China’s future may be brighter than anyone expects – it’s time to buy

A lot of people are negative on China these days.

The bears worry that China relies too much on investment, and not enough on consumer spending. If it wants to continue to grow sustainably, consumers need to pick up the slack. Otherwise there could be an almighty crash.

But research from a couple of Chinese academics suggests that Chinese consumers are in fact spending significantly more than official figures suggest.

If they’re right, it means that the Chinese economy is less likely to ‘hit the wall’ in the next few years.

That means, investing in China is less risky than many people think.

And that leaves the Chinese stock market looking pretty cheap…

Why over-investment can lead to crashes

If you’re wondering why too much investment might lead to a crash, it’s because you get diminishing returns if you invest too much.

If you build roads and railways that no one ever uses for example, then they won’t generate any revenue. So you’ve spent a load of money on a project that will never cover its costs, let alone generate a return.

If this continues, there will come a time when businesses realise it’s pointless, because they’re not getting any return on their latest investments.

When that happens, workers in construction and heavy industry will get laid off. That means rising unemployment and recession. There’s also the risk to the banking system if all of these dud projects have been funded with borrowed money.

If you look at China, it’s not hard to find signs of over-investment. The country is famously dotted with ‘ghost cities’. There are also some plain weird follies, like this giant copper-plated puffer fish.

So the question is: can China achieve a relatively smooth and pain-free transition from an investment-led economy to one based more on consumption?

Could the future be brighter for Chinese consumers?

Well, if you believe the official Chinese government figures, it’s a massive challenge. Household consumption comprises just 34% of China’s GDP, according to official figures. That’s way lower than the UK, on 65%, and the US on 70%.

The sort of dramatic shift in economic focus needed to get the Chinese consumption figure up from 34% to, say, 50%, could easily end in tears.

However, an article in yesterday’s FT gives grounds for optimism. It cites research from two Chinese academics, Jun Zhang and Tjan Zhu, which suggests that Chinese consumption has been under-reported for some time.

Indeed, Zhang and Zhu believe that a more accurate figure for household consumption would be around 45% of GDP.

How do they get to this figure? Well, arguably it’s by taking a more realistic view of corruption in the country. High earners prefer to hide the true extent of their consumption from government bureaucrats. Some even avoid being surveyed altogether.

This strikes me as a very plausible argument. And if it’s true, it suggests that the chances of a big Chinese crash are lower than many people realise.

Granted, even a 45% figure for household consumption isn’t really sustainable in the long-term. But it’s a much better place to begin a transition from, than the 34% official figure.

China looks cheap

Don’t get me wrong, there’s still a real risk that China could crash. But the point I’m making is that the risk is lower than widely thought.

And that matters, because right now, Chinese share prices look very cheap on many measures. That means they are pricing in a lot of potential drama.

For example, look at the table below, which compares the value of a country’s stock market to its GDP.

Source: GuruWatch

Just to explain – the total market/GDP ratio is just the value of the country’s stock market expressed as a percentage of the economy.

As you can see, the US is currently on the high side compared to history (the total value of the stock market is a little bit higher than the value of the economy, compared to a historic maximum of 149%). The UK is somewhere in the middle of its historic range, and Brazil is on the low side.

But China – with a stock market valued at half of GDP – is only just above its historic low. (As is Italy, another market we’ve viewed as cheap for some time).

I have to say, this table certainly increased my own interest in investing in China. What’s more, Pictet Asset Management says that we’re now seeing early signs of improved corporate governance in the country.

How to profit from a Chinese rebound

So what’s the best way to profit from a smooth transition to a consumption-based economy in China?

Well, the lowest risk approach is to invest in Western companies that do a lot of business in China. I’m thinking of consumer goods giants such as Diageo (LSE: DGE) or Unilever (LSE: ULVR).

Or you could take a bet on growth in Chinese tourism. The number of visitors to Thailand has doubled over the last year, according to the China Market Research Group. And I’m sure that we’ll see many more Chinese tourists here in Britain in the future.

InterContinental Hotels Group (LSE: IHG) looks well placed to benefit as it has a decent estate of hotels in China, plus many more in other major tourist destinations.

If you have an appetite for taking more risk – and have more of an eye for a potential bargain – you could buy shares in Chinese companies themselves. The danger here is you may not trust the Chinese government to treat overseas shareholders fairly – and you’d be right to be cautious.

Still, I quite like the JP Morgan Chinese Investment Trust (LSE: JMC). It’s been running since 1993 and has managed to avoid some of the riskiest Chinese shares.

Moreover, 45% of the fund is invested in shares listed in either Hong Kong or Taiwan where the governance should be better and the risk lower. It’s also trading on a 13% discount, so in effect you’re getting £1 of assets for 87p. If sentiment changes towards China, not only could the underlying shares rise, but the discount will probably close too – boosting your returns.

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