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Tocqueville Asset Management - China's Very Relative Malaise

July 12, 2013 | About:
Canadian Value

Canadian Value

117 followers
In the 16 years since I started visiting China at least once a year, the pace of change, both economic and social, has been dizzying, and the progress has been faster, smoother, and more durable than had seemed possible. Certainly, China’s transformation and enrichment have belied the warnings of impending bubbles or crashes that have regularly issued forth from Western media.

Westernized Chinese people are often referred to as bananas because they are deemed to be yellow outside but white inside. In contrast, Westerners who feel very close to China are sometimes referred to as eggs – white outside but yellow inside. I would not be so presumptuous as to pretend to full egg status but, over time, I have developed some feeling for China’s change and its people’s reaction and adaptation to it. This is what I have tried to chronicle shamelessly since my earliest visits.

On my most recent trip, in May, I was accompanied by my colleague Allen (Yibo) Huang, who was born and schooled in Shanghai but who received his higher education in the United States. He is an 11-year veteran of Tocqueville Asset Management.

During a six-city, three-week visit, we met with what could be described as a broad sample of the Chinese upper-middle class in the 25 to 50 age group; they are widely regarded as the typical participants in the Chinese miracle. There were exceptions on both ends of the spectrum: some very wealthy Chinese, but also a couple of farmer or ex-farmer types. In addition, due to China’s accelerated transformation, the experiences of the nearly 100 Chinese professionals and entrepreneurs we met were considerably more varied than their current situations might have indicated: Many had known much more modest times, including during the Cultural Revolution, and the experiences of the 20-somethings had been radically different from those of the 40- or 50-somethings.

In spite of these differences, what struck me most on this visit was a general feeling of unease that I had not previously sensed. Before some media addicts rush to interpret this observation as yet another warning of looming disaster, like those that have accompanied the Chinese stock market decline to multi-year lows, let me make clear that what we sensed was not a crisis mood: Just a vaguely uneasy feeling that seemed to be shared by most – but not always for the same reasons.

Unequal Slices of a Growing Pie

A number of our contacts claimed to be worried by the widening gap between China’s rich and poor. Professor Xu Xiaonian, a good friend of ours and a leading economist, recently told the Global Times (6/28/2013), “The core reason behind China’s tepid consumer demand is unequal distribution of wealth.” Prof. Xu has been an outspoken critic of the slow pace of structural reform in China, and has a wide following among the well educated. Still, the growing concern with the wealth gap sounds to me like a notion more directly relevant to the mature economies in the West than to China. As another Chinese university professor recently remarked on China Central Television, there is a big difference between countries where the gap between rich and poor is widening in a stalled or declining economy (like many in Europe) and a country like China, where growth remains among the fastest in the world and benefits almost everyone, albeit unequally.

The truth is that most economic classes in China are considerably better off today than ten or even five years ago, and this includes farmers and manual workers, for whom government policies have remained largely supportive: subsidies, price supports, lodging help, the beginnings of health insurance, large increases in mandated minimum wages, and soon, access to the benefits of city residency for the large number of migrant workers.

Thus, I suspect that China’s poor are not the group that is most sensitive to the emergence of a new class of outrageously visible billionaires. Rather, I believe that the most critical or even resentful may be the “merely rich” class of Chinese executives and entrepreneurs who achieved their success and wealth through hard work, only to discover that they had been leapfrogged by a relatively small number of highly visible individuals whose fortunes may have owed more to political rent than to business acumen.

My experience across countries is that truly struggling classes are too busy making ends meet to philosophize much about social themes. The gap between rich and poor has indeed been widening in China; but in my view, worrying about it is often a middle-class luxury. On the other hand, there is no doubt that comfortable young Chinese, who are largely wired into the Internet, are actively discussing themes like income and wealth disparities or environmental issues on Weibo (China’s Twitter equivalent) and suchlike, and in the process are raising the general awareness of these issues.

Environment

The massive spread of the Internet also helps explain the increasingly open debate about the country’s environmental problems. It is no secret that the very fast growth of the Chinese economy over the last 30 years has been achieved with broad disregard for its environmental and health consequences. But before there was a broad awakening to the environmental impact of breakneck industrial development, discontent was largely directed at local corruption.

