Investors can often make the mistake of anchoring their perceptions on the current environment rather than recognising there could be a different environment in future, and this is neatly illustrated by two separate but not entirely unconnected pieces of data about China.
Recent years have seen the country effectively dictate lending policy for its banks, which has included encouraging very significant investment in infrastructure and property. This has in turn led to huge amounts of money being spent on building up China’s steel and cement capacity to a mind-boggling degree.
As a result, idle – that is, currently unneeded – capacity in China’s steel sector is equivalent to the total steel production capacity of Japan and South Korea combined. Irrespective of this, China is in the process of building an additional 60 million tons of steel production.
As we also saw in the case of the Hong Kong-listed construction machinery manufacturer Zoomlion Heavy Industry Science and Technology in The hole truth, China’s solution to a lot of its problems is just to build more, even if the existing capacity is not being used – and it is the same story with cement. China consumes more cement than the rest of the world combined but it has idle capacity in cement production greater than the entire consumption of India, Japan and the US put together.
These are enormous imbalances and, in a fully functioning price mechanism, that capacity would not have been built. Quite simply, you do not build capacity in any area unless you have demand for it. It costs a lot of money to build supply and, if there is no demand, you will not make an economic return on your investment.
Of course, China may continue to grow rapidly and the capacity may be fully utilised some years in the future. Nevertheless, until the point is reached that the capacity is required, such a course of action represents an inefficient use of resources.
Consensus has it a ‘hard’ landing in China would be annual GDP growth of 5%, down from a current level of around 8%, but the allocation of resources in the country’s steel and concrete sectors are indicative of something potentially wrong with the Chinese model. If China does not continue to grow rapidly, a slowdown will not result in ‘only’ 5% GDP growth – the bear case is significantly lower.
Our point here is not to make any comment on what may or may not happen in China but to highlight how people are anchoring off the current environment and what has been achieved over the last decade. They see the 8% figure and then form the view a really bad number would be a couple of percentage points below that when a really bad number would actually be preceded by a minus sign.