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Tocqueville Asset Management - The Chinese Wall of Worry: Uncertainty Rhymes With Opportunity

August 01, 2014
Canadian Value

Canadian Value

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A former darling of investors, the Chinese stock market today has few friends

The U.S. stock market has had a well-publicized five-year rise without a major speculative blow-off. In a recent private letter to friends, Bob Farrell, one of my favorite stock market historians and analysts, sees huge excess potentially developing in the persistence of rising prices and the general complacency about risk. Yet for now, it seems to him, only one thing appears to matter: the Fed’s extended zero-interest-rate policy (ZIRP). He is not alone. According to the just-published annual report of the Bank for International Settlements (BIS), sometimes labeled “the central banks’ central bank”:

Financial markets have been acutely sensitive to monetary policy, both actual and anticipated…. High valuations on equities, narrow credit spreads, low volatility, and abundant corporate bond issuance all signaled a strong appetite for risk on the part of investors…. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.

I am sure that, sooner or later, we will have to pay the piper for whatever excesses have been developing; but an old stock market adage warns us not to fight the Fed. Indeed, it is probably futile to try and pinpoint the day of reckoning, but there is another adage that I like even better: “Don’t try to forecast the future, just be prepared.” It is the reason for my ongoing caution.

While we wait for the day of reckoning, though, we should not be oblivious to potential opportunities, wherever they may exist. China may be a case in point.

The Unloved Growth Champion

In a global world, no country or market can function in isolation. Yet the Chinese market, formerly a darling of global investors, has been declining steadily for almost five years while most other markets have been recovering. For example, as can be seen on the preceding chart, the Shanghai Composite lost nearly 40 percent since the end of 2009, while the S&P 500 gained almost 100 percent.

In late 2012, the Shanghai Composite Index touched the 2,000 level on the downside and has tested it repeatedly since, while making a succession of lower highs. Not surprisingly, predictions of a catastrophic ending to the current period of economic transition have multiplied and become more strident, as illustrated by the following sample of recent headlines:

“End to China's Property Boom Has Barely Begun”
Financial Times – July 7, 2014

Bad Debts To Send China into Deep Recession”
Independent – July 2, 2014

“Is a Property Bubble About To Burst in China?”
Bloomberg – July 7, 2014

“China's Melting Real Estate Market”
RealtyBizNews – June 18, 2014

“China May Face US-Style Financial Crisis”
Wall Street Journal – June 17, 2014

“China's Turn for a Debt Crisis”
Forbes – June 12, 2014

“China Trust 'Timebomb' Ticks”
Bloomberg – July 3, 2014

“China Reveals 300 Corruption Cases”
Sky News Australia – June 24, 2014

“China's SOEs: Too Big To Fail, Too Corrupt To Save”
TradingFloor.com – July 7, 2014

“China's Environment Goes from Bad to Worse”
Businessweek – June 10, 2014

“Another Ghost City in China”
Liberty News online – June 28, 2014

The Experts Are More Cyclical than the Economy

In a recent presentation for Matthews Asia, my colleague and China “sage” Andy Rothman mocked the army of China experts, who routinely predict fatal economic outcomes in the first half of every year, when Chinese statistics are seasonally weak; they then forget these predictions of doom in the second half, when statistics usually improve; and again shamelessly revive them early in the following year. Since we are at mid-year and I recently returned from China, I thought I would update my reading of what may turn out to be an interesting contrarian situation.

Many of the problems invoked in the headlines are real. But they are neither new nor, I believe on investigation, as catastrophic as implied. China’s economy clearly has been slowing down, though some of the worst forecasts of GDP growth, which had reached as low as 3 percent, already have been creeping back up. For the full year, GDP growth may well approach the official goal of 7.5 percent; and in fact, this is precisely what China just reported for the second quarter. Of course, official statistics do not mean a lot, since they are “man-made,” as Li Keqiang acknowledged some time before becoming Premier. But a look at the details can help.

Construction: the 800-Pound Gorilla in the Chinese Economy

According to China’s National Bureau of Statistics, consumption contributed 50 percent of GDP last year, well below the 65-plus percent typical of major developed economies. The main reason is not weak consumption, as one might assume; it is that, for the last 30 years, China’s modernization has necessitated an unprecedented boom in investment (housing, infrastructure, and plant construction), which now accounts for an unusually large share of GDP.

Following these boom years, it was to be expected that capital investment would slow down naturally as many of the original needs had been satisfied. And in fact, it has been slowing since 2009, with a collateral effect on the overall economy because the sectors it includes are intensive users of steel, cement, aluminum, glass, etc.

