Through sustained rampant growth, China has forged itself a place as an economic powerhouse in the international community. Typifying this trend, the past 10 years saw annual real GDP growth in China consistently range between roughly 9% and 14%. However, few, if any, economies can sustain such growth forever. Today, we believe China stands at the precipice of a major economic inflection.
A weak global economy has left the traditionally export-driven nation without a reliable outlet for extrinsically driven growth. The most recent additions to GDP have come from fixed-asset investments, but it seems that those avenues, too, have been exhausted. With the passage of the nation's 12th five-year economic plan, the shift toward a consumer-led economy is officially underway. The shift stands to take the wind out of the sails of commodity inputs relied upon throughout the nation's infrastructural binge.
Signs of a Turning Tide
In a report last year, Morningstar senior securities analyst Daniel Rohr noted that China's gross capital formation, or GCF (investment in physical capital), had grown to an astonishingly high 50% of GDP from 35% in 2000. The trend significantly reduced the impact of household consumption on overall GDP. While the PRC's most recent quarterly economic data indicate strength in fixed-asset investment, historically reliable indicators of GCF such as steel and cement production indicate the contrary. In a more recent piece, Rohr notes that year-over-year changes in steel and cement production levels have dropped by over 50%.
The interesting point here is not that infrastructural investment is a waning driver of growth. China built an expressway system that rivals that of the United States. The nation constructed millions of high-end commercial and retail properties priced so far above the common Chinese people's affordable range that vacancies have brought about the nickname "Ghost City." Expansion of supply without a demand to meet it couldn't have continued indefinitely. The economy is likely to shift further toward a consumer-driven growth balance. The peculiar point, however, is that the balance will likely come from a decrease in investment, not an increase in consumption.
China's Commodity Footprint
The shift toward a more consumer-centric growth balance in the future carries serious implications for the hard assets that the nation relied on for growth in the past. China has grown to demand the largest stakes of a number of commodities and understandably so. In addition to the infrastructural and real estate boom that required vast amounts of industrial commodity inputs, China also maintains the world's largest national population. This means that national demands for agricultural and energy products are accordingly lofty. The difference between the segments of commodities is that those used to satiate the day-to-day requirements of the populous are much less likely to see a Chinese-driven change in the near term. Their industrial counterparts, however, have seen a paradigm shift.
The demand that China provided the industrial metals space over the past decade was an inherently structural one. The nation staked its reputation on breakneck growth rates that could be achieved only through continued development. Such capital formation relied heavily on metals such as copper and steel. As the nation's fixed asset investment cycle slows, so too will a demand that had been baked into industrial commodities markets for at least the past decade.
Likely Victims
We mentioned steel earlier as an indicator of the state of fixed-capital investment. While China is, in fact, a substantial consumer of the metal, it satiates most if not all of its demand with its own production. To identify the repercussions of cooling fixed-asset investment here, we may need to look further upstream. True, China produces most of its steel, but it does so with imported iron ore. The nation has long been the top consumer and importer of the base metal, but the impacts of a shift would be felt in places such as Brazil and Australia. The world's largest iron ore producers are Vale (VALE), Rio Tinto (RIO) (both Brazilian), and BHP Billiton (BLT).
Copper is the second metal that is likely to see dampened demand in the event of a popped infrastructural development bubble in China. The nation has buoyed in its global share of consumption of copper and is expected to drive price support for the metal going forward. Being intimately tied to the health of the construction sector, such as steel/iron, "Doctor copper" will be adversely affected by the loss of a structural demand driver like Chinese fixed-capital investment.
Don't Look to a Broad Basket for a Niche Exposure
For those who see storm clouds on the horizon for China, expressing that opinion through a large marquee-name China ETF or index fund may seem convenient, but there are a number of concerns. Generally speaking, Chinese ETFs and index funds do not provide exposure to the broad economy. They tend to focus heavily on the largest of the nation's firms, which renders significant exposure to the financial sector and with it, governmental controls.
Those looking to expand their negative thesis to the broader BRIC region will find similar problems. While the most prominent emerging economies weigh heavily on the commodity sector, we would recommend against using a broad country allocation to capture movement in the price of the commodity itself. ETFs that invest directly in commodities are more appropriate in these cases.
Abraham Bailin is an ETF analyst with Morningstar.
