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What China's 'Rebalancing Act' Means For The World

China’s days as the world’s Happy Meal economy are over.

They’re not interested in making your shoes.  They’re interested in making the lithium batteries that power your Prius.

It’s not that China doesn’t want to make widgets. They still do, and they still will. Where else on Earth can you find half a billion people looking for work? But the old export driven China is moving inward towards a more consumer oriented society. Every China investor knows this. As China rebalances its economy, there will be growing pains.  Not only will there be growing pains for the Chinese economy, but also for commodities exporters like Brazil and South Africa.  The super-cycle in commodities — especially iron ore and copper — is done, say analysts from Morningstar in a 106 page report released this month.

Moving to a consumption-led economy will be harder and riskier than most investors expect. GDP growth in this “rebalancing act” is likely to disappoint, averaging no more than 5%, according to Morningstar.  For natural resources, China’s rebalancing act will be the defining development of the next decade, just as its investment boom set the tone for the last. The outlook is better for consumption-oriented commodities like palladium (cars) and potash (farming). As China rebalances, investors should focus on companies levered to these consumption-oriented commodities instead.

Most China-bound fund managers now accept the fact that China has exhausted the investment-led growth model. The government cannot continue to spend on roads and housing. There comes a time to pause, and that time is now.  Still, most underestimate the difficulty of a hand-off to consumption.

Successful rebalancing largely depends on the ability of household consumption to pick up the slack for waning investment growth.  It hasn’t been able to do that so far.

The good news is that there are powerful secular tailwinds that should aid China’s rebalancing act, says Morningstar. A rapidly depleting labor surplus, rising services share of GDP, and continued urbanization all can lead to strong consumption growth. But past rebalancing acts that followed other investment-led growth stories suggest China will see not only sharply lower investment growth in fixed assets, but lower household consumption growth too.

Beijing faces a dilemma. Some of the biggest companies in the world are paying close attention.
If the government acts too quickly, it risks triggering a crisis. Moving too slowly risks a continued build-up of excess within the system. More debt and more wasteful projects would make the day of reckoning more painful when it arrives.

China’s rebalancing act will prove harder than most expect. Growth rates amid the process are likely to disappoint, says Morningstar analyst Daniel Rohr.  Rohr and his colleague Zhao Hu now expect medium-term GDP growth of 5%, materially lower than the consensus estimate of 7.5%. And it’s likely to be a rather bumpy 5%.

What China’s slowdown means for the world is especially clear for the big commodities producers.  As China turns inward — and incomes rise — Chinese consumers are expected to buy more luxury goods than anyone else; more cars; take more business trips and buy homes abroad in increasing numbers. But none of this requires iron ore pellets or copper wire. Boeing won’t need to build additional airplanes to take these Chinese to Paris. Beijing will not be building a bridge to Malibu.

So that means that after more than a decade of surging Chinese demand and ascendant prices for metals, signs of weakness are everywhere. Chinese demand has slowed, hurting pure China plays like Brazilian miner Vale, the worst performing large cap stock in Brazil for the past year.

Rio Tinto isn’t far behind. Over a five year stretch, Vale is down 46% and Rio is down 44%. BHP Billiton is down 13.34% year-to-date; and so is Rio.  Vale is off 25.62%.

Morningstar says that shares of these “Big Three” iron ore producers look attractive at current levels, but urged caution because prices could get more attractive as the market likely hasn’t priced-in the full extent of slower growth in China. Of the three, Vale is the worst positioned.

Overall commodity prices have dropped significantly and China is one of the reasons why.  Over the last five years, the S&P Goldman Sachs Commodity Index is down 44.22%.

A Return To The Bad Old Days?

Outside China, demand was flat to negative for most mined commodities. It’s a return to the ” bad old days” of the pre-China boom, Morningstar says.  For example, prior to the year 2000 global crude steel consumption grew just 0.8% a year on average.  Then came China. World steel consumption jumped to 5.3% a year.  Mined commodity prices did even better, especially iron ore and coal.  Mined commodity prices prior to 2000 were actually in a decline by an average of 0.6% yearly. After 2000, mined commodities rose by an average 12.5% each year.

For the China-dependent mining industry, a wrenching rebalancing of Chinese GDP from extreme investment-intensity to a more balanced economic composition will be the defining macro theme for the next decade. And clearly, a rebalancing implies a very different set of winners and losers than we saw in the past decade.

This change is going to have mining companies digging up more palladium, a metal used in catalytic converters in automobile engines. China is the world’s No. 1 automotive sales market.
“ We expect China’s rebalancing act will heavily shape global commodity demand and mining company fortunes in the decade to come. Generally speaking, miner’s overweight investment-intensive commodities will find their profits under the most pressure,” writes Rohr. “Those with greater exposure to consumption-led commodities should find profits easier to come by,” he says.

It’s not all bad.

China’s rebalancing means a continued demand for natural resources, but not the kind used to build infrastructure. It means Chinese companies will increasingly invest overseas as they mature out of their home market, and become competition for the likes of Hyundai. Their demand might support, or drive up prices for precious metals and other commodities that speak more to the day-to-day of China life, from potash to oil.

For Morningstar’s analysts, China’s rebalancing means slower growth. And slower growth means stable demand, not booming demand, even for the commodities that Morningstar thinks stands to benefit from a China turning inward.

China-Linked Commodities

Chinese commodity demand growth through 2022: a very different set of winners and losers.

Annual growth rate greater than 8%:

Commodity       China % of World Demand 2012        China % of World Demand 2001

Diamonds                            10%                                    1%
Gold                                  26%                                    7%
Palladium                            19%                                    4%
Uranium                              3%                                     1%

Annual growth rate between 6% and 8%:

Lead                                    44%                                  14%
Oil                                     11%                                   7%
Platinum                             29%                                   25%

Source: Morningstar

http://www.forbes.com/sites/kenrapoza/2013/08/14/what-chinas-rebalancing-act-means-for-the-world/


Edward Lehman雷曼法学博士
Managing Director 董事长
elehman@lehmanlaw.com

LEHMAN, LEE & XU China Lawyers
雷曼律师事务所

LEHMAN, LEE & XU is a top-tier Chinese law firm specializing in corporate, commercial, intellectual property, and labor and employment matters. For further information on any issue discussed in this edition of China Mining Lawyers Alert or for all other enquiries, please e-mail us at mail@lehmanlaw.com or visit our website at www.lehmanlaw.com.


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