Saturday, September 5, 2015

Brian Gaynor: Why world catches cold when China sneezes



What is going on in China and why is it having such a profound impact on world financial markets? The first point to note is that information about the Chinese economy is sparse and somewhat unreliable. 

For example, the National Bureau of Statistics of China released the country’s June quarter GDP growth on July 16, just 16 days after the end of the quarter. These figures showed that the Chinese economy grew by 7 per cent in the three months ended June 30 compared with the same period in the previous year. How could a statistical organisation measure the performance of the huge Chinese economy in just 16 days?

By comparison, the United States Bureau of Economic Analysis released its preliminary June quarter GDP estimate 30 days after the end of the quarter, a second estimate 58 days after June 30 and its final assessment is due 87 days after the close of the three-month period.


China’s GDP growth was 7 per cent in both the March and June quarters, exactly the same as the official Government forecast.

According to the National Bureau of Statistics, the Chinese economy has grown by between 7 per cent and 7.9 per cent for 13 consecutive quarters, a remarkably consistent performance in a volatile world.

Many economists believe the Chinese economy is growing by much less than 7 per cent, probably more like 3 to 4 per cent, and the official figure is strongly influenced by the Government’s desire to portray a positive economic performance.

The performance of the Chinese economy – together with other emerging economies – is extremely important because this group has been the main driver of global growth since the global financial crisis.

A 2014 International Monetary Fund assessment concluded that China’s dramatic expansion has offered emerging market economies the scope to diversify their exports away from slow-growth advanced economies towards China.

The country’s investment-led growth has boosted imports from emerging countries, particularly commodities.

However, the converse of this is that a Chinese slowdown will also have a negative impact on other emerging countries and this group has contributed over 50 per cent of global growth in recent years.

One of the best ways to illustrate what has happened in China – and demonstrate why the country is having such a big influence on financial markets at present – is to look at the country’s steel industry, which has played a major role in the country’s two-decades-long economic expansion.

The Chinese steel industry, which was mainly based on Soviet technology, was small and inefficient before Deng Xiaoping’s growth-orientated reforms were introduced in the late 1970s.

Progress remained slow through the 1980s and early 1990s and the industry produced only 95 million tonnes of steel, or 12.6 per cent of the world total, in 1995 (see table).

However, production soared from 128 million tonnes in 2000, 15.1 per cent of the global total, to 639 million tonnes ten years later, representing 44.6 per cent of world output.

In 2014 China was the world’s dominant producer with just over 50 per cent of world steel output.

Steel production, which is mainly used in the Chinese construction, machinery, infrastructure and transport sectors, soared during the country’s investment-led economic boom.

China’s construction industry consumed about 305 million tonnes of steel in 2014, compared with only 50 million tonnes in 2000, as apartment, office and factory construction soared.

Iron ore is required to make steel and the accompanying table shows that Australian iron ore exports, mainly to China, skyrocketed from just 130 million tonnes in 1995 to 717 million tonnes last year.

The Chinese construction-led boom resulted in a massive increase in domestic steel production and iron ore imports. This generated substantial economic growth in China and Australia, a situation that has been repeated in many other industries, including dairying.

However, the construction growth has clearly ended and this is having a multiplier effect around the world.

Chinese steel demand has eased, with the domestic construction sector expected to consume between 280 to 290 million tonnes this year, compared with 305 million tonnes in 2014.

Surplus Chinese steel is flooding world markets and having a negative impact on prices and producers in other countries.

The iron ore sector is also under pressure, with many companies in serious trouble because of ambitious expansion plans and high debt levels.

Australian iron ore exports are expected to increase from 717 million tonnes last year to 748 million tonnes this year and 824 million tonnes in 2016. This growth is mainly due to Gina Rinehart’s massive new project at Roy Hill in Western Australia which will have annual production of 55 million tonnes on completion.

Australian analysts claim that the major West Australian iron producers are the world’s most efficient and low-cost producers.

Nevertheless, they will have to improve productivity and cut costs to maintain their market position as iron ore prices continue to fall.

Chinese growth is slowing and the steel industry is an illustration of how this will impact on Chinese and global economic growth.

A similar situation exists in many other industries in China and, as a consequence, across the globe. Chinese demand has flattened, there is surplus capacity in the country and these surplus products are being dumped on world markets. Meanwhile, the demand for commodities has decreased and prices have fallen.

The consequences of this Chinese downturn are being felt in New Zealand, particularly in the dairy and coal industries, where Fonterra is under pressure to improve its performance and Solid Energy is in voluntary administration.

This is a traditional outcome of a sustained economic boom and investors are worried that the slowdown in China and other emerging countries will lead to lower global growth in the years ahead.

There is no doubt that Chinese economic growth has been slowing for some time but global investors have only fully focused on the country since the devaluation of the yuan, and the Shanghai sharemarket crash.

The depth and duration of the Chinese slowdown, and its impact on the global economy, will be determined by a number of factors, including:
  • China’s ability to transform itself from investment-led growth, with a strong reliance on construction and steel, to consumer and service sector-driven growth.
  • The willingness of the Chinese Government to allow market forces to rationalise industrial overcapacity, including the domestic steel industry. This may be difficult to achieve because the large steel companies are majority Government owned.
  • The ability of the United States and developed economies to replace China and emerging markets as the main drivers of global growth. This week’s announcement that the US economy achieved GDP growth of 3.7 per cent in the June quarter is encouraging but there is a long way to go before growth in advanced countries replaces growth in China and other emerging countries.
The Chinese economy is now in the spotlight and we can expect financial markets to continue to respond to any positive or negative news from that country in the months ahead. Investors will be particularly interested to see if Chinese Government policy initiatives can arrest the slowdown in the country’s economic growth.

Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management. 


No comments: