Are we seeing the end of China's investment bonanza? (Part 1 of 5)
China’s investment boom
The below graph reflects the rapid growth, as well as extremely high level, of investment as a percentage of gross domestic product, or GDP, in China’s economy. Investment spiked with the creation and growth of “special economic zones” post-1992. The second wave of accelerating growth occurred as the world emerged from the dot com crisis post-2000. The third wave of accelerating growth occurred as the China government’s $586 billion stimulus package entered the economy post-2008. The question arises: In light of weak global economic data post-2008, is China’s high level of investment appropriate given altered global economic circumstances? This series examines trends in China’s investment data and considers the future implications of China’s equity markets.
China’s investment boom: Prudent economic planning or political desperation?
The above graph suggests that the level of investment as a percentage of GDP relative to consumption as a percentage of GDP may have become excessive. In particular, the resurgence in China’s investment post-2008 crisis, bringing investment to post-1982 highs as a percentage of GDP, is cause for concern. You’d wonder if pushing investment to peak levels during a period of slowing global economic growth is prudent economic planning, or simply a political act of desperation. With US fixed investment at approximately 13% of GDP and Japan at around 22% of GDP post-2008, can China sustain 40%-plus investment levels?
Is this level of consumption sustainable?
Plus, fixed investment continues to grow as a percentage of GDP, while consumption as a percentage of GDP continues to wane. While growth in fixed investment has been responsible for the rapid growth in China’s economy, rising from around $1 trillion in the year 2000 to over $8 trillion today, the continuation of such high levels of investment relative to slowing consumption is disconcerting. While it’s prudent financial planning to grow investment and curtail consumption when additional investments yield great returns, it’s also prudent financial planning to restrain additional investment when the returns on investment decline—and begin to become unattractive.
Gordon Chang notes in Forbes that the days of credit-fueled growth may be facing a dramatic slowdown, as every dollar in credit growth in 2007 was associated with 87 cents of growth, whereas currently, every dollar of credit growth is associated with a paltry 17 cents of growth. Given this dramatic deceleration of the multiplier effect associated with debt growth, it would appear that a very significant near-term deceleration of economic growth is underway in China. Unless China can pick up the pace of its own consumption, cheap Chinese goods will continue to pile up on Walmart shelves in the United States.
China’s 20-year gamble
As pointed out in the Wall Street Journal, China’s shift toward modernization and urbanization is a tremendous work in progress, based on a long-term economic view. While China’s central planning has performed fairly well so far, as noted in a prior series, there are many reasons to suggest that China is potentially taking a great leap of faith in pushing forward with aggressive expansionary policies. The media reports of the creation of “ghost cities” that have been built in anticipation of continued growth in urbanization. Unless consumption growth rates pick up in China and abroad, these ghost cities could see occupancy rates remain lower than expected for some time—an additional source of dead capital in tough economic times.
Should economic data remain soft in the United States and Europe, it may be increasingly challenging for China’s central planners to achieve their growth goals. With an economy that’s 30% exports, China may need to rethink the trend described in the above graph. The modest decline in investment growth may need to decelerate further and faster, and the modest increase in consumption in China may have to accelerate faster than anticipated. Too much investment and exportation, and not enough private consumption, render China a very vulnerable economy—just as Japan was in the 1980s. Make no mistake: China’s economy is highly leveraged to economic growth rates in the United States and Europe.
What this means for equity investors
Investors focused on China’s markets should exercise caution. Just because China builds something doesn’t necessarily mean the build will be a profitable investment in the near term. Plus, with the specter of sequester looming in the United States, pressures on China’s declining growth rates could intensify. As China migrates to a single-digit growth rate economy with higher wages, attention’s now turning to the banking sector’s ability to manage ballooning debt. One study by CLSA analyst Francis Cheung notes that total Chinese debt has doubled in the last four years and could rise from around 198% of GDP by the end of 2012 to 245% of GDP by 2015. The Fitch Ratings agency has signaled a warning on the growth rate of Chinese debt. Yes, this data has all the warning signs of a near-term bubble and correction for China.
Inventory buildup: A warning sign
While China’s export machine is a great source of low-cost manufactured goods, producing low-cost goods faster than the world can absorb them can lead to a significant back-up in production. CLSA analyst Chris Wood notes that inventory-to-revenue ratios have reached record highs in the first quarter of 2013—rising from nearly 70% in 2007 to nearly 140% today—essentially doubling. Until China can manage to consume more of its own products and inventory, corporate profits could come under pressure in the near term, and China’s equity markets could face another round of selling pressure.
For investors who think China can orchestrate a smooth deceleration in economic growth without significant disruptions to the banking system and also contain inflation, enhance productivity, manage investment growth, and grow domestic consumption, perhaps the weakness in Chinese equity prices over the past two or three years would present a more attractive price. China’s iShares FTSE China 25 Index Fund (FXI) is down roughly 15% from its November 2011 post-2008 highs. For China skeptics seeking to embrace the more recent economic trends seen in Japan and the United States, as reflected in Japan’s Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ), as well as the USA S&P 500 via the State Street Global Advisors S&P 500 SPDR (SPY) and Blackrock’s S&P 500 Index (IVV), the US and Japan markets may appear more attractive than China’s iShares FTSE China 25 Index Fund (FXI) and South Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further analysis as to why Chinese equities could continue to underperform Japanese equities, see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.”
For related analysis, please see the following series.
- Japanese exports: Are we seeing an “Abenomics”-led recovery in Japan?
- “Abenomics”: A bull market for Japan’s consumers?
- Analysis: Capital investment in Japan
- U.S. consumer spending: Sustaining the unsustainable?
- U.S. investment: Have capitalists gone on strike?
- China’s exports: Is the golden age of cheap labor coming to an end?
- Slowing export growth rates cull China’s equities
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