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An employee inspects the newly-made optical cables at a factory in Wuhan, Hubei province July 25, 2012. (DARLEY SHEN/REUTERS)
An employee inspects the newly-made optical cables at a factory in Wuhan, Hubei province July 25, 2012. (DARLEY SHEN/REUTERS)

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China’s overcapacity threatens Canadian equity performance Add to ...

Canadian investors are hoping for more Chinese stimulus. They should be careful what they wish for.

The danger is that more stimulus will add to China’s already vast store of unneeded industrial capacity, creating imbalances that will eventually pull the Asian country into a serious downturn.

That, of course, would be horrible news for commodity prices and for Canadian producers of those commodities.

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But that’s thinking long term. Right now most investors are focused on the next few months, when hope for a strong recovery for Canadian stocks hinges on central bank stimulus from the European Central Bank, the U.S. Federal Reserve – and the People’s Bank of China.

The problem? Even people who are bullish on China will admit that the country suffers from severe overcapacity. A recent IMF study estimated that the economy’s capacity utilization has fallen to 60 per cent, leaving 40 per cent of the country’s manufacturing facilities idle.

The Chinese government has obvious fiscal firepower to maintain growth levels. The question, given the current level of overcapacity, is whether they should use it to add even more unneeded factories and construction projects.

University of Peking economics professor Michael Pettis is firmly in the “don’t stimulate” camp.

“China has probably hit both constraints – capital is wasted, perhaps on an unprecedented scale, and the world is finding it increasingly difficult to absorb excess Chinese capacity,” writes Mr. Pettis. “For all its past success China now needs urgently to abandon the [current] development model because debt is rising furiously and at an unsustainable pace, and once China reaches its debt capacity limits, perhaps in four or five years, growth will come crashing down”

Evidence of overcapacity in the Chinese economy has been much more prevalent in recent months. U.S.-based Caterpillar announced Wednesday that the heavy equipment built in its 18 Chinese facilities will be sold outside the country for the first time due to weak demand.

The steel industry is also feeling the effects of overinvestment. “Overcapacity and rising costs depressed the average profit margins of Chinese steelmakers to just 3.5 per cent in 2010, the lowest of any industry, according to the government,” writes China DailyOvercapacity in China poses an economic threat to Canada. To take one example: Lower profits for Chinese steel makers are likely to lead to lower demand for the iron ore and metallurgical coal produced by Canadian miners.

But the exact impact of Chinese stimulus is hard to predict. Some observers speculate that government incentives for growth will take a different form than in years past. Instead of pouring money into construction projects, Beijing might make an effort to boost consumer spending. One rumor is that it will launch a rebate program for durable goods, in an effort to spur sales of appliances such as refrigerators and stoves.

This new type of stimulus would have mixed effects on Canadian resource companies. Copper producers would be better off because of increased demand for copper coils for small engines, but other industrial metals producers would not benefit.

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