China is enjoying a period of sustained growth as well as becoming a major player on the world stage. Although risks still remain, the benefits of investing in this emerging market are bountiful
China's growth over the last five to 10 years has been very strong. Historically, this has caused bubbles in inflation leading to rising interest rates and pain for investors. Now, however, China's economy is enjoying a period of greater stability with its prudent financial management and improved command over domestic, fiscal and monetary policy responsible for a sustained period of non-inflationary growth. Although risks remain, the rewards for investing in China outweigh the risks.
In recent years, because of its rapid growth, China has become a major player in global markets, both from a political and commercial standpoint. China's growth has been fuelled by foreign and domestic investment and it has become the destination of choice for companies seeking to outsource production. This process, which was made easier by China's entry into the World Trade Organisation in December 2001, looks set to continue during 2005.
Last year, China was again in the headlines as many of the key economic issues were actually caused or exacerbated by China's development, for example, increased demand for steel, higher prices for oil and other commodities, and rises in shipping rates.
In reality, China's impact cannot be overstated - when commentators around the globe were concerned about deflation, it was China's lower manufacturing costs and the impact of outsourcing production to China that was implicated. Now that inflation is creeping up the agenda, China's growth - and the increase in oil and other commodity prices that has accompanied that growth - has been highlighted. With China accounting for an ever-increasing proportion of world trade, this influence will continue.
It is expected for the growth rate of China's GDP to slow in 2005 from the 9.5% GDP growth rate recorded in 2004 to about 8.5%. Part of this reflects the forecast slowdown in exports as global economic growth recedes on the back of higher oil prices and the removal of the fiscal stimulus in the US. When evaluating growth in China, it is more important to look at the quality and direction of growth rather than the absolute number. From a policy standpoint, the Chinese government has a vested interest in growth, as job creation and the removal of legacy issues are dependent upon it. For this reason, the rhetoric will, on the whole, remain pro-growth, with occasional pauses to rein in any excess.
the drivers of China's growth
In 2005, domestic consumption is likely to become a key driver of growth in the Chinese economy. GDP per capita has already grown tenfold since 1986 to over Rmb 10,000 per head ($1,300) and is expected to continue to rise. Despite this growth in individual wealth, the savings rate in China is still among the highest in the world. The reality is that ordinary Chinese citizens have more disposable income than at any other time in their history and the ranks of the middle class are expanding rapidly. As the economy continues to develop, and sentiment regarding reforms and job security improves, then ultimately savings should turn into consumption.
This is not a uniform development across all provinces, however. Although a consumer society is now taking shape in the coastal provinces, many inland areas remain very poor. The challenge over the next few years is to extend the prosperity of coastal provinces to the poorer inland areas which will require significant investment in infrastructure and wholesale reforms of local government and rural collectives.
While domestic consumption is likely to increase, capital investment is likely to slow in 2005, even though it will still remain a positive contributor to GDP growth. In April 2004, the Chinese government slowed the capital investment boom with the introduction of controls on the extension of credit by financial institutions, in particular to the property, steel and aluminium sectors. This policy was crude but ultimately successful - it was slightly relaxed towards the end of 2004.
Despite our positive view on consumption, a slowdown in global growth and world trade would have a detrimental impact on the Chinese economy in 2005. Although slowing global trade would also have an impact on other Asian economies, the US is now a key trading partner for China. Its exports to the US in the first 11 months of 2004 reached $112bn, making up 7.5% of China's GDP. In particular, the strength of the US consumer is crucial as a large proportion of Chinese exports relate to low-end discretionary spending.
Pressure for a revaluation of the renminbi continues to increase, as the trade surplus with the US continues to rise and other Asian currencies have appreciated. However, the Chinese government is unlikely to rush to implement a revaluation which could have a detrimental effect on the stability which China requires to address the problems in its banking system. The issue of currency revaluation is a political football which will be kicked around for some time to come. The reality is that a 10% change in the level of the Chinese renminbi will have little or no impact on trade and could end up increasing speculative money flows and inflationary pressures globally.
A service sector has historically grown as a country develops and this is happening rapidly in China. The larger banks have already started the process of reform which will allow them to come to the market to raise equity and debt. Loans made in the past according to government policy left banks with huge bad debts in their loan books - now banks have started to sell off their loan books in large portfolios to third-parties at about 20% of face value. In 2005, we should see the first IPOs from the Chinese banking sector, which we suspect will be well received. Investment opportunities could arise, however, they are very much dependent on content and price.
In contrast with the credit restrictions, the 0.27% rise in Chinese interest rates in October, which left rates at 5.8%, only had a marginal impact on lending. This interest rate rise was the first in nine years, which does demonstrate the authorities' commitment to financial reform, and perhaps also the pressure that China was under to try to dampen growth at that point in time. The interest rate rise does mean that China faces slightly higher costs going forward. If the US continues to raise rates, further rate rises in China could be necessary. Increased inflationary pressures in China itself could also lead to further rate rises but this seems relatively unlikely at present.
Corporate earnings slowdown
It is possible there could be single digit earnings growth for many companies in 2005, compared with rates of over 30% in 2004. Higher input costs are also likely to constrain companies' profits this year, as interest rates have risen, as have oil prices and other commodity prices.
It is also important to remember that very few companies in China command brand loyalty partly because of the sensitivity to price but also owing to the lack of intellectual property rights which allow a proliferation of cheap and badly made impersonations. As a result, companies with defendable margins are hard to find and sometimes it is easier to play the growth theme with companies listed and operating outside of China. Regional energy and resource plays are prime examples of that.
However, the increasing purchasing power of the domestic Chinese consumer is a definite competitive advantage that should not be overlooked.
There are reasons to be optimistic about equity markets in China, despite 2004 having been disappointing. The high concentration of basic materials and energy stocks in the market may mean that the index as a whole does not perform strongly, as these sectors may struggle to post strong earnings growth, but we believe that specific sectors and stocks will deliver strong results in 2005. China's domestic consumption should increase as the population gains confidence, and if individuals spend more than they save, this will be of benefit to property, retail, telecoms and pharmaceutical stocks among others. China's long-term prospects appear to be very good. However, as with any emerging market, there are certain potential problems which could emerge to derail the short-term prospects and impact investor sentiment.
China's economy is enjoying a period of greater stability with its financial management and improved command over monetary policy responsible for a sustained period of non-inflationary growth.
China's domestic consumption should increase as the population gains confidence, and if individuals spend more than they save, this will be of benefit to property, retail, telecoms and pharmaceutical stocks among others.
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