China’s Red Hot Economy

Published on by on August 17, 2011 | Updated August 18, 2011

Investment opportunities abroad are generally associated with lucrative rewards and handfuls of volatility; however, the world’s second-largest economy may be an exception to the rule, offering a generous amount of potential coupled with manageable risk. China’s economy has grown on average 10% annually for the last 30 years and the world leader in manufacturing remains on an upward path of expansion while most developing economies lag behind.

China’s rapid expansion has been fueled by favorable demographic trends that are expected to continue to play out for the foreseeable future. Once a country of widespread rural areas, China has seen a massive influx of migrants from the undeveloped countryside to sprawling metropolises over the last several decades. China now has nearly 200 cities with populations of at least 1 million. By comparison, the U.S. has only nine.

As millions of Chinese citizens have moved from the isolated countryside, they have contributed to a swelling middle class that has powered the local economy. Urban relocation coincides with taking on non-agricultural employment for the first time, which translates into a new level of disposable income and increased demand for everything from automobiles to protein to electronics.

While urbanization has surely transformed the Chinese economy, there is still additional opportunity in this demographic shift. China’s percentage of urban population is relatively small compared to the U.S., and the middle class is expected to continue an impressive rate of expansion in coming years.

Increasing rates of urbanization fueled by favorable demographic trends and rising income levels are just a few of the economic factors pointing to a positive outlook for the growing giant. Additionally, the Chinese government is taking an active role in promoting healthy and sustainable economic development moving forward, by taking steps to tighten monetary policy and avoid common pitfalls associated with booming market economies. China’s latest 5-Year Plan (2011-2015), released earlier this year in March, emphasizes commitment to maintain near double-digit growth, the need to rebalance its sources of growth towards domestic demand, reduce income inequality, and promote environmentally friendly industries.

After moving from a centrally-planned economy to a more market based system in the late 1970s, China’s impact on global trade has since escalated and today the country holds a key role as an economic superpower. Reforms during the 1980s helped improve the standard of living, increase productivity, and drove foreign investments to help fuel economic growth. However, the country still faced rising unemployment, lacked the legal infrastructure necessary to promote significant private investments, and its banking sector was largely unorganized and plagued with bad loans. It wasn’t until after the Asian financial crisis and into the early 2000s when investors finally started taking notice of the unparalleled potential brewing overseas.

Why China Matters

Why China Matters
Second biggest economy in the world
One of the ten fastest growing nations
Largest labor force in the world
Per capita GDP still lower than world average
Underweighted in most U.S.-based portfolios

China is a crucial part of the global financial system and is currently the second biggest economy in the world with a GDP that is just over $10 trillion (in PPP terms). Not only is the country one of the biggest in terms of raw size, but it is also one of the ten fastest growing nations; GDP grew by 10% last year and it has increased by at least 9% in both of the previous two years as well. While that pace likely will not be maintained indefinitely, China’s economy is expected to grow more quickly than the rest of the world for the foreseeable future.

China Risks

Like any emerging market, China is fraught with a number of risks that stand as hurdles to a continuation of the country’s impressive growth going forward. At the forefront of these concerns is the red hot rate of inflation in the country, as the level of price increases is accelerating at a clip of roughly 5.5% year–well above the country’s target figure. Since much of the country is still very poor, such a high level of inflation has the impact of making it very tough for the average person to survive without seeing a massive decline in their standard of living.

China Risks
Runaway Inflation
Scarcity of High Quality Jobs
Political Risk (One Party State)
Geopolitical Tensions
Property Bubble
Shortage of Commodities
Low Quality Local Government Debt

Beyond inflationary concerns, there is always the risk of further unrest in the One-Party State stemming from issues such as a lack of political freedom and relative scarcity of high quality jobs for the growing class of Chinese college graduates that have very few options. Should either of these situations bubble over into a Tiananmen Square style protest, it could have a huge impact on the outlook for the Chinese economy and lead to further calls for reform to the political system.

Additional political issues could hit Mainland China from any number of regional tensions that plague the nation. First and foremost is the ongoing issue with Taiwan, which China considers to be a ‘providence in rebellion’ that must eventually be brought back under the rule of Beijing. Any tensions with Taiwan, which is a close ally of the U.S., could spark fears into investors and lead to a great deal of panic selling.

Beyond Taiwan, China is surrounded by a number of unstable nations as well as rising powers making the quest for resources and influence fraught with uncertainty. India and much of Southeast Asia are rising very quickly in world standing, while concerns along China’s western borders with large Muslim populations have led to several protests in recent years. Turning east, the situation on the Korean peninsula seems likely to shift in the near future although one has to wonder to what and if further conflict will be seen between the North and the South. Additionally, it remains to be seen how Japan, a traditional rival of China, will react to an increasingly influential China, especially considering Japan’s near dominance of the Near East region for the better part of the last century.

Beyond these issues, some investors are growing increasingly worried over a Chinese property bubble. However, unlike the American situation in 2008-2009, which was largely driven by overleveraging, the Chinese bubble is driven by overbuilding. Residential property prices have fallen by about 5% from the year ago period after years of double digit growth, worrying many investors since the property construction business accounted for nearly 13% of GDP in 2010, according to the Wall Street Journal.

Although there are a number of pressing risks facing China, the future remains bright in the country for a number of reasons. China has great flexibility in terms of its policy decisions as the country still has very low debt load, and it has massive foreign exchange reserves as well. By either deploying this cash or raising money in the bond market, China can continue to expand its rapidly improving infrastructure or increase safety nets for the poorer members of the nation that have been left out of the boom over the last few decades. By doing this, China can tap into its high savings rate and encourage more citizens to develop the consumer economy. Currently, the savings rate in the country is close to 40%, nearly eight times higher than the U.S. level. If China is able to encourage its citizens to spend even a fraction of this, an internal economy is likely to take off, further helping the country to lessen its dependence on foreign exports.

China’s Potential Rewards
Consumer Potential: Unlocking High Savings Rate
Current Account Surplus / Foreign Reserves
Low Public Debt
Undeveloped Interior
Yuan Issues

Beyond this opportunity, much of the Chinese interior remains extremely underdeveloped, especially when compared with the booming coastal regions of Shanghai and Guangzhou. The Chinese government has taken steps to encourage investments in this area by helping corporations set up and stimulate growth in the countryside. Wages tend to be far cheaper in this region and with infrastructure development likely to continue, we could see a more equitable distribution of China’s growth story. If this happens, investors could see even higher rates of growth out of China and a drastic increase in consumer spending as well. This could potentially create a second boom in China and led to a massive increase in nation’s standing on the global economic stage.

Yet, possibly the greatest potential for China stems from its currency, the yuan, which is currently trading in a narrow band against the U.S. dollar at roughly 6.48 yuan to one greenback. Many analysts believe that this is significantly less than what a yuan would fetch on the open market with some suggesting that the yuan could see an increase in value by close to 50% if allowed to trade freely. If ever allowed to move outside this tight band, exports would likely fall but imports would surge and the domestic economy will in turn take off.

Additionally, the yuan could also find itself as a pillar of global trade, used in international transactions alongside the U.S. dollar and to a lesser extent the euro. If that happens, demand for the Chinese currency is likely to skyrocket making the nation’s quest for more resources and commodities that much easier thanks in large part to a stronger currency.

Overall, China has the potential to be the most dominant and important economy in the world. But before it can reach this apex, the nation must survive a plethora of issues and challenges in order to unseat the U.S. as the world’s preeminent economic superpower. Luckily for China, the nation has a number of advantages stemming from decades of solid management and investment that could allow the country to take its place at the top of the economic pecking order.

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