As global investors we face a dilemma — whether to make the next round of investment in the once solid developed markets or always fragile but promising emerging markets. Conventional wisdom argues that developed nations historically lead the emerging world out of recessions. Is this time any different? While a return to economic stability in the developed world is a prerequisite, the burden of driving growth will fall more than ever on the shoulders of the big new emerging markets of the ‘dragon’ China and the ‘elephant’ India. In the next few years, China will likely overtake Japan to become the world’s second largest economy.
A rare and unpredictable year for China
While ‘tiger’ often suffixes China, and ox metaphors are du jour, our edgier ‘dragon’ underscores the unpredictability of 2009’s economic outcome, pivoting around a heroic fiscal stimulus plan and China’s large collateral impact on other emerging markets. A feared Chinese hard landing, defined as sub five percent real GDP growth, will no doubt have a ripple effect, since over half of Chinese trade is with other emerging markets. Another reason to be edgy on China this year is potential social unrest since 20 million migrant workers are estimated to have lost jobs in the current crisis, often returning to villages where their land has been repossessed for development. Also, China faces a rare triple anniversary of controversies, notably the 10th anniversary of Falun Gong’s banning, the 20th of the Tiananmen uprising and the 50th of the Tibetan uprising, including the Dalai Lama’s escape to India. While less melodramatic, this year will also be eventful for India given its much-anticipated mid-year national election.
Weak outlooks?
In 2009 we expect China and India will grow about 5.5 percent and five percent, respectively, which is more pessimistic than the current consensus view of 7.7 percent and six percent. This is still well ahead of world GDP, which is likely to shrink one percent in 2009, thus partially offsetting the US and EU drag of about -2.5 percent in 2009, before rebounding to 2.5 percent in 2010. The stated government growth targets for 2009 are lofty at eight percent for China and seven percent for India, both unrealistic and with more downside risk for India.
In the past year, the equity markets of both have crashed and are now at historical valuation lows. While global stocks, as measured by the MSCI World index, were down a stiff 42 percent in 2008, India swooned 52 percent, China A-Shares crashed 65 percent and China H-shares were off a relatively better 51 percent. Year to date, China A- shares are up strongly but H-shares are about flat and India is down seven percent. Both Indian and Chinese H- Share markets trade at almost trough valuations with price- earnings ratios below 10 times.
From these depressed valuation levels, which of the two will fare better in the recession and eventual recovery, China or India? Beyond the obvious disparity of centralized vs. federalized governance structure, there are critical differences between the two — in terms of domestic consumer spending, exposure to the overstretched US consumer, foreign exchange reserves, trade balance, fiscal deficit and, most importantly, the degree of stimulus spending. The interplay of these is important but difficult to forecast and complexity is compounded by the lack of transparency, especially in oft-murky Chinese statistics.
Recent data is dreadful, but more so for China
After an exceptional run of nine to 10 percent real GDP growth for the past quarter century, which peaked at 13 percent growth in 2007, Chinese growth is sputtering. The major reasons for this are exhaustion of the export driven growth model compounded by a credit crunch, which squeezed trade finance, tail-off in capital investment, inventory destocking and a continuation of the real estate slump. Other metrics that confirm this steep fall in economic activity include electricity consumption, a reliable proxy for industrial production, which was -4 percent in recent months versus 12 to 15 percent growth in recent years, far worse than in the prior downturns of 1998 and 2001. This decline is partly due to inventory destocking, but could have been worse had it not been for improved inventory management, which has resulted in inventory stock of 35 to 40 percent of GDP versus well above 50 percent in prior downturns. Finally, export growth, which was running at 20 percent or more in recent years, is down about 25 percent this year and would have been worse had China not diversified away from the US, which was over 30 percent of exports a year ago and is now below 20 percent.
