China's Addiction To Construction

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Includes: AAPL, CAT, F, MCD, YUM
by: Jacob Steinberg

In order to keep its GDP growth steady, China keeps constructing things. The country constructs shopping malls, large stadiums, highways, apartment blocks, hospitals, and schools -- among many other things -- at a rapid rate. This may sound like a great thing as the country is investing in its infrastructure, but things aren't really that bright for China. The shopping malls are being built, but there are no shops or customers in them. Large stadiums are being built, but there are no teams to play sports in them. Highways are being built, but they lead to nowhere and have no traffic on them. Apartment blocks are being built, but they have near zero demand. Hospitals are being built with no doctors and nurses in them. Schools are being built with no students or teachers in them. China is building things just for the sake of it.

On Tuesday, news stories out of the country claimed that China would speed up things even further by providing fast-track approvals for infrastructure projects. This is done in order to help the country's economic growth at the expense of tax payers.

Every year, tens of millions of Chinese move from farms and villages into cities and big towns, seeking higher-paying jobs and better lives. These individuals want to take a piece of China's economic boom pie. In order to keep the nation stable and reduce chances of possible public unrest, the country has to provide jobs for these incoming individuals -- many of which are fairly young. Because businesses aren't investing in the country fast enough, fearing that high inflation will lead to increased wages in the country, the government has to provide many jobs. Oftentimes, government funds construction of big projects with no actual demand for those projects. This leads to many ghost towns and ghost buildings across the country.

Can China keep building ghost cities forever? It has to keep building for the foreseeable future. As the wages in China and energy prices keep going up, the cost of producing goods in China also goes up. Many American companies are already moving their production plants back to the U.S. in order to save costs. I believe that in the next decade or so, industrial production will move from China to cheaper markets, such as Vietnam. If political stability and business-friendly reforms are achieved, even some African nations may be able to take manufacturing jobs away from China. This will push the Chinese government to increase the amount of its construction investment for as long as it can. Currently, Chinese local governments are weighed down by heavy debt burdens, and the federal government keeps supporting the local governments in hard times -- but this may not be a feasible solution forever.

China has come up with five-year development plans just like Soviets did in the old days. Of course, these five-year plans are updated far more frequently than every five years. In fact, oftentimes the five-year plans will be updated every year due to unforeseen circumstances. China's current five-year development plan includes a great deal of new construction. If the country wants to speed things up, the projects that were planned to start in a few years will be started much sooner. Chinese government has already increased spending more than 50% in 2012, and this is likely to increase even further.

Real estate prices are falling in the country as there is lack of demand for the newly built apartments. When many of these apartments were built, the income of average Chinese citizens wasn't taken into account. Many of these apartments were and still are too expensive for an average Chinese person to be able to purchase. One thing that makes these apartments particularly unaffordable is the requirement of down payments, which many times exceed 50% of the home's value. Many Chinese who bought homes in the last two to three years will never see their money returned as home prices are expected to keep dropping; analysts say home prices will drop by another 15% in the next two years. Constant construction only makes the situation worse.

This doesn't mean much to American investors in the short term. The only implication is that the Chinese economy will continue to grow at a fast rate, and American companies doing business in China will continue to see strong growth there. In the long term, we may see a Chinese debt problem, particularly if the country's economy crashes. This could lead to a global problem similar to what we saw in 2009.

For the time being, I suggest investing in companies that are seeing strong growth in China such as Apple (NASDAQ:AAPL), McDonald's (NYSE:MCD), Ford (NYSE:F) and Yum Brands (NYSE:YUM). These companies are not directly related to real estate but as the Chinese government keeps spending money on infrastructure, this will increase the average income of Chinese citizens, allowing them to buy more products and services from companies like these. Also, companies that produce steel and other construction materials may see strong demand from China. In addition, one of my favorite stocks, Caterpillar (NYSE:CAT), will also benefit from increased Chinese construction spending.

Disclosure: I am long AAPL, CAT, F, YUM, MCD.