quantstrategy 20130722-china how slow how soon

7/28/2019 QuantStrategy 20130722-China How Slow How Soon

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Equities Research – Quantitative Strategy

Issued by Wilson HTM Ltd ABN 68 010 529 665 - Australian Financial Services Licence No 238375, a participant of ASX Group and should be readin conjunction with the disclosures and disclaimer in this report. Important disclosures regarding companies that are subject of this report and anexplanation of recommendations can be found at the end of this document.

Subtitle Left Aligned and in Title Case

ACTION & RECOMMENDATION

Last year I thought that China was finally beginning the rebalancingprocess, but another burst of government spending proved me

wrong. I am wary of crying wolf but it is still a question of “when”,China rebalances not “if”. More importantly I am increasinglysceptical that there is a middle ground to the slow down, either Chinagets stimulus and growth holds up in the short term or it doesn't getstimulus and growth step changes materially lower. If China slowsdown then international assets will outperform Australian, for Australian market focussed investors the next best thing will bestocks with exposure to international markets – excluding resources.

Damien [email protected]. +61 2 8247 3101

While the longer term path to China rebalancing is relatively clear, in theshort term the key to the rebalancing process rests with a small number of

government officials in China who are not celebrated for transparency. So,while I prefer to invest on the basis that China will slow, another round of fiscal stimulus is a material risk to that view. The key issues are:

1. How much ideological conviction do Chinese politicians have in

rebalancing: The first steps to rebalancing are easy, the hard part isonce vested interest start to feel economic pain and exert grassrootspolitical pressure. Does the current Chinese leadership have thepolitical and ideological wherewithal to push through the measuresrequired or will they reverse? This is biggest unknown.

2. Where is the point of “no return”: When an economy is dominatedby investment like China, it relies on economic growth to encouragefurther investment which creates more growth and “hides” pastmistakes. However, if the growth slows too much then the economy willhit a point of no return where the losses on prior investment discouragefuture investment and the model unravels – usually dramatically. Thelevel at which this is an issue is a guess – I am thinking the point issomewhere around 5% nominal growth.

3. What scope does China have to stimulate if things get worse?: Debt levels have increased substantially since the Chinese stimulus of 2008/ 2009 which greatly limits the scope of future stimulus.

FIGURE 1: CHINA URBANISATION – THE 1ST DERIVATIVE MATTERS

Source: Wilson HTM, RBA

0

5

10

15

20

25

30

300

400

500

600

700

800

900

1,000

1,100

1990 2000 2010 2020 2030 2040

m Peoplem PeopleTotal urban population -

World Bank forecasts(LH)

Annual change in

urban population (RH)

22 July 2013

QUANTITATIVE STRATEGY

China: how slow, how soon?

… BUT the number moving tocities will decline rapidly in

coming years

The number of people living inChinese cities is expected togrow for another 20 years



22 July 2013

Quantitative Strategy

Equities Research – Quantitative Strategy 2

This document is organised into two parts:

1. An analysis of the current issues and how events could play out

2. A longer term look at why rebalancing is needed.

Current IssuesHOW MUCH IDEOLOGICAL CONVICTION DO CHINESE POLITICIANS HAVE IN

REBALANCING:

There is broad acknowledgement in China that the economy needs to rebalance awayfrom investment to more consumption, former Premier Wen described Chinese growthas “unbalanced, uncoordinated, and unsustainable” and the incoming leadership havediscussed the need for the rebalancing.

However the first steps to rebalancing are easy, the hard part is once vested interestsstart to feel economic pain and start to exert grassroots political pressure. While ChineseGDP growth has been impressive, the growth has not been evenly dispersed among

Chinese citizens. Estimates of the Gini coefficient, which measures inequality, havegrown dramatically in China and it is now one of the highest in the world.

