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CHINA GROWTH: NO MIRACLE;GOVERNMENT SPENDING NO LONG-TERM SOLUTION

May 17, 2009
Be careful about investing your hard-earned dollars in the latest Chinese five-year economic miracle.

One should not confuse China's latest economic growth -- retail sales up 14.8 percent, industrial production up 7.3 percent and car production ahead 18 percent -- with sustainable growth.

Now that the US consumer is de-leveraging and the global appetite for goods is declining, Chinese exports dropped 22.6 percent in April.

But this raises a question: How can China, a mainly export economy, continue to thrive when its exports are falling?

The answer is that today's China is a story of two competing economies: the real economy, producing goods and services for mostly external consumption, which is declining at a tremendous rate and the government-spending stimulated economy, which is currently expanding on steroids.

The latter one is clearly winning, for now. Here is why:

* The Chinese central bank has a significant advantage over ours. The Fed can print a lot of money -- and it has -- but there's almost nothing it can do to speed our spending. The Fed cannot force corporations and consumers to spend. Since China isn't a democracy, it doesn't suffer the problems of the democracy.

CHINA GROWTH: NO MIRACLE; GOVERNMENT SPENDING NO LONG-TERM SOLUTION

* China's communist government owns a large part of the money-creation and money-spending apparatus: Money supply therefore shot up 25.5 percent in March. Since it controls the banks, it forced them to lend.

* Finally, China can force government-owned corporate entities to borrow and spend. And the government itself can spend quickly -- which is important when trying to build infrastructure. If the Chinese government decides to build a highway, it simply draws a straight line on the map. Any obstacle -- like a hospital or a school -- becomes a casualty of the greater good.

The Chinese government goes to great lengths to stimulate its economy because it doesn't have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost.

Millions of people have migrated to its cities, and now they're hungry and unemployed. People without food or work tend to riot; to keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system re-stabilizes.

This type of growth is simply not sustainable, as it comes from borrowing. Its quality is low -- hundreds of billion-dollar decisions made on the fly don't inspire a lot of confidence in their efficiency. It will result in a huge pile of bad debt -- forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple -- there is no miracle in Chinese miracle growth, and China will pay a price -- the only question is when and how much.

Vitaliy N. Katsenelson

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).


Visit Vitaliy Katsenelson's Website


Rating: 3.2/5 (11 votes)

Comments

DaveinHackensack
DaveinHackensack - 5 years ago
In last week's Financial Times, James Kynge offered a different perspective on this ("Chinese tap an inner dynamic to drive growth"). Excerpt:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China's case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world's fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to "China Continental" - the transition of the world's most populous country into an increasingly self-propelling economic force.


You can read the article for the breakdown of those indicators. The author addresses the skepticism of folks like Katsenelson in his conclusion:

Some of this growth has come from the initial implementation of a Rmb4,000bn fiscal stimulus package, but the bulk of planned infrastructure spending has yet to get under way.

Sceptics argue that China's performance this year has come through huge but ultimately unsustainable government intervention. Such spending, they say, will boost growth for a time but achieve little but industrial overcapacity in the longer run. These arguments are not without merit, but they miss a newer, more interesting prospect; that Chinese growth is increasingly self-generating and continentally driven.


Sivaram
Sivaram - 5 years ago
Dave, thanks for providing the counter-argument. I share Vitaliy's stance (I'm skeptical of other high-growth markets like India, Eastern Europe (undergoing contraction now), Southeast Asia, Brazil (although Brazil isn't "too high") as well) so it's always good to get the opposite view. I don't have access to the FT article so I'm not sure exactly what the the author was saying but what you have quoted doesn't really disprove the emerging market bears like me. Here is my problem with China (and others):

China is definitely trying to switch to an internally-driven model--it has to; it's exports have collapsed. So I don't really disagree with that notion. My problem has to do with growth rates. I have said this many times but to reiterate, it is virtually impossible for a country to grow GDP at, say, 9% real and 15%+ nominal (depending on what you think inflation is) for long periods of time. China has supposedly been growing at 8% to 10% real for 20 years now (let's ignore the possibility that the numbers are fake because the market consensus is that the numbers are correct.) Growing at around 10% for a long period has probably never happened in the history of capitalism and it seems hard to believe (I will admit that there are probably exceptions for small countries or if you measure right after a major war but we are not dealing with that here.)

USA was the greatest emerging market in the 1800's and early 1900's yet my understanding is that it rarely ever grew at 10% (real) for very long. Any high growth generally involved subsequent contractions so the average over many years wasn't so high. USA certainly didn't grow anywhere near 10% in the early 1900's and, I'm a bit unsure about the data but, I believe it also didn't grow that fast in the late 1800's. (USA also had land mass and tons of resources so it should be better off in some sense.)

