China’s struggling capacity utilization is signal of effective demand limit

As output increases, there is an effective demand limit which slows down the utilization of capital and labor. Utilization of capital typically slows down before labor.

cap ut emp

The circled areas show times in the US when capacity utilization (blue) declined as employment (red) was rising or holding steady. This pattern normally happens before a contraction in the economy. We did not see this pattern before the recession at the end of 2007. Employment actually started to fall before capacity utilization.

So what has been happening with capacity utilization in China? Here are some excerpts in an article yesterday from (Bold is my emphasis)

“The Chinese economy is also thwarted by some deep-rooted obstacles, including excess capacity in certain industries.”

“Liu Shucheng, an economist and CPPCC member, said that, in 2014, China should remove excess capacity in certain industries, prevent risks of local government debt, calm rocketing home prices in some cities, and reduce enterprises’ production and operation costs.”

“Statistics show, by the end of 2012, capacity utilization of only 70 percent was registered in such sectors as iron and steel, cement, electrolytic aluminum, plate glass and ships. P Li, the CASS vice president, said the problem of excess capacity was related to a GDP incentive mechanism decided by an irrational development strategy, which should be reformed fundamentally.”

“The risk of local government debt, estimated at more than 20 trillion dollars by the end of 2013, is also an obstacle hindering the Chinese economy.

Jia, the Finance Ministry official, said, in order to prevent systemic risks due to lack of capital, it was imperative to set up a mechanism of early warning and emergency response for debt risks.”

“The Chinese economy is in a crucial, painful moment of transformation and structural readjustment,” said Feng, the State Council analyst.

Capacity utilization in China has hit the effective demand wall which comes from their limited domestic demand and from the US economy. As the US economy hits its own effective demand limit this year in 2014, China’s delusions of hope will only become more apparent.

China could have expected more potential output in the US recovery, but potential output in the US is looking much smaller than most have thought. And so expecting continued rapid economic growth in China while having to contract certain industries is not sound logic.

Investing in China is much less profitable than a few years ago. Beware…