yet surprisingly Chinese auto production took another step up in September.

Chinese industrial production returns to strong growth. For much of the year I have been writing about Chinese industrial production, tracking four categories in particular. As of September, the growth in these four categories is back above 20%, a level that might be considered “normal growth” for Chinese factory output.

It is true that factory and store inventories have been at depleted levels and some restocking is in order. Through the third quarter, beyond autos though, there is scant evidence that commercial inventories are being built back up in the U.S. or anywhere else that reports such data. So where is it all going? Is it being consumed by the Chinese domestic market, possibly the only healthy consumer market on the planet right now?

Retail sales have grown 15% throughout the year in China. Chinese consumer confidence began to decline in middle 2007 and declined for almost two years before bottoming out in March of this year. During this period of decline in confidence, retail sales for China continued to grow at double digit rates. If you look past a distinct season pattern (sales spike in December and January ahead of Chinese New Year), retail sales delivered 22% growth each month in 2008 and 15% growth in 2009 to date.

Retail sales growth in China never dropped below 10%. While the level of growth declined from 22% last year to 15% this year, the consistency on a monthly basis was amazing. Each month China reports sales for the month and cumulative YTD numbers as well as growth in those numbers from the same period the year prior. After a couple-month period of adjustment from late 2008 to early 2009, the readings for growth have been remarkably consistent at a time (March ’09) when the rest of the world was worried that we were headed for another Great Depression.

Many skeptics have accused the Chinese government of fabricating economic data. Where the industrial production growth figures swing wildly from month to month and year to year, the consumer spending numbers have a remarkable consistency. To me they do not particularly exude a sense of fabrication so much as management. They remind me of a control chart on an assembly line where a target is assigned and data collected. Each time data is collected it is analyzed and inputs to the process modified until the result approaches targeted levels. The irony here is that it is data on consumer behavior not factory output that looks to be conforming to a target.

Let’s get back to the original question: what is happening to all this factory output? We know that factories outside of China are beginning to grow again; Chinese factories are returning to “normal” double digit growth rates; yet trade (a good proxy for global consumption) is flat after having dropped 20-30%.

The answer is important because the broadly deployed “risk trade” that has been driving world markets since the summer is to borrow cheaply in U.S. dollars and invest in almost anything else, particularly oil, other commodities, and emerging markets. This implies a weak economy in America and other industrialized nations but that demand is sufficient in the rest of the world to make commodities scarce. As we have seen above the data out of China implies this might be plausible but is it real?

Of course, data fabrication is one possible explanation. However, to me it is too convenient. Life is rarely that simple. An alternative explanation is that incentives for Chinese production and consumption have been successful enough to drive consumption growth (in the face of declining consumer confidence) while at the same time letting inventories (which we can’t see) build above normal levels waiting for the global consumer to return. Is Chinese consumer consumption large enough for this to work? The answer is possibly but only for a little while.

It turns out that retail sales in China are on track to exceed $1.5 trillion (measured in USD). A 15% increase in consumption means that the Chinese domestic market can absorb $200-$250 billion more of products in 2009 than in 2008. According to the WTO, China’s exports for 2008 reached $1.4 trillion. With two-thirds of the year reported, exports to the U.S. are running about 15% behind last year’s pace. Exports to other destinations like Japan or Europe may be down even more. Assuming a 15% decline in exports out of China broadly, it means that the domestic market could, in theory, consume the $200 billion worth of goods not sent overseas. This assumes the factory output is exactly what the Chinese consumer wants to buy.

This, of course, only holds when factories are not increasing output and consumers in America and Europe are retrenching. The Chinese domestic market is large enough to offset declines in consumption in the West but not large enough to drive robust growth on top of that. If all the published data is to be believed, the best explanation is that government directed Chinese stimulus and incentives to date have coordinated a delicate balance of additional consumption and reduced factory output over the last year. This provides a possible explanation up until now.

At this point, something has to give. Factories in China and abroad revving back up. The Chinese government is reluctant to stimulate lending and the money supply any further. Without western consumers (America and EU in particular) growing their spending at a healthy clip, finished goods in China and elsewhere around the world are going to be piling up on the loading docks quickly, if they aren’t already.