China: Can the boom continue?
January 22, 2014
In China, when economic growth shows signs of faltering, local governments can ramp up building projects, spurring infrastructure spending to push growth back to target levels.
The practice is evident in a proprietary tool that Vanguard economists use in evaluating China. Their creation—known as a dashboard—examines more than 80 independent metrics that provide insight into China's economy beyond official gross domestic product (GDP) figures.
In both 2012 and 2013, Chinese GDP growth slowed toward the middle of the year. And in both years, growth accelerated on the strength of local governmental spending, negating the risk that the central government might miss its annual growth target.
"China hasn't missed a growth target in years," said Roger Aliaga-Díaz, head of Vanguard's Asia-Pacific Investment Strategy Group. "But is it investing in a way that will promote self-sustaining growth?"
"Bridges to nowhere"
China had a GDP of $8.22 trillion1 in 2012 and accounted for $3.86 trillion in global trade.2 What happens in China reverberates through investment markets worldwide.
"The dozens of different indicators that feed the dashboard provide an alternative to the official government GDP data," said Alexis Gray, an economist in the Investment Strategy Group who maintains the dashboard. Gray noted that the government releases its GDP figure just two weeks after each quarter's end and doesn't significantly revise it in subsequent quarters.
In the third quarter of 2013, China's GDP growth came in at 7.8%, its strongest performance of the year and above the year's target of 7.5% growth.
But while markets tend to cheer strength in China's economy, questions exist around how long the government can come to the rescue and whether its investments will pay off for the long term. "It doesn't make sense," Gray noted, "to build bridges to nowhere."
Behind the dashboard
The dashboard's indicators are assigned colors—green if the indicator signals expansion, red if it signals contraction, or yellow if it signals contraction at a decreasing pace. Each indicator carries the same weight on the dashboard.
In the third quarter of 2013, green indicators included property construction, property investment, industrial production, business loan demand, and inflation expectations. Among the red indicators were government revenue, consumer future-income confidence, and automobile sales.
A dashboard where half the indicators are green suggests a continuation of growth, according to recent trends. The China dashboard hasn't been at least 50% green since the second quarter of 2011, when GDP growth registered 9.6%.
The recent level of green indicators below 50% is consistent with Vanguard's long-term outlook for China's growth. "Essentially, growth is expected to remain close to the 7% target that the government announced in its five-year plan for 2011 to 2015, and perhaps a bit lower after that," Aliaga-Díaz said. "The 30-year average GDP growth of 10% per year is not likely to continue."
A new-look China
While other emerging markets challenge China's advantage in exports and fewer productive avenues exist for infrastructure spending, a vast consumer class waits to be tapped.
What might a China growing at 7% a year look like? Less export-oriented infrastructure and heavy industry, with more production for the domestic consumer market, Aliaga-Díaz said.
Capital investment, currently around 50% of GDP, may gradually decline, he said, to a more sustainable long-term level. Where there is capital outlay, Aliaga-Díaz said, it would best be undertaken by the private sector in areas such as commercial real estate, retail, services, technology, and pharmaceuticals.
"Education is another big one," Gray said. "As China makes the shift from an emerging to a developed economy over the coming decades it will need greater skills to produce higher-value goods."
A hint of reform
At a meeting of top government officials in November 2013, China said that its state-owned enterprises would continue to hold a dominant position in the economy, but also said that markets should play a decisive role in resource allocation. While the meeting produced a broad policy statement, any resulting change is likely to be gradual.
"Ideally, China will introduce greater competition in the banking system," Aliaga-Díaz said. "That would allow market forces to dictate how banks allocate credit to small companies and start-ups with the best investment ideas, those most likely to create products that the mass consumer markets will want to buy."
Implications for investors
China accounts for 11.4% of global GDP.3 Its companies make up 21% of the FTSE Emerging Index,4 and even more of its economic activity is reflected in the performance of developed market multinational companies.
But China's greatest importance as part of an equity portfolio is the diversification it provides, Aliaga-Díaz said. China's recent slower growth doesn't necessarily mean its equities will underperform the broad global market, just as its faster growth in the last decade didn't necessarily mean its equities would outperform. This point holds true for all emerging markets, Aliaga-Díaz noted.
To truly reflect global diversification, he suggested allocating equities on par with companies' and countries' relative size in world markets—allocations that are typically available in market-capitalization-weighted index funds.
1 Source: International Monetary Fund.
2 Source: CEIC. Figure includes both China's exports and China's imports.
3 Source: International Monetary Fund.
4 As of October 31, 2013.
- All investments involve some risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results.