The only reasonable argument by the China bulls that I have seen is that China is able to utilize rapid advances in technology and hence can grow faster. The thinking by some is that China is able to do in 10 years what it took 20 years a hundread years ago. This is the only argument that seems somewhat credible in my eyes. But even then, it's not clear how true it is. On the surface this may seem true because technology has advanced so much and China can tap all the knowledge of humanity. But, on the other hand, this is nothing new. USA was doing the same thing a hundread years ago. It was tapping all the high-tech from Europe, as well as developing its own, so it was leapfrogging what Europeans were able to accomplish a century earlier.

So, in my opinion, something doesn't add up when it comes to these high growth markets like China. Either the reported numbers are all wrong and overstated growth; or China is going to face a massive contraction--a bust. A bust doesn't mean that it is the end--USA had many busts during its growth phase--but it does mean that investors betting on China should be careful. One can probably still make money off investments, just like how one could have made money off homebuilders before the housing bust, but I think everyone should be cautious. The China high-growth story can continue for many years but I suspect any subsequent correction will be severe.

(It is possible that there won't be a major bust/contraction and, instead, we will see low growth--say 5% growth rather than 9%. For investors the outcome will likely be the same. The market will likely re-price everything so the risk will be similar. Similar to how commodity investors betting on high growth a few years ago ended up losing a fortune (likely permanently), re-pricing of long-term expectations can yield similar results.)
isiah
Isiah - 5 years ago
I am not sure what is a more sustainable economic model, but it will be a real stretch to say that the US has got one. It's as simple as taking a look at the whopping government debt and you will see...

Raised in China and studied in US, I have the benefit to see both countries with my own eyes. And that makes a difference.

No doubt China economy has many tough issues to deal with: investment efficiency, low value added, environmental protection, IP, etc. But few would argue it is in a better position than its western counterparts: Government has more strings to pull (e.g. lending rate is still 5%+) and Chinese average households have little leverage and has got money to spend. Consumption boost is happening and it is a matter of time before it will pick up and carry more weight in future GDP growth. For those American friends who have not yet experienced the consumption power of Chinese ever-growing middle class, they just need to spend a few nights in Shanghai, Beijing, or Shenzhen. Any of these cities boast 20mm+ of population, able and willing to spend.

Stock market itself may very well be getting ahead of the fundamental (YTD Shanghai Composite Index was up 50%) and under appreciative of the risk. But then again, who is that different from other markets?

On relative value basis and for the next 5 years, I will side with Jim Rogers and wager on China.
commodity
Commodity - 5 years ago
A house of cards based on fraud and lies.
mrubsam
Mrubsam - 5 years ago
Walmart just reported declining sales in China. Hard to believe China govt retail sales figures when WMT is showing decliining sales.
DaveinHackensack
DaveinHackensack - 5 years ago
Here's the entire FT article I excerpted before, since Sivaram said he was unable to see it via the link I provided above:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China's case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world's fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to "China Continental" - the transition of the world's most populous country into an increasingly self-propelling economic force. There are caveats, of course, but first the evidence.

Retail sales have held up much better in China this year than in other big economies, growing at a real 15.9 per cent in March year-on-year. But more important than the overall trend is the composition of the retail spending.

The most robust consumer spending figures are coming from inland and lower-tier cities rather than from the traditional growth powerhouses clustered around the Yangtze and Pearl river deltas. A China Confidential survey assessing consumer spending intentions among an estimated 64m middle and upper income households in 189 cities in March showed a much higher propensity to spend in lower-tier cities.

Overall, 51 per cent of respondents in 15 second-tier cities said they planned to increase spending this year from last - a full 9 percentage points more than the number from the first tier. In 170 third-tier cities, 49 per cent of respondents said they would boost their spending this year.

One upshot of this trend is a corporate rush to capture the spending power of the inland consumer. In sectors as diverse as hotels, paid-for education and general retail, companies are seeking to offset slackening sales growth in the big coastal cities by embracing China's continental geography. A subsidiary of Home Inns and Hotels Management, the budget hotel industry leader which already has a network of more than 600 hotels, aims to open 250 outlets by the end of 2010.

Wal-Mart plans to increase the number of its stores from five to nine in Chongqing, a city 2,500km up the Yangtze river from Shanghai. This will mean it has more stores in Chongqing than in Beijing or Tianjin.

