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Today, the materials industry is grappling with a significant downturn. The materials sector, once buoyed by China's urbanization and industrialization initiatives, now finds itself in a state of oversupply. This oversupply has led to flattened margins, and the early signs of significant rationalization. Only now has the industry begun to understand the full extent of this new reality. While the initial blame was laid at the door of the pandemic and post-COVID recovery, the complexities of this downturn suggest a larger narrative shift is underway. Navigating this uncertain future means re-evaluating what we believe about China’s growth story.
For years, the world watched as China executed a capital-intensive growth model, powering its way to the forefront of global industry dominance. With an insatiable appetite for materials, China seemed poised to continue this trajectory, moving steadily up the technology pyramid. According to this narrative, China was simply too big, too strategic, and too determined to fail in the long run. In spite of what we know from economics of the perils of central planning (i.e. misallocation of capital), many view its current economic challenges as mere blips, temporary setbacks on an otherwise upward path. Is this the case? Is the juggernaut still powered-up and plowing forward as ever?
A closer examination suggests a more nuanced story that can help answer that question. The capital-intensive model with significant forward build requires 2 factors to be successful: continued economic and population growth to fuel demand and large supplies of speculative capital to finance the forward build. As long as there is excess demand, and plenty of capital, the model works. Looking at what’s happened already in 2 key industries on which China has run this model: real estate and basic materials, we see a really different picture. Though real estate is a domestic market and China has been selective in reporting, the evidence is clear. The overbuild has come to a halt with significant excess inventory that will never get filled. Largest real estate developers are in financial collapse as are local governments which were heavily invested in this sector. More important is that real estate served as a way for domestic Chinese individuals to invest, and buying real estate speculatively was common. Real estate speculation became a national pastime, a bubble that many overlooked until it burst. The capital destruction involved in this market failure is significant, with an estimate at $18 trillion, greater than China's GDP and greater than the 2007 financial crisis. A big part of that is accumulated savings, and standard of living.
The materials sector followed this pattern. With China unable to keep up with domestic demand growth due to construction and the additional materials consumption that comes from standard of living improvements, building new capacity seemed an easy financial decision. China was on the verge of reaching self-sufficiency in key materials such as polyolefins when real estate tanked. A near supply deficit flipped to a gross over-supply, with 5 years of new capacity still under construction. This oversupply is so large that it’s plunged many of the global materials markets into significant financial turmoil.
Among many factors, we see two that signal the end of China’s capital-intense forward-build model. The first is capital hesitancy. The model works with speculative capital until the bubble bursts once. After that smarter money will be cautious about speculation. Local government capital is in short supply. And the Chinese people will be very cautious about risking their life savings again. It’s hard to see where speculative capital could come from. Private foreign investment, which came in at the end of the run-up, isn’t going to see the same attractive conditions and has better options.
But the real nail in the coffin is one that is certain and cannot change. China’s population is in the midst of a demographic collapse, which is irreversible. Between the early 1-child policy, and the natural birth rate decline accompanying the fastest economic ascendancy in history, China’s has a disastrously low youth population, and total population is already in decline. Using officially reported figures, estimates are that half the population will be lost by end of century. But official figures are now coming into question (even within China), and significant shifts in those bases, coming out of the younger demographics would cause a far more precipitous decline. What’s certain is that this is already impacting Chinese labor costs which is increasing at the fastest of any economy in history.
We think these 2 factors are critical for getting the forward narrative right.
We see the China narrative in a much more pessimistic light than the conventional historical narrative would suggest. And in a sense the vindication of the skeptics of central planning. It took a long time but the bubble has clearly burst, and another isn’t soon to follow.
China is in a much weaker position that it lets on, both from a demand-side, and an investment-side. China’s turning its face to export markets (in basic materials and even in high-tech) rather than being a sign of dominance is one of desperation, as it looks to prop up businesses by mopping up capacity with global demand. It’s essentially trying to socialize its central-planning folly onto global markets. Let’s hope global markets don’t stand for it.
But the damage has already been done in materials and sunk capacity investments are placing global materials markets in bad positions already. In light of these developments, materials industry leaders must reevaluate all growth assumptions. Two critical questions need answering: What do our projections look like if China's material demand growth, or more-likely decline, is no longer a factor? And how much tougher will producers domestic growth become if our value chains are saturated with oversupply and Chinese products make their way into our markets?
Furthermore, geopolitical policies play a vital role. China's entry into global markets was contingent on its reforms and integration into the World Trade Organization (WTO). However, it seems to be doubling down on authoritarian controls, asking the world to bear the costs of its policies. This shift demands a reevaluation of political strategies.
We think an attitude of fear regarding China is misplaced. Instead, policy that hastens rationalization with China bearing a significant portion of that will be a healthy outcome for the industry.
China’s oversupply in materials markets does near-term harm to global markets, and rational producers will pull all levers to stay viable including structural cost changes, and possible rationalization, something already happening in Europe, the region in the weakest position and facing acute de-industrialization.
China's growth narrative is shifting, and this new story will have profound implications for global industries. The materials sector, in particular, must adapt by critically assessing growth assumptions and geopolitical strategies. The challenge is to navigate this evolving landscape with foresight and flexibility, ensuring that we don't just survive but thrive in an uncertain future.
Until next week,
Kendall -
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