PIVOT CAPITAL MANAGEMENT - China's Investment Boom the Great Leap Into the Unknown

China’s Investment Boom: the Great Leap into the Unknown

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In this report we describe the background to and the extent of the capital spending bubble in China and identify factorsthat will precipitate its deflation. We focus on Chinese capital spending firstly because it is the single most importantdriver of current Chinese and global growth expectations and, secondly and more importantly, investment-drivengrowth cycles tend to overshoot and end in a destructive way.We conclude that the capital spending boom in China will not be sustained at current rates and that the chances of ahard landing are increasing. Given China’s importance to the thesis that emerging markets will lead the worldeconomy out of its slump, we believe the coming slowdown in China has the potential to be a similar watershed eventfor world markets as the reversal of the US subprime and housing boom. The ramifications will be far-reaching acrossmost asset classes, and will present major opportunities to exploit. There are three key reasons why we take this view:

China’s expansion cycle surpassing historical precedents:

It is widely believed that China is still in an earlydevelopment phase and therefore in a position to expand capital spending for years to come. However, both in itsduration and intensity, China’s capital spending boom is now outstripping previous great transformation periods.

Policy actions not sustainable into 2010

. This year’s burst in economic activity has been inflated by a front-loadedstimulus package and a surge in credit growth. Given their exceptional and forced nature we believe growth rates ingovernment-driven lending and capital spending will collapse in 2010.

Overcapacity and falling marginal returns on investment:

Analysis of industrial capacity, urbanisation andinfrastructure development shows that China’s industrialisation and structural modernisation are largely complete.Combine this with falling returns on investment, and it becomes obvious that China’s long-term investment needs aregrossly overestimated.

China’s Capital Spending in Uncharted Waters

In our view investors have underestimated both the maturity of the Chinese growth cycle as well as the degree towhich recent growth is a direct extension of the global credit bubble. This bubble had two major manifestations. Thefirst, which started unravelling globally in early 2007, was evident in excesses in real estate, consumption and privateequity. The second manifestation, which has yet to fully deflate, was a boom in capital expenditure, led primarily byChina.The Chinese economic “miracle”, referring to the past 30 years of growth at an average real rate of 10% can bebroadly split into three periods. In the 1980s, the first stage was unleashed by modest reforms of Deng Xiapoing suchas liberalisation of prices in the agricultural sector. After a brief pause coinciding with the Tiananmen events, thesecond stage concentrated on rationalization of labour that saw a proliferation of light industries at the expense of agriculture and State Owned Enterprises (SOEs). The third stage has been focused on expansion of heavy industriesand infrastructure. What all three stages had in common was a central role of investments as a driver of economicgrowth. Indeed, China has emulated the path of other countries that have rapidly developed in the second half of the20

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century driven by high investment to GDP ratios (we focus on Gross Fixed Capital Formation, GFCF, which is abroad definition of investment). However, both in its duration and intensity, China’s capital spending boom is nowoutstripping previous great transformation periods (e.g. postwar Germany and Japan or South Korea in the 1980-90s,chart 1).The gradual increase in China’s investment ratio that started in 1998 has now reached unprecedented levels. As aresult, capital spending has become the dominant growth driver. We estimate that GFCF accounted for 70% of China’s growth in 2008 and close to 90% of China’s H1 2009 growth (chart 2).

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Amazingly, the ratio of GFCF to GDP is expected to exceed 50% this year, which would be well above the highestGFCF to GDP ratio any Asian country reached in their mid 1990s booms. Another salient observation is that thelongest period any country maintained GFCF to GDP in excess of 33 % was nine years (Thailand 1989-97, Singapore1991-99, chart 3). China is now in its twelfth year of investment boom.The experience of the Asian tigers, as well as the post-war reconstruction periods of Germany and Japan, provideshighly relevant benchmarks for analyzing China’s multi-decade growth process and current situation. The eventualreversion of investment ratios in those countries tells a cautionary tale on its own, however, what makes the situationeven more alarming, is the rapidly decreasing efficiency of China’s investments. In the third decade of expansion, theIncremental Capital Output Ratio (ICOR)

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in China has markedly deteriorated compared to the previous two decadesas well as to other high-growth countries in their pre-peak investment stages. In 2009 China’s ICOR will be more than2 times higher than the 80s and 90s average (chart 4).The falling marginal returns on investment are symptomatic of the increasingly speculative nature of China’s capitalspending boom, where a self feeding process of credit growth and investments in manufacturing, infrastructure andreal estate is currently under way. This process has been reinforced by central and local party officials eager to addressbottlenecks through building so much capacity as to make sure they would not need to ask for more money in thecurrent 5-year plan, simultaneously maximizing short-term growth. However, the decreasing efficiency of investmentswill ultimately lead to a pullback in capital expenditures.

In a soft landing scenario, China is likely to shift to a lowergrowth trajectory for the next decade. In a hard landing scenario, which is entirely feasible, there would be an abruptdecline in capital spending exacerbated by a banking crisis.

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Incremental Capital Output Ratio is defined as the ratio of Gross Fixed Capital Formation to GDP divided by real GDP growth.The lower the ratio, the more efficient capital spending is at generating growth.

