Much has been said about the recent data coming out of China. Not only has the aggregate rate of growth fallen below 8% but recent anecdotal evidence in iron ore prices in particular has also been pointing to weakness. We remain bullish on the overall Chinese growth story and see the current economic softening most likely as an intentional government driven slowdown, rather than a bust. We don’t currently subscribe to the doomsday scenario that China is about to drift into insignificance and the points to back our investment thesis are summarized below. Our view is based on a long term ideology.
The Chinese Government and Economy are Intertwined
First of all, the structure and strategy around the Chinese economy cannot be viewed in the same way as other western developed economies. An investment view on China needs to consider one of the most important underlying elements – the ability of the central government to navigate its way through challenges. The Communist party needs the economy and associated flows of capital in order to sustain its existence. For many Chinese, this is the only system of government they have known. The US and European economies can withstand a severe financial shock without a shock to the underlying system of government, but in China the same does not hold. The Communist party will do all it can in order to sustain social and political order and the economy is to a large extent the most important part.
A collapse in China’s economy could see a collapse to the system of government, something the ruling party cannot tolerate. So the allocation of resources and fiscal approach is not purely driven by short term economics.
China’s planners are in the late stages of forming the next major economic shift – outwards from coastal cities towards the less developed rural communities. More on this point shortly. China knows that its coastal cities will soon start to lose their competitive cost advantage to other economies in Southeast Asia and even places like Mexico. This means more investment in social housing, public infrastructure and industry to ensure a more even allocation of employment opportunities and social order should the recent migration towards coastal centres reverse. Balancing out an economy as vast and diverse as China’s isn’t an easy task and a lot of hard work to ensure sustainable growth has been put into place during 2012. The intensity in infrastructure investment, which was initiated in 2009 due to the threat from global forces, has largely phased out but not disappeared. This has seen the iron ore price for example fall from around US$180 per tonne to around US$90-100 recently. The commonly quoted spot price for iron ore, unlike copper or gold for example, isn’t the best measure – it’s one reference point. Many iron ore producers in Australia, for example, negotiate various prices based on grades and shipping rates to individual steel mills.
China’s steel mills would have to drastically stop consuming for the iron ore price to remain below US$100 per tonne. The marginal cost of production, when excluding huge capital costs, is currently at around US$50 per tonne. To put the current spot iron ore price into perspective, Australian potato growers are currently getting around $240 per tonne of produce sold into the wholesale market. A tonne of wheat is trading at a similar amount in European markets. A ramp down of China’s steel industry would see large job losses throughout the whole construction industry and large social unrest when applying the impact throughout the whole Chinese economy. This brings pressure from local and provincial governments towards the central government, a threat which should not be underestimated. China is the largest global manufacturer of steel, around 10 times the size of Russia and around 15 times the size of Germany.
China and Copper
Iron ore as a commodity class is not the only indicator of China’s production capacity. Copper is also an important point of reference. Used in a whole range of industries, China is also the largest marginal consumer of copper by a large factor. Chinese consumption of copper per capital is still almost half that of North America. Not all of China’s consumption finds its way into exported goods, in fact the proportion of copper used in domestic consumption has been growing over the past decade. The current copper price near US$3.45/lb at the time of writing is somewhat off its highs above US$4/lb but still well above the recent historical average. Copper stockpiles as measured by the London Metals Exchange are sitting towards the lower end of their five-year historical averages. Many copper producers – including the top ten global producers – are struggling to maintain grades above an industry average of 1.4% per unit of ore. New mines come with large capital costs and often sovereign risk factors, not to mention rising operating costs. The world class Escondida mine in Chile is a perfect example, so too is BHP Biliton’s (BLT) decision not to proceed with its Olympic Dam project in South Australia last month due to rising capital cost constraints.
