Putting China into Perspective

Conclusion: In the note below, we attempt to quantify and contextualize Chinese economic growth scenarios over both the intermediate and long term. Needless to say, a structural downshift in rates of Chinese economic growth is not at all out of the band of probable outcomes over the long term and this has major implications for a great many corporations and investor portfolios worldwide.

In the near-manic construct that has become financial analysis, it helps to have a little context. Specifically, we think it’s worth reminding that Chinese growth has been slowing for the larger part of the past two years and the consensus freak-out you’re seeing/hearing about Chinese economic growth is largely overdone. We do, however, agree with the Chinese equity market and the price of copper that the -280bps (-23.5%) slowdown in China’s YoY Real GDP growth rate from the 1Q10 cyclical peak remains a headwind to global growth.

Putting China into Perspective - 1

For reference, if the U.S. had slowed by a comparable amount from its 2010 cycle peak, our domestic Real GDP growth would be only +0.7% YoY (down from the latest reading of +1.6% YoY).

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Speaking of the market, Chinese equities, which are down for the second straight year and have fallen -27.3% since the start of 2010, have been discounting this deceleration in growth for quite some time now. Given, we don’t think it pays to use today’s GDP print as an opportunity to jump on the “Chinese GDP is getting halved bandwagon” (which is expected to happen within the next year by 12% of the respondents in the latest Bloomberg Global Poll of Investors).

That said, however, we continue to believe that bottoms are processes – not points – and China is no different than anything else in the price discovery matrix. In our opinion, valuation remains no catalyst here until inflection points in each of our three core factors (growth, inflation, and monetary/fiscal policy) are within reach. The rub, as always, will be in determining what is within reach (catalysts becoming supportive) vs. what is priced in (consensus sentiment presenting an asymmetric opportunity).

Quantitatively speaking, our models are currently pointing to a 1Q12 bottom in Chinese real economic growth in the mid-to-high 8% range (pending more data, of course). That doesn’t seem so bad from current levels, but it’s an enormous delta from the pre-crisis peak quarterly growth rate of +14% YoY registered in 1Q07 (down nearly -40%, to be exact).

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Keeping that in perspective, we argue that consensus has been having a “big boy talk” with China pertaining to the sustainability of its current economic growth model of investing in what are widely rumored to be largely unproductive property assets and transportation infrastructure. Fixed asset investment now accounts for 69.3% of Chinese nominal GDP – up +2,870bps/+70.1% from the 40.6% ratio recorded just eight years ago! As of 2010, gross domestic capital formation contributed nearly half of all of China’s economic growth (48.6%) – 1,360bps higher than India, which we’d argue is a comparable country in both size and economic development. Additionally, at nearly half of GDP, modern-day China is more levered to gross domestic capital formation as a means of economic growth more so than Malaysia, Thailand, Indonesia, South Korea, and Hong Kong were in the years leading up to the 1997-98 Asian Financial crisis.

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Putting China into Perspective - 5

 

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Given the long-term headwinds facing both China’s property market and banking sector (which we have quantified in recent notes; email us for copies), it’s likely that the peak in these ratios is in the rear-view or within reach. 

Whether China will be able to gracefully rebalance its economy towards a more consumer-driven growth model in the process – as outlined in the current 5yr plan which calls for only +7% economic growth rates – will go a long way towards determining the slope of global economic growth over the long-term TAIL – particularly given the debt, deleveraging, demographics, property market, and structural unemployment headwinds facing the U.S. and parts of the E.U. Obviously this has major implications for a great many corporations and investor portfolios worldwide.

Indeed, that is a TAIL risk worth pondering for any long-term investor. As the law of large numbers reminds us, as China continues to grow larger (now the world’s second-largest single-nation economy), a structural downshift in rates of Chinese economic growth is not at all out of the band of probable outcomes over the long term.

Darius Dale

Analyst