Will slowing foreign investment cool consumption in China?
China’s waning foreign investment
The below graph reflects an ongoing decline in the percentage of foreign direct investment (FDI) in China as a percent of China’s gross domestic product (GDP). You can see the dramatic increase in FDI that occurred in China in 1992, when China began to create its “special economic zones,” which served as the early manufacturing areas in China’s transition to a more open capitalist economic system.
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While the absolute rate of FDI as a percentage of GDP has been declining, you should remember that China’s GDP, when measured by the current US dollar, was just passing the $1 trillion mark in the year 2000 and is now exceeding $8 trillion, 13 years later. So the rate of FDI in the year 2000 may be around the same rate of FDI today, though the absolute magnitude of overall FDI is also nearly eight times as high as well. This article examines the role of FDI in China’s economy, and considers the implications for China’s economic system and equity markets in the future.
As the above graph reflects, the current level of FDI as a percentage of GDP is roughly half of China’s peak levels. Similarly, in the United States, current levels of FDI as a percentage of GDP are also half of where they were during peak levels of the year 2000—when the dot com bubble was at its peak. These high levels of FDI are consistent with the trend in economic globalization, in which global investment capital flows are free to seek out higher returning investments globally. This has been a great boon to the development of the Chinese economy, as multinational companies, especially in the manufacturing sector, have invested heavily in China-based manufacturing facilities, and have earned handsome profits as a result.
The global competition for investment capital and comparative advantage
The global competition for capital has led to strong capital flows into China, as the above graph demonstrates. In theory, this is a positive step in economic evolution, which should lead to higher levels of productivity growth on a global level, as countries such as the US can outsource low-end manufacturing labor jobs in favor of higher productivity and higher-paying jobs in the service sector.
This phenomenon is known as “economic comparative advantage.” Each country simply invests its resources into what it can produce most efficiently in relation to its competitors, while outsourcing the goods and services that it produces least efficiently. In other words, consumers run trade deficits with their local grocery store because farmers grow food more productively than they do at home. Consumers run large trade surpluses with their employers in order to acquire food and other resources that they also can’t produce efficiently on their own.
When comparative advantage works well
As reflected in the above graph, the rapid rise in FDI in China led to the dramatic development in China’s low-end manufacturing base from 1991 to 2000. During this time, you could argue that investment capital in the US was “freed up,” to invest in new higher-productivity technologies that would lead to an increase in global GDP and thereby raise living standards. Some may argue that this is exactly what happened. During this period, capital flowed aggressively into the dot com bubble or digital revolution in the US, setting off an investment renaissance in the US and Europe. This development was a large positive factor for raising equity prices in the US and abroad, and the US economy generated strong growth, consumption, and tax revenues during this time. Accordingly, the Clinton Administration, unlike the Obama Administration, had the luxury of tackling high-quality problems.
The extent to which the dot com bubble or digital revolution could have been caused by China’s emergence as a major exporter, or simply corresponded with China’s emergence as a major exporting power can be debated. As economists point out, major breakthroughs in economies that come about through innovative revolutions are hard to predict—whether such innovations be the car, the jet aircraft, or the Internet.
Regardless, you can argue that, on net, an economy is more likely to aggressively invest in innovation in a period of weaker capital demand and lower interest rates. However, on net, such dynamics are a function of the cost of investment capital that prevail at that time (cost of equity and the cost of debt financing) in relation to the expected return of the new innovation that could potentially be monetized. In other words, people are likely to invest in new ideas when the old ones have run their course and become less profitable. However, the appetite to make new investments depends on the perceived value of the new investment, and the economy’s perceived ability to consume the new technology in the future.
When comparative advantage struggles
Comparative advantage can struggle when the excess investment returns in the innovating country decline. For example, if low-end manufacturing companies in the US earning single-digit returns in their capital are replaced by Chinese low-end manufacturing companies that can earn double-digit returns on their capital, that can be a good thing if new companies in the US invest in new innovative technologies that also lead to double digit returns on their capital. In this scenario, both countries gain double-digit returns on investment capital and shed single-digit returns on less productive capital—or at least dilute the single-digit return portion of the economy. However, when the innovating country’s returns on capital slowly decline, and possibly fall below the returns on capital of the outsourced provider, the innovating country can see its economic growth decelerate. So, while comparative advantage seems to work well in the long run, it can encounter inter-temporal headwinds.
Where we are today
As noted in a prior series on the US, the US has been experiencing a long-term decline in its rate of investment growth—mainly long-term fixed investments. This trend has picked up significant momentum post-2000, and it also reflects in the above graph in the form of FDI investment as a percentage of the US economy. The US economy has become increasingly reliant upon consumption to sustain economic growth. While consumption as a percentage of GDP remains relatively high in the US, the rate of growth in consumption has continued to slow, and perhaps it’s reaching its limit. So the US government has had to step in, post-2008, with large government deficits in order to maintain a minimal level of economic growth that is consistent with, at minimum, avoiding a significant economic decline across the board.
Where we’re headed
While the US economy shows modest signs of recovery, there remains a variety of issues for the Chinese economy. As noted in the series on China’s exports, despite China’s stable trade surplus, import and export growth rates have rapidly decelerated post-2008. Plus, as noted in Part 1 of this series, China’s consumer confidence has been on a significant decline post-2008, and is at all-time lows since adopting capitalism in the 1990s. While FDI is still at a high level in China, should the current trends in both China and the US continue, growing consumption could become increasingly challenging.
These dynamics present near-term headwinds for China’s equity markets. Investors will need to carefully monitor both consumer confidence and absolute consumption levels in China and the US. While low interest rates and government spending have been positive sources of economic support, it’s yet not clear that the global economy can stand on its own two feet without government assistance, and thereby kick its Keynesian crutches.
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.”