China's miracle growth is largely driven by the manufacturing sector. Historically its industrial production grew at a faster rate than GDP. The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. High commodity prices and rapid wage inflation has driven those costs up. Once a factory is built the costs of running it are to a large degree independent of the utilization level – they are fixed – a classical definition of operational leverage. On top of these factors, laying off workers is a politically sensitive process in China, which creates another layer of fixed costs.

High financial leverage: Debt is the instrument of choice in China. Due to a lack of equity-fund- raising alternatives (their stock market is very young), bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China – this generates a great degree of financial leverage. (Though according to my friend Bill Mann, The Motley Fool’s advisor of Global Gains newsletter and a frequent visitor to China, state owned enterprises are much more leveraged than private enterprises.)

Total operational leverage: Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage.

Total operational leverage in China is elevated further as factories are built to accommodate future demand – this is a classical byproduct of LGSO. It is a human tendency to draw straight lines and thus making linear projections from the past into the future. During the fast growth period the angle of the straight lines is tilted upward, causing an over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. (Fear of over investment is overrun by fear of losing customers.)

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