Investing in the next phase of China's growth story

As China transforms itself into a domestic consumption-driven economy, energy and resources-intensive industries will slow. Australian investors need to tilt their equities exposures to growing industries, explains Diane Lin.

The extent and velocity of China’s recent economic development is unprecedented. Benefiting from low labour costs and the influx of foreign investment looking for lower manufacturing costs, China has experienced extraordinary growth over the last three decades.

Gross domestic product (GDP) per capita grew from US$239 in 1978 to over US$3,659 in 2009. China’s global prominence has surged as its economy has achieved significant scale, overtaking Japan as the world’s second largest economy in 2010, with annual GDP of US$5,878 billion. 

Despite this phenomenal progress, China's GDP per capita is ranked just 91st globally. The Chinese government’s long-term economic target is to reach GDP per capita of US$10,000 over the next five to seven years, based on the assumption that the economy will continue to grow at a double-digit rate in nominal terms and that its currency will appreciate against the US dollar (by an expected 5 per cent per annum). 

However, China’s rapid growth has thrown up some structural issues and these may jeopardize future development. Over the last 10 years, China’s economic growth has been driven predominantly by capital investment.

Fixed asset investment, including government spending on infrastructure and private sector housing investment, accounted for nearly 50 per cent of growth on average in the 2000-2009 period, compared to about 30 per cent in the previous decade.

In 2010, China’s capital investment accounted for 47 per cent of GDP, compared to Japan’s peak of 39 per cent in 1970.

When an economy goes through the initial stages of industrialisation, it is not uncommon to see economic activity driven by capital formation as there will be a significant need to build (social) infrastructure. Building such an infrastructure relies on an increase of production facilities in heavy industries such as petrochemical, steel and cement.

China is to an extent exceptional in that its economy is even more reliant on capital investment than any other industrialised economy has been in the past. There are two main reasons:

• Firstly, the reform of China’s housing market in the late 1990s as private housing ownership was introduced, for the first time since 1949, triggered a wave of housing investment by the private sector; and, 
• Secondly, the entry of China into the World Trade Organization (WTO) in 2001 saw China’s government initiate large-scale construction of port, road and airport infrastructure.

The combination of housing investment and transport infrastructure construction drove fixed asset investment to levels unseen historically. The resulting strong demand for building materials also led to substantial capacity expansion in heavy industries throughout the 2000s.

China today holds over 50 per cent of the world’s capacity in most building materials, including steel, cement and glass – and China now accounts for a large proportion of global consumption of most metals and materials. 

However, after decades of phenomenal growth, China has become extremely energy and resources intensive and inefficient. In order to create new economic growth drivers and achieve sustainable growth longer term, a structural change is needed to develop new, less energy-intensive industries. 

In addition, changing demographics are also driving the need for structural change. The proportion of China’s working age (15-64) to total population bottomed out in the 1970s and rose over the last 30 years, giving China access to an ever-increasing supply of labour.

This is starting to reverse as a consequence of the introduction in the 1980s of a one-child policy to address population growth concerns. The resulting birth rate decline is now, 30 years later, starting to affect labour supply, while the most recent population census (2010) paints a picture of a society about to age significantly.

The proportion of the population aged below 14 (the future labour force) as a percentage of total population has declined to a historic low of 16.6 per cent from 23 per cent 10 years ago.

The proportion of those 65 or older has increased to 9 per cent from 7 per cent, a record high. The ratio of working population to total population reached 74 per cent in 2010, a likely peak before a decline from 2013/2015 onwards – the end of China’s longstanding labour dividend. 

In addition, the increasing number of well-educated and highly skilled workers is also starting to have an influence on economic structures. The number of university graduates has increased from 1.2 million in 2002 to 6.4 million in 2010.

These structural changes in demographic patterns have two main implications.

First, the government’s future spending will have to reallocate some of its previous infrastructure spend to building a social safety net and covering pension and healthcare for the rising number of retirees.

Simultaneously, as the benefits of low labour costs start to disappear and the pool of high skilled labour grows, corporate China will have to focus on productivity growth and move up the value chain. 

In order to reduce the need for high economic growth to achieve full employment, create the type of jobs needed to absorb surplus highly skilled workers and, ultimately, maintain social stability going forward, China’s government will focus on quality rather than quantity of growth. In doing so, it will support the development of high value-add industries such as healthcare, IT and machine tools. 

Sectors that will benefit from China’s future structural transformation include:

• Energy efficiency: renewable energy such as wind, solar and nuclear power, and emission reduction technology
• Private consumption and internet: technology companies across the region as well as Chinese IT software and service companies; and,
• High value-add manufacturing: capital goods companies across the region, especially component suppliers in Japan, benefiting from Chinese companies moving up the value chain.

Sectors that will face headwinds from China’s structural changes include industries with high energy and resources intensity such as steel, cement and coal across the region.

Nearly half of Australia’s exports go to two single countries: China and Japan. A similar percentage of our exports consists of just two commodities: iron ore and coal, in the latter case also spread amongst other countries such as South Korea.

This dependence on a narrow commodity base is only growing, with expansion already underway in the two base commodities. Fortescue is planning to increase its output of iron ore to match that of BHP Billiton and Rio Tinto, and there is significant capacity growth in conventional liquefied natural gas, as well as coal-seam methane.

Meanwhile, other major ‘export’ industries such as tourism and education are shrinking, certainly in relative, but most likely also in absolute terms, as a consequence of the extraordinary rise of the Australian dollar. 

If China successfully transforms itself from a capital investment to a domestic consumption-driven economy, energy and resources intensive industries will experience slower growth. This will negatively impact Australia’s economy if it fails to reduce its dependence on the mining industry as a growth driver. 

To hedge this risk, investing in Asian equities with a tilt towards structurally growing industries that Australian equities do not provide exposure to – for example, IT, healthcare and consumer – is essential for Australian investors who are currently exposed to China’s economy directly and through equity exposure tied to the fortunes of resources.

Both have driven wealth in tandem and could turn in tandem. Asian equities can help ensure such a turn does not slash investors’ wealth irrevocably.

This is an abridged extract from a paper presented at the 2011 PortfolioConstruction Forum Conference. The full paper is available at www.PortfolioConstruction.com.au.