This type of thinking results in tremendous overcapacity when demand cools. Here is an example: Let’s say a company saw demand for its widgets rise 10% year after year. It builds a new factory to accommodate future demand, let’s say five years. It will likely model a 10% annual increase in demand as well. But what if demand comes in at 6% a year over the next five years? This will translate into overcapacity - not 4% but 20% (4% per year times five years). Suddenly you don’t need to build factories or add capacity for awhile.

This greatly leveraged growth is terrific as long as the economy continues to grow at a fast pace: sales rise, costs rise at a slower rate (in large they are fixed) - margins expand - the beauty of leverage. However, leverage is not so sweet and soft when sales decline. Overcapacity is a death sentence in the manufacturing (fixed costs) world. As companies face overcapacity or slowdown in demand, they try to stimulate sales by cutting prices, which in part lead to price wars (similar to what we observed in the U.S. between Sprint, MCI and AT&T in the long distance business during the mid 90s) and to a fatal deflation. Sales decline, costs remain the same – margins collapse.

The weakness in the US and European economies will temper demand for Chinese made goods. China is already showing first signs of slow down - inflation is increasing and rate of real growth is decreasing.

It gets worse: high commodity prices.

Chinese demand for stuff (oil, metals, machinery etc.has a tremendous impact on commodities, driving their prices many fold. High (and rising) commodity prices are negative for developed world economies but they are catastrophic to developing economies – they bring comparatively higher inflation and often stagflation.

Here is why: Inflation is sourced from two broad categories: commodities (stuff) and wages.
Emerging markets are twice as cursed when it comes to inflation: Commodity prices (less shipping costs and government controls – the Chinese government limits price increases on certain commodities, but we know that doesn’t work in the long-term) are the same around the world.

Thus the US and China will see a similar increase in commodity prices (at least in dollar terms). But the commodity component represents a larger portion of the total product cost in China than in the U.S., as wages in China are a less significant component of total cost.

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