The China Boom Won't Break

Will China fail? It's an important question because Australia, like the rest of the world, is increasingly dependent on the rapidly expanding economy of the most populous nation. Few believe it will come to a grinding halt, or that its communist rulers will, one day, suddenly decide to jettison the market-orientated system that they have allowed to come to dominate. Nevertheless, many wonder if an economy that has grown at an astonishing 9 per cent since 1980 can keep it up. China’s economy has grown 800 per cent in the past 25 years and will double again in eight years if the present rate of growth is maintained.

Most nations would be exhausted by such a prolonged burst of activity, but it would be a mistake to assume '” as many analysts do '” that China will relapse into its former torpor. Even during the “normal” recessionary years for the world economy, during which the powerful contribution made by trade is likely to weaken, the momentum of China's gigantic internal demand may sustain its economy at no less than 7 per cent growth.

This is because the source of that domestic demand growth is not merely cyclical, as in most other nations, but also genuinely transformational. In other words, it is difficult to imagine a scenario in which China’s growth falls below that of the developed world until its economy reaches full maturity. Its potent combination of demographics, internal migration, industrialisation, infrastructure investment, technology-driven productivity improvements and the progressive acceleration of consumerism will prevent a return to the lethargy that characterised China for decades.

Consequently, with one-fifth of the global population actively embracing an efficient market system, the years ahead are likely to be ones of profound transformation for Australia and its immediate region as well as for the entire global economy. China’s awakening has become a powerful factor in preventing economic laxity elsewhere '” certainly in the developing nations of Asia and Latin America. Also, as the “China effect” cascades from one region to another, raising the rate of global growth, the volatility of the traditional world boom-bust cycle is likely to be lessened.

The dead hand of communist control and central planning is continuing to give ground to the sharp-witted risk-taking of private enterprise. Since large-scale privatisation began in 1997, much of the new commercial activity has been supported by the knowhow and accumulated capital of those returning Chinese who fled from an environment of anti-capitalist ideology. This, in turn, is driving deep reform of repressive legal and landholding systems, making possible a vast internal migration of labour to the newly productive and better-paid manufacturing and service sectors.

As employment and incomes rise, so too does demand for greater choice in spending on higher-value goods and services. This then feeds back into yet greater opportunities for creating wealth.

The urbanisation of the nation and its new exposure to external trade are spurring innovation in the financing of this activity. Debt financing through the banking system is gradually giving way to equity as sharemarkets grow in importance and
depth. Despite the volatility of the markets, more and more middle-class urban Chinese are investing in listed local shares rather than depositing their savings in the state-owned bank. Foreign investment is also responding to new laws protecting ownership by lifting investment in the equities market. What this means is that, as the dependence on fallible banks diminishes, the unavoidable risks of rapid growth are spread wider. With that growing diversification of risk comes the greater financial stability that builds long-term confidence.

China will not let Australia down because:

• The high growth rates of the past quarter century are likely to continue well into the first quarter of the 21st century. If this happens, it will be many years before China’s trend growth rate falls to the modest annual 3-5 per cent that characterise even the best mature economies.

• Chinese demand for raw materials will continue to rise. Growth in the consumption of energy and minerals will comfortably exceed GDP growth until a new “post-industrial” equilibrium is reached, perhaps by 2050.
• Chinese competition for essential raw materials will keep global resources prices high and rising; and the continued growth of China’s export capacity will keep global prices of manufactures depressed. This is bad news for competitors such Europe and Japan but good news for commodity suppliers and goods importers such as Australia.

China’s pragmatic rulers recognise that, to maintain political stability, they must continue to meet the high economic expectations they have raised. Their policies reflect that there is no possibility of putting the cat back in the bag.

The consequences of China’s irreversible expansion are being felt globally in trade, inflation and interest rates; currency alignments; food and energy prices; military and diplomatic alliances; manufacturing employment, wages and corporate profits; and the physical environment.

The repercussions of all are hard to predict because they will be so persistent, far-reaching and interconnected that our poor analytical models will be overwhelmed by their complexity.

Australia will be squarely in the front line of these earth-shaking consequences. Our geographical location and natural endowments tie us tightly to China’s destiny '” but as a partner rather than as a competitor. This will make Australia a highly desired investment destination.

The continued industrialisation of China makes these developments inevitable. So too does the enormous investment reqired in the basic national infrastructure, without which industrialisation cannot proceed. The extension and modernisation of the land transport system, and production of the road and rail vehicles to use it, will require mountains of steel and non-ferrous metals. Most of those materials will be newly mined since developing countries have very little scrap to be recycled. Urban commercial and residential construction will absorb further mountains of raw materials before they can accommodate the flood of new immigrant employees from the countryside.

Given the urgency and magnitude of these requirements, it is hardly surprising that new capital expenditure in China is continuing at around 40 per cent of GDP '” a ratio so high that its many critics have long predicted its implosion. We are far less sceptical because we see less evidence of speculative capital investment in China than in many developed Western economies. We are also far less apprehensive than most analysts about the durability of the investment boom because it is financed chiefly through domestic saving, which is running at about 40 per cent of disposable incomes. By contrast, Australia’s much more modest capital-spending ratio is mostly funded by foreigners because Australians save too little. In the US, where the savings-to-GDP ratio is now negative, that situation is even more precarious.

