Investment may slow: Will consumption fill the void?
The below graph reflects the rapid growth, as well as extremely high level, of investment as a percentage of gross domestic product, 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 China’s 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 implication for China’s equity markets. More specifically, will the recent trend of domestic consumption growth be sustained, supporting the China-based revenues of Apple and Google as well as China’s Baidu?
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 a 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 U.S. fixed investment at approximately 13% of GDP and Japan at around 22% of GDP post-2008, can China sustain 40%-plus levels of investment?
Is this level of investment sustainable?
Plus, fixed investment continues to grow as a percentage of GDP while consumption as a percentage of GDP remains low. While growth in fixed investment has been responsible for the rapid growth in China’s economy, rising from around $1 trillion in 2000 to over $8 trillion today, the continuation of such high levels of investment relative to consumption are 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 become unattractive. (Note that the above consumption data for 2013 is an estimate.)
Debt returns decline
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 mere 17 cents of growth. Given this dramatic deceleration of the multiplier effect associated with debt growth, it would appear that a 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 the shelves in Walmart in the USA, where inventory growth rates have outpaced sales growth rates in 10 of the last 12 quarters.
China’s 20-year gamble
As the Wall Street Journal pointed out, 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 we noted in a related article, 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 USA 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. China’s economy is highly leveraged to economic growth rates in the USA and Europe. The current improvement in consumption growth in China is encouraging. However, it would be more comforting to see further gains in consumption as potentially excessive investment levels decline. In the near term, it’s important that China not create an excessive production capacity overhang, and capacity utilization levels need to improve before more production capacity develops. The supply chain in China is still looking a little top-heavy.
As the above graph suggests, Apple—not to mention Google and Baidu—enjoyed a welcome reprieve from the 2008 crisis when the Chinese government rolled out the large-scale stimulus package. Investment levels soared, wage growth also hit record levels in 2012, and sales were brisk. However, even though we’re now seeing a modest pick-up in domestic consumption, this improvement in consumption may rest heavily on China’s post-2008 investment campaign. While wage growth in China is still in the lower double digits, an investment-related overhang could limit average wage growth in the future, and the large market of China’s consumers outside of the already well-penetrated major cities may not be interested in acquiring smartphones over standard cell phones anytime soon. The results from Apple’s recent tie-up with China Mobile will reflect the extent to which China’s non-urban consumers can add to higher-end items such as Apple’s iPhone or PCs. Early indications from the China Mobile partnership are encouraging, though the next three quarters will tell a more complete story of Apple’s China-related growth rate will pan out.
To see how the “investment-related overhang” reflects in China’s weak purchasing price index, please see the next article in this series.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.