In coming years, the economy is expected to continue slowing down, driven by more “normal” growth of capital investment. Since, on the other hand, consumption is expected to continue to grow apace, the percentage of GDP represented by consumption will rise automatically. Note that a structural slowdown of GDP should not come as a total shock: Once it has reached a certain size, an economy cannot continue to grow at 10-plus percent per annum, especially when this means growing by more than the GDP of Indonesia every year!

More recently, the slowdown in investment has also been a response to government policy. Even in a command economy like China’s, where state-owned enterprises (which include practically the whole banking system) are meant to execute the central government’s directives, macroeconomic tools are very imprecise. As a result, efforts to fight off some regional speculative pockets in the property market have resulted in a slowdown of the whole sector. However, despite these instances of overinvestment, few relevant comparisons exist with the situation in the United States before the Great Recession.

Why Construction Should Not Collapse

In China, most residential property is owner-occupied, generally by first-time owners who have little incentive to trade their recently acquired roof. Not only have 20 percent of these owners paid all cash, but most others have put at least 30 percent down. In most important cities, there are strict limits on second-home financing, including very high cash-down requirements. Further, it is difficult and costly to use one’s home as a cash machine by borrowing against appreciated property values for consumption or other purposes. Finally, persistent rumors of graduated residential taxes on homes are creating a new incentive to sell whatever homes might have been purchased for speculation.

Except for tier-one (largest) cities – where property values have become expensive for the middle class, as in most international capitals – affordability is not a problem. For China as a whole, new-home prices have been growing at around 9 percent per year, which is slower than nominal urban income growth at more than 12 percent per year.

All in all, therefore, there is nowhere near the extent of speculative home-buying and homeowner leverage that prevailed in the United States before 2007, and conditions do not resemble the situation that preceded America’s sub-prime debacle.

While homeowners’ leverage is much lower than in the United States, this cannot be said for property developers. There has been speculation in property development, facilitated by easy lending from banks. But, if I remember correctly, land acquired for development must be improved within a given period of time. This time pressure may have caused overbuilding on land bought for speculation; but over time, as with all cases of inventory overbuilding, supply and demand will converge. Some property developers and possibly some banks will suffer, but this is unlikely to cause a systemic trauma, especially since the government owns the banks.

As for infrastructure construction, to a significant extent it is driven by the same socioeconomic goals as housing. Giving workers access to home ownership requires building the infrastructure to accommodate new housing developments. Massively moving Chinese farmers to the cities, which has been orchestrated by the government, further amplifies the need for urban infrastructure. As a result of these programs, investment in infrastructure has been very strong; and it was further boosted after 2009 by a stimulus program designed to sustain the economy in the wake of the global recession.

So, while construction of housing and infrastructure is likely to slow over time, it is unlikely to collapse, because of the continued need to urbanize the large migrant population.

A Middle Class in Reserve

As recently as 1980, less than 20 percent of the Chinese population lived in cities; and, in spite of the accelerated urbanization of the country over the past 34 years, that proportion remains under 54 percent. This compares with an average of 80 percent in developed countries, and 60 percent in developing countries with per capita incomes similar to China’s. Thus, continued urbanization over the coming 10 years should sustain housing and infrastructure construction at healthy levels.

An estimated 270 million migrant workers, mostly born on farms but working in cities, still make up one-fifth of the Chinese population. With incomes close to $5,000 a year, these migrant workers are considered middle class for emerging markets, according to the Asian Development Bank. However, under the hukou (working/residence permit) system, most migrants lack full resident rights in the cities, such as qualifying for education, healthcare, and home ownership.

This means that, in spite of their official classification as “middle class,” most migrant workers retain a very insecure status and have no real incentive or way to settle down.

The central government has now outlined a 10-year plan to grant urban hukou to 100 million migrant workers, rebuild slum housing in cities to accommodate them, and “guide the urbanization” of an additional 100 million farmers into smaller cities in the west and central regions of China. [Note: I have a friend born in Xian but living in Shanghai. He is a well-to-do young executive and entrepreneur but, not being a full Shanghai resident, he is not allowed to buy an apartment there. This is an example of pent-up demand for housing that will be released as soon as the hukou system is relaxed.]

The timing of hukou reform remains a bit elusive. One obstacle is that local governments do not have enough taxing power to finance the infrastructure needed for further urbanization. The way they have financed these investments in the past has been to acquire land cheaply from farmers and resell it at a gain to property developers. Despite longer-term plans to improve tax collection and allow local governments to issue bonds, revenues are currently slowed by new auditing procedures imposed by Beijing, the anti-corruption campaign, and property-price weakness resulting from recent credit tightening measures aimed at pockets of speculation.

