On current assumptions, China is expected to overtake the US as the world’s largest economy in the next decade, before India assumes pole position by 2050.
While China’s long-term rise looks unstoppable, its ‘growth miracle’ has slowed somewhat recently, and debate on whether its eventual landing will be soft or hard remains ongoing.
With powerful fundamentals still in place, consensus is tipped towards the soft, but advocates of a hard landing scenario present compelling arguments, particularly against a backdrop of slumping property prices and rising anxiety.
As the world’s two largest economies, the US-China relationship is important for the world, and cracks are already emerging in the run-up to the former’s election and imminent leadership changes in the latter.
Republican candidate Mitt Romney has angered China with provocative language, talking about measures to discourage any “aggressive or coercive behavior” towards its neighbours.
In any case, after a long period of broad bullishness on China – at least from a macro perspective – it is worth considering the consequences for investors if the country disappoints.
Hard landing
At the most bearish end of the spectrum is local economist Jim Walker from Asianomics, who believes China has made so many mistakes over the past few years that a hard landing is inevitable.
“China has taken on the notion of credit at all costs to fuel growth at all costs,” he says. Even though the Government is trying to control the adverse effects of its credit expansion in 2008, Walker thinks misallocation of capital will lead to a property crash.
He also questions the reliability of China’s figures – citing the example of the banking crisis in the late ’90s, when 40% of assets in the system were non-performing and simply moved into asset management companies.
Elsewhere, chief Asian economist at Capital Economics Mark Williams believes the property market is key, and questions whether a strong economic recovery is possible in China without solid growth in real estate.
“It is hard to overstate property’s importance to the wider economy and even to the rest of the world,” he says.
“China has built over 90 million properties in the past 15 years, enough to house the combined populations of Germany, France and the UK. Along the way, construction activity has boosted economic growth and been a key source of jobs for migrant workers.”
Empty property
According to Williams, the upshot is that a return to rapid economic growth in China is extremely unlikely as long as property is struggling.
“Roughly two million properties were sitting empty at the end of July and a further thirty million are under construction,” he adds.
“That is enough to meet property demand for the next three or four years, and in these circumstances, only the bravest developers will embark on new projects. In other words, a property sector rebound seems unlikely, and so a sluggish economic recovery looks the most probable scenario whatever the Government decides.”
That said, Capital Economics actually sees sluggish recovery as the best outcome, citing unsustainable growth on the property side.
“Urban residential real estate investment accounts for double the share of total spending in the economy than it did a decade ago and a period of below-trend growth is needed to put the sector back on a sustainable path,” adds Williams.
“If that means the economy ends up growing slower than China has been used to, this is something worth putting up with. Another wave of property investment would bring short-term benefits, but result in an even bigger economic downturn a few years down the line.”
High-risk market
Considering this increasing uncertainty in the region, how can UK investors best play China? Darius McDermott, managing director of Chelsea Financial Services, says that China’s underperformance in the past two years has reminded investors that the country remains a high-risk emerging market.
His preferred fund to access the region is First State Greater China, where manager Martin Lau is cautious on slowing growth and concerned about the lack of fiscal and monetary firepower for the incoming government.
“Consensus seems to be moving more negative on China, albeit acknowledging that even slower growth in the 4-6% range will be much higher than the West,” says McDermott.
“With this caution in mind, the best way for most UK investors to play China is through a broader emerging markets fund, where the allocation can vary depending on conditions.”
In the past, Chelsea used First State’s emerging market portfolios but is now on the hunt for alternatives.
“We like the Martin Currie emerging market franchise but the team’s mid and small-cap bias has hit performance, and we also rate Charlie Awdry on Henderson China Opportunities, who has suffered a similarly tough 12 months,” he adds.
“One thing we can say is that China is becoming increasingly cheap so there are opportunities to be had for higher-risk clients.”
Walker says it is possible to make money from the China theme, primarily by playing on the country’s mistakes.
“Australia, for example, has benefited from China’s misallocation of capital, which led to a huge demand for commodities,” he says.
Walker cautions against owning Chinese companies and suggests investors are better off buying into economies where the cost of capital is commensurate with the growth rate.
Chinese exposure
A look at activity among multi-managers is also instructive, with many paring back Chinese exposure. Cazenove’s head of multi-manager Marcus Brookes is among those making such changes, seeing the region’s growing problems as under-appreciated.
“Even without assuming a hard landing, there remain enough impediments to current levels of growth that are not yet fully priced into many markets,” he says.
“The strangely common belief that the Chinese Government can control every aspect of growth in all its minutiae, where most have struggled through history, still seems somewhat questionable to us.”
Brookes says that while Chinese growth will continue to outpace the West, 7% GDP will feel slow compared with recent years and 6% would potentially be approaching recession territory.
Like many China watchers, he is particularly concerned with developments in the property market.
“In a global context, the Chinese market has only been open for around a decade and with its currency fixed to the dollar, authorities have had to print huge amounts of the currency to keep up,” he says.
“Much of that has gone into forming a huge construction bubble and in the most expensive city, mortgages now require massive multiples of salary.”
Hedging portfolios
To hedge his portfolios – and potentially benefit if the country continues to struggle – Brookes has bought noted China sceptic Hugh Hendry’s Eclectica Fund.
“Hendry’s fund is built on a similar view to ours – namely that several markets around the world are still pricing in a fairly rosy scenario for China,” he adds.
“If you look at Japanese steelmakers, for example, they are some of the most leveraged companies in the world but have thrived in recent years because they sell to China. A small decrease in their turnover would have a huge affect on operating profits and credit servicing and continued Chinese strength is built into so many assumptions.”
