“We have no historical criteria by which to judge the efficiency with which investment responds to the shifting demands of our manufacturing industries. If we accept – or better, define – the dispersion of industry rates of return as the measure of the disequilibrium in any year, we can at least make several comparative statements. Dispersion is relatively greater in years of depressions: industries cannot adapt to sudden decreases in demand as well as they can to expansions – in part, perhaps, because fixed capital is easier to increase than to decrease in the short run. Dispersion is larger (as well as more stable) in concentrated industries: whether because of monopoly power (of which we find no reflection in average rates of return) or because of lesser flexibility of response to changing conditions, the industries dominated by relatively few firms are somewhat less efficient in adjusting their capital stock.”

Chapter 1: Introduction
Capital and Rates of Return in Manufacturing Industries
By George J. Stigler, 1963

 

China continues to grow at a rapid pace. According to the latest economic data released by the country, the economy grew over 6% year over year in the first half of the year. This growth occurred despite the noise on trade. Propelling Chinese growth was consumption and government spending, with consumer spending growing almost 10%, and infrastructure Fixed Asset Investment increasing over 6%. In addition, other economic data points, such as steel production growing 10% year over year, confirm this top level data. This seemingly unstoppable combination appears to have taken over from investment to drive its economy.

 

However, all does not appear as it seems. Auto sales dropped 12.4% year over year in the first half of 2019. In most countries, a double digit decline in auto sales would be called a recession. The Government deficit exceeds 10% of GDP, as the government moves to stimulate the economy. The Central Bank continues to increase the amount of monetary stimulus, whether through outright monetary growth or through lowering Required Reserve Requirements. All of these are classic actions to fight a recession. But, in China, that word does not exist.

If this were a normal recession, with the accompanying economic pain, and the government applied this traditional stimulus, a true recovery would ensue with economic growth accelerating to well above average coming out of the recession. But this is not a normal slowdown. China stands in the midst of a trade fight with the United States, its largest trading partner. With the ability of corporations to move capital around the world, what economists call Capital Mobility, companies have begun to reorder their supply chains. And instead of building their next plant or product in China, other countries, such as Vietnam, Malaysia, and Singapore, have become the objects of affection. For example, Vietnam’s exports to the United States rose over 36% in the first 5 months of the year to over $25 billion.

With foreign companies investing less in China, while near term exports will see only a limited impact, longer term effects could become quite substantial. This shock to the system comes from something called the J Curve. Traditionally, this is used by economists in understanding the impacts of currency movements. For example, if a currency appreciates 10% on a trade weighted basis, initially a country’s trade balance improves, as existing contracts continue. But because a country’s currency rose, its companies are less competitive in the global marketplace and foreign goods are relatively more attractive. This typically leads to lower exports and higher imports after 12 months. A country’s trade surplus, in nominal terms, initially improves and then deteriorates as time goes on, looking like the letter J, but in this case upside down. And the more the currency appreciation, the larger the downside over a period of years, potentially making the descending side of the J quite large. For China, this extended J Curve likely stands as the outcome of the dynamic of plants being moved abroad. Initially, exports continue as contracts exist and plant construction takes time. A typical plant can take 2 years or more to build along with all the planning necessary on the logistics side to move goods to market. However, as contracts expire and these plants outside China come online and ramp their output, production will exit China, impacting its exports and capacity utilization of its manufacturing capacity. And with no new products to replace the products moving abroad, investment will come under pressure and plants will face closure. Already, foreign companies have moved to resource their production to other countries. And, on top of this, in a surprise move, select Chinese companies started to invest abroad instead of inside the country in order to maintain their global market share. Both of these actions will impact investment in the short term and the long term. And while plants don’t face closure issues today, the future continues to rush forward. For China, this likely stands as a 2021 or 2022 issue. (How much domestic Chinese companies can move production abroad stands in question as the government exerts significant control over these actions and much of the country’s industry falls under the control of State Owned Enterprises.)

While China continues to report growth over 6%, this growth stands suspect given the auto data and as numerous countries move to limit the role of Chinese imports. In addition, recent academic studies demonstrate Chinese real economic growth 1.8% or more below that reported over the past five years. In other words, the economy only grew at 4.5% or less per year. Furthermore, other Asian economic competitors to China have moved to limit Chinese goods in their economies even more than the U.S. For example, India slapped tariffs on Chinese chemicals such as MPDA to protect its domestic producers. (MPDA is a critical intermediate chemical for dyes and photographic chemicals.) This stands as just another in a long list of goods India has tariffed out of its markets. And while China can maintain its growth over the short term, as fiscal and monetary stimulus moves to offset export pressures, longer term these pressures will mount at an accelerating rate. And with China’s Productivity Growth negative for the past 4 years, according to the Conference Board, coupled with a shrinking labor force, offsetting these pressures with fundamental growth looks difficult at best. Given Export pressures coupled with Capital Mobility, from both foreign and Chinese companies, China likely faces the consequences of the J Curve and Slowing Growth Ahead with all its messy consequences for the country. For companies and investors who have come to depend on China’s steady 6%+ growth rate, a new landscape stands ahead much different than that over the past 20 years. (Data from public sources coupled with Green Drake Advisors analysis.)

 

 

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