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Investment Boom Unsustainable

China’s household consumption will need to grow in a big way if it is to maintain its heady GDP growth rates in the decade to come.

Daniel Rohr, CFA, 12/01/2011

The Chinese fixed-asset investment boom of the past decade has been, in a word, unprecedented. All low-income countries have required outsized capital stock additions to make the leap to middle-income status, but China’s boom is unmatched by anything on the record books. In fact, by some measures of physical capital, China looks more like one of the world’s leading developed economies, rather than the middle-income economy it is.

As a consequence, we see very little reason to believe China can continue to rely on building ever-more skyscrapers, highways, and manufacturing plants to sustain the kind of GDP numbers to which Chinese citizens and global investors have grown accustomed. In the next 10 years, the onus for growth will rest squarely on Chinese households and their willingness and ability to consume. If consumption fails to grow at a rate well above historical norms, the economy may be able to muster only 5% growth at best, a far cry from the 10% it averaged from 2001 to 2010.

A Decade of Growing Imbalances
The macroeconomic facts of the story provide a sense of just how dramatic China’s fixed-asset investment boom has been (Exhibit 1).

In 2000, before the boom kicked off in earnest, gross capital formation (the GDP accounting term for investments in physical capital, otherwise known for its abbreviation, GCF) accounted for 35% of Chinese economic output. While large by developed economy standards (the U.S. 10-year average is 19%, Japan’s is 23%), it wasn’t terribly atypical for a high-growth emerging economy. Nor was it unusual for China: A decade prior, GCF also had a 35% share. The consistent share of GCF reflected the balanced growth China enjoyed in the 1990s. By 2000, the Chinese economy was 170% larger than it was in 1990, driven by a 173% increase in investment and an only slightly lower 156% increase in consumption.

Chinese GDP expanded at a similarly impressive rate in the 2000s. By 2010, the Chinese economy was 171% larger than it was in 2000. But by then, the sources of growth were anything but balanced. A massive share came from a surge in fixed-asset investment. China was spending 273% more on physical capital than it was in 2000, with GCF accounting for a staggering 49% share of output by decade’s end. Yet households were "only" consuming 97% more than they were in 2000, depressing the share of household consumption of total GDP to 34% in 2010, a paltry share by any standard and the lowest level seen in China since the founding of the People’s Republic.

Unprecedented Intensity
The extreme imbalance between investment and consumption is striking in and of itself. After all, the ultimate purpose of any investment is to consume (eventually). But it appears even more exceptional in the context of the three biggest investment-led success stories of the past 50 years: Japan, Korea, and Taiwan (Exhibit 2). By any measure of fixed asset investment intensity--growth rates, share of cumulative GDP growth, or share of GDP--China has far surpassed the precedents set by these three countries in their boom years. We estimate that, relative to the starting size of the economy, cumulative additions to Chinese capital stock in its boom decade have been 43% greater than Japan’s, 33% greater than Korea’s, and 49% greater than Taiwan’s.

Just as striking is the relatively feeble contribution of consumption to Chinese growth rates. While GCF grew faster than consumption in the boom decades of Japan, Korea, and Taiwan, consumption still accounted for at least half of total economic expansion in each case, versus the paltry 26% share we see in China. Somewhat shockingly, while the investment share of Chinese GDP has exceeded the consumption share in every year since 2003, this feat was not achieved in any year by Japan, Korea, or Taiwan.

China’s Capital Needs
Various "hard" measures of GCF confirm the outsized role of fixed-asset investment in the Chinese growth story. As noted, the Chinese economy is roughly 170% larger than it was a decade ago. But the economy now consumes 383% more aluminum and 393% more steel. Total expressway mileage is up 354% over the past decade, the number of tunnels is up 338%, and floor space under construction, a concrete measure of real estate activity, is up 337%.

China bulls, nonetheless, argue that this rapid build-out of Chinese real estate and infrastructure makes sense because it correctly anticipates a rapid increase in consumption. Even if a good deal of the new floor space goes unoccupied at the moment, continued urbanization and rising incomes will eventually fill that vacuum. And although some of the new expressways, bridges, and tunnels may see only a trickle of traffic today, rising automobile ownership rates will ultimately generate a steady stream of vehicular flow. From this perspective, today’s investment is nothing more than down payment on tomorrow’s consumption.

But given the immense investments made in the past decade, consumption has a lot of catching up to do. And even if the massive capital additions have correctly anticipated the consumption growth we’ll see in the decades to come, the economic rationale for further outsized capital outlays grows increasingly weak with each passing year. After all, any nation, even a rapidly growing one, needs only so many airports, highways, high-speed rail lines, and luxury apartments.

Indeed, by some measures, China’s physical capital base already looks like that of a major developed economy. Consider, for example, the installed capacity of China’s steel industry. Now roughly five times the size of what it was a decade ago, capacity is nearly twice that of the United States, Japan, and the EU-27 countries combined. Notably, the latter collection of economies has nearly 1 billion people of its own and collective GDP of about $36.6 trillion, making it more than six times the size of China’s economy.

