China stimulus will have little global impact, says J.P. Morgan

Increased demand for commodities will affect mainly cement and steel, neither of which will benefit companies outside China, argues Frank Gong.
The Rmb4 trillion ($587 billion) stimulus package announced by China this past weekend is large enough to cushion the downturn in the domestic economy and ensure that the countryÆs economy continues grow above 8% a year, but its impact on the global economy and even the rest of Asia is likely to be much smaller than initially anticipated, according to Frank Gong, J.P. MorganÆs head of China research and strategy.

ôThis package alone will not be able to turn the global commodities markets around,ö he said at a press briefing yesterday. ôFor infrastructure spending you probably need steel, cement, heavy machinery and a lot of cheap labour, but China is still going to see a big slowdown in exports and industrial output. Also, infrastructure doesnÆt need much energy or industrial metals like aluminium, nickel, tin, copper etcetera and cement is a commodity that is made locally so the increase in demand will have no global significance.ö

Having had a few days to take a closer look at the two-year package, Gong estimates that the incremental infrastructure spending as a result of this fiscal stimulus û on top of what is already included in the current five-year plan for 2006-2010 û will be about Rmb2 trillion to Rmb2.5 trillion, translating into 8%-10% of GDP in total or 4%-5% of GDP per year. While smaller than the Rmb4 trillion headline number (as most commentators have argued it would be) the planned spending dwarfs all previous monetary and fiscal measures and shows that China is serious about maintaining strong economic growth. Or in the words of Gong: ôThis is really ChinaÆs Big Deal.ö

Academic research shows that the positive impact on GDP from Chinese government spending is about 1.3 times the amount actually spent, which means that Rmb2.5 trillion of incremental spending could add 6.5 percentage points worth of annual growth. And since China would ôeasilyö grow at 3%-4% per year without this package, this should ensure that the economy will continue to expand at an 8% plus pace.

That said, the domestic beneficiaries too will be limited to a few key sectors, Gong argues. With a large part of the money expected to go towards the expansion and upgrade of ChinaÆs railway system, infrastructure companies like China Railway Group and China Railway Construction Corp, both of which have listed in Hong Kong in the past 12 months, should be definite winners. The cement sector should also get a boost as demand will increase and the supply-demand situation in the industry is currently quite balanced. Cement is also quite energy-intensive which means the decline in oil prices is an added positive on the cost side.

The other key commodity for railway construction is steel, but ChinaÆs steel industry is already facing 20%-30% of overcapacity because of weakening of external demand which means prices in the domestic market (which has to absorb this extra capacity) are likely to be pushed down significantly. At the same time, the Chinese steel companies locked-in iron ore deliveries for one year at a price equal to a 97% increase in the iron ore price in June/July û almost at the peak of the cycle. As a result, the steel manufacturers are likely to see a huge margin squeeze and almost the entire sector will be loss-making, Gong says. Consequently, he advises investors to stay away from steel stocks.

ôMy position is that if there is a good bounce in commodities û sell,ö he says. ôThe only beneficiary in commodities these days is cement.ö

Meanwhile, banks are likely to benefit as the government usually only puts up 20%-30% of its infrastructure spending upfront, while the rest is typically financed by bank loans. This, according to Gong, should help to cushion the slowdown in loan growth and since these loans will be guaranteed by the government, it should also improve the risk profile of the banksÆ loan portfolios. And if the increased fiscal spending does help to stabilise the financial markets, then insurance companies û which are large holders of listed securities û may also benefit. China Life, which is often regarded as a proxy for the A-share market, is one name to watch, Gong says.

However, the package alone wonÆt be able to turn the economy around and Gong warns that it is unlikely to have much impact on discretionary spending, since China will be replacing high-paying jobs within the export and industrial sectors with low-paying jobs in the construction sector.

ôThe employment level may not change much, but the structure of employment will change and the result is that the wage flow will slow down and discretionary spending will continue to slow down, although consumer staples will do better,ö Gong says. The demand for cars is already declining with auto sales growth having slowed to single digits this year for the first time since the pickup began in the early part of this decade and in August and September, monthly sales actually declined on a year-on-year basis.

Since much of the infrastructure work will be in rural areas and is likely to provide jobs for peasants, the income for this group can, however, be expected to increase and that will be positive for consumer staples and telecom companies such as China Mobile which has been aggressively expanding in rural areas.

With regard to the rest of Asia, ChinaÆs demand for heavy machinery used in the infrastructure industry is likely to increase and while the country is largely self-sufficient on this front, it does import some machinery from South Korea and Japan. On the other hand, demand for high-end and luxury consumer goods that China imports mainly from Korea, Japan and Taiwan are likely to slow as the fiscal stimulus package is focusing primarily at supporting low-income earners.

ôBut if China can prevent a sharp slowdown, it means that its imports wonÆt collapse. And we are talking about a slowdown in high-end consumption growth. The Chinese economy will probably still grow at about 8% and China will continue to buy what it has been buying,ö Gong says. The fiscal stimulus ôwill cushion the downside for the rest of Asia and if investors have been pricing in a collapse they may have to rethink their expectations, but it wonÆt provide a boostö.

Gong also argues that China should have no problem to finance the stimulus package since the upfront spending will only amount to about 2%-3% of GDP. And with its current and expected budgets almost in balance, this should only lead to a budget deficit of about 3% in 2009 û an amount that it can easily offset by selling Treasury bonds. With a current national debt/GDP ratio of only 15%, even two years of budget deficits in the range of 3% would push this just above 20%, which compares with 50%-100% in most other emerging markets, 75% in the US and 150% in Japan.

Gong notes that this is an ôideal timeö for the government to step up its spending on infrastructure, not only because there is no longer any risk that it will lead to overheating (private sector spending has stopped due to the downturn), but because the fall in commodity prices will ensure that it gets more for its money.

It may also increase ChinaÆs bargaining power in the international community at a time when world leaders are debating various means, including increased regulations and a restructuring of global financial institutions like the IMF, to ensure the current financial crisis and credit crunch is never repeated.

Announced just in time for the G20 summit this weekend, where China is sure to face pressure to contribute money to help ôsaveö the global economy, the fiscal stimulus package will enable President Hu Jintao to argue that China is doing everything it can to keep up demand at home, which it views as the biggest contribution it can make to fend off the financial crisis.

ôChina is expected to contribute more money to the International Monetary Fund, but at the same time, it will ask for more power and say in restructuring the global financial system,ö argues Gong.
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