Getting China right is one of the most important calls investors have to make. The importance of China is driven by its impact on global growth, incremental consumption of commodities and its emergence as the second-largest economy in the world. If the economic boom in China persists, global economic growth will continue, emerging markets should continue to outperform and global commodity prices will be robust. However, if the bears are right, and we see a huge over-investment-related bust, industrial commodities will collapse, global growth will get a shock and all risk assets may encounter turbulence.
Both sides of the debate seem to agree that China will slow in 2011, and even 2012. Nobody expects China to continue growing at 10 per cent-plus, with expectations converging around 7 to 8 per cent in the foreseeable future. It is being agreed that domestic consumption will increasingly drive this growth. The Chinese government has introduced a slew of measures to raise consumption, such as lowering taxes, improving the social safety net and boosting workers’ disposable incomes.
The bulls believe that China will have a soft landing , exports will hold up and domestic consumption will accelerate — all this will compensate for some weakness in capital spending.
The bears are calling for a hard landing, with a sharp slowdown in capital spending led by real estate and construction in particular. This is the crucial point of difference. China bears are convinced that there has been huge over-investment, poor capital allocation and an asset bubble, while the bulls are far more sanguine. There was a fascinating article on this subject recently in the BCA, some points from which I have tried to encapsulate below.
The bearish case is based on the following:
- China’s investment rate is too high, and has been at elevated levels for far too long. Investment in China is running at 47 per cent of GDP, and has been over 40 per cent since 2005. In both Japan and South Korea, the investment rate peaked at about 38 or 39 per cent. It is hard to believe that there has not been a significant misallocation of capital in a country that has been investing so much and where local governments and state-controlled banks are heavily involved in capital allocation decisions. This poor capital allocation will eventually lead to the creation of non-performing assets in the banking system, poor profitability, stranded assets and falling returns on capital.
- The second point deals with property prices and the imminent bust in construction activity. Various commentators have pointed out that in real terms, property prices in China are one standard deviation above the mean, even assuming that this mean value is rising over time as incomes increase. The average property price-to-income ratio is already about 10 across China and over 15 in the larger cities. The US housing bubble peaked with this ratio at six. Obviously, the ratio will be higher in China since incomes are rising much faster, but the gap remains excessive. The problem is that people who need to buy cannot afford to do that since first-time buyers are priced out of the market. As far as over-building is concerned, residential floor space under construction in urban China has surged seven-fold in the past decade to over 3 billion square metres. The number of new housing units constructed as a percentage of the number of households in China (over the last 15 years) is much higher than in Japan or the US at any point in their history. China also consumes 50 per cent of the world’s cement. Also, per capita cement consumption in China is now higher than any other nation, despite half of the country’s population living in rural areas. Such cement intensity hints at massive over-building in the cities. Data from BCA also show that investment in residential construction as a share of GDP in China exceeds that of Japan and Korea at the peak of their construction booms.
The bears make the case that as the government is tightening monetary conditions and putting in curbs on speculative property purchases, demand for housing at current price points will drop, just as a huge slug of new supply comes to market. This will force property prices to correct, and private construction activity will contract significantly, hitting growth and commodity prices. Many real estate firms will get into serious trouble and banks will be stuck with dud collateral and assets.
The bulls obviously disagree and make the following case:
- As regards over-investment, the incremental capital output ratio (ICOR) in China is not much higher than its Asian peers and does not indicate any gross inefficiency in capital spends. China has also been the biggest recipient of foreign direct investment over the years, indicating that global multinationals are able to earn reasonable returns on capital, unless you assume all these companies have been, and continue to be, irrational. The return on equity in China is reasonable and stable, with no collapse in return ratios. The improvements in infrastructure brought about by this investment are also noticeable and are enhancing productivity in the economy. Just because China invests so much does not imply that it is inefficient.
- On the over-build in the housing sector and the imminent bust in construction activity, the bulls totally disagree. They think that data on excess housing units, constructed or under-construction, do not take into account the removal of poor quality housing stock from the system. Even if one assumes that only 1 per cent of the existing housing stock is replaced, the net increase in housing stock over the past decade has barely kept up with household formation. Data on housing prices on a national basis also show that since 1998 – when China implemented housing reforms and privatisation – home prices have lagged household incomes, implying no deterioration in affordability on a nationwide basis. China is still in the middle of its urbanisation process, with half the country’s population still residing in rural areas. All other major economies that rapidly underwent urbanisation experienced a massive boom in residential construction, much like China today. While private construction activity may slow, as rising rates crimp demand in the short term, the government’s desire to build 36 million units of low-cost housing should cushion construction and investment activity. The froth largely exists in the top-end of the market, and is not large enough to impact the broad economy.
It seems if China has a problem it will be short-term and cyclical. Given the type of productivity growth still available to an economy that has 670 million people living in the countryside even today, most of whom will move to manufacturing or service jobs in the cities, it is difficult to see China go into any type of an extended slowdown. The government has enough fiscal levers available to cushion the economy, and domestic consumption still has a long growth runway left. China’s global competitiveness as a production base is still unquestioned.
One hopes that China will slow to cool off commodity prices, which will bring India great relief. But do not bet on any slowdown being significant in either duration or depth.
The author is fund manager and chief executive officer of Amansa Capital
