August 9, 2009

• Public spending is helping nurture Asian green shoots.
• The impact of weakness in the external economic environment (notably the US and Europe) is moderating.
• Among the major economies, China is currently on the most stable footing and is poised to be the first to fully recover.
• China’s structural shift is stimulating global demand.
• The Chinese economy is coming back with three legs of growth – production, investment, and consumption – all moving forward.

The world economy is on the road to a policy-induced recovery thanks to aggressive monetary and fiscal measures taken by governments around the world.  Ample liquidity provided by the major central banks has helped stabilize financial markets. Risk measures, such as narrowing credit spreads, point to improving credit conditions and increased bank liquidity.

Aggregately, leading indicators signal that the worst is over and that China is leading the way. China was at risk of falling into recession at the start of the year, but has rejoined the small club of countries with growing economic output, now including India, Indonesia, and Bangladesh.  Stronger Chinese import demand will help lift Asia out of the recession soon.

This is good news not just for Asia, but also for the world, since China will likely pull the global economy out of recession.  The likely shape of global recovery will be a revival in trade and growth among developing countries (aka emerging markets) first, with developed countries following.  China is carefully preparing for this role, signing trade and investment agreements with many emerging nations.

The composition of China’s import mix is changing to reflect the country’s shift to domestic demand-led growth. The world’s second largest importer of goods has gone from importing to produce exports to importing to build infrastructure. This has not only boosted global demand for raw materials (good for commodities investors) but also helped spur industrial production in Taiwan, South Korea, Germany, and Japan (although we still prefer to invest in Asia ex-Japan).

China has made structural changes and has been successful in shifting its growth drivers.  Of course, that shift has been made easier for China than it has for others given their massive fiscal surplus (over $2 trillion) which has allowed them to unleash a 4 trillion renminbi ($585 billion) fiscal stimulus. Not only is this one of one of the world’s largest in terms of dollars, but China’s fiscal stimulus efforts are also bigger and more front-loaded than the U.S.’s relative to Gross Domestic Product (GDP). China’s stimulus efforts have so far been successful in strengthening domestic demand and further developing infrastructure (including green technologies). 

Then combine that fiscal stimulus with the fact that the state-controlled banking system has engineered one of the most dramatic monetary expansions in history.  Banks have issued twice as much in new loans so far this year ($1.1 trillion) than they did in the first half of 2008, and Chinese money supply is now expanding at nearly triple the rate in the US.

There is clear evidence that this infrastructure-led recovery is going to be more sustainable than previously expected.  China’s factory output growth has rebounded alongside stronger expansion in credit and consumer spending – so much so that China has overtaken Japan as the world’s second largest economy.  (Interestingly, China has 5% of the world’s GDP, or 10% if you adjusted for purchasing power parity.  Yet Chinese equity exposure is only about 1.5% of the world’s index funds making it dramatically underweight in most investor’s portfolios.)

Manufacturing in China looks set to accelerate in coming months. The purchasing managers’ index (PMI), a forward-looking indicator, remained in expansionary territory in July for the fifth straight month.  New orders remained strong in July thanks to the aforementioned fiscal stimulus and bank lending. The reacceleration in credit growth around midyear will likely add steam to manufacturing in coming months, especially for infrastructure projects.

Also, the industrialized Asian economies are also benefiting from a strong recovery in the information and communications technology industry, which was hit especially hard during the financial meltdown in the final quarter of 2008. The weaker Korean won also has made manufacturers in that country more competitive, boosting information and communications technology production and export growth in recent months.

Still, the best hope for a sustained investment boom may lie in China’s strong housing market (yet another example of China’s shift toward a growing and sustainable domestic demand).  Residential property sales were up 50% in June alone.  Developers have resumed building, encouraged by easy financing and rising sales.

Outside of the residential side, commercial construction starts were up 12% from a year earlier in June, marking the first increase after eleven straight months of decline.  Although slower than the 20% to 30% gains of recent years, the improvement is encouraging because construction (both commercial and residential) drives demand for steel, home appliances, and other goods and services. 

Earlier we indicated a shift in Chinese economic structure, where more weight has smartly been placed on domestic demand as foreign demand has waned.  Although export growth has contracted substantially, China has diversified future exports away from the US economy and toward countries within the Asia Pacific basin, as well as with Europe. 

China is expanding its free trade agreements (FTAs) with trading partners.  Currently China has eight FTAs with 16 nations and regions worldwide.  It is currently engaged in FTA talks with Chile, Costa Rica, Norway, & Pakistan.  The global recession’s impact on China’s trade has run its course.  Foreign demand for Chinese goods is still declining, but at a decelerating rate.

It is worth noting that contrary to popular belief, China’s growth is not driven by trade.  Only around 10% of all jobs are export related.  Net exports contribute around two percentage points to Chinese GDP growth (currently GDP growth is closer to seven percent total); most growth is powered by domestic demand, chiefly investment.  Private consumption makes up 30% of total GDP, compared with 70% to 80% for most of the worlds’ large industrialized countries.

Bottom Line: Equity prices in the Chinese market have established a renewed uptrend.  The market is expecting an economic recovery in China – a soft landing, not the hard landing experienced by levered economies such as the US and the UK.  Relatively unscathed by the direct effects of the credit crisis, China stands to benefit from fiscal and monetary stimulus.