Plans for a Central Plains Economic Zone in China
We understand that Beijing is currently finalizing plans for a Central Plains Economic zone – a region which has traditionally served Northern China’s agricultural belt and been an important corridor for the transport of goods between rural and coastal economic centres. The new zone will cover almost 300 thousand square kilometres and encroach into Henan and neighbouring provinces. The aim is to create a buffer to any social fallout in the moderating economic activity in the coastal hubs. As workers migrate back inland, the aim is to have the Central Plains regions self sufficient so workers can bring back their capital and skills with job prospects. The Central Plains Economic zone is expected to commence in 2015 and will by then be the largest single zone in terms of land mass and population. The region also houses an enormous and relatively young population, which means it has a large potential labour force and decent consumer base.
This is only a temporary period of moderation
We note this not because the Central Plains Economic zone is likely to solve all of China’s economic issues but that it is an example of a new strategy to shift growth policies inwards. The pipeline for future development opportunities like this is huge and thus will underpin a very long investment process in China, which in turn will require global commodities like iron ore. There will be a timing gap between new projects like the Central Plains Economic zone coming online and the 2009-led intensive construction boom phasing out. Perhaps we’re seeing the timing impact of this right now, which is leading to lower iron ore and coal prices, but our point is to again stress that this is only a temporary period of moderation. Henan in the central planes is still relatively small in its share of attracting foreign direct investment, around $10 billion last year but this was up by almost 50% on the prior year. Companies like Pepsi (PEP) and Foxconn (02038) have been part of this investment shift. China understands the importance of such development in order to address the social needs of its nearly 300 million migrant workers – roughly the size of the USA’s total population.
China's Banking Sector Remains Strong
There are other signs of optimism outside of official government investment plans. The Chinese banking system has held up relatively well despite the liquidity issues in Europe and the engineered slowdown in the domestic economy. Industrial and Commercial Bank of China (601398) – the world’s largest bank by market capitalisation – booked an 11% increase in its second quarter earnings which was broadly in line with hosed down market expectations. Six months ago many market commentators were calling for a collapse in the price of banking stocks due to an impending property collapse in China, which has not occurred. The rise in profits came despite an elevation of higher bad debt charges. Despite this, bad loan ratios in China are still less than 1% which is the envy of many European counterparts. As interest rates fall in China, so too does the deposit rate which many Chinese rely on as their source of saving. It provides a cheap source of funding for the banks and insulates their earnings from potential bad charges.
Gambling on Macau
My last point is on Macau – one of two special administrative regions of China which is quickly growing to become the gambling capital of the world. Macau’s gaming numbers are a good forward indicator to confidence in the mainland economy. Gamblers in Macau are not a perfect sample for the broader economic picture but they form part of the puzzle, much like Las Vegas visitor numbers correlate to confidence in the US economy. Gross table gaming revenue for the first two weeks of August showed an improvement on the prior month despite adverse weather impacts. July booked one of the slowest monthly gains since 2009 so the improvement is welcomed. Many gaming analysts have recently revised upwards their August numbers to anywhere from 4%-6% compared to 1.5% growth booked in July. This compares with 12.2% and 7.3% booked in June and May respectively.
Market Trends and Prices
Over the next few months we will continue to expand our investment thesis on China. The current negative sentiment around China could remain until the last two months of 2012 before government fiscal plans like the Central Plains Economic zone are announced and further monetary loosening takes place. City Index sees inflation as likely rising towards the People's Bank of China's official 4% target range in the first months of 2013. August PMI is likely to surprise on the downside given recent flash data but the trend should improve in September-November.
Copper has found solid support above US$3.30/lb and investors continue to see this as an opportunistic entry point. A further selloff in iron ore stocks could provide a great medium term trading opportunity for those with patience – BHP Biliton (BLT), Rio Tinto (RIO), Atlas Iron (AGO) and Fortescue Metals (FMG) could all represent compelling value at current prices.
We also note the issues Glencore (GLEN) is having with its proposed tie up with Xstrata (XTA) after Qatar’s sovereign wealth fund vowed to vote against the merger. Despite being a global commodities trader and mine operator, Glencore lacks decent iron ore exposure and might see the current circumstances as an opportunity to shelve Xstrata plans and focus elsewhere. This may lead the firm to perhaps take a strategic holding in one of the Australian iron ore companies.This article was originally published on Morningstar under the title: Is The Chinese Growth Story Over?
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