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Investing: China Fears Much Ado About Nothing (FXI, GXC, YAO, EWH, HAO)

September 15th, 2011

Frank Holmes: Markets in Hong Kong, Vietnam, Taiwan and Korea were closed  last week as people across Asia celebrated Moon Festival, one  of the culture’s most beloved holidays along with Chinese New Year. Moon  Festival’s origins center around a husband (Houyi) and wife (Chang’e), who were  sentenced to live eternally separated on the sun and the moon.

Chang’e, representing “Yin,” lives on the moon and Houyi,  representing “Yang,” lives on the sun. Once a year, on the night of the  Mid-Autumn Festival, Houyi visits his wife and that is the reason why the full  moon burns brightly on this night.

For many, the yin and the yang illustrate the importance of  having balance in life. Investors must find the right risk/reward balance.  Businesses must find the right capital spending/revenues balance. And, we all  must strive to find the right work/life balance.


China’s Economy Finds Balance

Balance  is also a crucial goal for China’s economy – the economy must not grow too  quickly or risk a sharp correction. Just this year, China has weathered an epic  battle with inflation, drought and floods, poor global macroeconomic  conditions, massive accounting/corruption scandals and a tragic accident on one  of its marquee achievements-the country’s high speed rail system.

We’ve discussed the tremendous  build-out of China’s high-speed rail system before. And earlier this month,  I was lucky enough to see what traveling at the speed of China feels like  firsthand. I was on a train that averaged 185 miles per hour during the  923-mile trip from Shanghai to Beijing. I’ve traveled to all corners of the  world and have seen many things during my travels, but viewing China’s  explosive growth as it flies by you is something I will never forget.

China remains the beacon of hope for the global economy, the  largest and, many times, the “sole engine of the world economy,” BCA Research  says. China’s real gross domestic product (GDP) is forecasted to grow 8.9% in  2011 and 7.8% in 2012, according to ISI Group. This is a slower rate of growth  compared to recent years but “doesn’t look like an economy struggling under  tighter credit conditions,” GaveKal research says.

The key to China’s economic growth isn’t “how fast?” or “how  much?” The most critical question is “what’s driving it?”

Many of China’s critics, such as Jim Chanos and Hugh Hendry,  claim China’s current economic status is a mirage created by government  stimulus and relies on exports. However, examination of China’s economic growth  over time (see chart) reveals that consumption and gross capital formation are  the two pillars lifting China to the top.

Ending the country’s dependence on exports is the “professed  pursuit of quality over quantity,” says GaveKal and became an immediate  necessity for China to maintain economic stability after exports collapsed by  40% from September 2008 to January 2009, triggering a sharp slowdown in growth,  BCA says. Recent  data shows China has kicked the habit as exports have contributed little to the  country’s growth in 2011. Net exports accounted for 18% of China’s total  14.2% GDP growth in 2007, according to CLSA’s Andy Rothman. During the first  half of 2011, exports have a negative contribution of -0.7% of China’s 9.6% GDP  growth and accounted for only 12% of total industrial sales revenues. We’ll  debunk more tall tales of China’s export economy in a moment.


Strong income growth has triggered a rise in domestic  consumption. CLSA says inflation-adjusted wages in urban areas rose 7.8% in  2010 and have risen another 7.6% during the first half of 2011. As a result,  urban retail sales and household expenditures increased 17.4% and 12% during  the second quarter of 2011, respectively. In addition, rising migrant wages and  higher farm-gate prices have led to a 13.7% increase in real rural incomes and  16.8% increase in rural retail sales during the first half of 2011, CLSA says.

ISI Group reports that retail sales increased 17% on a  year-over-year basis in August and the firm sees “no reason at present to  anticipate any lasting weakness in China’s healthy consumer sector.” As one  example, China recently surpassed the U.S. to become the world’s largest  personal-computer market, The Wall  Street Journal reports. An analyst from research firm International  Data Corporation (IDC) told The Journal that they estimate  China’s PC shipments will reach 85.1 million in 2012.

ISI is especially bullish  on luxury goods citing the “work, earn, consume” lifestyle much of the  Chinese population has adopted in recent years. We’ve discussed the potential  of the luxury goods market in China several times but the sector has been held  back by high luxury taxes that can reach up to 50% on some products. Sales are  growing quickly but luxury sales only make up around 1% of the current market,  GaveKal says.

A primary driver of China’s economic growth has been fixed  asset investment (FAI), which slowed to 23% in August but is maintaining the  23-25% pace the country has seen in recent years, CLSA says. Strong FAI is  bullish for commodities demand as increased industrial activity and  construction gobbles up more cement, iron ore, crude oil and copper.