1. China’s investment boom unprecedented 2. Growth dependent on capital spending

GFCF/GDP of various countries

15%20%25%30%35%40%45%50%55%

1 9 8 0 1 9 8 2 1 9 8 4 1 9 8 6 1 9 8 8 1 9 9 0 1 9 9 2 1 9 9 4 1 9 9 6 1 9 9 8 2 0 0 0 2 0 0 2 2 0 0 4 2 0 0 6 2 0 0 8

Japan (1960 - 1988)Germany (1954 - 1982)South Korea (1978 - 2006)China (1981 - 2009E)South Korea 1991, 39%China 2009E, 50%Germany 1964, 27%Japan 1973, 36%

Contribution of GFCF to GDP Growth

0%10%20%30%40%50%60%70%80%90%100%

1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 E H 1 2 0 0 9 E

Source: IMF, Pivot Source: National Bureau of Statistics, Pivot

3. China’s Capex boom breaking all records 4. Efficiency of Chinese investments deteriorating

Intensity and duration of capex booms*

China (98-09E)Singapore (91-99)Malaysia (90-97)Thailand (89-97)Korea (90-97)Japan (68-74)

33%38%43%48%53%567891011121314Number of sequential years of capex boomPeakGFCF/GDP

Incremental Capital Output Ratio (ICOR) for China and selectedcountries

0.01.02.03.04.05.06.07.08.0China1981-90China1991-00China2001-08China2009EGermany1951-60Japan1961-70Korea1981-90

Source: IMF, Pivot Source: IMF, Pivot * Capex boom is defined as sequential years with GFCF/GDP in excess of 33%

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Credit Growth at Critical Point

Similarly to the housing and consumption bubbles in the Western economies, credit has played a pivotal role in theinvestment bubble in China. Since the beginning of the decade up to H1 2009, domestic credit in China has expanded50% more than GDP (chart 5). China is an outlier compared to the other “BRIC” countries in terms of the credit toGDP ratio (140% as of H1 2009) and is already beyond the levels that historically have led to sharp and brief creditcrises in the past (chart 6). If loans continue to grow at the current 35% rate, credit to GDP ratio will be close to 200%in China already in 2010, even with GDP expanding at 10%. This is a level similar to the pre-crisis Japan in 1991 andUSA in 2008. All this points to that credit in China is not going to be able to grow for much longer without risking amajor crisis.At the same time, the effectiveness of domestic credit in generating growth is collapsing. In the period from 2000 to2008, it took on average $1.5 of credit to generate $1 of GDP growth in China. This compares very favourably withthe peak $4 of credit for $1 of GDP in USA in 2008. However in H1 2009 in China this ratio was already at around $7to $1. Credit might be going into the luxury property and stock markets, but the trickle down to the real economy isvery poor.It is important not to forget that China was a big beneficiary of the global credit bubble as it had an effect of stimulating demand for its exports. China’s net exports grew ten times between 2003 and 2008. These externalinflows, coupled with FDI and “unexplained” inflows through the formally controlled capital account helped firms,especially in the exporting sector, to raise funding necessary for capital investment to complement the loans

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. Indeed,in 2007 and 2008, trade surplus, FDI and “hot money” were even more important sources of liquidity than credit(chart 7).Year to date 2009, China’s trade balance has shrunk 20% and FDI has fallen 18% compared to last year. In June andJuly 2009 the trade surplus was lower than respective months in 2005 and it is quite conceivable that it will be close tozero by the end of 2009. Part of the explanation for that might be rising commodity prices; however, fundamentallythe contraction of China’s surplus is a natural part of the correction of the “global imbalances”. In addition to that,“hot money” inflows also turned around, resulting in a substantial slowdown in accumulation of reserves.One of the counter-arguments to the facts mentioned above is that China can

afford

capex spending at these levels fora prolonged

period of time. After all, China’s government does not have much explicit debt (23% of GDP) and sits on$2tn worth of foreign exchange reserves.

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Official statistics attribute as much as 60-70% of total sources for capex to “self-raising funds”, but we doubt that thesenumbers are correct. Capital investment accounted for half of the growth in GDP from 2003, so if 60% of that was generated through internal cash flow or other non-debt means, domestic credit would simply not grow as much, especially given that 80% of credit in China is extended to the corporate sector.

5. Credit expanded faster than GDP 6. Credit boom can quickly morph into bust*

Credit and GDP in China

010,00020,00030,00040,00050,000

2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 H 1

CNY, bn

Domestic creditGDP

Credit expansion and ratio to GDP in credit crises and BRICcountries*

India (2008)Russia (2008)Brazil (2008)USA (2008)Japan (1991)China (2010?)Finland (1991)Indonesia (1997)Korea (1997)Mexico (1994)Norway (1987)Philippines (1997)Sweden (1990)Thailand (1997)China (2009H1)

0%5%10%15%20%25%30%35%40%0%50%100%150%200%250%Credit/GDPGrowth incredit/gdp from3 years priorcrisis

Source: PBoC Source: IMF, Pivot

*Previous instances of credit crises marked with red dots. “BRIC” levels are in blue for comparison purposes. China in 2010 based on 35% credit growth and 10% GDP growth for 2009 and 2010.