Monday, November 23, 2009

>China’s Investment Boom: the Great Leap into the Unknown

In this report we describe the background to and the extent of the capital spending bubble in China and identify factors that will precipitate its deflation. We focus on Chinese capital spending firstly because it is the single most important driver of current Chinese and global growth expectations and, secondly and more importantly, investment-driven growth cycles tend to overshoot and end in a destructive way.

We conclude that the capital spending boom in China will not be sustained at current rates and that the chances of a hard landing are increasing. Given China’s importance to the thesis that emerging markets will lead the world economy out of its slump, we believe the coming slowdown in China has the potential to be a similar watershed event for world markets as the reversal of the US subprime and housing boom. The ramifications will be far-reaching across most asset classes, and will present major opportunities to exploit. There are three key reasons why we take this view:

China’s expansion cycle surpassing historical precedents: It is widely believed that China is still in an early development phase and therefore in a position to expand capital spending for years to come. However, both in its duration and intensity, China’s capital spending boom is now outstripping previous great transformation periods.

Policy actions not sustainable into 2010. This year’s burst in economic activity has been inflated by a front-loaded stimulus package and a surge in credit growth. Given their exceptional and forced nature we believe growth rates in government-driven lending and capital spending will collapse in 2010.

Overcapacity and falling marginal returns on investment: Analysis of industrial capacity, urbanisation and infrastructure development shows that China’s industrialisation and structural modernisation are largely complete. Combine this with falling returns on investment, and it becomes obvious that China’s long-term investment needs are grossly overestimated.

China’s Capital Spending in Uncharted Waters
In our view investors have underestimated both the maturity of the Chinese growth cycle as well as the degree to which recent growth is a direct extension of the global credit bubble. This bubble had two major manifestations. The first, which started unravelling globally in early 2007, was evident in excesses in real estate, consumption and private equity. The second manifestation, which has yet to fully deflate, was a boom in capital expenditure, led primarily by

The Chinese economic “miracle”, referring to the past 30 years of growth at an average real rate of 10% can be broadly split into three periods. In the 1980s, the first stage was unleashed by modest reforms of Deng Xiapoing such as liberalisation of prices in the agricultural sector. After a brief pause coinciding with the Tiananmen events, the second stage concentrated on rationalization of labour that saw a proliferation of light industries at the expense of agriculture and State Owned Enterprises (SOEs). The third stage has been focused on expansion of heavy industries and infrastructure. What all three stages had in common was a central role of investments as a driver of economic growth. Indeed, China has emulated the path of other countries that have rapidly developed in the second half of the 20th century driven by high investment to GDP ratios (we focus on Gross Fixed Capital Formation, GFCF, which is a broad definition of investment). However, both in its duration and intensity, China’s capital spending boom is now outstripping previous great transformation periods (e.g. postwar Germany and Japan or South Korea in the 1980-90s, chart 1).

Credit Growth at Critical Point
Similarly to the housing and consumption bubbles in the Western economies, credit has played a pivotal role in the investment bubble in China. Since the beginning of the decade up to H1 2009, domestic credit in China has expanded 50% more than GDP (chart 5). China is an outlier compared to the other “BRIC” countries in terms of the credit to GDP ratio (140% as of H1 2009) and is already beyond the levels that historically have led to sharp and brief credit crises in the past (chart 6). If loans continue to grow at the current 35% rate, credit to GDP ratio will be close to 200% in China already in 2010, even with GDP expanding at 10%. This is a level similar to the pre-crisis Japan in 1991 and USA in 2008. All this points to that credit in China is not going to be able to grow for much longer without risking a major crisis.

Permanent Reduction in Capital Spending Activity
As the dust settles, we believe China will enter a phase of permanently reduced capital spending activity, whereby consumption will become the upper boundary of growth. The deteriorating ICOR ratio discussed above clearly demonstrates that China is running out of easy ways to boost growth through investment. Below we have reviewed the three major destinations for capital spending in the recent years: manufacturing, real estate and infrastructure. Our analysis demonstrates that China is already a country with ample manufacturing capacity and an increasingly welldeveloped infrastructure, which does not support the notion of significant pent-up investment needs in China. Consequently further expansion will not have nearly as much impact on growth as in the past.

Consumption Growth Cannot “Replace” the Investment Boom
In the best-case scenario emphasised by China bulls, private consumption will smoothly overtake investment as the growth engine so that there is no pullback in the overall growth rates. Here, we will start with a very simple fact that private consumption in China accounts for about a third of GDP. As we discussed previously, after a bumper year for credit and investment activity, it is going to be hard for investments to continue growing at 30% in 2010. Even if we assume optimistic investment growth rates of 10% for 2010 and 0% for 2011, leaving the trade balance where it is now, private consumption would have to grow at an average real rate of 20-30% for the next two years for overall GDP real growth levels to hit the magic 10%.

Chinese Investment Slowdown a Global Market Event
Considering China’s role as a trailblazer and locomotive for the current global recovery efforts, any signs of a Chinese slowdown would have significant global consequences. Not only would it challenge the notion of emerging markets leading the world economy out of its slump, but it would also raise doubts over the sustainability and effectiveness of the various stimulus efforts under way in other countries.

Given the stakes involved, we can expect the Chinese as well as other governments to introduce further stimulus measures as signs of weakness appear. This may prolong the top, but as discussed in the report, China has reached an impasse in terms of its dependency on capital spending to generate growth. Although the transition from a high growth model dependent on investments to a slower growth model driven by consumption demand can be pushed slightly into the future (at the risk of causing a credit bust), it cannot be avoided.

To read the full report: INVESTMENT BOOM