FIGURE 2: CHINESE GINI COEFFICIENT

Source: National Bureau of Statistics (NBS) , China Statistical Yearbook, China Statistics Press, Beijing, Huang & Wang

This creates a number of issues. I am going to ignore the potential for large scalepolitical upheaval, not because it is unlikely but because human beings have proven tobe very poor at predicting regime change and I am unlikely to be any better. Its a riskthat needs to be kept in mind, but there is little an investor can do right now as regimescan last decades beyond expectations or fall within weeks of all of the expertssuggesting there is no possibility.

What the imbalances do create though is the bane of political systems the world over and something I am much more comfortable forecasting – political self interest.

The GINI coefficient above shows that the growth in wealth for a number of people withinChina has been spectacular and based on the existing arrangements where investmentgrowth is high.

Additionally local governments are highly reliant on land sales to developers. Reportsabout Chinese party officials owning tens or even hundreds of properties, plus that China

does not rate well on most measures of corruption (on the Transparency International2012 study China was ranked 80th, citing graft, bribery, embezzlement, backdoor deals,

nepotism, patronage, and statistical falsification) suggests that the relationship betweenparty officials and developers is unlikely to be entirely above board.



22 July 2013



So, rebalancing means less investment which then means less chance for lower levelcommunist party officials to “supplement” their income. As rebalancing occurs it will

create (probably quite intense) political pressure for Chinese leadership.

Does the Chinese leadership have the fortitude to stand up to vested interests? No oneknows – probably not even the Chinese leadership.

What this means for investors is that it is wise to position portfolios for a rebalancing, butto be mindful that as the rebalancing occurs that there will be a risk that leadership willcave to vested interests and begin a round of stimulus.

WHERE IS THE POINT OF NO RETURN?

My thesis is that there are “points of stability” in any economy, if an economy grows toofast above the point of stability then eventually you get overheating and a recession inorder to “reset” growth levels to a more sustainable level.

For China my contention is that there are two points of stability. One is at 8-10% GDPgrowth where the growth in the economy is enough that it can sustain further investment

growth (for a few years but not many) despite the low returns on investment.

However, if economic growth drops below the “critical point” then there is the possibility

(probability?) of financial crisis while investment levels reset themselves to sustainablelevels. Where is the critical point? Impossible to predict. I am pretty sure 0% nominalgrowth is low enough to spark a crisis and 10% nominal growth is probably high enoughto avoid a crisis (at least in the short term) but beyond that it will be about watchingindicators.

There are a number of sub-issues here:

High growth in an economy encourages more investment

In a high growth economy investment mistakes are less important

When investment becomes too large of a part of the economy then economic growth

starts to depend on growth in investment rather than the return on investment

When economic growth drops too low then all of these factors can unravel quickly.



22 July 2013



High growth in an economy encourages more investment

To a certain extent growth is often reinforcing in an economy. High rates of growth attractmore investment capital which in itself helps to grow the economy.

FIGURE 3: INVESTMENT CYCLES

Source: Wilson HTM

However the process is self-reinforcing on both the way up and on the way down. If economic growth slows below a certain level then potential investors are less likely toinvest and the rates of investment can drop precipitously.

High growth in an economy hides investment mistakes

At a high economic growth rate mis-investment is less of a problem. For example $1bmis-invested while an economy is growing at nominal growth rates of 15%+ (as Chinahas) becomes less of a problem every year – after 5 years an economy with growth rateslike 15% has doubled in size and so the problem has shrunk and can be written off /

down with more ease.

However, as an economy starts to slow prior investment mistakes do not shrink asquickly (in a relative sense) and so a slowing economic growth can also be self-reinforcing as fewer projects are “saved” by growth and the projects that do fail make up

a larger proportion of the economy..

When investment becomes too large of a part of the economy then economicgrowth starts to depend on growth in investment rather than the return oninvestment

Ordinarily investment makes up 10-20% of an economy and what is important over themedium term is that the investment earns an appropriate return which then grows theeconomy.