Where will the resources come from to fuel China’s growth? China is rich in fossil fuels, with some 800 billion tonnes of known coal reserves and more than 24 billion barrels of oil reserves (about Nigeria’s). A lot more may be found in the arid far-western Tarim Basin, from which a new 4000-kilometre pipeline has recently been commissioned. Water resources and hydro-electric generating capacity are also very large. But, in per-capita terms, China is relatively impoverished in almost everything '” and its self-sufficiency is already becoming visibly strained. Oil, for example, can no longer be exported, even though the nation is the fifth-biggest oil producer. China also ranks first in global steel, raw coal and cement production, and in the output of several non-ferrous metals. Nevertheless, it already needs all it can produce, and, despite vigorous efforts to economise and recycle, it will need a lot more as its mines and wells are depleted.

The implication is clear: imports of raw materials must rise exponentially as the constraints on domestic production begin to bite and as, inexorably, demand increases. Moreover, China will have to compete for supplies against industrialising nations whose own growth it will have stimulated. To access these raw materials, China must make an irreversible commitment, under World Trade Organisation rules, to free trade, and make as many bilateral free trade agreements as possible with partners such as Australia.

Important developments have begun to emerge in the currency markets. Under extreme pressure from all sides to revalue the yuan, China has now embarked on a "dirty float" against a basket of currencies which should result in an extended and tightly controlled upward drift rather than a jarring jump against the dollar. The initial gain has been smoothly contained to less than 3 per cent, which illustrates several big strategic wins by the central bank's new strategy.

First, the fact of the tiny revaluation to date, and the graciousness with which it was offered, draws the fangs of its opponents and buys China valuable time with which to pursue its more fundamental diplomatic efforts to defuse the currency conflict -- by offering compromises, for example, on quotas and export rebates, on voluntary export restraint in many sensitive sectors, and on controlling the brazen piracy of foreigners' intellectual property rights. Then, the decision to manage the yuan's flexible partial
float against a currency basket in effect locks in the Chinese undervaluation far more broadly than before, while cleverly diluting
criticism at the same time. And finally, the new yuan-rate management mechanism effectively drives off the now-profitless currency speculators, further easing the upward pressure. All in all, this has been a masterful exercise in managing international tensions.

These fundamental changes occurring in China have powerfully positive long-term implications for Australia’s terms of trade, inflation and interest-rate trends, and exchange rate. In terms of total annual export and import values, China is Australia's third-largest trading partner after Japan and the USA. As China begins to buy Australian foodstuffs, and as Australia begins to buy Chinese motor vehicles and other machinery and appliances, the trading relationship will intensify. Trade in services '” tourism, hospitality, education and financial '” will also accelerate enormously as China’s middle class grows in wealth and numbers.

Australia will be able to export, at better prices, more of what it makes best, and pay relatively less for manufactures that China and its competitors can make more cheaply.

Overall, the “commodities super-cycle”, which is now a reality, favours Australia because inflation and industrial pollution are exported to China along with our old manufacturing jobs. In exchange, Australia gets low interest rates, a shift towards highly paid service-sector jobs and a cleaner environment. Not a bad bargain at all, provided Australia can overcome its historic complacency.

ACTION PLAN

How should an Australian investor best respond to the development of China and to the effects of the commodities super-cycle?

In making strategic investment decisions, focus only on the likely intensity and direction of asset-price trends that are driven by comparative economic advantage. You cannot afford to confuse these with the short-term cyclical cross currents that preoccupy professional tactical investors and traders.

You should, therefore, allow your thinking about China to be conditioned by two broad insights from your particular perspective: we have the natural resources that the Chinese need; and they can cheaply produce the manufactures that we will want.

You can profitably ride the investment trends flowing from these interlocking economic relationships through cycle after cycle. Those trends are your friends, so stay with them.

There are five outstanding resource sectors where investment opportunies may occur:

• Energy: Especially in uranium and liquefied natural gas. China’s power requirements will be insatiable and these “clean” sources will be increasingly preferred to domestic coal.

• Nuclear Power: Australia could safely and profitably store nuclear waste from Asian power stations.
• Iron ore and bauxite: Together with their bulk-handling infrastructures, these two resource sectors are also areas for long-term investment.
• Industrial diamonds: China is badly deficient in industrial diamonds, which Australia produces.
• Gold: China has a ravenous gold appetite, and it can only grow.

Australia has few natural advantages in selling non-bulk commodities into the Chinese mass market '” but there will be many opportunities to sell services and some premium produce to the enormous emerging middle classes. Specialist tourism and education, and their associated infrastructures '” including student accommodation and services '” will be natural growth areas. So, too, will premium foodstuffs as middle-class tastes evolve. Wine will become an important commodity as this occurs.

The old rule of thumb when dealing with developing economies is that it is usually more profitable to buy from them than to sell to them. But China is very different because it is not in exotic commodities but in manufactures that its comparative advantage lies. China can flood the world with cheap and increasingly well-made goods. You should therefore invest in their distribution networks and divest your portfolio of anything that competes with their manufactures.

Do this first, or the waking giant will eat you for breakfast.