China's pursuit of economic growth - investment implications

Not long ago, growth expectations for China were being revised down aggressively on weakening global demand, slumping exports, collapsing industrial production and soaring unemployment. Few imagined that China would be capable of achieving its magic 'target' of 8% GDP growth in 2009, with estimates being as low as 5.5%. However, given the surprisingly fast pace at which China has mobilised its financial institutions to direct lending and drive growth, economists are hastily revising up their GDP forecasts once more, having seen the proverbial green shoots of China's recovery in economic data in March. Fixed-asset investment was much higher than expected, the official purchasing managers' index registered a welcome improvement to a level above 50, retail sales figures remained firm, and industrial production growth recovered to 8.3% (on a year-on-year basis).

When China sets out to achieve something, it is often successful. However, this time around we believe that, while government action looks to have been successful in the short term, the country is storing up significant long-term problems in its pursuit of economic growth. Currently the government is deploying as much ammunition as possible to counter slowing growth, using in particular a well-publicised RMB4trillion ($585bn) fiscal stimulus package to maintain demand, production and employment. We have concerns about the quality, manner and speed of the implementation of this stimulus and we foresee risks to the longer-term outlook.

China is pursuing its policy of loose fiscal and monetary stimulus blindly in order to boost investment (which accounted for 43% of the country's economic activity in 2008 - source: Standard Chartered Research, April 2009).

In a world in which end demand is weak and in which 'deleveraging' (the repayment of debt) is underway, we find it perplexing that fixed-asset investment remains so strong (see chart above); adding capacity in the current environment can only build up more excesses and give rise to more problems in the future. In attempting to reflate their economy, the Chinese have embarked on yet another debt-driven boom of their own. When we look at the Chinese loan growth numbers, we can see just how loose the People's Bank of China's monetary policy is. In the first quarter alone, RMB4.58trillion (US$640bn), being equivalent to about 70% of quarterly GDP, was lent out. To put that into perspective, the amount was nearly as much as all new lending in 2008.

Worryingly, a large part of the lending is being used for working capital purposes and it is propping up unprofitable companies that would otherwise fail, with state-owned enterprises being the main beneficiaries. Spare industrial capacity is being maintained and market forces are impotent while such government intervention is in place. While governments elsewhere have been slow to put fiscal stimulus into action, implementation in China was achieved easily since all the banks are effectively owned by the government and senior bankers are still appointed by the Communist Party. Companies who may have had difficulty servicing existing debt have merely taken on new debt to ease their (short-term) cash flows. Others have taken on new debt simply because they could and, inevitably, some of this debt has ended up in local stock markets. Of course, in this environment, non-performing loans diminish in the short term as the cracks are papered over, and the ratios of non-performing loans are flattered by a rapidly accelerating 'denominator' (the value of total loans outstanding). This is unsustainable and we expect non-performing loans to increase dramatically, perhaps from around the end of this year, but certainly by next year, given that nobody quite knows where the loans have ended up or what the asset quality of these loans is like. For this reason, our Asian equity funds have a zero weighting in Chinese banks.

In the meantime, people might become overly optimistic that the worst is behind us and that the fourth quarter of 2008 and the first quarter of 2009 marked an economic trough (GDP growth was 6.8% and 6.1% annualised respectively in those quarters). We believe it is likely that China will continue to produce better than expected growth numbers until the first quarter of 2010. However, the quality of this growth will be poor and we are very cautious about what will happen when the credit 'binge' ends.Although China's banking regulator is aware of the problems in store, and is examining the situation, we believe that any action will come too late. China has stated that its main priority remains to revive growth and a drastic tightening of the purse strings is not expected therefore.

For these reasons we are generally underweight in Chinese equities; this may lead to a little short-term relative underperformance, but we are confident that it will pay off on a one to two-year view. One other consequence of China's economic approach is an accelerated 'hollowing out' of the manufacturing sector elsewhere in Asia as companies continue to face relentless competition from Chinese counterparts who have overproduced because they have enjoyed all-too-easy access to capital. We are cautious elsewhere in Asia therefore on industries which, within China, are being supported by such favourable conditions.

Despite our cautious view on China, we are encouraged by the country's attempts to support longer-term consumption growth through the establishment of more substantial social security provision, in particular in the areas of healthcare and education. High savings are very much embedded in the Chinese culture, and the government is doing what it can to make consumers feel more confident about spending more by providing basic requirements and services to stimulate spending. Hence, we feel relatively comfortable with the healthcare sector, which continues to benefit from structural trends such as an ageing population and increasing healthcare consumption. By 2050, over 20% of the population will be over the age of 65, versus around 12% currently (see chart below), a by-product of China's one-child policy which was implemented in 1979. A second positive factor is China's rural land reform, which should also be given credit and by which land leases for farmers are being made permanent; this will help to increase farmers' incomes, improve agricultural infrastructure and support the rural economy generally. These changes are further promising signs that China also has an eye on longer-term remedies rather than merely the 'quick-fix' solutions that are evident today.