May 2009

BRICS: Little trouble in big China

The largest and most important of the Bric economies, China has remained relatively resilient to the global economic meltdown. Jason M. Hepner, of Standard Life Investments, explains how investors can profit from trends there... China is the most important of the Bric economies and is close to officially becoming the world’s second largest economy, as measured in US dollars. It will likely overtake Japan on this measure within the next few years. Within five years, on current trajectories, China and the US will be the two clear leading global economies. Within ten years, barring unforeseen shocks, China will likely emerge as a rival to US dominance. During the recent economic and financial crisis, it has become even more significant, both in terms of its ability to avoid recession and also the way in which its policy response has impacted financial markets. For these reasons, it is important for investors to understand what is happening in China and how to profit from these trends.

In the late 1970s China, under Deng Xiaoping, embarked on a major programme to open up the economy, via a series of economic reforms. Since then, China has undergone a sequence of urbanisation and industrialisation initiatives. Its population of well over 1bn people is inexorably making the transition from rural societies into an ever-expanding plethora of cities. In that sense it is undergoing a similar process to that seen in the UK in the 18th and 19th centuries, and to the US experience of the late 19th and early 20th century. Taiwan, Korea and Japan experienced their own equivalents in the late 20th century.

The importance of China’s development is that it is a far larger country in terms of population than any of the aforementioned.  Presently, the US has a population of some 300m, compared with China’s 1.3bn people – hence the relative scale of the challenge that China faces is considerable. Although China has allowed large numbers of people to move from rural areas towards cities, which are obviously growing rapidly in size, some 800m people are still estimated to live in rural areas. This illustrates just how much of this process may still lie ahead. Urbanisation is eventually expected to reach around 70% of the population by 2030, compared with about 40% at present.

The combination of these economic reforms; continued population growth and household formation; the shift from a less productive rural economy to a more productive manufacturing economy; and latterly China’s entry onto the world trading stage via its membership of the World Trade Organisation, have all allowed China to grow by a compound annual growth rate of close to 10% for the best part of 30 years. This is unprecedented for any major country.

Exports down
Nevertheless, the global credit crunch has caused China severe cyclical headwinds. China is a major trading economy, with exports making up about 30% of GDP. With the US, the UK, Europe and Japan all mired in recession, Chinese exports have suffered sharply in the early part of this year, down a remarkable 25% from a year earlier. This has caused the economy to slow materially, although it has avoided recession. In 2008, China’s economy grew by an impressive rate of around 13%. However, due to the present malaise in the global economy, the growth rate that China can achieve this year may well be only around 6%.  That in itself would be a remarkable achievement in the present climate, given that some other Asian countries, notably Japan, are likely to see their GDP contract by 6% this year.

One reason that China can continue to grow at such rates is its very strong balance sheet. China has a very low public sector ‘debt to GDP’ ratio and has accumulated around US$2 trillion (€1.49 trillion) in foreign exchange reserves. As a result of this, it is better able to spend its way out of the economic mire than many other countries. In the autumn, the government announced a fiscal stimulus package that totalled nearly $600bn. It has used its foreign exchange reserves to support trade flows with key economies supplying raw materials. That is not to say that China emerges unscathed from the debt deleveraging process – far from it! However, thanks to its current structural advantages, it can sustain economic growth at a moderate level, something that most other nations cannot do at this time.

When we look at the impact of the global recession, we can see that many other emerging market economies will not fare so well. Most of the emerging Asian countries will suffer a GDP contraction this year. Eastern Europe in particular has been badly hit by the recession in mainland Europe, and the drying up of credit conditions for such economies as the Baltic States, Bulgaria and Hungary. Even Latin America will likely see recession this year, despite its predominately investment-grade credit ratings and generally robust macroeconomic fundamentals. China can be seen as an area of relative resilience compared with its emerging market peers.

Challenges and obstacles
It must be emphasised that China still faces serious challenges in the months and years ahead. Not least is the massive cyclical headwind caused by the US and European recessions, the main source of demand for Chinese goods. China too has to deal with a large rise in unemployment; indeed there are some reports that this could total around 35m people, a significant problem for the government to deal with. Another problem is the potential for overcapacity resulting from this very large fiscal stimulus. Given that the government is spending so much money at a time of a collapse in external demand, the risk is one of what are commonly known as ‘white elephant projects’ springing up. The focus needs to be on investment that will lay the foundations for future growth – outlays that will make China more productive in the long run.  Examples would be education, health and efficient transport networks. A further key challenge is that China needs to stimulate its consumer sector. China’s population is traditionally made up of savers, not spenders. It needs to rebalance its economy by replacing external demand with domestic demand as a strong driver.

In recent months, investors have become more positive on China’s ability to expand compared with the slower growth OECD economies. This was one factor leading to a spring rally in riskier assets across global emerging markets. Investors will need to consider whether all the good news is currently priced into Chinese stocks after their recent rally! We have lowered our holdings in Chinese steel stocks although we still see value in other sectors such as healthcare and mobile telecoms which will benefit from the infrastructure spending. Many companies, and indeed countries outside of China, can benefit from the trends identified in this article. One good example would be Brazil. A key position for us is the Brazilian currency. It offers high yield and Brazil is an economy with strong links to the Chinese growth story. As China demonstrated at the recent G20 Summit, it has come of age in the global economy, and investors need to pay much more attention to its impact on global financial markets in the years to come.

• Jason M. Hepner is investment director – global strategy at Standard Life Investments

©2009 funds europe

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