September 25, 2013
China's shift toward an economic model emphasizing domestic consumption over government stimulus will have repercussions throughout the global economy. The resulting changes present investors with opportunities and risks.
China's leadership is seeking to engineer a transition from an export-driven economy to one reliant on domestic consumers. Key to this transition is an enormous and expanding middle class, which is on track to double its share to nearly half of the Chinese population in less than a decade. The transition will require fundamental economic and political reforms. It's also unfolding at a time when the Chinese economy is slowing, raising worries about high debt levels resulting from recent stimulus spending.
"This transition presents very different challenges for China," explains Anh Lu, portfolio manager of the T. Rowe Price New Asia Fund, "not because the politics have changed, but because the economy has changed, the world has changed, and the working environment in China has changed."
Despite its growing clout, China's middle class is not yet ready to drive the country's economy in the absence of state-sponsored stimulus programs. The middle class currently accounts for less than 20% of China's total population,1 insufficient to generate the levels of demand common in most developed economies. Moreover, China is a nation of savers, with an average urban household savings rate of more than 30% of disposable income, according to the International Monetary Fund.2 With a weak social safety net, Chinese workers are unwilling to consume to the same extent as Americans or Europeans.
China's most recent five-year plan—a high-level economic blueprint covering the period from 2011 through 2015—aims to bolster the middle class and increase its ability to reap the benefits of economic growth. The plan targets a minimum wage growth of at least 13% per year. Steadily increasing wages is a necessary step toward stronger domestic consumption and higher living standards. But rapid wage growth can also lead to inflation, negating many of its benefits. "Wage inflation clearly increases the cost of production in China and will have some detrimental impact on China's competitiveness," Lu says. "However, wage inflation has tended to far outstrip overall inflation."
The latest five-year plan states the necessity of improving public welfare and social justice. A nationwide social insurance program would help reduce the dependence on personal savings and free up more money for consumption. "The government is aware of these issues and is slowly putting in reforms," explains Ernest Yeung, who manages the Asian emerging markets portion of the small-cap T. Rowe Price International Discovery Fund. "Once they solve these problems, I believe households will spend more."
Boosting consumption is not the only obstacle policymakers face as they attempt to overhaul the country's economic drivers. A $600 billion stimulus program announced in late 2008 triggered massive spending and lending, much of which drove real estate purchases. As a result, land prices have run up in many Chinese cities and have raised concerns about a housing bubble, which, if it were to collapse, would weigh heavily on the economy.
Most worrisome is China's rising indebtedness. Infrastructure projects started in the wake of the stimulus have saddled local banks and governments with loans, some of which are likely to go unpaid. The country's total debt-to-gross domestic product (GDP) ratio has soared in recent years to just over 200%, according to Lu, who notes that other emerging markets have encountered problems at that level. A surge in lending by lightly regulated trust companies and underground banks—otherwise known as "shadow lending"—has spurred worries that a credit bubble is forming in China, with the potential for severe damage to the economy. Additionally, because political factors often determine lending decisions, many local bank loans ended up financing unprofitable ventures. Should the economy slow too much or too quickly, borrowers might be unable to pay off their loans. That could lead to defaults and a potential financial crisis. "Some of the debts are interlinked, with one party guaranteeing the debt for another company," says Yeung. "If China's slowdown persists, it could jeopardize the system, in particular the financial companies that did the lending and the construction-related companies with the highest debt burdens."
China's recent stock market performance appears to have priced in a substantial slowdown in the country's economy. The benchmark Shanghai Composite Index has trailed the broader MSCI Emerging Markets Index since May 2010 and closed at its lowest level in four and a half years in June. T. Rowe Price analysts and portfolio managers have a guarded view about certain sectors, such as debt-laden Chinese banks and other financial institutions. But they see numerous opportunities in other parts of the market.
Many T. Rowe Price fund managers believe that long-term growth opportunities resulting from Chinese consumer spending outweigh the short-term risks, such as a downturn in retail spending. "I continue to see consumer companies as a multiyear theme," says Yeung. "Their balance sheets are in much better shape than they have been in the past, and they can continue to expand their businesses. I believe the recent slowdown is temporary."
Lu believes that stock prices in China's consumer discretionary sector reflect overly pessimistic projections that assume no earnings growth for the next three years. Lu anticipates China will endure a period of slow growth, not a recession, and has identified opportunities in well-run companies—such as restaurant chains and auto distributors—that have the potential to maintain earnings growth in an increasingly competitive environment. Moreover, many companies in Taiwan, South Korea, and Europe that sell to China's consumers are benefiting from the increase in middle-class spending because they provide services or products not offered by Chinese companies, such as luxury vehicles or high-end handbags.
Substantial opportunities lie in regulated assets, including ports, electricity producers, and toll roads, say T. Rowe Price portfolio managers. The companies operating these facilities absorbed large cost increases over the years, which pressured profit margins and hurt their stock prices. But costs are leveling out, even as inflationary pressures may result in tariff increases. "All of a sudden, you have a company that goes from negative free cash flow to a very positive cash flow," says Lu. "That is attractive from an investment standpoint, in part because it enables the company to pay higher dividends."
China's new leaders, who assumed power in the fall of 2012, have pledged to clean up widespread government corruption. The war on official graft includes a highly publicized crackdown on the practice of "gifting," or peddling influence through gift-giving. Robert Smith, portfolio manager of the T. Rowe Price International Stock Fund, believes that the clampdown on corruption may add to the short-term pressures on some areas in the consumer discretionary segment. "Some of the luxury companies have benefited from gifting-related sales," he says. "In the near term, a crackdown on gifting will hurt."
Other consumer discretionary companies are unattractive investments, despite appealing market opportunities. For instance, beer companies enjoy a huge market in China, yet China's brewers have very low margins compared with their international peers because of intense competition. Lu says brewing companies spend money on promotion at the expense of increasing their earnings to gain market share. This type of industry is unlikely to benefit from a growing consumer class, Lu says.
Many companies in the industrials and business services sector are also unlikely to benefit from China's economic transition. Companies saddled with excess capacity are not well positioned to thrive amid an economic slowdown and a withdrawal of stimulus spending. The same goes for companies in energy-intensive industries or those that rely on the inexpensive discharge of pollutants. Costly upgrades to meet stricter environmental standards may soon be necessary before those companies can expand, Yeung says. "Some companies may suffer longlasting impacts as their end customers replace the high pollutant process with other, cleaner sources of production."
China's overall push for cleaner energy represents an opportunity for alternative energy companies if the government makes the necessary upgrades to its energy infrastructure. For example, shares of wind power companies have suffered from an inability to adequately transmit power from rural areas of production to urban consumption centers due to a lack of interconnection in the power grid, says Smith.
China's long-planned evolution to a consumer-driven economy results from fundamental economic changes, both at home and abroad. T. Rowe Price analysts and portfolio managers believe that China will ultimately be successful in negotiating this transition, which will take many years. The process presents considerable uncertainty but also a unique opportunity for investors who have the resources to do extensive research and the willingness to take a long-term view. "We're most likely not going to wake up one morning and see a profoundly different China," Smith says. "But we will look back in five years and see that things have really changed."
Note that the T. Rowe Price New Asia Fund's relatively limited geographic orientation and exposure to emerging markets increase its risk level. The fund price is subject to market risk in addition to risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad.
2International Monetary Fund, Sino-Spending, September 2012.
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