Can China continue growing up?

China has recently overtaken Japan to become the world’s second largest economy; can it continue its almighty ascent as an economic superpower?.

In my opinion the answer is yes. Although I don’t expect the path to greater prosperity will be a smooth one.

China’s gross domestic product (GDP – i.e. total annual economic output) is around $5 trillion. The US is the largest world economy with a GDP of about $14.2 trillion while the UK is in 6th place on $2.2 trillion.

However, at 1.34 billion, China’s population is over four times bigger than that of the US (310 million) and over 20 times bigger than the UK (62 million). So although China’s economy is massive, its average citizen is still quite poor in the scheme of things. Even taking into account the local cost of living, Chinese GDP per capita ranks 99th in the world at $6,567, versus the US in 6th place at $46,381 and the UK in 19th place with $34,619 (Qatar tops the list with $83,841).

The reason for mentioning the per capita figure is that it highlights just how much more scope there is for China to grow. Sure, there’s a risk of falling demand for Chinese exports from the West if our economies continue to struggle, but the scope for Chinese domestic growth is mind boggling – provided its population becomes steadily wealthier.

For example, just one in three people have internet access and only one in six have a credit card - the popularity of both is growing fast. But while the communications and financials sectors look the most explosive shorter term, it’s growth in the motor industry that offers massive longer term potential. Currently the Chinese own 41 cars per 1,000 people – in the US it’s over 900.

China also has the advantage of being pretty autocratic (thanks to its communist heritage). While this might not be great for human rights (which is a concern), it does mean that things get done, fast, which is helpful when overhauling a country’s infrastructure.

But ongoing growth in China won’t be plain sailing. Aside from the usual developing world issues of politics and corruption, there’s still a huge disparity between the rich and everyone else. The Chinese government is trying to address this and the disparity should narrow over time, but a more even distribution of wealth will be key to sustaining the growth in domestic consumer demand.

Chinese currency is also likely to strengthen versus others over time (China relaxed its currency peg in June), making Chinese exports more expensive which could hurt foreign demand for Chinese goods and services.

And high growth risks high inflation (which is bad because it stifles investment), although inflation appears to be under control, so far. A stronger currency should help in this respect too as it’ll lower the cost of imports.

On balance I believe the prospects look very good for the next 10-20 years. But have Chinese stockmarkets already priced in high growth on company valuations?

Chinese companies are currently priced at an average 20 times their annual earnings on the Shanghai Stock Exchange and 37 times their earnings on the Shenzhen Stock Exchange. This compares to an average 13.6 times earnings for the FTSE All Share Index.

So, yes, higher growth is priced in, which reduces the scope for shorter term profits unless growth (expected or actual) is higher than anticipated. But longer term this is less of an issue and I don’t think it jeopardise the case for investing in China over a 10-20 time horizon.

(GDP figures sourced from the IMF).

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