Much has been written about China’s Belt and Road Initiative but Morningstar equity analysts think much of the overwhelmingly positive commentary lacks context and is wide of the mark. Major iron ore miners such as BHP Billiton (BLT), Rio Tinto (RIO), and Fortescue (FMG) all expect BRI to drive further growth in steel demand in China, and in turn support growing demand for iron ore. BHP expects China’s steel demand to continue to grow at about 1% a year until the middle of the next decade.
However, we think the likely spend on Belt and Road, and its consequent boost to steel and iron ore demand, is small in context of China’s already heady spending on fixed asset investment. China’s increasing reliance on fixed asset investment to drive economic growth has the unwelcome impact of growing debt, declining productivity and a diminishing pool projects worthy of investment and capable of delivering an acceptable return.
Fortescue was an early vocal supporter of Belt and Road, but more recently, BHP has grabbed headlines with a bullish take on its potential to drive China’s steel consumption. Recent commentary from BHP makes BRI sound like a very big deal, saying it is seven times larger than the Marshall Plan to rebuild post-war Europe and estimates total spending of $1.3 trillion. The company says Belt and Road could drive an additional 150 million tonnes of incremental steel demand in 10 years, approximately 15 million tonnes a year.
This all sounds material and positive for the miners, however, we think context is important. China’s steel consumption in 2016 was about 713 million tonnes, so if BHP’s estimate of 15 million tonnes of additional steel consumption is correct, it would translate to a one-time increase in China’s steel consumption of about 2%. Versus global steel output, which in 2017 is tracking towards 1.69 billion tonnes given year-to-date growth in output of 4.9%, BHP’s estimate of the impact on steel demand from Belt and Road translates to a once-off 0.9% rise.
A possible once-off 0.9% increase in steel demand from Belt and Road is small given our view of the headwinds facing steel demand, namely from a likely material decline in fixed asset investment growth in China as investment projects become increasingly inefficient and bad debt builds as a consequence. With respect to BHP’s Marshall Plan comparison, it is notable that global steel production in 2017 is about nine times larger than the 189 million tonnes seen in the 1950s.
China's Steel Consumption Set to Decline
Contrary to the upbeat commentary from the miners, we think the recent uptick in commodity demand and prices is just a cyclical upturn driven by China’s 2016 stimulus. Long term, structural headwinds remain and China’s steel consumption is likely to decline in the next decade. This, along with further low-cost iron ore supply additions, should drive a flattening of the iron ore cost curve and producer margins.
The major miners remain overvalued with the market too optimistic on future demand growth for mined commodities, particularly for the steel making materials - iron ore and coking coal. China’s economy has reached diminishing returns from increasing fixed asset investment and we think future demand growth for mined commodities is likely to suffer as a result. BHP’s London-listed Plc stock is the cheapest of the major miners, but still somewhat overvalued, trading at an approximate 20% premium to our fair value estimate.
We think BHP, particularly its Plc shares, is less overvalued than its peers given its greater exposure to oil and lesser exposure to iron ore. BHP’s Australian listed BHP Limited shares and Rio Tinto’s London-listed Plc shares trade at close to 40% premiums to our fair value estimates while the higher-cost or more iron ore exposed miners, such as Fortescue, Vale (VALE) and Anglo American (AAL), trade at premiums of at least 60% to our fair value estimates.
Stock Valuations are Too High
Our key disagreement with the market on valuation is around long-term commodity prices and likely midcycle earnings. Current conditions are very favourable for the miners, reflecting the reduction in capital and operating costs since 2014 and the upturn in prices. Our forecast-adjusted earnings of 6.39 Australian dollars a share for Rio Tinto in 2017 is in line with 2012 levels, when the China boom was still going strong. We expect Rio Tinto’s midcycle earnings in 2021 to be approximately 40% lower versus consensus expectations for broadly steady earnings.
External estimates we have seen suggest Belt and Road spending of around $900 billion in total, equating to an annual spend of approximately $90 billion were outlays spread evenly over a 10-year period. That's slightly below BHP’s $130 billion a year estimate. Again, this figure needs to be seen in context.
We expect China’s gross capital formation, or spending on infrastructure projects, in 2017 to be about $5.4 trillion, so a Belt and Road spend of $90 billion gives a one-time boost to gross capital formation of 1.7%. Assuming a similar intensity of steel use as for China’s other gross capital formation spend nets a once-off 12 million tonne boost to China’s steel consumption from Belt and Road.
We contend continued elevated expenditure on fixed asset investment is driving a reduction in China’s total factor productivity. Between 2011 and 2016, the largest contribution to China’s GDP growth was growth in capital formation at 5.2% a year, broadly in line with the two decades ended 2010. However, the contribution to GDP growth from total factor productivity declined to 2.3% versus nearly 5% a year in the two decades ended 2010.
We think an increasing proportion of investment in unworthy projects and stalled economic reform is weighing on total factor productivity and overall GDP growth. China’s GDP growth is increasingly tied to growth in fixed asset investment, yet the lack of projects with reasonable returns means pulling the investment lever has reached the point of diminishing returns.
Falling Returns on Investment
Since 2008, returns from investment have faltered due to repeated stimulus and stalled reforms. China's total capital-output ratio, which measures how efficiently the country's total capital stock is being used, has deteriorated by nearly one third amid overinvestment across vast swathes of the economy. China’s stock of capital is increasingly akin to a developed country.
For example, by 2016, China's National Trunk Highway System spanned 130,973 km, making it more than two thirds longer than the 77,334km long Interstate Highway System in the United States, a country of comparable landmass. While China has one third fewer motor vehicles than the US - 186 million versus 265 million - it now has more than double the expressway kilometres per vehicle.
It's not just broad economic figures showing capital misallocation in China. There are several tangible examples of mis-steps regionally as part of the Belt and Road. There’s Sri Lanka’s Mattala Rajapaksa International Airport which has capacity for one million passengers a year, yet receives just one or two flights a day. The proposed high-speed rail link between Northern Myanmar and Rangoon seems a wasteful luxury for a country with one-quarter of its population in poverty and lacking basic infrastructure.
Ratings agency Fitch has been one of few critics of China’s Belt and Road, saying the effort is driven by the government’s attempts to “relieve domestic overcapacity”. Fitch said the projects might not address the most pressing infrastructure needs and may fail to deliver expected returns. Excess capacity has arisen as China’s economy transitions from investment-led growth and Belt and Road is an effort to export the spare capacity. Part of the goal of China’s Belt and Road is to grow its geopolitical influence through the region and this could see investment in otherwise unviable projects, resulting in growth in bad debt.
China can no longer rely on brute capital accumulation as a major source of productivity gains. If anything, maintaining the current level of spending would likely reduce productivity growth. Overinvestment and overborrowing are direct consequences of China's political economy, which prioritises and incentivises growth at all costs and does not subject government-linked borrowers to market discipline.
These problems are structural and, as such, cannot be solved with political discipline. Beijing's frequent admonitions of reckless borrowing and spending by provincial and local governments have had little impact over the years. President Xi's various "supply-side reforms," which include capacity reduction quotas, debt-to-equity swaps, and hybrid ownership structures, are also unlikely to have lasting consequences.
Until Beijing abandons overly ambitious GDP growth targets, repeated stimulus efforts are likely despite diminishing returns. Barring true structural change, returns on capital will deteriorate further, bad debt will continue to accumulate, and productivity growth will come under added pressure.