Many provincial or city officials acquired property cheaply from farmers and sold it for personal profit to real-estate developers; they then built housing or industrial plants that would pollute rivers and nearby underground water reservoirs, thus endangering food supplies and the remaining farmers’ livelihoods. At the same time, a largely coal-fueled industry and a multiplying automobile population made the air increasingly unbreathable, while the incessant creation of new cities and expansion of old ones accelerated massive tree-cutting in neighboring forests and caused the desertification of large areas of northern and western China. All of this enriched many entrepreneurs and the officials who facilitated their projects, but deteriorated the quality of life for all. The consequences were environmental, but the immediate causes were clearly traceable to local corruption.

China’s central government long paid lip service to the country’s deteriorating environment, but either took little action or saw its directives circumvented or plainly ignored by local officials and businesses. The development of the Internet, however, has brought the problem into the open and has fueled a grass-roots debate and resentment at the national (rather than purely local) level, which is something that Chinese leaders always have been careful to avoid.

The current environmental situation in China has clearly become unbearable. And, since this is all happening while the new leadership is acknowledging and even acting to foster a transition of the Chinese economy from quantitative to more qualitative growth, a proactive attitude toward the environment fits perfectly into their new objectives.

This is why there is reason to believe that the challenge will finally be tackled. Of course, the results of such a momentous endeavor will take time to show, but a local friend of ours, who is a hands-on expert in environmental issues and has long been critical of China’s actions (or the lack thereof) in that domain, seemed more hopeful on this recent visit.

The Cost of Virtue

Historically, changes in central government have triggered accusations of corruption mostly as excuses to chase out or demote officials viewed as uncooperative or potentially dangerous to the new administration. With environmental issues and other dysfunctional aspects of the Chinese economy closely tied to local corruption, it made sense for the new leadership to initiate change with an anti-corruption campaign as well.

This time, however, the excesses and highly visible lifestyles of some local officials, and especially of their siblings, have themselves become the focus of much discussion over the Internet. With the prospect that the transition shaping up in the Chinese economy will likely be accompanied by some slowdown in growth, it has become important for the leadership to prevent the Party’s officialdom from appearing to be ostentatiously immune to this new moderation. As a result, a serious, and perhaps even durable, campaign has gotten underway to monitor the spending and lifestyles of all officials and their families.

But the importance of officialdom in total consumer spending (especially on luxuries) may, in fact, have been underestimated. Sales of very high-end fashion, accessories, cars, and fancy restaurant meals have recently suffered visible declines as a result of this new “ambience.” Two anecdotal examples:

  • A leading luxury restaurant in Shanghai, where city officials routinely had been having business and social meals in recent years, has experienced a marked decline in visits by that clientele since the beginning of the year. Private banquets (weddings, birthdays, etc.) are taking their place, but the new patrons are much more price-conscious than the lavish officials, so margins have suffered.


  • A small, Hong Kong-originated retailer called Milan Station is experiencing a booming business specializing in secondhand but hardly used (and still very expensive) bags from Hermès, Chanel, and the like. One (unverified) explanation is that many officials used to offer such items to their girlfriends; when the giving dried up, the girlfriends supplemented their pocket money by selling some of their many valuable accessories. Since the top-brand firms have had a strategy of controlling supply to engineer a scarcity of their bags, Milan Station capitalized on this market with both a ready supply and an eager clientele.


What makes this explanation credible is that the recent weakness in the prices of contemporary Chinese art is reportedly traced to a similar (unverified) cause. Apparently, a way of thanking officials for help or favors had been to offer them a piece of art that they routinely would sell at auction in Hong Kong. This business, too, seems to have abated.

So, even a morally commendable turn toward virtue can create uncertainty for otherwise legitimate businesses.

When It Rains, It Pours

Other complaints we heard have become fairly standard ones all over the world, but we seem to have heard more of them this time.

