Potential For Stimulus Boosts Infrastructure Construction Outlook

BMI View: We continue to hold the view that China's construction and infrastructure sectors are in a structural slowdown. 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. This however, does not mean a dearth of growth opportunities in both sectors.

In our January 2014 analysis of China's infrastructure and construction sectors, we held the view that the recovery in construction activity experienced in 2013 will not be sustainable in 2014 ( see 'Construction On Course For A Slower 2014 Despite Reforms', January 5 2014). This view has already started to unfold in the first half of 2014. Official data dating up to May 2014 showed that fixed asset investment into the real estate and infrastructure sectors (the most up-to-date proxy on the trends within the construction and infrastructure industries) grew at a slower rate in 2014 than in the same period in 2013.

Data from the National Bureau of Statistics of China (NBS) show that fixed asset investment into the real estate sector increased by 14.2% year-on-year (y-o-y) between January and May 2014, lower than the 23.6% y-o-y seen during the same period in 2013.

Tapering Down
China - Real Estate Fixed Asset Investment (FAI) Data

BMI View: We continue to hold the view that China's construction and infrastructure sectors are in a structural slowdown. 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. This however, does not mean a dearth of growth opportunities in both sectors.

In our January 2014 analysis of China's infrastructure and construction sectors, we held the view that the recovery in construction activity experienced in 2013 will not be sustainable in 2014 ( see 'Construction On Course For A Slower 2014 Despite Reforms', January 5 2014). This view has already started to unfold in the first half of 2014. Official data dating up to May 2014 showed that fixed asset investment into the real estate and infrastructure sectors (the most up-to-date proxy on the trends within the construction and infrastructure industries) grew at a slower rate in 2014 than in the same period in 2013.

Data from the National Bureau of Statistics of China (NBS) show that fixed asset investment into the real estate sector increased by 14.2% year-on-year (y-o-y) between January and May 2014, lower than the 23.6% y-o-y seen during the same period in 2013.

Tapering Down
China - Real Estate Fixed Asset Investment (FAI) Data

Meanwhile, the three largest components of infrastructure investment in China - roads, railways, and power generation - experienced a significant slowdown in investment growth, with railways experiencing the sharpest decline. Data from China's railway ministry shows that fixed asset investment into railways contracted by 2.8% y-o-y between January and April 2014, significantly lower than the 23.8% y-o-y growth during the same period in 2013.

Slowing Down
China - Fixed Asset Investment (FAI) Data, Railways (LHS) And Highways (RHS)

This decline in fixed asset investment growth has already dampened economic growth in China, with real GDP growth reaching 7.4% in Q114, the slowest quarterly growth rate since Q312. Our Country Risk team expects economic growth to continue to slow down over the rest of 2014, and are maintaining their full-year real GDP growth forecast of 7.1% for 2014 ( see ' Beijing Strikes Confident Tone In The Face Of Slowdown', June 20 2014).

Not Like Before
China - Quarterly Real GDP Growth, % chg y-o-y

Potential For Stimulus Rising

Having said that, the government is becoming increasingly concerned about the potential for a sharper-than-expected economic slowdown ( see 'Surprise PMI Print Elicits Upside Risk To Growth', June 23 2014), and we are seeing signs that the government is gradually increasing and accelerating the amount of fixed asset investment to reach its desired real GDP growth target of 7.5% ( see ' Infrastructure Stimulus Still Favoured', May 6 2014).

  • At the end of May 2014, China's finance ministry called for local governments to speed up their spending plans for 2014 (such as on railways and public housing) or risk losing the funds allocated to them for 2014.

  • Following that announcement, Reuters reported at the end of June 2014 that seven Chinese regional governments were seeking at least CNY1.5trn worth of state and private investment to finance their fixed asset development plans.

These announcements suggest that even though the Chinese central government is increasingly aiming for economic growth to be driven by private consumption instead of fixed asset investment, the latter - particularly into infrastructure sector - continues to be viewed by the central government as a critical way to generate a satisfactory economic growth rate in the near term. As such, we believe that additional monetary easing as well as targeted stimulus measures aimed at infrastructure development are increasingly likely over the coming months, and these will translate to a stronger growth in China's infrastructure and construction industry value. This is reflected in our forecasts for both sectors. We have revised up real growth for China's infrastructure and construction sectors to 7.1% and 6.8% in 2014, compared to our previous forecasts of 5.7% and 5.1% respectively.

Structural Slowdown Still Expected
China - Construction And Infrastructure Growth Forecasts, % chg y-o-y

Structural Questions To Persist In 2015

However, our modest optimism for the sector does not extend to 2015. We continue to believe that the structural problems in the Chinese economy will lead to a sustained 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 5.1% and 4.9% in 2015 respectively.

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 did not take place as successive stimulus packages were increasingly lesser in scale. 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.

Less Bang For Buck
China - Manufacturing Purchasing Managers Index

Furthermore, we are still seeing a sizeable percentage of China's credit supply flowing through informal channels such as wealth management products, which increase the potential for a buildup of non-productive and non-viable projects. We estimate that the stock of total social financing (TSF, the broadest measure of the country's money supply) grew by an average of 17.6% y-o-y between April 2013 and March 2014, with non-traditional lending accounting for around 40% of total credit by the end of March 2014. This is much higher than during the 2008-09 credit stimulus, during which 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

Still Plenty To Offer

We do however, highlight that this structural slowdown in China's construction and infrastructure sectors does not mean a sharp collapse of large-scale spending on projects. China is expected to remain as the world's largest construction market over the next decade 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. In addition, pollution is also becoming a serious issue in China and the government remains keen to address this issue by investing in infrastructure projects that combat water and air pollution ( see 'Greater Water Opportunities Not Without Risks', February 19 2014).

We also expect major flagship projects like a second international airport in Beijing 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 out a lot of the planned or under construction projects away, eroding a large portion of construction industry value.

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