However, there is a broad consensus in favor of this urbanization plan, which should result in a continued, reasonably high level of investment in housing, infrastructure, and transport systems over the next 10 years. In addition, to the extent that China’s high savings rate is due to the insufficiency of social insurance, giving this growing middle class access to residency benefits should help sustain consumption.

A Complicated but Dynamic Consumer Market

Retail sales in China are somewhat difficult to analyze, due to regional disparities in consumption patterns and the fast-growing impact of e-commerce, but they still seem to be growing at 11-12 percent a year. As for total real consumption, according to the IMF it grew at 8.8 percent per annum between 2008 and 2012 in China vs. 5.1 percent in India and 2.3 percent in Korea, for example. This is why, to Andy Rothman, China remains “the world’s best consumption story.”

For demographic and other reasons, it is unlikely that today’s pace of consumption can accelerate much. On the other hand, it should not slow down either, with blue-collar wages continuing to rise strongly (10 percent in Q1 2014 after a period of partly mandated, even faster catch-up in 2011-2012). Depending on the vagaries of food prices, this remains comfortably above the cost-of-living trend.

Hence, the much-awaited “rebalancing” of the Chinese economy may look like a non-event. Consumption growth is more likely to be sustained at the current healthy rate than to accelerate further. But since investment growth, which is half of GDP, is likely to slow, so probably will the overall economy. As a percentage of the total, consumption will weigh more as a result, and everyone will probably hail the Chinese economy’s “rebalancing.”

More Attention to the RMB than to Trade

Much is often made of China’s famous export machine and its reputation as “the factory of the world.” In fact, whereas exports are still growing at a fairly decent pace of 6 percent per annum, the country’s previously chronic current-account surplus has been shrinking steadily from more than 9 percent of GDP in 2007 to less than 1 percent recently. This reflects in part lower export demand due to the global recession. But there also is a new trend of “offshoring” production to neighboring countries with lower costs or other advantages.

Because China exports many manufactured products and imports lots of “inputs,” such as raw materials, energy, etc., any impact of slowing exports would probably be more visible on employment than on GDP or overall growth. Nevertheless, since employment is not a current or imminent problem overall, trade is unlikely to become a primary concern in the next several years. Today, renminbi policy seems concerned less with trade and more with the internationalization of the country’s currency.

Until early 2014, under a “soft,” or managed-peg, policy, the government let the renminbi appreciate slowly but steadily, by about 10 percent since 2010. Recently, however, the government has seemed more concerned with getting better control of capital flows, and has been testing a more international role for the renminbi – initially within the Pacific zone. With this in view, the central bank had become concerned that, if it kept appreciating, the renminbi might become a one-way bet that would attract too much speculative money in spite of existing currency controls. Hence the decision to engineer a mild decline in the first half of 2014.

We Are the Party and We Are Here To Help…the Financial Institutions

Very often, Western commentaries about China remind me of Professor Higgins’ song in My Fair Lady: “Why Can’t a Woman Be More Like a Man?” Many observers would like China’s political, economic, and financial systems to function like ours. Maybe one day; but for now, looking at China this way is a source of many misconceptions.

For example, just speaking about “the government” ignores the fact that it is the Party that really controls much of the economy (at least outside of the fast-growing but politically weak private sector). Every important enterprise or institution has, at or near its top, a member of the Party whose official title may grossly understate his or her true influence. The many layers of the Party are Beijing’s instruments to enforce the directives proclaimed by the country’s leaders. This is why, while ostensibly further de-controlling parts of the economy, President Xi Jinping has in fact aggressively and sometimes brutally been reinforcing his control of the Party.

Since I find even U.S. banks and most other financial institutions too complex to analyze nowadays, I won’t pretend to debate the solidity of the Chinese financial system, where reporting is uneven and relationships opaque. For example, according to Matthews Asia, estimates of China’s ratio of government debt to GDP vary from 45 to 80 percent, with the IMF’s estimate around 50 percent. (This includes debts of the central government, local governments, policy banks, the Ministry of Railways, and state-owned enterprises.) The current total is definitively higher than it has been, but many developing and developed nations have had ratios at or above that level without collapsing.

Matthews Asia also points out that China has negligible foreign-currency debt, low foreign ownership of its bonds, and a closed capital account, so that sudden and massive capital withdrawals are unlikely.

In spite of this, most informed observers acknowledge that the fast growth of credit inside China (partly a continuing effect of the RMB4-trillion stimulus in 2008-2009) deserves watching. Regulators have already broadened their supervision and implemented stricter auditing and enforcement procedures. Above all, it must always be remembered that Chinese banks are owned by the state. Some particularly badly managed ones might be allowed to default or go bankrupt, but primarily to serve as examples, we believe, and without real risk of a domino effect.

