History repeats itself. The first time as tragedy, the second time as farce, and the third time as an opportunity to make profits. Nowhere is this (slightly modified) adage (albeit often illustrated with the new technology bubble) more apt a description of reality than in considering the economies of East Asia.
Only 20 years ago, Japan was all the rage. Management consultants and economic journalists the world over spouted fashionable nonsense about the new Japanese economic model and its supposed superiority. One of the recurring themes in these analyses was that Japan enjoyed a permanent advantage stemming from its “low cost of capital” combined with a corporate culture that eschewed short term profits in favor of maximization of market share.
10 years ago, the same consultants and journalists were selling a new product known as the “Asia 4 Tigers.” The Tigers were a group of small countries Hong Kong, Singapore, South Korea, and Taiwan that seemed to have invincible economies. Once again, pundits babbled about new economic models and “Confucian values.”
Today, of course, it is clear that neither Japan nor the East Asian Tigers enjoyed any reprieve from the fundamental laws of economics or of gravity. Both Japan and the other Asian countries clearly enjoyed periods of rapid growth due to massive and not particularly efficient capital investments.
As has become increasingly clear, much of this investment was made at ridiculously low levels of profitability, and the resultant over-capacity was the core structural problem that led to Japan’s protracted slowdown and the Asian Crisis of 1997. Adding insult to injury, the solution that resolved the Asian crises appears to have been to drop the Confucian emphasis on savings for its own sake. Instead, the Asian countries have been shifting towards a more traditional economic approach, in which the ultimate economic objective is the pursuit of consumption.
As for investment, Asian giants such as Hitachi, Samsung Electronics, and Toyota no longer build unprofitable factories in order to capture market share. Rather, they focus on profitability and shareholder value just like their counterparts in the US and Europe.
All this, of course, is bad news for the management consulting business. Not to worry they have found a new product: the rise of China. Fortunately, we aren’t being bombarded with pseudo-academic explanations seeking to account for China’s spectacular rate of economic growth. Instead, China’s boom is being taken as a given and the emphasis of the pundits is to tell us how to prepare for the era of Chinese domination of world markets.
But what actually is driving China’s stunning economic growth? Massive savings (45% of GDP!) that are being channeled into investments in factories and infrastructure likely to generate returns on capital of roughly 2%.
Does this sound familiar? China’s economic development is following the exact same path as those of other Asian nations and, unsurprisingly, China is developing the same economic distortions that have bedeviled its neighbors.
It is a safe bet that China will soon face an economic crisis driven by over-investment and over-capacity. The exact features of this impending crisis are unclear. It may play out as a chronic recession, as it did in Japan. Alternatively, it could take the form of a short-lived but severe financial collapse such as that which swept Asia in 1997. Most likely, however, it will be something new and unique.
When all is said and done, however, China’s economic retrenchment will have two major consequences. First, the world will be left with massive excess capacity in many basic manufacturing industries such as steel, aluminum, and machine tools. Second, the Chinese tired of scrimping and saving in order to earn paltry returns are going to reduce their savings rate and increase their level of consumption.
How do smart investors play these trends? A peak at the portfolio of the Forum International Equity Fund, sub-advised by the investment firm known as Wellington Management, offers some clues.
Consider the Fund’s sectoral weightings. Compared to the fund’s benchmark the MSCI World Equity Index the Forum fund is 10% overweight in consumer goods. Not surprisingly, the fund is also 10% underweight in industrials and basic materials.
What motivates these choices? Currently, industrials such as steel manufacturers are enjoying record profitability due to demand from China. China, however, is using all this steel to build amongst other things a lot of steel mills. By the end of 2005, China will be a net exporter of steel, and by 2006 the price of steel, and the profitability of steel producers, is projected by some to collapse. Hence, the fund has chosen to avoid this sector.
On the other hand, the Chinese will inevitably reduce their savings rate and shift their income to consumption goods. Hence, the overweight position in consumption goods in general and firms whose goods are popular in China in particular.
Consider two examples. The Fund’s largest overweight holding is Altria. Altria is a conglomerate with holdings in tobacco (Phillip Morris), food processing (Kraft Foods), and beer (SAB-Miller). All Most of Altria’s products are popular in China, a country thousands of dollars in GDP per capita away from becoming health conscious. As the Chinese begin to consume more, they will inevitably indulge themselves in unhealthy habits such as smoking, drinking, and the eating of fatty foods.
On the subject of fatty foods, the Fund’s third largest overweight holding in Yum!Brands. Yum is a fast food conglomerate whose brands include fine eateries such as Pizza Hut, Kentucky Fried Chicken, and Taco Bell. KFC in particular has really taken off in China, where the brand is as popular as McDonalds. As over a billion consumers reduce their savings rate from 45% to a more sensible 30%, there will clearly be good times ahead for KFC (although the chickens themselves may not see it that way).
Dr. Jonathan Lipow is Chief Economist at Forum Consulting and Business Development. He was formerly Vice President of Banc of America Securities responsible for business development in Israel.
Published by Globes [online], Israel business news - www.globes.co.il - on May 5, 2005