Construction On Course For A Slower 2014 Despite Reforms

BMI View: We continue to hold the view that the recovery in China's construction activity in 2013 will not be sustainable in 2014 - we are forecasting construction real growth to fall from 6.6% in 2013 to 5.1% in 2014. The key reason for this outlook is because we believe that the basis for this increase in fixed asset investment is through the increase in liquidity in China's financial system, an unsustainable investment model due to the diminishing marginal return on expenditure. The Chinese government is implementing reforms that could lead to a sustainable increase in construction activity (namely rural and privatisation reforms), but we believe they are unlikely to have a material impact over the near-term.

As highlighted previously, we believe the recovery in China's economic activity in 2013 has been largely down to a boost in infrastructure activity and sustained expansion in the real estate sector. Official data dating up to November 2013 showed that fixed asset investment into the infrastructure sector (the most up-to-date proxy on the trends within the construction and infrastructure industries) increased by 17.0% year-on-year (y-o-y) between January and November 2013, slightly higher than the 16.2% y-o-y seen during the same period in 2012. Fixed asset investment into real estate also remains considerable, though the rate of increase in investment inflows is gradually declining. Investment into the real estate sector grew by 20.2% y-o-y between January and November 2013, slightly lower than the 22.2% y-o-y seen over the same period in 2012.

The increase in infrastructure investment was driven by investment into the transport infrastructure sector, where roads and railways (the two largest components of transport infrastructure investment in China) saw significant increases in investment. Fixed asset investment into railways grew by 2.4% y-o-y between January and November 2013, higher than the growth of 0.9% over the same period in 2012. Meanwhile, fixed asset investment into roads continued to grow robustly, increasing by 22.6% y-o-y between January and November 2013, slightly lower than the 24.3% y-o-y seen over the same period in 2012.

Fuelled By Liquidity Surge
China - Infrastructure* And Real Estate Fixed Asset Investment (FAI) Data

BMI View: We continue to hold the view that the recovery in China's construction activity in 2013 will not be sustainable in 2014 - we are forecasting construction real growth to fall from 6.6% in 2013 to 5.1% in 2014. The key reason for this outlook is because we believe that the basis for this increase in fixed asset investment is through the increase in liquidity in China's financial system, an unsustainable investment model due to the diminishing marginal return on expenditure. The Chinese government is implementing reforms that could lead to a sustainable increase in construction activity (namely rural and privatisation reforms), but we believe they are unlikely to have a material impact over the near-term.

As highlighted previously, we believe the recovery in China's economic activity in 2013 has been largely down to a boost in infrastructure activity and sustained expansion in the real estate sector. Official data dating up to November 2013 showed that fixed asset investment into the infrastructure sector (the most up-to-date proxy on the trends within the construction and infrastructure industries) increased by 17.0% year-on-year (y-o-y) between January and November 2013, slightly higher than the 16.2% y-o-y seen during the same period in 2012. Fixed asset investment into real estate also remains considerable, though the rate of increase in investment inflows is gradually declining. Investment into the real estate sector grew by 20.2% y-o-y between January and November 2013, slightly lower than the 22.2% y-o-y seen over the same period in 2012.

Fuelled By Liquidity Surge
China - Infrastructure* And Real Estate Fixed Asset Investment (FAI) Data

The increase in infrastructure investment was driven by investment into the transport infrastructure sector, where roads and railways (the two largest components of transport infrastructure investment in China) saw significant increases in investment. Fixed asset investment into railways grew by 2.4% y-o-y between January and November 2013, higher than the growth of 0.9% over the same period in 2012. Meanwhile, fixed asset investment into roads continued to grow robustly, increasing by 22.6% y-o-y between January and November 2013, slightly lower than the 24.3% y-o-y seen over the same period in 2012.

Rail/Roads The Main Beneficiaries
China - Fixed Asset Investment (FAI) Data, Railways (LHS) And Highways (RHS)

These figures all suggest that even though the Chinese central government is increasingly aiming for economic growth to be driven by private consumption and not by fixed asset investment, the latter - particularly into infrastructure sector - continues to be viewed by the central government as the easiest way to generate a satisfactory economic growth rate in the near term. Indeed, data from China National Statistics show that the non-residential building sector, which primarily consist of buildings aimed at generating goods and services for consumption (such as offices, shopping centres, factories), forms a negligible 2.3% of China's total fixed asset investment between January and November 2013. To put things in perspective, the non-residential building sector accounts for around 35% of total construction works in the US between January and November 2013.

Non-Residential Presence Negligible
China - Infrastructure*, Non-Residential Buildings**, Real Estate Fixed Asset Investment (FAI), CNYbn

Overall, we believe that China has met its fixed asset investment targets and this will fuel a recovery in infrastructure and construction growth industry value. This is reflected in our forecasts for both sectors, with real growth for China's infrastructure and construction sector reaching 6.9% and 6.6% in 2013 respectively, compared to 4.2% and 5.0% in 2012.

