A sneeze can travel at about 100 km/hour
Slow growth could help China’s economy, but hurt mining, supply chain
and investors
Over the past three years, there
has been a remarkable transformation in global perceptions about the
sustainability of Chinese growth. As Europe faltered and the US fought a
massively oversupplied housing market, China managed to sail through difficult global
economic conditions and seemingly avoided the difficulties that ensnared much
of the West.
In 2010, the world was convinced
that Chinese economic growth would save the world. China had grown to become
the world's second largest economy and many extrapolated this trend to the day
that China would be larger than the United States. Few questioned this belief,
and investors titled their portfolios towards assets that would fare well in a
world of strong continued Chinese growth.
The sustainability of China's
high growth rates is now being questioned, and with good reason. Headline GDP
growth was 7.6 percent in the most recent quarter, the sixth straight quarter
of slowing growth.
Chinese officials at the highest
levels regularly comment today about measures to support continued growth.
Benchmark interest rates were cut in June and July, and while real estate
markets have recently demonstrated some resilience, prices remain – on average
– below last year's levels and inventories are noticeably high. Recent earnings
reports from multinational corporations continue to confirm the official data:
China is slowing, with significant implications.
The credit-fueled investment boom
is ending, with serious ramifications for the supply-chain to China. The short
of it is that China has simply built too much stuff, and while it will
eventually need the currently empty malls, buildings and infrastructure – one
can even add entire cities to this list! – demand for the raw materials used to
build them will plunge. Given that approximately 75 percent or so of recent
Chinese GDP growth has come from capital investing, building less stuff in
China has the potential to cut growth rates to the low- or mid-single-digit
range.
While the list of casualties may
be quite long, three of Wall Street’s favorite investments appear particularly
vulnerable; two other expected “casualties” may actually stumble through
without much pain.
As a result of its building boom,
China has had a domineering influence on the market for industrial commodities.
The magnitude of Chinese demand on selected industrial commodities is
noteworthy: more than 60 percent of global demand for cement and iron ore, more
than 40 percent for steel and aluminum in 2011. Inspired by strong growth in
demand for their products over the past several years, many mining companies
have embarked on multiyear expansion projects – with an underlying assumption
of continued growth in Chinese demand.
Reduced demand from China
combined with expanded supply will lower prices. Consider iron ore, selling for
~$50/ton in 2007. In 2011, it was trading for ~$200/ton at one point and was
recently quoted ~$110/ton. If the Chinese building boom busts, demand for iron
ore, a key input in steel-making, will surely plunge. Iron ore could revisit
the ~$50/ton price point, if not lower. In general, however, it’s conceivable
that India and other emerging markets could pick up the slack capacity of what
are fundamentally scarce resources in the long-run – more than five years).
Australia, in particular, is in
the cross-hairs of a slowdown in Chinese investment spending as it’s a major
supplier of key industrial commodities – bauxite, alumina, gold iron ore, lead,
zinc, uranium, aluminum, brown coal and more.
Years of strong growth from China
have also led to a continued influx of immigrants participating in the booming
mining business, resulting in inflationary pressures in both labor and housing
markets. Many of the Australian mines have expanded to meet an expectation of
continued Chinese demand growth.
The risk of commodity weakness
infecting Australia's banking and housing finance system is quite high because
most mortgages are kept on the books of banks. Investors should exercise
caution when investing in Australian assets -- be they equities, debt, or even
the Australian dollar (Figure 2). As a relatively high-yielding option in a
low-yield world, Australian sovereign debt has benefited from strong inflows of
yield-hungry capital. Mid-single digit yields, sufficiently attractive to date,
may not appear adequate in the face of currency declines exceeding the yield.
A material slowdown in China
would affect other emerging markets despite arguments about decoupling. Even if
one believes that the real economies of the emerging markets have decoupled due
to domestic consumption drivers – though in China, for instance, consumption
accounts for about a third of GDP (versus more than 50 percent in both India
and Korea) – it’s clear that the financial markets remain interconnected. In
fact, if anything, the emergence of exchange-traded funds and other pooled
investing products has created greater financial interconnections than ever
before.
Further, the mere fact that
India, China, Russia, Thailand and other developing countries are pooled into a
single asset class known as "emerging markets" connects them via
portfolio managers that view them as linked. If Russia were to fall by 20
percent, for instance, and all other markets were flat, emerging-markets
managers would find themselves overweight non-Russia markets. Indiscriminate
selling might follow as portfolio managers rebalanced, generating the financial
contagion all desperately sought to avoid.
In addition, approximately 25
percent of the S&P 500's earnings is directly derived from emerging
markets, with a large amount (perhaps around 20 percent), coming indirectly
from emerging markets. Unfortunately, this means that multinational
corporations may soon find that earnings are harder to grow than previously
expected.
While it is not impossible, it
seems unlikely that the world is about to descend into a multi-decade
debt-deflation spiral. Some areas may not be so vulnerable.
Paradoxically, China probably
won’t be a severe casualty of a massive deceleration in investment spending.
Social stability is on the top of Chinese leaders’ minds, particularly as the
country goes through a leadership transition. They will deploy all resources at
their disposal to prevent social unrest that might emerge from slower economic
growth.
And even if the country grows GDP
at roughly 3 to 5 percent per annum over the next decade, that’s impressive
growth that will result in a significantly larger middle class: Consumption as
a percentage of GDP is destined to rise, creating winners amidst the wreckage
and placing the Chinese economy on a more resilient foundation.
Several commodities are not as
affected by the China factor as industrial commodities, specifically
agricultural and energy commodities. The middle classes of India and China are
growing rapidly, even if GDP rates slow in these countries, and accompanying
this growth is demand for animal protein and transportation fuels. Families,
accustomed to adding some chicken or pork on top of their rice for dinner, are
unlikely to cut back to just rice.
Likewise, the demand shock to
energy is growing as individuals go from riding bikes to mopeds, to motorcycles
and cars. Such demand trends are unlikely to reverse. Hence, the globe can
anticipate higher prices for food and fuel commodities for the foreseeable
future.
Last year, most analysts expected
the Chinese economy to eclipse the US economy within 10 years. The combination
of a rapid Chinese slowdown and a US renaissance driven by American agriculture
and natural gas, i.e, food and fuel, may in fact push the crossover date out by
years, if not decades – making analyst credibility perhaps the most visible of
casualties.
Vikram Mansharamani
(Vikram Mansharamani is a
lecturer at Yale University and the author of Boombustology: Spotting Financial
Bubbles Before They Burst. Reprinted with permission from the Yale Center for
the Study of Globalization)
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