Thursday, June 11, 2009

The One Caveat to China’s Growth Story

By Ashish Advani The entire world has been monitoring the signs of new growth in China…even I myself have seen green shoots starting to pop up.

However, you need to be careful with this China story. It’s not 100% absolutely certain yet. For starters, while I (and indeed most other emerging market analysts) gladly accept that growth is happening somewhere in the world, the quality of China’s growth worries me.

Indeed, China’s economic downturn may have bottomed. And I agree with Chuck – China may be the first nation to recover from this downturn. But the quality of growth is poor and is overly reliant on public demand.

The economy may grow at 8%, but at what cost?

Manufacturing still accounts for 43% of GDP in China. When you compare this to India (24%), Korea (27%) and Taiwan (26%), this growth is lopsided. In the U.S., manufacturing contributes 12% of GDP growth.

If the rest of the world does not buy “Made in China” products, then the local buyers will struggle to fill the gap. While local demand has grown, it grew at half the pace of external demand.

What All This Stimulus Is Really Doing to China’s Economy…

The fiscal stimulus will assist in the current growth targets. The stimulus is focused on public infrastructure. This will help growth rates. The stimulus is also spurring sales of manufactured goods and offers internal subsidies. Yet, fiscal deficit spending can only provide a temporary bridge for the current challenges.

Most importantly, stronger domestic demand may struggle to fully pick up the slack left by weaker external demand. In other words, Chinese consumers need to buy if we aren’t. The lack of expenditure-based GDP numbers makes analysis difficult.

So for now, China may achieve its stated goal of 8% GDP growth. But the cost of this growth will show signs of unraveling by 2011. The non-performing bank loans (NPL) could become delinquent and then the production driven growth will start to reverse.

The “Miracle Grow” for those Green Shoots

If China is to succeed, it will have to make a switch, and the production / manufacturing driven growth will have to be replaced.

A stronger service sector is a potential growth driver. In order for that to happen, more radical reforms are needed. The service sector is one of the country’s last untapped growth drivers. It accounts for a low 40% of GDP, versus 50% in Korea and 70% in Taiwan, mainly as a result of heavy regulation and state monopolies in the sector.

A more vibrant services sector would not only be a major employer, but services consumption is also typically an important driver of private consumption.

Let us wait and watch how China negotiates this internal change.

I am confident that the lessons of 1997 and this decade will have taught them valuable lessons. While I am sure they will emerge successfully, I want to see more structural reforms before I fully buy into the China growth story. For now, place your China-based trades on the green shoots story…not “green leaves.”

EDITOR’S NOTE: Ashish has been looking at several currencies that promise to rally in the short-term based on this developing story. In fact, he recommended one easy-to-buy and trade currency play that took advantage of the fledgling signs of growth in the May issue of Currency Capitalist – and it jumped over 5% in a single month. Members, be sure to check out your portfolio for more. Not a member yet? I urge you to take just a moment and see what we have to offer.