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China, investment potential or potential nightmare?

I have to confess that as an investor China terrifies me.

Corporate governance is generally dreadful, while the economy faces a serious challenge in transitioning away from its one dimensional credit-fuelled investment-driven model. This latter point was made in a recent FT article by Martin Wolf, ‘China will struggle to keep its momentum’. Wolf notes that:

“A salient aspect of the unbalanced economy is the high savings rate and thus its reliance on investment as a source of demand. Yet, as the economy slows, the demand for investment is likely to fall more than proportionately. The reason is that past investment was done on the assumption of annual growth at 10 per cent. With growth substantially slower, excess capacity will be chronic. What do people do when they have excess capacity? They stop investing. That is also why China’s government needs to keep growth up: if it fails to do so, investment might collapse, with devastating effects.”

The extent of the investment boom that China has experienced in recent decades is made clear in an article by Robert Wilson on the website The Energy Collective. Wilson notes that:

“In 2011 China produced approximately 1.6 tonnes of cement per person. This is four times higher than the historic peak in the United States, and higher than all but five other countries. A revealing historical comparison is with South Korea, which experienced a similar rapid economic rise, often called ‘The Miracle on the Han River’. China’s per capita cement consumption now far exceeds that of South Korea’s at its peak. South Korea peaked at 1.3 tonnes per capita, while China looks set to potentially move past 2 tonnes per capita.”

Even Bill Gates was moved to tweet a few months ago about what he thought was the most mind-blowing fact he had learned in 2014, namely that China used more cement in the three years from 2011 to 2013 than the US used in the entire 20th century (6.6 gigatons versus 4.5 gigatons). These numbers are truly off the scale and it is impossible, at least for me, to understand how the country can gently wean itself off this thirst, rather than crash headlong into a proverbial brick wall (one made with vast amounts of cement presumably).

Wolf’s article cites two reasons to be positive about China: first, its track record of having generated growth that has taken its GDP per capita from 2% of US levels in 1980 to 24% last year; second, the country’s huge strengths and potential. Can one conscionably invest customers’ money in the country on the basis of these two facts alone? I believe the answer is ‘yes’, but one must be very long-term – to counter the very real possibility of a hard landing – and one must be very selective – the weaknesses of poorly-governed companies eventually get exposed, hard landing or not.

The environmental Kuznets curve: Cement consumption per capita vs. 2012 GDP per capita.

Kuznets curve: cement consumption

Graph Source: European School of Management and Technology Annual Forum 2014 – Energy and transport in 2050 & Deutsche Bank (2014)

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The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
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