Manufacturing activity has increased 32% so far in 2011,  outpacing that of a year ago and driving the profits of industrial firms to  rise 28% on a year-over-year basis, data from CLSA says. Since 2004, total FAI  for manufacturing has jumped a staggering 261% in RMB terms, nearly double the  increase for real estate, 167% over the same time period, says data from ISI.

In addition, FAI by private companies has outpaced that of  state-owned enterprises for 17 consecutive months. Rothman says this is  indicative that private firms are financially healthy and anticipate strong  demand. This isn’t because the Chinese government doesn’t have the money.  Revenue increased more than 21% in 2010 and has already jumped more than 31 %  in 2011, CLSA data shows. According to BCA, “China has one of the smallest  fiscal deficits and fastest nominal GDP growth rates among major world  economies.” Government expenditures for this “socialist” country only account  for 23% of GDP, well behind other countries such as Brazil and the U.S. (both  roughly 40%), the United Kingdom (about 43%) and Ireland (around 70%).


The low level of government expenditure as a percentage of  growth is not by chance, but a specific model the Chinese government has  adopted.

“China relies on its real economy to create value and  money,” Guan Jianzhong, the head of state-owned Chinese rating agency Dagong,  recently told German news outlet Spiegel. “If we can draw some  lessons from the Western experience, we should insist on letting real economy  create value and money while discouraging the Chinese from borrowing too much  money.”

Transitioning Workforce and the Importance of Housing in China

While China’s “ghost cities” have stolen headlines, China’s  real estate market sits on a much stronger foundation than China bears would  have you believe. In reality, the property market is actually in a much  healthier position than it was at the start of the year. CLSA says the  government’s focus on keeping housing price growth under control and limiting  the availability of mortgages has resulted in “none of the 70 cities monitored  by NBS [reporting] price increases of more than 1%” on a month-over-month basis  in July.

This is in stark contrast to July 2010 when CLSA’s composite  of 40 cities across the country jumped 17% on a year-over-year basis. For the  year, new-home sales were up 12% on a year-over-year basis through July and  year-over-year residential starts increased 27 %. In addition, construction on  most of the social housing projects planned for 2011 has already begun, GaveKal  says.

Despite this relatively tame market, GaveKal cites Nouriel  Roubini as saying these “ghost towns” are evidence that China’s excessive investment in capital stock has crossed a critical threshold – a bubble.

With respect to Dr. Doom, that’s not the case. For starters,  as GaveKal cleverly points out, the Shanghai province of Pudong was once “the  biggest ghost town of them all.” Today, millions of Chinese citizens and  China’s largest state-owned and private banks call Pudong home, making it one  of the financial centers of the Eastern Hemisphere. Roubini isn’t the first one  to get it wrong either. GaveKal says upon visiting Pudong in 1998, legendary  economist Milton Friedman lambasted the province as “a statist monument for a  dead pharaoh on the level of the pyramids.”

Says GaveKal: “Hundreds of once-empty districts across the  country, from Shangdi in northwest Beijing to Donghu in southeast Wuhan, have  turned into flourishing neighborhoods.”

According to GaveKal’s research, China’s cities absorb 20  million new people each year, creating a current shortfall of 75 million  housing units. They estimate 40-50 million new urban households will need to be  constructed by 2020 in order to meet demand. The chart on the left illustrates  that a large portion of China’s urban growth will take place in suburbs as  cities with 1 million people or less experiencing the most growth.


Although China has seen a decade of economic transformation,  detractors have also compared China’s growth to the Japanese bubble economy  during the late 1980s and South Korea just prior to the Asian financial crisis  in the late 1990s. GaveKal argues that China is more similar to 1960s Japan and  1970s South Korea, with “rapid catch-up growth still ahead.”

Around the globe, no “rich countries” have more than 10% of  their workforce in agriculture and no “fairly well-off” countries have more  than 20%. The chart on the right compares GDP per capita of China, South Korea  and Taiwan as their workforces transitioned away from agriculture. When China’s  workforce hit the 50% level, the country’s GDP per capita was $2,000 – roughly  the same as Taiwan. Today, China’s GDP per capita stands at $7,500 but the  country is still carrying a larger percentage of farmers and ranchers than  South Korea and Taiwan were at the same level.

GaveKal’s research estimates that between 33% and 40% of  China’s workforce is currently employed in the agriculture sector. As more of  China’s workforce shifts to more modern jobs, their productivity and incomes  increase. GaveKal says this means the country is “far from exhausting the  economic gains of shifting its workforce to more productive activities.”