1. Investment

returns high.More

investment

attracted

2. Extra

investment

increaseseconomic

growth rates

3. More

investmentcapital

attracted and

so investment

returns fall

4. Economic

slowdown,possible debt

crisis

5. Investment

returns fall

further, newinvestment

dries up

6. Economy

bottoms butlittle

investment due

to prior losses



22 July 2013



However, investment in China is at unprecedented levels, making up around 50% of theChinese economy (see chart below):

FIGURE 4: INVESTMENT AS A % OF GDP

Source: IMF, Alsosprachanalyst.com

What this means is that while return on investment is inescapably important for thelonger term, for the short term the most important thing is the change of investmentdollars itself – the tail wagging the dog.

WHAT SCOPE DOES CHINA HAVE TO STIMULATE

Not as much as you might remember from a few years ago. Total social financing (whichis a curious Chinese measure of both debt outstanding and equity raised) has increasedrelatively dramatically in recent years, and is now close to 200% of GDP.

FIGURE 5: SOCIAL FINANCE (% GDP)

Source: IMF



22 July 2013



Looking at peer economies, China’s stock of credit is among the highest in the world for

economies with a similar level of GDP per capita.

FIGURE 6: NET DOMESTIC CREDIT VS GDP / CAPITA (% GDP)

Source: IMF

Finally, and just as interestingly, the IMF calculate an “augmented” level of governmentdebt where they add in the debts accrued by local government land financing deals andother “off balance sheet” transactions by governments in China. The conclusion is that

the level of government deficit is closer to 10 percent of GDP, which would put it at oneof the highest government deficits in the world.

FIGURE 7: AUGMENTED GOVERNMENT DEFICIT

Source: IMF

Putting it all together adds up to a view of a greatly reduced capacity for the Chinesegovernment to launch stimulus packages, and if the IMF calculations are correct then thegovernment will struggle to maintain current levels of spending for more than a handful of years.

China has more debt than most similar

countries



22 July 2013



SOME OTHER QUESTIONS AND ANSWERS

We have recently seen instability in interbank lending rates what do these

portend?

In the weeks prior to 30 June 2013 interbank lending rates spiked higher, with some

suggesting that it was the start of a financial crisis and others suggesting that it was anintentional move by the central bank to rein in shadow banking.

It is unlikely in my view that a central bank would risk the financial system in order to getthe banks to rein in lending. A more likely answer is that rates spiked higher and thecentral bank was caught off guard. To the extent that swerving into on-coming traffic getsthe screaming kids in the back seat to finally shut up, the central bank is probably quietlypleased, but I doubt it is an exercise they would intentionally repeat.

While I won’t go as far as to suggest that it was the start of a financial crisis, but what it

does suggest is that there are considerable imbalances in the Chinese economy that willcontinue create issues that will require intervention. And this means there is a chance of policy mistakes and unintended consequences.

Are Wealth Management Products and shadow banking accidents waiting tohappen?

Basically these are products designed to get around banking regulations and controlsand they would appear to carry a lot of risk. It would appear as well that these productspay a low amount of interest for the level of risk that backs the loan, and that the loansare being largely used to fund property development.

So, all of the ingredients are there for a debt crisis. Now that does not mean that a loancrisis is inevitable, but given the growth rate in the number of these products it suggeststhat these products could turn a relatively a minor debt crisis into a more major one..



22 July 2013



Why will China rebalance

The biggest risk to Australian economic growth continues to be a significant

slowdown in Chinese growth. Our base case is for a hard landing in the

construction sector in China. While there may yet be a soft landing overall(largely dependent on government stimulus) what matters for the Australian

economy, and in particular for the resource sector is what happens in the

construction sector.

Booms last for longer than most people expect at the start and then finish faster thananyone expects at the end.

The question of whether China will soft or hard land is a little academic (for Australia)though, because with so much of our economy geared to resources what reallymatters is whether fixed investment slows. The Chinese economy could grow at 5%(a hard landing) but if made from significant construction but low consumption growththen commodity prices could well increase. On the other hand, 9% GDP growth madeup of a massive increase in consumption but negative growth in construction could be

dire for commodity prices and Australia. Our thesis is:

China has been over-investing for some time and since 2009, the Chinese

stimulus has been focussed on building projects that were big users of steel. Ironore and coking coal are two of Australia’s largest exports, both key inputs in steelmaking.