Structural Questions To Return In 2014

However, we maintain our view that the recovery in infrastructure and construction activity will be unsustainable in 2014. We continue to believe that the structural problems in the Chinese economy will lead to a decline in infrastructure and construction growth over the coming years and this is reflected in our forecasts, with real growth for infrastructure and construction reaching 5.7% and 5.1% in 2014 respectively.

Structural Slowdown Still Expected
China - Construction, Infrastructure, Residential and Non-Residential Industry Value Real Growth Forecasts, % y-o-y

The key reason for this outlook is because we believe that the basis for this increase in fixed asset investment is through the increase in liquidity in China's financial system, an unsustainable investment model due to the diminishing marginal return on expenditure. In a nutshell, the base effects of expenditure dictate that a new credit injection and new government spending would have to be larger than the previous one to generate an additional unit of nominal GDP. In China, this is clearly not the case. The accompanying chart shows the impact of three of major stimulus packages on manufacturing activity. With each passing installment, the scale of stimulus has fallen and clearly so too has the magnitude and duration of the rebound in activity. In the infrastructure sector, the stimulus announced in September 2012 (which included US$100bn for railways for 2013) and in July 2013 (which included a US$6.5bn increase in the railway fixed asset investment target for 2013), while sizeable, was a fraction of the 2009 stimulus that fuelled nearly 50% in railways construction and other infrastructure.

Less Bang For Buck
China - Manufacturing Purchasing Managers Index

Furthermore, we are seeing a growing percentage of China's credit supply flowing through informal channels such as wealth management products. We estimate that the stock of total social financing (TSF, the broadest measure of the country's money supply) grew by an average of 19.6% y-o-y between January and November 2013, with non-traditional lending accounting for around 50% of total credit by the end of November 2013. This is much higher than during the 2008-09 credit stimulus, where only around 15% of total credit was directed through informal channels. In our opinion, this increase in non-traditional lending creates greater opaqueness in the use of credit, which increases the potential for the buildup of non-productive capacity such as steel mills and infrastructure projects that are not financially viable. It also fuels investment into speculative assets such as real estate, with the value of land sales and housing prices in major Chinese cities hitting new all-time highs in 2013.

Bubble Not Sustainable
China - Total Social Financing (TSF) Stock, % chg y-o-y

We do however highlight that this structural slowdown in China's construction and infrastructure sectors does not mean the sharp collapse of large-scale spending on projects. China is expected to overtake the US as the world's largest construction market by 2013 and it continues to experience a structural deficit in areas of urban infrastructure - traffic congestion remains a perennial problem in major cities - and rail freight infrastructure - about 80% of freight in China is transported by roads, an inefficient mode of transport. The government remains keen to address this deficit - in January 2014, Sheng Guangzu, general manager of state-owned railway operator China Railway Corporation (CRC), announced (cited from the China Daily) that about CNY630bn will be allocated as fixed asset investment into the railway sector, with more than 6600km of new railway lines to be built in China in 2014.

We also expect major flagship projects like the new Beijing airport or the Bohai Sea tunnel to go ahead. What underpins the reduction in growth in our forecasts is much associated with the grass-roots of the industry; the plethora of smaller projects in second and third tier cities financed by local governments and developers, which to begin with had a questionable economic viability. We believe that a prolonged credit crunch will wipe a lot of the planned or under construction projects away, eroding a large portion of construction industry value.

Reforms A Long-Term Positive

An upside to our forecasts is the plans by the government to increase fixed asset investment from non-government sources. For example, the Chinese government is planning to develop a railway development fund as a platform to attract private investment and diversify the financing channels of CRC. Besides the development fund, the government will also carry out reforms that allow non-government entities to finance primary railway lines and develop secondary railway lines (e.g. branch, intercity and resource-related) under a public-private partnership framework. As a statement of intent, the Chinese government broke up the Ministry of Railways in March 2013 to form the CRC and the new railway regulator State Railway Administration to reduce red tape and increase operational transparency for investors.

These initiatives are expected to be completed by the end of 2013, but we believe they are unlikely to gain traction with the private sector over the near term. This is primarily due to three factors: the time taken for private participation reforms to mature and be fully implemented, the general unattractiveness of infrastructure assets in China due to their elevated levels of leverage, and the economic viability of the infrastructure projects on offer to the private sector (s ee 'Railway Measures To Have Limited Near-Term Impact', July 30 2013).

The Chinese government is also planning to push forward reforms that improve rural land rights and revamp the hukou system. Both are key impediments to agriculture productivity as well as social and job mobility within China, and reforms in these areas could facilitate greater urbanisation and unlock greater demand for infrastructure and buildings in urban and rural China. However, given that reforms in these areas have the potential to deeply change China's social and economic structure, we believe the reform process will be slow and long-drawn, making it unlikely for these reforms to make a material impact on our 10-year forecasts. Indeed, our Country Risk team highlights three main misgivings to China's reform drive - namely the negative effects from greater investment into unproductive fixed assets to encourage urbanisation, the negative impact to economic growth from these reforms, and the potential for these liberalisation reforms to die out or reverse should they prove detrimental to economic growth ( see 'Can Reforms Prevent The Credit Hangover', December 18 2013).

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Sector: Infrastructure
Geography: China
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