New Model. For Latin America. Arthur Kroeber March 2013

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1 China s New Model And dwhat It Means For Latin America Arthur Kroeber March 2013

2 China is still growing but differently 1. GDP growth will average 7% in , down from 11% in Structural reforms are necessary for that level of growth; new leaders will deliver enough despite political opposition and debt constraints 3. The growth driver is already shiftin i g from investment to consumption 4. Demand for investment t in infrastru ucture, housing and new plant is still strong and will be a key swing factor 5. Financial liberalization is moving faster than many realize, but capital account opening is constrained by financial repression elsewhere 2

3 Catch-up growth still has a long way to run 3

4 Slower growth does not mean China gets less important 4

5 Policy shifts from cyclical management to structural reform Government s ability to smooth cycles by pumping up credit and dinvestment is constrained db by high hinvestment and debt ratios Achieving potential growth requires reforms to improve capital allocation: o Financial liberalization (highe er return on investment) o Competition (curtail SOEs and local protectionism) o Fiscal (impro ove local govt incentives) o Factor prices (energy, water, land) New leaders will pursue reform m, but cautiously and incrementally 5

6 One policy constraint: Debt levels are now higher 6

7 Another constraint: Tight job market means more inflationary pressure 7

8 Diminishing returns from a high investment rate 8

9 How low could investment growth go? Period Average real growth in investment Average e real growth in final consumption Average real GDP growth Investment ratio at end of period % 8.9% 8.6% 34% % 8.6% 9.8% 40% % 11.1% 11.2% 46% e 6.5% 10.4% 7.8% 44% e 3.2% 9.8% 6.7% 39% 9

10 Acceleration means fast growth in high-value consumption 10

11 Income inequality means a fat tail of affluent consumers 11

12 External imbalances are much less severe 12

13 No capital misallocation: Returns in industry rise as state role shrinks 13

14 A chronic housing shortage We estimate China s urban housing stock to comprise around m units of independent housing (those with their own kitchen and bathroom) by This is significantly less than the total number of urban households. The remaining under-housed population is mostly migrant workers whose living quarters do not meet the definition of independent housing. The government-led boost in the construction of lowcost housing since 2009 will help gradually address this shortage. 14

15 De facto interest rate liberalization is advancing 15

16 A switch to promoting rather than restricting portfolio capital 16

17 The changing environment for Chinese companies Last decade Next decade Revenue Fast growth as most markets in early stages of development Limited it competition due to structural undersupply All firms have pricing power Growth in sales volume slows as markets mature More competition as capacity catches up to demand Pricing power falls Costs Plentiful supply of labor at Restricted labor supply; high low prices and rising wages Low and undifferentiated Higher and more real interest rates differentiated cost of capital Winners Fast-growing markets reward those who can enter first and expand capacit ty most quickly Slower-growing, more crowded markets reward those who can control costs and develop durable competitive advantages 17

18 Implications for Latin America Strong Chinese commodity demand will remain, but the growth is far lower; volumes and prices will be stable Markets for consumer goods and services will expand faster than many expect; but competition will be fierce Financial liberalization will continue, with benefits to foreign portfolio investors; but progress will be gradual Chinese capital goods / infrastructure firms will seek more foreign business as dom mestic market slows 18

19 Contact & disclaimer Thank you! Please contact us or your GaveKal representative with any questions or comments. All research is available onli ne at: research.gavekal.com Copyright GaveKal Ltd. Redistribution prohibited without prior consent. This report has been prepared by GK Dragonomics mainly for distribution to market professionals and institutional investors. It should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 19

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