Sunday, August 26, 2012

Can China's Stimulus Spending be Relied on?

Most investor focus has been on the European sovereign debt crisis in recent months but China is demonstrably slowing too. The bearish case on China should be well known by now, but I think the real moot point for China’s future growth is too little discussed. The Bullish thesis has it that China can always stimulate its economy via utilising its foreign currency reserves and vast budget surplus. It is a strong argument –at least I hope so because I’ve held it in the past- but I’m not so sure now.

The issue is a significant one for investors. Companies like Caterpillar (NYSE: CAT) or Joy Global (NYSE: JOY) are largely dependent on future growth for what happens in China’s construction and mining industries. These sort of companies are the obvious beneficiaries but someone like LED manufacturer Cree (NASDAQ: CREE) is also expecting a pick-up in LED street lighting investment from China.

Similarly, telecoms equipment suppliers like Cisco or Juniper (NYSE: JNPR) will be hoping that China picks up the slack from weaker North American service provider spending in the second half.  The key point is that so much of marginal global growth has been coming from China and if it s going to disappoint then there is no way that the globally exposed companies can be immune. Someone like GE (NYSE: GE) is exposed across a range of its long cycle capital infrastructural industries.

Western Political Democracy and Economic Liberalism Hasn’t Triumphed

The essence of the problem is that China may not be the kind of economy that we all perceive it to be. Those of us old enough to remember Francis Fukuyama’s epoch defining book ‘The End of History and the Last Man’ will recall how the relevance of the debate of the book’s conclusions are still apparent today.

Fukuyama did nothing less than pro-claim the final victory of Western political democracy and economic liberalism. Events proved otherwise, and I can’t help note that so many of the erroneous underlying assumptions made then are being made now when discussing China.

Culture matters. It is how we interact with people and organise our affairs. Moreover, culture has a symbiotic relationship with economic policy. For example the Anglo-Saxon countries seem to have a penchant for societies characterised by significant disparities between the wealthy and the poor. Meanwhile, places like Japan, Germany and the Scandinavian countries have a much more egalitarian income distribution and a much more communitarian sensibility.

With this in mind we are entitled to ask that if there is no conformity within Westernised democracies over the structure of their society and polity along the lines that Fukuyama argues, how on earth can we expect this homogenised ideal to apply to China?

China is Not a Capitalist Country

China is still a communist country and despite no end of efforts to convince unsuspecting investors to the contrary, this fact makes it fundamentally different. Essentially its recent history is a story of the wonderful release of energy and productivity that occurs when economic liberalization takes place. Of course we have seen this before. In China! Or rather in the bit of China that calls itself Hong Kong.

It is also a story of a closed capital system where RMB are printed and issued in order to keep the currency weak against exporting currencies. Ultimately, this capital has to end up somewhere and increasingly it looks like a good old property bubble is bursting in China. In addition, and in the absence of developed capital markets Chinese investors have sought the safe haven of Gold.

The Chinese Government is now faced with a difficult set of circumstances. The property market is slowing, its export led economy is facing challenges as Global growth remains weak and significant social unrest is possible if the economy turns sour on the masses of recently urbanized workers see their aspirations threatened.

The solution is well discussed in investment circles and by the Government itself. China needs to stimulate its economy and it needs to shift towards domestic consumption.

The Solution is Well Known but is it Feasible?

The issue here is that China’s political structure may make it extremely difficult to successfully stimulate the economy via stimulus spending. China is a communist country. Its local governments are inefficient and by most accounts, riddled with corruption. Meeting central government targets is one thing for an ambitious official aiming for promotion, but ensuring that capital is allocated appropriately and with the aim of generating return is something that we should expect that administrator to achieve.

In other words, China might find it hard to get efficacious spending into the areas of the country where it matters. Chou En Lai and Mao Tse Tung didn’t exactly have much success when they engaged in their long term planning efforts. Why are some so keen to assume that the current Chinese Government will be any better?

Of course, the difference between then and now is that a significant part of the decision making in China is now made by the private sector.  However, we are discussing a scenario whereby public investment replenishes a country’s growth prospects when its private sector is experiencing a weaker environment.

Capital Allocation Still Matters

Culture and economic policy are not necessarily universal but the principle that there is a benefit in allocating capital more efficiently is. This is a point frequently lost by China Bulls who tend to point out that it doesn’t matter so much that capital is actually thrown at the economy. The problem with this argument is that once capital starts to be mis-allocated, it then creates pricing signals which then leads to more capital being allocated towards increasingly unproductive ends. In other words a classic investment bubble ensues. China is no different to any other country in this regard.

Where Next for China?

China has been slow to release stimulus spending and the reasons expressed above are largely the cause. It is not so easy for the central Government to insure that investment is efficaciously filtered down into the economy and anyone investing in companies on this basis could be due a rude surprise. China is still a communist country and I find it hard to rewrite the history of how inefficiently capital has been allocated by similar systems –not least in China- over the years.

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