China’s expressways, called the National Trunk Highway System, look overbuilt (Exhibit 3). By year-end 2011, the highway system will have quintupled its 2000 length. Heading into the year, the total length of China’s highways (45,554 miles) was already on par with that of the U.S. Interstate Highway System (46,876 miles), a country of similar geographic size, but with three times as many cars on the road. While growing Chinese vehicle ownership rates are likely to trim some of the bloat in the next couple of decades, the rationale for building more expressways at a rate comparable to what we’ve seen in the past 10 years is very limited.

The biggest contributor to China’s fixed-asset investment boom, particularly in the past few years, has been residential real estate. Throughout the 2000s, China built housing at a truly blistering pace, adding a cumulative 120 square feet in residential floor space per person from 2001 to 2010 (Exhibit 4). This year alone, China will add nearly 18 square feet in residential floor space per person.

In some respects, this housing boom is understandable, given the significant additions China made to its urban population over the period. What is less understandable is the roughly 80% surge in the rate of floor space additions we’ve seen in the past few years, which has not been accompanied by a comparable surge in urbanization. At present, on a per-capita basis, China now has nearly five times the amount of residential floor space under construction as peak-housingboom United States. This is particularly remarkable because, despite enormous gains in wealth and income, the Chinese remain on average much poorer than their American counterparts, and they tend to occupy residences that are much smaller.

33 New Yorks
Perhaps the biggest counterargument to the overbuilding thesis goes as follows: Despite the massive urbanization of the past couple of decades, China remains rural by global standards and will continue to require large additions to its capital stock as it accommodates new urbanites. According to Chinese government figures, even after an influx of 207 million new urban residents in the past decade, only 50% of the population resides in urban areas (Exhibit 5). An increase to 70% urban, a level typical of the high middle-income status to which China aspires, would add another 272 million to China’s urban total. That’s equivalent to adding 33 cities the size of New York.

While the notion of "33 New Yorks" is intuitively powerful, we’d strongly caution investors against taking the data underpinning the "stronger for longer" urbanization story at face value. That’s because countries use very different definitions of what constitutes urban. As a result, relying on headline data alone can lead to ill-informed conclusions. Consider the fact that China’s self-reported urban share of 50% is equivalent to reported figures from Ghana (50.7%) and apparently well below that of North Korea (60.1%), which remains largely a subsistence agriculture economy.

As it turns out, China’s definition of urban is stricter than most, effectively portraying the country as more rural than it might otherwise appear and potentially overstating the remaining runway for further urbanization. China’s statistics bureau generally requires a density of 1,500 people per square kilometer for a population cohort to be deemed urban. By this hurdle rate, four of the top 10 largest U.S. cities would fail to meet China’s definition of urban, not to mention hundreds of suburbs. While the granular data necessary to reformulate China’s urban/rural breakdown on a more apples-to-apples basis with that of the United States isn’t made available, it seems fair to assume that such an undertaking might add at least 10 percentage points to China’s urbanization level, significantly curtailing the urbanization upside promoted by China bulls.

Paths to Rebalancing
All told, we expect to see significantly lower GCF growth in the coming decade than China had in the decade just past. As a result, for China to sustain robust economic growth over the next 10 years, household consumption will need to grow at above-trend rates. In effect, China will need to rebalance its economy toward a more normal composition of consumption and investment. Chinese policymakers are not blind to the need to increase consumption. Government officials recently said that their objective is to increase consumption’s share of GDP to 50% by the end of the decade.

There are two ways to achieve this rebalancing, of course: 1) stronger growth in consumer spending or 2) weaker growth in fixed-asset investment. Unfortunately, the track record established by previous booms suggests that the latter outcome is more likely than the former. Consider the average GCF growth turned in by Japan, Korea, and Taiwan in the decade after each country’s investment boom: 1.2%, 2.4%, and 5.9%, respectively (Exhibit 6). If China were to achieve the average of those three (about 3%) in its own postboom decade and household consumption continued to expand at the rate it has in the past decade (7%), total GDP would grow at 4.8%, well below the 10.5% it averaged in the 2000s. Even if consumption were to expand at 12% annually, a level it achieved not once in the past decade, GDP would grow at 7.5%--stellar by developed-markets standards, but below what Chinese citizens and global investors have come to expect.

Notably, in the case of Japan, Korea, and Taiwan, GCF growth postboom was inversely related to the size of the boom. Japan and Korea had larger booms (GCF averaged a 37% share of GDP in the boom decade), leading to weaker GCF growth postboom. Taiwan had a relatively smaller boom (31% share of GDP) and saw fairly robust GCF growth postboom. With this in mind, it seems reasonable to believe that, because China’s investment boom has been both longer and stronger than its antecedents, its postboom decade will require more-modest additions to the capital stock than the cases of Japan, Korea, or Taiwan. This suggests even 3% GCF growth would be a fairly rosy outcome by historical standards. Assuming instead 1% GCF growth and 7% consumption growth would put GDP growth at 3.8%--a potentially troubling outcome not only for China but also for the global economy as a whole.

Daniel Rohr, CFA, is a senior securities analyst at Morningstar.

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