Is China Running Out of Steam?
By Matthew Rubin, Ing-Chea Ang, Justin Gaines
June 19, 2012
The Chinese growth story is especially impressive. At a time when many economies have struggled, China has continued to expand rapidly, helped by its dominant position in manufacturing, growing middle class and, after the 2008 credit crisis, its successful injections of capital and stimulus to ward off recession. Nevertheless, recent data have suggested that the Chinese expansion is now slowing more quickly than most investors expected. Is the multi-decade growth miracle over? Or have we entered a temporary lull which represents a buying opportunity? We address these questions in this edition of Strategic Spotlight.
Slowdown in Growth
China has been marred this year by bad news including a major political scandal and the declining growth rate, which have served to potentially discourage investors. Forecasters have been downgrading expectations as a wide range of economic indicators such as the Purchasing Managers Index, electricity usage and consumer sentiment have weakened more drastically than previously anticipated. Last month, the World Bank cut its economic growth forecast for China from 8.4% to 8.2% for 2012, reinforcing ongoing concerns.
CHINAâ€™S GROWTH HAS SLOWEDâ€”BUT SO HAS INFLATION
This outlook has been duly noted by the capital markets. As of June 1, 2012, the MSCI China Index has declined approximately 20% from a year ago, strongly underperforming the MSCI All Country World Index, which is down about 5% for the same period. The slowdown in the overall economy is partly a result of self-induced credit tightening to tame inflation and manage growth in the housing sector. Using a combination of fiscal and monetary policy, the government has successfully driven inflation from a peak of 6.5% last July to 3% in May 2012. In addition, the European sovereign debt crisis has had a larger-than-expected impact on exports, reducing Chinese economic activity in key areas such as manufacturing.
We believe that much of the recent slowdown can be attributed to cyclical factors. It also reflects changing priorities within the government to manage growth in a more judicious fashion. For example, recent longer-term policy changes reflect the governmentâ€™s inclination to create a more balanced growth profile for China. Many investors would like to see the economy rely more on domestic consumption than on exports and investments. The transition to a consumption-driven economy will not be easy, as household consumption constitutes only 35% of GDP. However, the rising middle class has the potential to further drive growth in a more stable and sustainable fashion.
Additional concerns include issues related to Chinaâ€™s local government debt and unregulated lending in the private sector. Efforts have been made to fix these issues and we believe the government is serious about instituting meaningful reforms. Furthermore, leaders have been proactive in calling for greater economic liberalization, including reducing the dominance of state-owned companies in the banking sector and developing a more market-based interest rate system. We believe these changes are positive for the economy and can bring improved efficiencies.
While important steps have been taken to fine-tune Chinaâ€™s economy, we believe there remains plenty of room for improvement. At its current level of GDP per capita, China has reached a point where we believe growth could accelerate similarly to Japan in the 1960s or Korea in the 1980s. With wages rising at annual rates of 15%ÂˇV20%, Chinaâ€™s stock of cheap labor has, in large part, been depleted and it will have to rely on higher value-added industries to propel it into the next growth phase. Chinaâ€™s rising middle class, with its high savings rate and low debt levels, remains an underutilized resource waiting to be unleashed, potentially through social reforms that would encourage spending.
Time to Reload
In general, history has shown that economic growth can be choppy, especially where political systems are somewhat opaque, as in China. Large portions of the Chinese economy continue to be inefficient; however, we believe that anticipation of a nearterm collapse is premature given the financial strength of the government and the health of consumer balance sheets. Indeed, there are reasons to be optimistic in the near term. With inflation currently at 3%â€”below the governmentâ€™s target of 4% for 2012â€”there is an expectation within the investment community of more fiscal and monetary easing, even beyond recent cuts in interest rates and banksâ€™ reserve requirement ratios.
Calling for a bottom in the slowdown is somewhat impractical since policy actions act with a lag and external macroeconomic factors such as the European debt crisis could have major consequences. However, itâ€™s worth noting that the valuations of Chinese equities are at very low levelsâ€”the MSCI China Index is trading at about eight times forward earnings (as of June 1, 2012), which is similar to levels seen during the 2008 financial crisis, when Chinaâ€™s real GDP growth rate was at 6.8%*â€”considerably less than the current expectation of 8.2% for 2012. For the long-term investor, Chinese equities could represent opportunity in a time when economic growth is scarce and appears to be becoming scarcer.
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