The Chinese economy needs to re-balance to be more consumption led, and the

Chinese 5 year plan agrees. Working the numbers, a “good” outcome would beChinese investment growth close to 0% in the medium term.

China is getting very close to an inflection point in their urbanisation path where

urbanisation will continue, but the absolute number of people moving to urbanareas will decline (see chart below).

None of these are necessarily “sell right now” issues. If Chinese authorities wish

they could easily launch a stimulus package that would put these issues onto theback burner, although the longer they extend the spending the harder theeventual decline will be. Regardless, at some stage over the next few yearsthe level of building in China will decline considerably. Will that time be now?Maybe.

FIGURE 8: TYPICAL URBANISATION PATH OF A DEVELOPING COUNTRY

Source: Wilson HTM

Low growth that starts to

accelerate

However once youpass the mid point

growth slows

China

Urban

population

as % of total

Time

Past the midpoint, theabsolute number of people being urbanised (i.e.

needing a home built) islower every year



22 July 2013



A “BRING FORWARD” OF DEMAND?

Given the apparent over-construction of housing in particular following the huge fiscalstimulus post-2008 financial crisis, it is likely that this component of GDP will slowmore sharply than the rest of the economy. In effect, some of the construction for theurbanisation of the population has been “brought forward”. Figure 9 shows the growthin fixed asset investment in China over recent years – the fiscal stimulus post 2008financial crisis is clear and we do not expect to see a similar stimulus again not onlybecause it appears to have created an overhang of the stock of housing but it alsocreated the inflationary pressures that required a foot on the policy brake.

While we will go through a period of “payback” after such a building surge, theurbanisation of China still has many years to run if previous countries’ experiences areanything to go by. However, for Australian resource companies as China continues toprogress from a developing to a developed economy the real question is what level of building is sustainable?

FIGURE 9: CHINA FIXED ASSET INVESTMENT (YOY %)

Source: Bloomberg, WHTM

THE CHINA INVESTMENT PUZZLE

While investment is generally a “good thing”, at some stage you can have too much of

a good thing. Specifically, investment which is debt funded and does not earn a high

enough return to pay back the debt is not good investment. Judging the return on an

investment is hard enough to measure for commercial operations, but when you are

building public structures like bridges or roads then measuring the return is even

harder again.

So is China earning an economic return on its investment? When you look at a countrylike China 20-30 years ago with little investment, just starting to invest then they will

generally choose the most efficient investments first (give or take) and as time goes on

they start to invest in projects than earn a lower and lower marginal return.

At some stage, if investment is high enough, this return will fall below the cost of

capital – the key question is when? In our view China is likely to have reached this

level. While it is possible that China can keep increasing its investment, any increase

f rom here is likely only to make the “bubble bigger”.

China already spends a prodigious amount on investment – 50% of the GDP is spent

at the moment which is well over the rate achieved in a range of other economies

during their growth phases:

20

22

24

26

28

30

32

34

36

2007 2008 2009 2010 2011 2012

%



22 July 2013



FIGURE 10: INVESTMENT AS A % OF GDP

Source: IMF, Alsosprachanalyst.com

REBALANCING

So, if we assume that at some stage the Chinese economy will rebalance, then the

key questions become how and when?

For the “how does China rebalance?” question, we are unsure - in the vast majority of

similar cases, investment spending continues to increase as long as it can before

ending in a crash (eg Japan, the Asian crisis, Russia etc). Basically, the level of

investment spending gets so high the entire economy becomes dependent on creating

investment and it is hard politically to diversify away from this as it involves short term

pain for a longer term gain.