China Bears Doth Protest Too Much

Perhaps some of China’s negative press stems from American’s  fear that China is taking our place atop the global hierarchy. There are a  couple of reasons that’s just not true. One, many American companies are riding  the wave of China’s growth all the way to the bank.

Of the companies held in the S&P Composite 1500 Index,  707 have revenue growth above 10 %. Many are America’s largest and oldest  companies, who long ago recognized China’s transformation and shifted capital  overseas to continue growing their revenues.

Caterpillar already has 16 manufacturing facilities, three  research and development centers, and 3 logistics and parts centers located in  China. In a recent announcement, the world’s leading manufacturer of  construction and mining equipment says it is expanding operations again. Up and  running by the fall of 2012, Caterpillar plans on building a state-of-the-art  proving ground and a large wheel loader manufacturing facility, a company press  release indicates. Executives of Caterpillar say this new facility will support  a growing customer base in China and across Asia.

Likewise, The Coca-Cola Co. (NYSE:KO) announced that the company  was investing $4 billion over the next three years in China, bringing the total  investment to more than $7 billion beginning in 2012.

“China is one of our most important growth markets in the  world as we work to achieve our 2020 Vision goal of doubling system revenues  and servings this decade,” said Muhtar Kent, chairman and chief executive  officer of Coca-Cola.

Illinois-based Kraft Foods Inc. (NYSE:KFT) entered the China market  way back in 1984. Today, it has eight manufacturing facilities, offices in 250  cities and 4,000 employees, and the company is still growing and introducing  new production lines. This summer, the company opened an $8 million production  line, with the president of Kraft Foods China indicating that the country is  “one of the top 10 markets in terms of development priority for Kraft Foods.”

These are only a few examples of how American business is  keeping its entrepreneurial spirit and sustaining jobs by reinventing itself in  the developing world. Some will say that they are sending American jobs  overseas but the U.S. economy is actually much more domestic-oriented than  you’d think.

For example, U.S. imports only accounted for 16% of U.S. GDP  in 2010 with imports from China totaling 2.5% of GDP. U.S. consumer spending on  goods from China was only 2.7% of total spending in 2010, according to a new  report from the Federal Reserve Bank of San Francisco. Consumer spending on  items manufactured in America was nearly 90% of the total.

A greater myth is that most of the $100 you spent shopping  at Wal-Mart Stores Inc. (NYSE:WMT)  last weekend heads back to China. However, the San Francisco Fed reports shows  that for every dollar spent on a China-made item in the U.S., 55 cents lands in  the pocket of U.S. businesses for services such as marketing and sales.

There’s also a trickle-down effect of Chinese goods. Laura  Baughman, president of the Trade Partnership told USA Today that “because we import from China, prices are  cheaper, consumers have more money in their pocket, and they go out and spend  more,” which creates a greater number of jobs than are lost.

Andy Rothman argues that the increase in China’s share of  personal consumption expenditure for the U.S. – which has doubled over the past  decade – has come at the expense of other countries looking to export goods to  the U.S. because “the overall import content of U.S. consumer goods has  remained relatively constant while the Chinese share has doubled.”

America also sends goods in the other direction. China is  America’s third-largest export market with the total U.S. exports of  electronics, agricultural and other products to China rising an astounding 468  % from 2000 to 2010, according to USA  Today.

Conclusion

There are many questions surrounding the global market but  the Chinese economy remains headed toward the moon. The country, of course,  remains vulnerable to external forces but we believe the economy’s strong  momentum will be enough to carry the country through, should volatile times persist.

Related Tickers: iShares China 25 Index ETF (NYSE:FXI), SPDR S&P China ETF (NYSE:GXC), Guggenheim China All-Cap ETF (NYSE:YAO), iShares Hong Kong ETF (NYSE:EWH), Guggenheim China Small Cap ETF (NYSE:HAO).

Written By Frank Holmes For Money Morning

We’re in the midst of the greatest investing boom in almost 60 years. And rest assured – this boom is not about to end anytime soon. You see, the flattening of the world continues to spawn new markets worth trillions of dollars; new customers that measure in the billions; an insatiable global demand for basic resources that’s growing exponentially ; and a technological revolution even in the most distant markets on the planet.And Money Morning is here to help investors profit handsomely on this seismic shift in the global economy. In fact, we believe this is where the only real fortunes will be made in the months and years to come.



NYSE:EWH, NYSE:FXI, NYSE:GXC, NYSE:HAO, NYSE:YAO


 

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