Has China Hit Its Growth Limit?
China's historical growth drivers have started to plateau, but many untapped industries--particularly in the services sector--are set to take the lead, says Seafarer's Andrew Foster.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Is China’s growth poised to radically slow down? I'm here today with Andrew Foster, the chief investment officer of Seafarer Capital Partners, to take a look at Chinese growth and see how investors can best access the market. Andrew, thanks for joining me today.
Andrew Foster: It's my pleasure, Jeremy.
Glaser: So to start off, can you give us just your overall take on what’s happening in China right now from a macroeconomic standpoint?
Foster: Yes, China’s growth has been slowing, and it's been slowing for few years now. It's definitely the case that China is struggling in the current global environment with the impact of its export sector declining particularly because of the woes that are taking place in Europe. But I think what’s also happening in China at the same time is the economy is going through a tremendous amount of transition. The drivers of its growth in the past have reached some limits in their ability to propel the economy further. I think the internal baton, if you will, of the sectors and industries that are driving growth within China are changing, and that is leading to some uncertainty, doubt, and frankly slower growth amid transition.
Glaser: So what are some of those biggest drivers of the economy right now?
Foster: I think the unsung driver of the economy is the tertiary sector--a fancy word for the services sector or the supporting sectors within China. If you look at China’s growth over the last eight or nine years or so, despite all the headlines we read over physical infrastructure and residential property and construction and exports leading China’s growth, actually the fastest-growing sector has been the domestic-services sector. It's outpaced the other sectors by not a whole lot, but by a little bit. It's been growing around 12% over the last eight, nine years, whereas the other sectors that you hear so much about are growing slightly slower than that around the 11%-11.5% range, and consequently the services sector is becoming the biggest of driver of growth over time. I very much expect this trend to continue, and I think that the Chinese services sector is really woefully underdeveloped internally within China. By my own estimates, the private services sector accounts for less than a third of China’s GDP right now, and I think it's going to grow quite considerably. Our own services sector in the U.S., the private services sector accounts for two thirds of GDP, and I think China will look more like the U.S. over the next few decades.
Glaser: So, what are some of the biggest risks to Chinese growth then? Is it a real estate bubble? Is it political risk? What are the bigger problems that you see on the horizon?
Foster: I think the potential for a real estate bubble is real in specific cities and specific markets, but I'm certainly not a believer that China’s property market as a whole is necessarily engulfed in a bubble. I think that Chinese property prices have been trading sideways for the last year or so. I think that's just about the best possible outcome. Those markets did need to cool off. In some cases, some markets are going to be struggling because prices have gotten overheated, but I don’t think this is the Achilles' heel of the economy.
What I'm actually most worried about is the social contract in China. I think the level of corruption and venality that has been exposed in the Communist Party over the summer and the spring, I think, has been shocking. We all knew it was there, but the extent to which it has pervaded the party is really worrisome. So I think China has to find a way to grapple with this issue and move to a more open form of government, even if the Communist Party stays in charge. So, I think, that is the real issue that China is going to be struggling with in the backdrop and also this transition to a new set of economic drivers, which almost by definition will breed some uncertainty. China has been able to grow almost monotonically by relying on its export sector and its construction sector, and I think those days are behind us.
Glaser: As China makes that transition, what does it mean for the rest of developing Asian countries, which rely somewhat on China growth in order to fuel their own growth?
Foster: I think this is a really tough question to answer. I think it's definitely the case over the last decade or even a bit longer than that that Southeast Asia, East Asia has really oriented itself toward harmonizing with China’s economic cycles. A lot of Southeast and East Asia produce components or other piece goods that ultimately make their way into China for assembly and also a number of countries export for final consumption into China.
So as China slows, I think this will have some knock-on effects on the rest of the region, but it's difficult to say. I think that especially those industries that export into China for final consumption as opposed to export elsewhere in the world, I think those final consumption markets in China, in other words, the consumer markets there, are going to continue to grow fairly steadily. It's only conjecture, but I think that growth won’t necessarily suffer a great deal in the rest of Asia, even though I imagine it will slow.
Glaser: So if we're seeing this transition and seeing this slowdown in Chinese growth, why should investors still think about allocating money toward Chinese equities?
Foster: I think there are two or three main reasons to think about this. China has plenty of room still to grow, even though I'm concerned that its historical growth drivers have to some extent plateaued. I think there are plenty of new growth drivers as China mines this services sector and really expands a number of domestic industries that have been untapped--industries that you wouldn’t normally associate with China, whether it's commercial services, such as transport and logistics, or consumer services such as health care, media, and entertainment, and business services, such as software and consultancy. So I think those growth drivers as they come to the fore give China plenty of room to expand.
The other thing I think that's compelling is the valuation case. I think Chinese equities have generally underperformed than most in the world over the last year or so, and I think there are some reasonable valuations, particularly in the sectors that I mentioned that are relatively undertapped within China. So I think those are the things to pay attention there to in the Chinese context.
Glaser: When thinking about building a position in China, a lot of investors are facing the choice of whether to buy Chinese-domiciled equities or buy multinationals that do a lot of business in China. What's your opinion on the best way to access the market?
Foster: I would recommend unequivocally a decade ago that you go with a local company. Multinationals, though, have really bolstered their presence within China, and the contribution they receive from China is far more meaningful and is more likely to say move the stock price of the multinational than in the past. So I think that's one thing that investors can contemplate.
But the markets that I'm talking about, the services sector, are very localized markets. They require a great deal of local knowledge and a great deal of local customization. And unfortunately in some cases foreign companies are outright forbidden from participating. So I think in some these services sectors you’ll see local companies still continue to take the lead. These are fairly nascent markets, nascent industries, and so I think by and large investors are better off to focus on local companies, but it's not unequivocally the case as it was say a decade ago.
Glaser: Well, Andrew, I really thank you for your insight today.
Foster: Thank you very much.
Glaser: For Morningstar, I'm Jeremy Glaser.