On the other hand, India has also slowed from a peak of 9.5 percent real GDP growth in 2007 to 5.5 percent, with exports down 15 percent in recent months. However, it is less pressured than China because of its less cyclical economic structure, with much heavier services mix and less export dependence on the US and EU. India’s exports are less cyclical, since services are about 35 percent of exports and least-cyclical IT services are 40 to 45 percent of service exports. Finally, Indian exports, which have tripled in the past five years, are now more competitive due to a sharp 25 percent recent fall in the currency relative to both US dollars and China’s yen. While China might be tempted to dangerously devalue as they did in 1994, they will be held back by political pressure from its vital trade partner, the US. In fact, we are likely to see continued appreciation if growth rebounds, albeit at a reduced pace versus the past three years.
Stimulus is far greater in China and could rise
China has launched a more aggressive stimulus policy than India and most other emerging markets. While it has grandiosely announced plans to spend $586 billion over two years, which equates to seven percent of GDP per year, some analysts have tarred it as an inflated plan that includes a rehash of previously committed spending. Even if the real spend is only half that figure, it still exceeds India’s paltry one percent of GDP. The equity markets have already priced in these announcements but we expect there could be more stimulus to come from China since the current announcements result in a deficit of ‘only’ 2.6 percent in 2009, lower than India’s — and America’s — elephantine annual fiscal deficit of about 10 percent. If GDP growth disappoints, we expect additional stimulus deficit spending in China, exceeding the governments’ current goal of limiting it to three percent of GDP. Given India’s already-high deficit, it has very limited room for additional stimulus, hence the higher downside risk.
Key structural differences will endure
As the table [on the previous page] shows, there are vast differences between the two countries’ economic attributes, which hint at continued growth opportunities well past the current turmoil. China is poor with GDP per capita of about $3,300 and about one third of its 1.4 billion population living on less than $2 per day, while India is worse off with GDP per capita of about $1,000 and over two thirds of its 1.2 billion people get by on a $2 daily budget. India’s population density is substantially higher and getting worse with an annual growth of 1.2 percent per year, double China’s 0.6 percent per year. Over the next couple of decades, this will result in a gray China and a youthful India, a demographic dividend that will translate into productivity only if India improves its lagging primary education system, especially in the rural areas where the bulk of the population resides. Finally, India is less cyclical because its GDP is about two-thirds domestic consumer spending driven, versus only about a third for China. China’s core challenge in the near future is to shift the economy from being manufacturing and export driven to being more like India, with higher services and domestic consumption.
Average into China now, await lower Indian entry point
Waiting for a turn in macroeconomic data is too late since equity markets will attempt to lead by about six months. In China, while news flow might worsen in the next month or two, some early indicators point to the fiscal stimulus working, such as bank loan growth, which is up strongly recently. While one statistic does not make a trend, oversold markets could result in large upside moves. We favor the H-share route given they trade at a wide discount to A-shares and have better transparency in these murky times. Since bottom picking seldom works, we advocate averaging in over the next six months, accumulating on dips and accelerating if the HSCEI index retests October lows of 5,000, especially if you have at least a five-year horizon to mitigate market risk. If you think that is an awfully long horizon, keep in mind that once-emerging Japan equities still trade 75 percent below their 1989 peak. Also, diversify and allocate your portfolio wisely, since Chinese equities are only about seven percent global stock market capitalization and India’s even less at two percent.
With India, saunter slowly like the elephant, and start to build positions in the mid-to-late second quarter around the national elections, which will likely have major impact on investor sentiment. During the last major election of 2004, an unfavorable outcome resulted in a 20 percent market drop within two months and we would buy into any similar dislocation. Since fiscal pump priming is limited by the deficit-laden nature of the budget and the high 72 percent debt to GDP ratio, a favorable election outcome will be defined as a stable reformist government given the fractious political landscape. Such stability is key to macroeconomic reform, especially financial services reform and privatization of inefficient national assets, which are critical to unlock economic potential.
Borrowing from a former president of the US — the country where this recession began — the Chinese use two brush strokes to write the word ‘crisis’: one brush stroke stands for danger, the other for opportunity. In this crisis, be aware of the danger, but recognize the opportunity, as a lot of negative news is being priced into the markets.
Rehan Syed is the head of portfolio management at the ABN AMRO Private Bank in Dubai. The opinions expressed here are personal and not necessarily those of his employer
