Monday, 10 August 2009

China, the engine of global growth or a bubble in the making?

The case for
Chinese GDP in the second quarter was a whopping +14.6% p.a., contributing 1.6% to global GDP, which without China would have been flat.

The surge in the copper price and the fall in the US Dollar are testament to the fact that China has become an undisputed key force in many markets. If China is the engine of global GDP then its demand for materials and assets will drive global asset prices higher.

The case against
Chinese economic data and its method of calculation is questionable (e.g. goods count as having been sold when shipped to retailers, not when purchased by consumers). Furthermore, the latest set of first-half GDP numbers from provincial authorities are far higher than Beijing’s national figure, raising questions on the accuracy of statistics.

The current liquidity boom is reminiscent of the US from 2000 to 2007, with cheap money fuelling asset price bubbles. Loan growth is unsustainable and instead of being deployed strategically, must have been used speculatively judging by the rally in the real estate prices and the Shanghai Composite index (+80% year to date!). The Shanghai Composite index trades on 24 times forward earnings, which is 41% premium to the S&P 500, which trades on 17 times expected earnings.

Other evidence of a bubble can be found in recent Chinese IPOs. China State Construction Engineering Corp smashed IPO records, raising 50.2 billion yuan (or 43x recorded earnings) and was up 56% in its first day's trading! When a market is that 'hot' it is either fuelled by retail demand or a sign of far too much easy money chasing too few good investments opportunities. Both signal overvaluation and impending correction. As every tech bubble veteran knows, the hotter they are, the harder they fall.

Finally, as if all of the above was not bad enough, Chinese asset prices appear to be under the control of the country's government who themselves admit that fresh asset bubbles are forming. On Wednesday 29th July the Chinese equity market fell 7% on news that the government would restrict the amount of bank lending. Realising the impact of their announcement, the following day the government announced it would 'unswervingly continue to apply appropriate loose monetary policy' and stocks recovered the previous day's losses. For this reason alone, Chinese equities deserve a higher risk premium since they are vulnerable to government intervention. Although, so are most Western markets.

In the long term China will undoubtedly become an engine of future global growth. However, in the short term, investors in Chinese assets have got ahead of themselves and allowed prices to go too far, whilst ignoring the risks associated with a torrent of liquidity. If left unchecked, such aggressive stimulus risks bursting what is now a bubble, as Nouriel Roubini notes in a recent post on his blog:

Aggressive government led stimulus (direct government investment and encouraging banks to lend) contributed to a reacceleration of growth in Q2 2009, one of the first countries to have a growth acceleration in H1 2009. While upside risk is certainly present for China's GDP growth outlook, serious downside risks from China's fiscal and monetary expansion remain. In particular the risks that stimulus is contributing to asset bubbles in property and equity markets, worsening the risk of non-performing loans and adding to overcapacity could, especially in the absence of a rebound of external demand contribute to weaker than trend growth in 2010-11.

Asian Development Bank predicts Asia ex Japan GDP to recover to pre recession level of 6% in 2010...

... however, it is too early to declare V for victory. Governments have substituted public investment for private investment and exports that have evaporated. With Western demand unlikely to pick up the slack, 6% GDP must come from domestic demand, which is unlikely. The ADB report shows that Asian demand, including China, accounts for 22% of demand for Asian exports. Moreover, H1 Chinese imports fell -25%. So, until Asian economies can create sustainable domestic demand, their recovery will remain fragile.