The China Dichotomy

| About: BHP Billiton (BHP)
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The Chinese Economy has two faces. Really, it does. In one hand, it's the factory of the world - and to be the factory of the world, it needs gigantic infrastructure, which to exist, needs endless investment. It is thus not a coincidence that around 50% of China's GDP comes from investment. This compares to around 20% in developed economies. On the other hand, for China's economy to be so reliant in investment, it smothers consumption. This, however, cannot go on infinitely - at some point industries start out-producing what the market will bear, gluts happen, and investment in those sectors inevitably declines.

China is facing the limits of its investment boom as we speak. One of the sectors where such is more obvious is real estate, and within real estate, residential real estate. I've covered at length how China's real estate prices are already dropping, and soon enough activity will follow, with consequences in many different sectors, namely those connected to supplying basic construction materials (copper, steel, iron, cement, glass, aluminum, etc).

Amazingly enough, two simple statistics can illustrate what's being said here, and what kind of transition one can expect. Below are two tables, the first represents how many dwellings were started in China during 2011, versus in the U.S. today and at the top of the U.S. real estate bubble, and compares both to the population. The second does the same for autos. (sources: CIA factbook, National Bureau of Statistics of China,Wikipedia)

What we observe is clear. China was starting a lot more dwellings per pop during 2011 than even the U.S. at the top of its bubble. It is thus no surprise that China is now facing a similar slowdown in its residential real estate market. But, on the other hand, even after many years of growth and becoming the largest auto market in the world, China is still only producing/buying around one-fourth of the automobiles per pop that get sold in the U.S. And remember this, buying a house is much more of a financial commitment than buying an auto. It would thus appear that while the real estate has room to drop considerably, the same is not really true for the auto market - indeed, there would seem to be room for growth there, considering that China also has a much lower stock of autos on the road, as well.

On the whole, the transformation from a society based on investment to one more reliant on consumption should allow China to continue growing in overall terms. However, specific sectors will still face very different consequences. This is most evident regarding the sectors that supply mostly the construction space, from building materials, to real estate brokers and construction companies. For international investors that don't play the Hong Kong market, the most obvious victims of this transition continue to be the iron ore suppliers:

  • Rio Tinto (RIO), around 45% of RIO's 2011 revenues came from iron ore with it also representing around 70% of 2011 EBITDA, showing how high margins were. Aluminum and copper are also significant.
  • VALE S.A. (VALE), around 72.5% of VALE's 2011 revenues came from iron ore.
  • BHP Billiton (BHP), almost 50% of BHP's 2011 EBIT was from iron ore at a 65% EBIT margin.

Given Australia's exposure to mineral exports toward China, the Australian dollar (FXA) and stock market (EWA) will probably also be affected by this transition.

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