Labor turnover remains a challenge, though mostly in some service sectors and management functions where the required education level is higher. Three different entrepreneurs mentioned that the salary expectations of Chinese college graduates speaking a foreign language have become so high that it is often cheaper to import a mid-level executive from Europe…and those employees are less likely to leave for a slightly higher offer at another firm. However, this has not yet become general problem: In legacy industries, such as assembly, reserves of productivity gains still exist, and raises in minimum wages remain relatively predictable and, manageable – especially when relocating to western China is a logistical option.

Another cost factor mentioned by firms selling their wares internationally was the growing overvaluation of the renminbi: It is felt when competing not only against local firms in Europe and the United States, but also against other Asian or Mexican exporters to these same markets. And finally, as an echo to what we have grown accustomed to hearing in Europe and the United States, everybody complained about high taxes, which tend to be somewhat arbitrary at the local level and against which there seems to be no legal recourse.

The Big Transition Is Psychological

Altogether, not everyone seems concerned about the same thing, but everyone does seem to find something to be uneasy about. Without drawing a parallel that would not stand full scrutiny, it is striking that many Russians today recall with nostalgia the ordered life of the old Soviet Union: Incomes were paltry and there were chronic shortages, but everyone had a job, there were rules covering every aspect of life, and practically all shared in the same misery. In other words, life was predictable.

My own analysis of China’s current malaise is that it is facing a transformation that goes beyond the scope of most of the economic and political analyses published in recent months.

In spite of the amazing liberation of its business sector over the last 30 years, China has been operating under what can be described as a command economy. The government would establish multi-year plans (a legacy of the Soviet system) to indicate the medium-term goals and which activities would be favored and even assisted. To encourage or punish, the government collected all taxes and influenced budgets (national, provincial, and local); it dictated when and to which sectors banks would lend and not lend; it provided price supports or protection against imports where and when needed; and, through the Party, it controlled state-owned enterprises, which, at one time, accounted for a large majority of GDP.

As a developing nation and a potentially huge market, China also benefited from avoiding some of the responsibilities imposed on other large economies. As a result, both businesses and individuals enjoyed a fast catch-up in growth and prosperity and a high degree of visibility: What the government had decreed would happen.

Since joining the World Trade Organization in 2001, China has been expected to make progress toward assuming the same responsibilities and abiding by the same competition rules as other developed countries. In addition, with its manufacturing costs having caught up with and sometimes surpassed those of its international competitors, it can no longer count on exports of simple manufactured goods as the principal engine of its economic growth. Although much infrastructure work remains to be done to absorb migrant workers from the farms into the cities, it will pale in comparison with the massive investment of recent years. So, it is hoped that personal consumption will be the next locomotive to sustain superior growth.

But consumption already has been growing at a hefty pace, and will remain restrained by the absence of comprehensive health insurance and an effective pension system. In addition, many Chinese families feel the need to save to guarantee a higher education for their children. As a result, consumption is unlikely to respond to short-term policy incentives as predictably as more traditional sectors like infrastructure or even housing.

Finally, the weight of state-owned enterprises in the economy has declined sharply, and the recent growth of the private sector has been in services and technology, which are less directly responsive to government stimulus than traditional manufacturing.

In other words, China’s economy likely has, in normal fashion, entered a new age of not only slightly slower, but also more volatile, growth. The government must navigate this new economy with less-precise policy tools than in the past. It probably remains better equipped to do so than governments in most developed economies, but the public’s perception of more volatility and less predictability is creating a slight feeling of disorientation that stands in marked contrast to the overwhelming confidence that prevailed in recent years, and the high expectations this had created.

Conclusion

In China, what we observe is a psychological adjustment to a growth rate and volatility that would be the envy of all Western economies and most developing ones. In the Western media and some academic circles, this is amplified by forecasts of a collapse of “shadow banks” and of housing (where speculation is supposed to have gone wild), among other catastrophes. We are always highly suspicious of such analyses when they appear after a stock market decline of nearly 60 percent over three years. As a result, China’s current relative malaise is beginning to look to us like an investment opportunity.

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Canadian Value
http://valueinvestorcanada.blogspot.com/

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