China's Competitive Edge: Beyond Cheap Labor - Part 2

by: Stock Whiz

<< Return to Part 1

For a prolonged period, growth in China has been seen as nothing other than a structural bull case. Since 1991 Chinese GDP growth has averaged 10.3% and has not dipped below 7.6%. However, the story is becoming less straightforward. Chinese corporate have developed to the level where they can now out-compete their international peers at home and abroad. We will now look at the macro factors at work that pose a threat to major players in Europe and the US.

5. China's investment Share of GDP: The investment rate to GDP ratio has grown sharply since 1980s and is now above the peak industrialization levels witnessed by Japan (36%). This implies over-investment pointed to excess capacity, which can only be mopped up by exports.

China - Investment to GDP ratio:

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Source: World Bank.

This is further compounded by the relatively low consumption share of GDP in China, at just 35% and Chinese producers to export a large percentage of their goods and services.

China - Consumption to GDP ratio:

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Source: World Bank.

6. Undervalued Renminbi: Chinese Renminbi still remains undervalued, despite the 12% jump between June 2010 and February 2012 on an inflation-adjusted basis and 40% since 2005. The renminbi still remains undervalued, relative to all other currencies, by 5-20%, according to various estimates. For more than a decade, economists and officials in other countries have charged that the Chinese government has kept the value of its currency artificially low to make the country's exports more affordable. It is unlikely that the Chinese government will bow to international pressure and allow any quick unwinding of the RMB peg, given the obvious risk that sudden changes would be disruptive economically and politically.

7. Inappropriate cost of capital: Excess capacity and an undervalued exchange rate have led to inappropriately low cost of capital for China. Moreover, in the long run, nominal interest rates should roughly equate to nominal GDP growth as seen in developed market.

Interest rates in China are around 5.3% juxtaposed against nominal GDP growth of 15%. Thus, the cost of capital in China looks about 10% points too low.

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8. Critical mass: China's growth means it is now the dominant market in many sectors. For Example in 2010, China represented the largest global market for cars. In line with the economic growth, the relative growth that many Chinese (and Indian) companies have enjoyed over the last 5-6 years has brought them up to critical mass in the global market place.

BRIC Market Cap, as a percentage of MSCI AC market cap:

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BRIC's share of MSCI All Country market cap has risen from only 1.4% five years ago, to 6.2% currently (vs China 2.3%, Brazil 2.2%, India 0.9%, Russia 0.8%)

We will now look into some of the investment options of companies that stand to benefit from this trend.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.