However, there is the hope that this time China will be able to rebalance more

gradually – they have recognised the problem at least in their five year plan, the

question is whether politically it is possible to make the change given:

it is likely to generate higher short term unemployment

local governments have become dependent on profits from land sales

vested interests will likely lobby to maintain the construction spend

Forgetting the political issues for a moment, let’s make the assumption that China

wanted to rebalance smoothly over the next 10 years back to 50% consumption, 30%

investment (which would still put them at the top of the chart above). What growth

rates would have to occur for this to happen (see Figure 11)?



22 July 2013



FIGURE 11: A (HYPOTHETICAL) SMOOTH PATH TO REBALANCING

Source: Wilson HTM

The maths is relatively simple on an economy-wide basis. GDP = consumption +

investment + government spending + net exports.

Let’s assume exports and government spending net out to not change as a proportion

of GDP (arguably net exports will probably decrease as Chinese consumption growth

is likely to exceed consumption growth in the rest of the world while government

spending will probably increase due to increased social services).

So, we are left with the two key variables, consumption which is around 33% of GDP

and investment which is around 50% and we want to know the growth rate which will

reverse these numbers.

If consumption started growing at 12% real (say 15-16% nominal growth) and

gradually edged down to 8% (11-12% nominal) per annum over the next 10 years,

then investment would have no real growth at all in order to rebalance the Chinese

economy

We can play with those numbers a lot, but realistically there is a limit to how fast

consumption can grow, and even if you increase the starting growth rate of

consumption to 15% and extend the period to 15 years rather than 10 you still only getinvestment growth rates of around 5-6%.

So, the question is whether China does it the “easy” way with very low to no growth in

investment or the “hard way” with lots of investment growth for as long as possible

followed by negative investment growth.

The path most countries take is the hard one – politically it is too hard to make the

change, there are too many vested interests, and its too easy to hope that “this time

will be different”.

Support for this argument lies in the capacity utilisation rate in China (i.e. how much of

the prior investment is actually being used) we see in Figure 12FIGURE 12 thatChina’s capacity utilisation is at around 60%, not only far below typical international

utilisation rates of around 80%, but also well below China’s own history

0%

10%

20%

30%

40%

50%

60%

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

% of GDP

Consumption Government Spending Investment



22 July 2013



FIGURE 12: CAPACITY UTILISATION

Source: IMF

So, not only has China spent a far greater proportion of GDP on investment than any

other developing economy, it would appear that so little of the recent investment is

being used that the total capacity has declined to 60%.

But China is such a poor country – surely it still needs to invest?

Absolutely. We are not advocating that China never invests again – even if it keeps

the dollar level of investment flat it will still be spending a huge amount on investment

– more than any other major economy as a proportion of GDP. The important point is

that we don’t think that investment is likely to grow from current levels, and there aredownside risks.

Take for example urbanisation. China has been urbanising between 1.2% and 1.6% of

its population every year – roughly 20-25m people. But this number is not likely to

grow. The number of people living in cities is growing but the number of people

moving to cities is not – see Figure 13 below.

FIGURE 13: CHINESE URBAN POPULATION – RBA FORECAST

Source: RBA, CEIC, United Nations for total urban population, Wilson HTM calculated the change implied

0

5

10

15

20

25

30

300

400

500

600

700

800

900

1000

1100

1990 2000 2010 2020 2030 2040

m Peoplem People

Total urban population (LH)

Annual change in

urban population (RH)



22 July 2013



If China builds enough houses and infrastructure last year to move 25m people into

cities, it does not need to move 30m people into cities this year – in fact the likelihood

is that while the total urban population will grow, the absolute number of people

moving to cities each year is likely to fall – as you can see above from the red line.

RESIDENTIAL CONSTRUCTION – THE KEY VARIABLE:

The use of steel in China is varied (see Figure 14 below), but by far the largest

proportion of this steel is used in the construction of property and infrastructure – over

55% of steel used.