Reforms, Long in Coming, Are Shaping Up

One of the main areas of concern has been the lack of control over deficit-ridden local governments’ borrowing – often short-term, to finance long-term projects. The Finance Ministry has just published a new agenda for budgetary reform. While the publication of such agendas is not exactly a rare occurrence, the detailed nature of this one has impressed observers. The idea is to shift local government borrowing from property-based bank loans into longer-term bonds, while requiring more transparency on local budgets and imposing financial and fiscal discipline on local governments. Of course, new taxes on property, resources, and pollution will be part and parcel of these reforms.

Another broad idea is that local governments control tens of thousands of enterprises, which own valuable (though often poorly-performing) assets that can be monetized. This will take time, since at this point local governments seem willing to sell only minority interests without surrendering control of these enterprises. Minority interests in poorly managed firms may not attract a clamoring crowd of potential buyers. But it has escaped no one’s attention that private firms have grown faster and more profitably than state-owned enterprises in recent years. The pressure is mounting, and I believe that where there is a will there will eventually be a way. The Ministry of Finance has recently raised the dividend it is imposing on almost 800 government-controlled firms – generally to a rate of 15-20 percent of profits – and some local governments already have indicated a willingness to cede control of their enterprises.

The other area of concern has been “shadow banking,” whose name may be more menacing than its reality. Non-bank financial intermediaries that perform some of the functions of commercial banks exist in most countries, both emerging and developed. They might for example include hedge funds, money-market funds, broker-dealers who extend margin credit, etc. But in China, they also include informal family, village, and social networks that provide capital to individuals and businesses with limited access to formal banking channels. According to Matthews Asia, shadow banking in China represents a smaller percentage of GDP than do its counterparts in the Netherlands, the U.K., South Korea, India, France, and the US, among many others. As the traditional banking system modernizes, shadow banking should become less opaque as well.

Governing China Has Become More Difficult

Successive leaders since the Mao era have skillfully handled periodic local unrest that generally was not aimed at the central power, but at corrupt or brutal practices by local officials.

In fact, the central government has often been viewed as the people’s last defense against such excesses. However, almost to a man, China’s leaders have been nearly paranoid about anything that could possibly morph into a national movement. This explains their suspicion about religion in general and sects like Falun Gong in particular.

The advent of the Internet and its massive use in China has considerably increased the potential for national movements to emerge. For example, many policies were announced and directives issued in past years to fight pollution, but little concrete action followed until the subject became one of the major topics of discussion and criticism on China’s Internet. Other areas of active discussion include official corruption and a desire to see China exert greater international assertiveness, commensurate with its new economic power.

It should be remembered that China has possibly the world’s most sophisticated and heavily staffed censure apparatus (two million Internet police). So what transpires on its Internet channels is not exactly random. I believe Internet policy reflects two complementary factors. One is a version of the old political precept, “I have to follow them; I am their leader.” As a leadership that claims to be working toward a better society and quality of life for its people, Messrs. Xi and Li must be alert to what matters most to their population.

The other factor, which we must always remember, is that what transpires on the Internet after censure generally reflects what suits Beijing. Thus, the anti-corruption campaign also serves to strengthen the control of the Party over society by eliminating stubborn old-guard members; the anti-pollution campaign is a way to rationalize industry by closing inefficient smaller plants; and the new international assertiveness plays to the aspirations of the younger generation of successful entrepreneurs and executives, who might otherwise develop democratic fancies.

Testing the Limits of Adaptability?

One of the most striking characteristics of the broad Chinese middle class, and arguably the secret to its amazing success, has been its unique ability to adapt to change, be it political or economic. Not only has China had a long history of wars (both internal and invasive), natural disasters, and government upheavals, but its modern history (since the founding of the People’s Republic in 1949) has been a constant lesson in survival. I have several friends in their fifties whose families alternated between privilege and power or exile and starvation in distant working farms, depending on whether they were in favor or disfavor under Mao Zedong’s successive “regimes.” But it may not be so easy to adapt to today’s complex transformations.

In one respect at least, China’s current leaders do not deviate from their predecessors: They seem perfectly willing, even desirous, to free the economy further as long as the Party retains a firm grip on the country’s social and political organization. This is especially important at a time when a flurry of reforms, both initiated and announced, are attempting to design a new China, with the ultimate goals and the paths to them not yet entirely clear. All this change is creating great uncertainty, reflected in the title of a section of the June 2014 China Economic Quarterly: “Be afraid, very afraid – but why?”

