Why China's Slowdown May Get Even Worse


It's clear that China's growth is slowing. But many still believe that a "hard landing" scenario is avoidable. Arguing that the vast and populous nation possesses the resources necessary to stimulate its economy might be wrong.

China's deceptive recent growth
To get a better sense of China's economic outlook, it helps to understand how its economy has grown thus far. At a broad level -- and I don't think this is an oversimplification -- China has continued to grow because it has continued to invest. Ever since the early 1960s, China's investment (defined as public and private gross capital formation) as a share of GDP has been on an upward trend. And it continues to rise, having accelerated dramatically in recent years.

With the onset of the global financial crisis, China promised to "spend, spend, spend" to rescue the world economy from the doldrums. In 2008, it unveiled a $586 billion stimulus program that flooded the economy with credit. Banks were encouraged to ramp up loans to support infrastructure and real estate projects, and local governments were all too eager to take advantage of the cheap credit. Subways, airports, luxury condominiums, and five-star hotels began popping up everywhere.

The Chinese had embarked on an investment rampage, one that has since proved difficult to subdue. Fixed-asset investments accounted for a whopping 90% of the country's economic growth last year. And while investment growth has slowed substantially over the past eight months, China just gave the go-ahead to more than $150 billion in infrastructure projects. With the country's main export markets likely to remain weak for some time, it looks like China's addiction to investment spending will take time to cure.

A tricky rebalancing act
Why is this an issue? Because it's the opposite of what China needs to be doing. It's abundantly clear that the nation's economy has become lopsided, relying too much on investment and exports, and too little on domestic demand.

Laudably, the authorities in Beijing recognized this early on and made it a top priority to readjust the economy -- away from investment and toward consumption. But unfortunately, little progress has been made to make rebalancing a reality.

To be sure, economic rebalancing is no overnight task, especially for an economy as vast as China's. It requires massive, gradually implemented reforms, many of which would be adamantly opposed by the powerful vested interests that have built up within the country.

The key is for household income to rise faster than GDP. But for this to happen, it requires some combination of rising wages, a revalued renminbi, and a higher real interest rate -- the most important step according to Michael Pettis, a professor at Peking University and an expert on Chinese financial markets.

A silver lining?
But as Pettis notes, "these measures will necessarily slow growth." He sums up why:

Raising the real borrowing cost cannot help but reduce investment growth and increase cash flow pressure on local governments, and so with the rise in real rates China's GDP growth rate must fall sharply. ... The problem is mainly one of arithmetic. China's investment growth rate must fall for many years before the household income share of GDP is high enough for consumption to replace investment as the engine of rapid growth.

But it's not all gloom and doom. There may actually be some good news. If recent inflation numbers are to be believed, inflation is declining faster than interest rates. This has forced up the real return on household deposits -- a crucial step in the rebalancing process. Pettis writes, "As China rebalances we would expect slowing growth and rapidly rising real interest rates, which is exactly what we are seeing. Rather than panicking and demanding that Beijing reverse the process, we should be relieved that China is finally solving its problems."

How to invest in China
Despite the bearish scenario I've outlined, it would be silly -- and, in fact, nearly impossible -- to avoid exposure to China in some form or the other. Even if GDP growth is cut in half over the coming years, as some experts suspect it might be, there are certainly ways to invest in the world's second largest economy.

One relatively safe way might be through multinational companies that have a strong and growing presence in the country. Apple (NAS: AAPL) , which calls China its second-largest market, is a prominent example. The Cupertino-based tech giant is currently up against South Korea's Samsung Electronics, as the two companies try to clinch dominant market share in what is expected to become the world's biggest smartphone market this year.

Another way to invest in China, specifically the growing number of Internet users in the country, might be to check out Chinese tech companies traded on American exchanges like Baidu (NAS: BIDU) , China's equivalent of Google, or Renren (NYS: RENN) , which wants to become China's version of Facebook.

Baidu looks to be the more promising of the two -- it's been growing at a rapid clip and should have plenty of room to grow, given its dominant market share, as well as China's relatively low Internet penetration levels. While a recent threat to the company emerged in the form of competitor Qihoo 360 (NYS: QIHU) , the newcomer's impact on Baidu's future growth prospects may be overstated.

Fool technology analyst Eric Bleeker also likes Baidu's current valuation and thinks now is the time to buy. If you're interested, be sure to check out this premium research report on the company. It not only gives a comprehensive commentary on Baidu, but it also comes with continuing updates through the year. Get started.

While I'll take Eric's word on Baidu, keep in mind that even Chinese companies traded on international exchanges aren't immune to fraud allegations. For instance, John Paulson's Advantage funds, which invested heavily in Sino-Forest (TSX: TRE), a Chinese timber company, watched in horror as shares plummeted after the release of a research report questioning the company's financial statements and suggesting that it had grossly overstated its timber holdings.

Final thoughts
Opportunities and risks are both very high in China. Still, let me be clear. I'm not suggesting China will collapse, as seems to be an increasingly popular message these days. Rather, I would urge people to recognize that what the global economy needs from China is not 8%-10% investment-fueled growth, but rather a rebalancing toward an economy fueled by Chinese household demand. Astute investors would be wise to readjust their expectations for Chinese growth, as the country works its way through a readjustment of its own.

The article Why China's Slowdown May Get Even Worse originally appeared on Fool.com.

Fool contributorArjun Sreekumarowns no shares of any companies listed above. The Motley Fool owns shares of Apple, Facebook, and Baidu.com. Motley Fool newsletter services have recommended buying shares of Google, Baidu.com, Apple, and Facebook and creating a bull call spread position in Apple. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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