FYI | Jun 15 2011
By Carl Delfeld
Give China its due. In 1990, its economy was the same size as Taiwan’s.
Now it’s more than 10 times larger.
This explosive growth has led many China bulls out there to fervently believe that Chinese economic growth and its stock market are on an unstoppable upward trend. And that it’s a one-way bet and a sure ticket to heart-stopping returns.
We’ve heard these sentiments before. “The market can never go down.” This is a cause for concern, because the ash heap of investing history is reserved for those who believe they could never be wrong.
There are good reasons to be confident in the market long term. With its growing population, expanding middle class and strong manufacturing base, the nation’s market is rising along with capitalism. But what’s also interesting is that the China bull story is so strong and captivating that many haven’t even noticed that the Shanghai market is down approximately 20 percent since July 2009.
Sure, this could be just a lull, and cheap Chinese stocks are ready for another take off. But it’s important to take a minute and look at five macro-risks in China before you can drill down and find favorable long-term investments.
China’s Formula For Success
The recipe for Chinese growth so far isn’t some magic formula. It’s been based on low wages, huge amounts of investments and a focus on export growth.
But I have some unwelcome news. The country has substantial overcapacity in manufacturing and infrastructure, as well as deteriorating credit quality and weakening export markets. And they’re experiencing a sharp correction in housing prices after more than two decades of explosive growth. This morning, The Wall Street Journal reported that real estate prices in nine of its largest cities fell by 4.9 percent year-over-year in April alone. This after prices rose 21.5 percent the year prior. With investors now seeing downturns in their real estate holdings, this could impact consumer spending in the short to mid term.
– Economic growth is slowing as the effects of China’s giant stimulus program end.
– The residents in Beijing are wrestling with higher food prices and wages that are eroding the country’s competitive edge.
– Spooked by this higher inflation, the country is entering into its ninth month of monetary tightening.
Unfortunately, its brittle political system will make the chances of coping with all these issues and adjusting to consumer-led economic growth a real challenge. A growth rate far below that expected by the markets could, in turn, lead to a Chinese crisis.
China’s Industrial Growth Slowing
China’s industrial growth, already in its fourteenth year, isn’t charging at the same rate it once was. Investment has increased at a faster rate than GDP in nine of the past 10 years. Furthermore, research by Pivot Capital Management shows that the longest previous period of investment-led economic growth was nine years, experienced by both Thailand and Singapore.
Many think that China’s growth is built on exports, but investments represent 70 percent of GDP, and the return on every extra dollar invested in China is decreasing.
– In 2000, it took $1.50 of credit to generate $1 of GDP.
– But by 2009, it took $8 of new credit to generate a $1-increase in GDP.
Some examples of Chinese overcapacity are its steel capacity, equal to that of America, Japan, Russia and the 27 countries of the European Union all put together, and an aluminum capacity eight times larger than America on a per capita basis.
Wage and Global Manufacturing Edge Down
China’s role as a low-cost base for global manufacturing is also diminishing.
Apax Partners studied five manufacturing segments over a five-year period and found that China’s pricing advantage for goods arriving in California relative to domestic prices has declined from a 22 percent advantage to just five percent. Are American CEOs going to want to continue to assemble stuff in China given all the logistical headaches that go with 6,000-mile supply lines? Especially since a recent study by the International Labor Organization found Mexico’s manufacturing wages to be only 13 percent higher than that of China.
Private Exporters Struggling
Meanwhile, small- and middle-sized Chinese private company exporters, already struggling with paper thin margins, are being battered by rising raw material costs and limited access to bank lending. This is serious business since small- and medium-sized enterprises account for 80 percent of all jobs and 60 percent of industrial output, according to government officials.
About 90 percent of lending by China’s four leading state-owned banks goes to other state-owned enterprises. This should put aside cherished hopes that China will, over time, turn more control and ownership to private capital and management. One need look no further than China’s 10 largest companies, which are all state owned or controlled, as are 34 of the top 35 companies listed on the Shanghai exchange.
China’s Grave Environmental Situation
Three decades of rapid economic growth have left China with a “very grave” environmental situation, according to Ministry of Environmental Protection Vice Minister Li Ganjie. Pollution has plagued the countryside, he added, as dirty industries shifted from cities to rural areas. The country lacks a true governmental agency to monitor environmental conditions, or our version of the EPA. In fact, despite its massive holdings of U.S. treasuries, China still depends on U.S. handouts to monitor ecological damage created by their energy production. In 2010 alone, the EPA offered six grants, valued at $1.28 million, to China to promote environmental research, reduce carbon emissions and study methane in coal mines. With such little structure in its environmental monitoring, one should question the other gaps in oversight that might plague the economy.
China’s leadership, which faces a shake-up next year, celebrated its sixtieth anniversary of communist party rule with chants of, “Nothing can stop us. Go. Go. Go.”
But I suggest raging China bulls take a minute and “Think. Think. Think.” Sure, there are reasons to be optimistic about the long-term growth of the Chinese market, but every investment has risks, and China is certainly no exception. Come back next week when we’ll take a deeper look at various industries in China and several opportunities for investors looking to capitalize on long-term growth of the market.
Good investing,
Carl Delfeld
Reprinted with permission of the publisher. The above story can be read on the website www.investmentU.com. The direct link is: http://www.investmentu.com/2011/china-bulls-risk-and-reward.html
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