China PMI And The Global Economy

China’s PMI was at a standstill last month. China’s official Purchasing Managers’ Index dropped to 50.9 in June from 52.0 in May. That was barely higher than the 50 mark that separates expansion from contraction. The information was released by the China Federation of Logistics and Purchasing and National Bureau of Statistics. The numbers are probably a canary in a coal mine for global economic activity.

The PMI slowdown was blamed on monetary tightening by the central government. Companies find it much more expensive to get capital for expansion. But that is hardly an explanation. It ignores supply and demand principles. The numbers also imply that China’s manufacturing capacity is too large.

U.S. GDP was below 2% in the second quarter. Most EU economies have contracted this year. Nations that have entered periods of austerity are likely to be driven into recession as governments and central banks withdraw stimulus programs. Demand for manufactured goods, mostly from China, has almost certainly been on a downward trend all year. The Japan earthquake has hurt demand from that nation. China’s most powerful engine for demand for its factory goods may now be its own consumers. They are, as a group, not large enough to offset overseas demand weaknesses.

The PMI numbers may also show that China has too much production capacity. Purchasing manufacturers may have large inventories of unfinished goods. These are spread across factories that have increased in number almost every year over the last two decades. Each purchaser’s activity is affected by the number of competing plants. Overcapacity breeds slow growth for most manufacturers even if outside demand does not fall.

Purchasing may also have been harmed by extremely high commodities prices. The cost of goods sold sways decisions to manufacture finished product as all factory owners become concerned that margins may be negative on produced goods. Transportation costs also push down margins.

None of the factors that have an effect on the slowdown of PMI would matter as much if demand from overseas was robust. Strong demand would have allowed manufacturers to raise prices in many cases to offset commodity inflation. Demand would have also increased factory utilization. Every sign about factory activity points toward one conclusion: global demand for finished goods has stumbled.

Douglas A. McIntyre