From my point of view, if there be malaise, it has two main sources: 1) the accelerating shift of the Chinese economy to a new model of (slower) growth; and 2) the muscular and unrelenting anti-corruption campaign launched by the new leadership.

  1. In the early years of China’s economic boom and until fairly recently, the model for private entrepreneurs was to manufacture cheaply in China, thanks to very low labor costs and fewer regulatory constraints (labor laws, environment, etc.), and then to sell abroad aggressively. Others, such as Japan and Korea, had followed the same model in earlier times and, as happened to them, China’s economy now has matured to the point where the old model no longer promises even consistent returns, let alone guaranteed success.

    Labor costs have risen to the point where offshoring the most labor-intensive operations to neighboring countries has become a strategic necessity. But this requires new management and supervision skills. A friend who runs a supply-chain business tells us that middle managers in China are now often more expensive than expats from Europe or the United States with similar credentials, but usually less of a tendency to job-hop. In industries with low labor content or significant high-skill content, some companies even find it more efficient to manufacture in relatively high-cost Taiwan or in the United States.

    Services are now growing much faster than manufacturing. But, as their name indicates, they require more service: more targeted marketing, more customer interaction, more product differentiation by regions, and often faster innovation. The old model – based on low-cost, fairly standardized manufacturing, mostly for export – is being replaced by more-complex ones involving domestic market analyses, improved merchandising, and, for manufactured goods, new distribution logistics. Much testing and experimentation is taking place in retail, for example, with fast-growing e-commerce adding another unknown. Many of the early generation of entrepreneurs now find themselves, again, in virgin – and, for the time being, slower-growth – territory.

  2. President Xi has surprised most observers with the toughness and scope of his anti-corruption campaign, as senior officials at central ministries, provincial and municipal governments, and large state-owned enterprises have all been investigated (China Economic Quarterly, June 2014). No one really believes that this campaign is purely idealistic. In great part, it probably is a way to rid the Party of the vested interests that might impede the ambitious reforms that Xi has in mind – especially among the multitude of inefficient State-Owned Enterprises (SOEs).

    The desirability of SOE reform is evident. According to Asianomics (June 24, 2014), China has more than 100,000 SOEs, with combined assets of approximately US$15 trillion, and 28 percent of these SOEs are losing money. Further, while SOEs receive around three-quarters of all bank loans in the country, private-sector firms use their capital twice as efficiently and create about three times more jobs per amount of capital invested.

    Unfortunately, since most successful businesspersons and influential bureaucrats have, at one time or another in their careers, been close to powerful national, regional, or local government officials, no one is sure that they cannot be touched by the purge. This has resulted in a paralysis of many decision-makers: Government officials are reluctant to grant permits or to initiate new projects, and business leaders are shy to commit to new investments.

    Temporarily, I believe, the powerful Chinese are taking for themselves an old French adage: “To live happy, live hidden.” Retail sales in Hong Kong, where the rich Mainland Chinese were very visibly doing their luxury shopping, were down 15 percent through May. A high-end restaurant in Shanghai where city officials used to entertain lavishly has experienced a sharp decline in that business. Official banquets have been replaced by weddings and family affairs, but at substantially lower margins.

A last factor worth mentioning is the large number of wealthy Chinese either leaving the country or planning for an eventual departure. The Hurun Report, which surveys the rich in China, estimates that more than 60 percent of the people it surveys have already moved to another country or are considering doing so.

The official reasons most mentioned are better education for the children, lower pollution, and safer food. My impression, admittedly from a smaller sample of what I would qualify as upper middle class rather than mega-rich, is that the easy days are over in business and that the various political crackdowns are adding to the general uncertainty.

In Markets, Uncertainty Often Rhymes with “Opportunity”…

…and I am equally sure that (despite the spelling) certainty more often rhymes with “risk” than with “opportunity.”

I already mentioned the gross underperformance of the Chinese stock market over the last four-plus years, which has given weak investors ample time to grow disenchanted with that market.

13D Research (June 17, 2014) notes that prices of A shares in Shanghai are trading at a 9.5-percent discount from their H-share equivalents traded in Hong Kong, which is paradoxical since serious consideration is being given to merging the two exchanges.

At the same time, preparations are in the wings to include China’s market in various global stock market indexes, which should increase the demand for listed shares (FTSE Paper, June 2014).

Finally, a look at the chart below triggers the following question:

“Does the Chinese stock market deserve to sell at a price first reached in 2001?”

If the answer is “no,” then opportunity awaits.

François Sicart
7/22/2014

http://www.tocqueville.com/

About the author:

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

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