China – now the world’s most important trading nation

Recent data have shown that in 2012, China overtook the USA to become the world’s most important trading nation. On the basis of aggregating total imports and total exports, China’s total international trade amounted to $3.87 trillion, and that of the US was $3.82 trillion. Given that the Chinese economy is only one third the size of the US economy, China has become the most significant trading nation on the planet in terms of both absolute trade and its importance to their economy.

The turn of the twentieth century was when this title last changed hands, when it moved from the UK to the US, and in the following decades the more populous and faster-growing economy (then the US) meant that it became a more and more powerful force in the world economy, culminating in its currency becoming the world’s primary reserve currency.  This status accords a huge advantage to the holder, in that there is an underlying demand from all other nations to hold the reserve currency in order to maintain the ability to trade.  This has been clearly visible for the US, as the dollar makes up the largest proportion of foreign exchange reserves, and most trade in commodities is conducted in dollars.

The dollar is not going to lose its reserve currency status overnight – the yuan is not yet freely convertible and today barely features in the international financial markets. However China’s stated ambition is that it will become the world’s primary reserve currency and take on that role from the dollar.  Since 2005, however, China has slowly but steadily been internationalising its financial markets by (i) allowing more foreign exchange trading, (ii) the issuance of yuan-denominated bonds and (iii) giving more access to foreigners wanting to invest in China’s stock markets.

Just as London maintained its presence as an important centre for financial markets as the US economy and New York overtook it in the twentieth century, though losing market share, so in the this century will Asia and China become the key centre for financial markets.  Success in the investment world in the next few decades will require substantial exposure to Asian markets and an increasing understanding of the impact of Asian economic policies and decisions on our own economy and markets.  We maintain a heavy commitment to Asian equities in portfolios.

Buy Asia

It has been well understood for some years now that the driving force of global growth over the next decade is most likely to be the rise of the middle class consumer in the larger emerging economies, mostly in Asia.  This argues for heavy exposure, on a long term or secular view, to Asian stock markets and those Western companies that are successful in selling to the Asian consumer.

This secular view does however, from time to time, encompass cyclical periods of weakness, and the Asian stock markets have endured such a period over the last year and a half.  Current price levels in Asia provide an excellent opportunity for investors to buy into the key secular trend at a cyclically opportune moment.

The recently announced change in Chinese leadership has, arguably, inhibited the Chinese leaders from taking stronger policy action to support its economy, as attention within Beijing in the last year has focussed on internal Party matters, rather than the state of the economy.  The economy has been surprisingly weak for several quarters, and the official data was even permitted to show the last quarter as delivering 7.4% growth, which is slightly below the government’s 7.5% target. Other data from non-government bodies have appeared to show a much weaker economy this year.

The two major issues holding back a more supportive economic policy have been sharply rising food and house prices, both of which hurt the poorer sections of Chinese society.  In recent months however, both of these areas have shown distinct slowing in their inflation rates, and this has given policymakers more scope to ease policy. The economic data published over the last two months have also indicated signs that the tide of the economy is clearly stabilising and may be turning up.  The reason for this upturn seems to be an improvement in Asian consumer demand, rather than export demand from the West.  China’s new leadership team will thus be taking over at a good moment.

The Shanghai stock market has been a very poor performer since its peak in 2007, and has only been lower than current levels in late 2008.  Turnover in the Shanghai market is currently very low and is dominated by private Chinese investors seeking to make short-term trading profits.   Interest could easily be revived by some good news from the Chinese economy as valuations are historically low.  The other Asian markets, with their greater base of institutional shareholders (particularly foreign) and more-established, better-governed companies, have outperformed the Shanghai market, but valuations are still well below historic averages at a time of above-average profitability.

The secular thesis of much stronger growth in Asia than in the West is still very much intact; the recent cyclical weakness caused by a tightening of Chinese policy in 2011 and the slowdown  in Europe, China’s largest regional trading partner, has led to underperformance of the Asian equity markets over the last eighteen months. Recent data give grounds for believing this cyclical weakness is ending and that now provides an excellent opportunity to increase investment exposure to Asian equities.

Whilst the world watches Europe, it is missing the Chinese slowdown

The official Chinese GDP data show economic growth of 8.1% in the year to end March, as always a little above the recently-reduced official target of 7.5%. There is though a considerable degree of scepticism over this number (in 2007, the GDP data series were described as “for reference only” by Li Keqiang, who becomes Prime Minister in November) as other data series are much weaker. Power output (a data series likely to be accurately measured and very significant in a manufacturing-based economy) rose by only 0.7% over the same period, car retailers are reporting a huge build-up in inventories indicating a fall in consumer confidence, and sales of bulldozers are down by 51% compared with a year ago which indicates weakness in construction. These are worrying figures.

In the very worst of the global economic crisis in 2008/09, China embarked on a staggeringly large investment and infrastructure spending programme in a bid to maintain demand in the economy in 2009 and 2010 whilst they hoped that the rest of the world would sort out their banking crises and associated problems. They were hoping that by the time their own stimulus programme had run its course, the rest of the global economy would have regained its poise and would once again provide the strong consumer demand for Chinese exports. With the US also spending heavily, the world did come out of recession in 2009, and 2010 was also a reasonable year. However Western consumer confidence has not recovered and consumer spending has not returned to make the recovery self-sustaining – and the eurozone’s problems have only made things worse. So the hoped-for recovery in Western demand for Chinese exports has not occurred.

Worse still for the Chinese, the enormous stimulus they delivered has had two serious negative consequences. First was a house price boom in the major cities of China, as the extra spending engendered confidence that Chinese growth would continue to be strong, interest rates were held at low levels and banks were strongly encouraged to lend. In 2011 the authorities became concerned about this and sought ways to reduce the flow of credit for speculative house purchases. Secondly, the infrastructure projects that were built were brought forward from plans for several years hence, and so there are now many entire “ghost” towns built with roads, houses, and shops where nobody lives or works – the infrastructure of China is now years ahead of its current stage of economic development and the demand for that infrastructure. In economic terms the returns from much of the investment boom China undertook have been very low or possibly zero.

China’s economy is now hugely imbalanced with consumer spending just 35% of the economy. Contrast this with the UK and US where consumer spending represents nearly 70% of the economy. If China’s growth story is to be sustained it will need to produce its own consumer demand rather than rely on the Western consumer, and a major rebalancing between investment spending and consumer spending is required. Wages have been growing very quickly, but the Chinese love to save and encouraging them to spend has so far proved difficult. Ironically, whilst the West’s problems are an unaffordable welfare state system and a crumbling infrastructure, China currently has too much infrastructure and not enough of a welfare state. The cost of healthcare in China is very high and pension provision is poor – a stronger safety net might encourage Chinese workers to hold lower savings and go on a mini-consumption boom.

China’s economy is slowing more dramatically than the official data show; commentators have been assuming that in this situation, further economic stimulus would be the policy response. Such a stimulus should not however be a repeat of the government-directed investment spending. Instead to be effective, more subtle policies aimed at boosting consumption are required. Until then, whilst the world watches the Eurozone fall apart they may be missing the problems that are emerging in China. Chinese and Asian equities are the preferred asset class over the next decade, and long term investors should be seeking a heavy exposure in their portfolios. Over the next few months however, there remains scope for investors to be disappointed with Chinese economic developments, and a better buying opportunity is likely to emerge.