FIGURE 14: STEEL USE IN CHINA

Source: Roberts & Rush 2010

While we acknowledge that some infrastructure is “independent” of the building of

residential property, a significant proportion of the infrastructure build is dependent on

the residential property build – i.e. if China builds less residential property per annum

then they will need fewer roads and bridges per annum to connect new areas, fewer

new train lines and fewer airports per annum etc.

So, we focus on the residential construction cycle where fortunately last year the RBAwrote a discussion paper from which we include a number of interesting charts below.

First, is the RBA’s take on urban construction completed where we see the floor space

completed below. The interesting thing for us is that the rate of completion increased

sharply following the Chinese stimulus package in 2008.

Construction,

55%

Machinery, 18%

Automobiles, 6%

Rail, Shipping,

5%

Home

Appliances, 2%

Other, 14%



22 July 2013



FIGURE 15: CHINA URBAN FLOOR SPACE COMPLETED

Source: RBA

So based on these figures, if we assume that there is about 24.5sqm per person then

this implies that China finished enough houses in 2010 and 2011 to urbanise 9% (just

under 4.5% per annum) of the Chinese population. Plus there was enough houses for

almost another 1% per annum of the population to move into a new rural house.

However, the urbanisation rate in China has been pretty consistent and has not

significantly increased, it is still around 1.5% per annum. This suggests there were

only three other explanations for where the property is going:

A sudden increase in the size of each apartment: Now, this factor is the least

likely to have had a sudden increase, the increase in size is generally a slow andsteady one for most economies so while it would have played some small part, inthe absence of even anecdotal evidence we assume this not to have been themain driver of the significant increase.

A sudden increase in the number of demolitions: This does appear to be true

as official stats indicate that from 2008-2011 that around 4% of properties per annum were demolished. While further statistics are hard to find, the Beijing Year book for 2009 suggests that there were 6.2x more demolitions in the first 9 monthsof 2009 compared to 2008, further supporting this view.

A sudden increase in the number of vacant properties. This is a favourite

argument of most China bears. While it may well be true, there are not a lot of direct statistics to back this up – most of the statistics are indirect ones (eg water or electricity use) or anecdotal ones.

So, while we don’t know which of the above are playing the key role (and all three are

probably having some effect) , for property building to continue at the current high

level (i.e. 4.5% of the Chinese population) either the significant increase in demolitions

needs to be maintained (i.e. knock down enough buildings to create demand for the

new ones that are being built) or the number of unused apartments needs to increase.

Either way this path is unsustainable in the medium term.



22 July 2013



THE PATH TO URBANISATION

Could China increase its urbanisation rate so that the building boom continues?

We showed in Figure 8 above that China has left the “steep” part of the urbanisation

curve and moved onto the less steep part of the curve – indicating that while China

has been urbanising around 20m people per annum that this number is now set to fall.

For China to urbanise 4% of people per annum would be “off the charts” compared toany prior experience. Figure 16 below (apologies for the number of lines) shows theurbanisation path of 20 countries that urbanised since 1950, centred (on 0) at thecurrent Chinese urban population and showing the growth path for the next 15 years:

FIGURE 16: URBAN POPULATION AS A % OF TOTAL POPULATION

Source: World Bank

So, we can see from this graph that there are 3 key groupings:

The high growth countries: This included only two countries, South Korea and

Lebanon which continued to urbanise around 1.5% of their populations per annum

The medium growth countries: A range of countries slowed their rate of growth

down to around 1% per year, including Russia

The low growth countries: another group of countries slowed even further, with

urbanisation rates pulling back to around 0.7% per annum – this group includesJapan.

Most forecasters, including the World Bank have China following a path similar toRussia.

So, China has been urbanising at around 1.5% of its population per year, and the bestthat any other country has been able to do is to maintain that rate – the more likely

path is that China will slow soon to around 1% of its population per year.

