27th October 2015
James Yardley, Senior Research Analyst
Where Next for China?
I've spoken to a lot of fund managers about China, and the general consensus is that China will be OK, but the contrarian in me can't help feeling a bit uncomfortable that fund managers don't seem more worried. Nobody really wants to consider the possibility that the situation in China might deteriorate. Unemployment in China is never mentioned and, even though many agree the growth data may be exaggerated, I've never even heard anyone consider the possibility of a Chinese recession at some point. There seems to be a natural unconscious tendency to support the view that China is all right, perhaps because the alternative is too discomforting to consider.
A lot of China's GDP growth has been driven by massive government building programmes. This huge investment has taken China's overall debt to GDP from 150% to 280% since 2008. Worryingly, debt is rising much faster than GDP. This is not sustainable, at some point China's building programme is going to have to slow down and that is going to have huge consequences.
China's capital spending as a percentage of GDP is currently 45%. This compares with a more normal spend of around 18% in the UK (although you could argue we could do with spending more on our infrastructure!). Japan's capital spend, as a percentage of GDP, peaked at 36% in the 1970s. South Korea's peaked at the same level in 1990. In both cases the level was unsustainably high and subsequently fell. There is massive overcapacity in the Chinese economy, and capital expenditure will have to fall to at least 35% and probably further.
China's huge increase in gross capital spending has been matched by a massive increase in the capacity of many industries. Most notably the steel industry, where capacity has more than doubled since 2006 from under 500 million tonnes to over 1.15 billion tonnes today. Just last week China's leading steel maker opened its new blast furnace in Guangdong Province, which will add another 10 million tonnes of capacity a year.* This combination of increased capacity and slowing demand has caused steel prices to plummet, and the result has been catastrophic for the industry in other parts of the world, as we are witnessing in Britain today.
A collapse in steel prices is being compounded by Chinese state-owned enterprises. 500 million of 800 million tonnes of Chinese steel production is losing money. This is largely because of the strength of the Chinese currency, which has appreciated versus most of its competitors making their steel production less competitive globally. It may partly explain China's recent devaluation of the Renminbi as it seeks to become more competitive. Rather than shutting down loss-making production, the Chinese state is subsidising the losses. This is because China employs an estimated 250 million people in state-owned enterprises and it fears making those people unemployed. That could both weaken the economy further and increase social instability.
The Chinese Housing Market
The recent collapse in the domestic stock market has had a fairly limited effect on the Chinese consumer as only about 10-12% of households own shares.**
The same cannot be said for the Chinese housing market. Chinese home ownership is almost 90% and is amongst the highest in the world. House prices are therefore extremely important for consumers' confidence and their willingness to spend (the wealth effect). Any fall in house prices would be extremely detrimental to the wider economy.
As with all markets, there are two aspects which determine price. Supply and demand. Buyers are required to put down at least a 30% deposit when they buy a property so levels of leverage are relatively low. The real problem with the Chinese housing market is again on the supply side. It comes back to capital expenditure as 45% of GDP. A large part of that investment has gone into building new apartments. The size of the floor space being built is staggering.
In the past 20 years China has built 29 billion square metres of residential floor space, an amount equating to about 21 square metres for every man, woman and child. But what is of more concern is the 12.5 billion square metres of residential floor space currently under construction. It's unlikely the market will be able to absorb that many homes without consequences. At the very least the number of homes being built will have to slow down and that has huge consequences for the mining, steel and cement industries.
What on the face of it appears an even bigger concern is the commercial real estate market. Since 1995 China has built 7.5 billion square metres of commercial floor space, with a further 4.8 billion on the way. That looks excessive. Again it would appear that a slow down is inevitable.
Whilst international markets understand the inevitable slowdown in Chinese real estate they may be underestimating the effect on the Chinese consumer. A massive 49 million people are employed in the construction industry alone.***
Economists estimate that real estate and related industries account for 16% to 25% of GDP.****
China is the second largest economy in the world and its economic performance has huge implications for you and your investments wherever they may be. China undoubtedly has big challenges ahead. Fixed assets are an unsustainably high portion of GDP and this level will inevitably fall. The enormous growth in construction will have to slow down and it is difficult to imagine commodities used in fixed assets recovering in this environment. China's economy needs a radical rebalancing. Were China an open democracy with large external debts it would be difficult to imagine it succeeding. However because of the government's unprecedented level of control and its ability to bail out the banking system it may yet succeed. If anyone can manage this it will be them. Time will tell as to whether they succeed.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.
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