45

50

55

60

65

70

75

80

-5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Brazil China Colombia Cuba Czech Rep. Finland Greece

Hungary Iran Iraq Ireland Japan Korea, Rep. Lebanon

Malaysia Mexico Norway Russia Spain Turkey Ukraine

High Growth =

South Korea,

Lebanon

Med Growth =

includes Russia

Low Growth =includes Japan



22 July 2013



Adding it all up, the answer is that it looks highly unlikely that China could expand itsurbanisation rate to the 3-4% necessary to justify building the number of apartmentsthat it did over the last few years.

OTHER ARGUMENTS SUGGESTING INCREASED STEEL DEMANDHow about steel use – as China is building taller apartments that will need more

steel won’t the steel use per dwelling increase?

Yes, dwellings in China will likely increase in size, and there will be more apartmentswhich use considerably more steel. So, the steel usage will not decline as fast as thenumber of dwellings built, but this effect is unlikely to be large enough for steelconsumption to grow in any meaningful way.

What about India – don’t they have a lot of people and a significant amount of

infrastructure to build as well?

Yes, and five years ago it seemed like a reasonable proposition that India would soonbe ready to start on the path of increased urbanisation. Unfortunately, five years on it

does not seem likely that any urbanisation programs are imminent. India generally hasvery low levels of investment and a bloated bureaucratic process that tends to stiflenew investment. While the potential is there, it could still be there in another ten years.

What about Africa – don’t they have a lot of people and a significant amount of

infrastructure to build as well?

Yes, but generally countries are not ready for the urbanisation / investment path takenby a number of developing countries. Additionally, Africa has a lot of iron ore, but notthe infrastructure to get it out. Therefore it may be that when Africa is ready for thatstage of development that they will also have enough iron ore to satisfy the demand.Once again while the potential is there, it will probably still just be potential in another ten years.

How about recycling?

Steel recycling is not particularly significant in China – largely as historically Chinadidn’t use much steel and so there is simply not the supply of scrap. However, as time

goes on the level of scrap and recycling is likely to increase, which will also lower thedemand for “fresh” iron ore.

What about the recent Reserve Bank of Australia (RBA) white paper that

concluded that steel usage was going to increase?

The RBA recently published an analysis of steel use in China and the chart below

shows their estimate for residential construction. While we have no issue with the

majority of the assumptions used in their analysis, we do have a significant problem

with their assumption of the level of demolition activity in China. Effectively they takethe increased level of demolitions and extend it for 15 years at an elevated (but

gradually declining) level.

We don’t agree with this view – we believe that the last 3 years have been anaberration and that knocking down houses to build new ones is a short term stimulusled strategy that is unlikely to be sustained.



22 July 2013



Below is Figure 17 showing the approximate difference between their methodologyand ours.

FIGURE 17: URBAN RESIDENTIAL CONSTRUCTION

Source: Purple line = CEIC actuals, RBA estimates. Red line = WHTM estimate of a more normal demolition rate

What about steel intensity (i.e. the amount of steel used per capita) – doesn’t

China have a long way to go on that measure?

This is an argument that suggests that China will increase its use of steel on a per

capita basis for a while and then it will begin to decline.

We have a few issues with this as a concept.

China is already at a similar level of steel use per capita relative to other

economies, so it is an argument that China will increase beyond other countriesfirst before declining.

There is generally less steel used now in the consumption of many buildings and

cars, and so comparing the steel use of a country that is developing now vs acountry that was developing 50 years ago could create some issues.

The key comparison on this analysis is almost always South Korea. However this

argument is undermined by:

1. South Korea is an outlier that uses significantly more steel than other

countries

2. Partly this is due to South Korea urbanising faster than any other country

3. It is also due to the high level of exports per capita in particular ships and cars

While there may be scope for China to displace some of the ship or car exports, this

will not create a greater demand for steel in the world, merely displace steel demand

from South Korea to China.

Wilson HTMestimate

RBA Estimate



22 July 2013



FIGURE 18: CRUDE STEEL OUTPUT PER CAPITA

Source: Huw McKay, Yu Sheng and Ligang Song

Given the increase insteel use in China over

the last 4 years, China is already higher than

most developedcountries



22 July 2013


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