Other signs of the China Continental theme can be seen in the fact that domestically bound cargo traffic through ports is increasing year-on-year, while foreign trade volumes are slumping. Property transactions are surging across the country.

Recent key reforms may also work to create inner-dynamism. A healthcare plan, which envisages spending Rmb850bn ($125bn, €100bn, £85bn) until 2011 on basic health insurance and grassroots clinics, is intended, in part, to expand disposable income. The spreading monetisation of agricultural land, under which farmers have started to use land as collateral for loans or as registered capital for setting up companies, has the potential over time to transform the rural economy.

The unlocking of inner sources of strength will be crucial for China if it is to grow robustly in the face of declining global demand. Foreign trade for the first quarter fell 24.9 per cent year-on-year, but overall gross domestic product grew by 6.1 per cent during the same period.

Some of this growth has come from the initial implementation of a Rmb4,000bn fiscal stimulus package, but the bulk of planned infrastructure spending has yet to get under way.

Sceptics argue that China's performance this year has come through huge but ultimately unsustainable government intervention. Such spending, they say, will boost growth for a time but achieve little but industrial overcapacity in the longer run. These arguments are not without merit, but they miss a newer, more interesting prospect; that Chinese growth is increasingly self-generating and continentally driven.

James Kynge is editor of www.ftchinaconfidential.com.
Sivaram
Sivaram - 5 years ago
Thanks Dave...
Sivaram
Sivaram - 5 years ago
ISIAH: "I am not sure what is a more sustainable economic model, but it will be a real stretch to say that the US has got one. It's as simple as taking a look at the whopping government debt and you will see..."

The US debt is not very large if you exclude GSE obligations (Fannie Mae, Freddie Mac and Farmer Mac) and ignore social security/medicare. Items like social security and medicare are an issue but solutions are likely easy since the obligations are to citizens themselves. For instance, slightly curbing the benefits that are paid out or some such measure will significantly lower the debt. As for Fannie & Freddie, technically, their obligations are backed by incoming-producing (except upon default) hard assets (basically real estate.) So that's not as bad as normal govt debt. So, if you ignore those, the US debt is relative to GDP is smaller than it was in the 40's to 50's. For example, countries like France, Japan, Germany and even Canada have larger debt to GDP ratios.

Anyway, I'm not saying the US debt situation is good; all I'm saying is that it is not as bad as it seems. Now, if USA ends up leveraging up its government balance sheet to combat the credit bust, as Japan has done, then the debt will start being a concern.

"Government has more strings to pull (e.g. lending rate is still 5%+) and Chinese average households have little leverage and has got money to spend."

The China bears, which includes me, do not look at the first part of that as being overly positive. Governments, by their nature, are inefficient. They are very poor allocators of capital and generally perform far worse than the free market. Unfettered free markets with greed running rampant, as has been the case in America in the last decade, is also very bad but governments aren't any better. The huge risk--and this is a massive one--is that, although China is growing fast, and the government seems to be helping the situation, they are likely misallocating resources. The thing is, we just don't know where capital is being destroyed.

As for the households, they are in good shape but there is a potential problem. What has been happening in China is that the citizen savings is being recycled by the government into foreign investments, mostly US government securities but also other assets. If these investments ever turn sour--we all know how badly some pension funds, not to mention sovereign wealth funds in Abu Dhabi and Singapore have lost tens of billions--the citizens will take massive losses. I believe the probability of massive losses is low but some do think that the potential exists. For instance, some claim that US Treasuries are in a massive bubble about to burst; others claim that USA will print money (resuling in inflation) to service their debt. I am in the mild deflation camp (at least right now) so I do not believe those scenarios but it's something that can happen.

When was the last time a centrally planned government ran a large economy successfully for a long period of time? That is the risk in China.
isiah
Isiah - 5 years ago
I guess you are most likely working in the financial service industry, either a research analyst, a banker or investment manager.

I guess you are not in any "real" industrial, or trading business

Because if you are, you will be less concerned about the ideology or academic theory, less worried about central plan vs. market driven (I can make an argument that China today is more capitalist than US in many senses, at least our people knows to depend on ourselves first when dealing with adversity rather than just blaming the government, but that is not my point here). All you need to do is to take a good look at your own businesses and gauge the existing or potential threat of China as a legitimate competitor. From the early waves of manufacturing of shoes, textile, white goods, the Chinese businessmen (SOE or private), have persistently gaining market shares in what previously thought as high value-added industries. In my daily work as a private equity investor in this part of the world, I am meeting smart and hard working businessmen who now engage in making of telecom equipment, cosmetic products, medical devices, etc. All of them are trying hard to make these things better and cheaper. And most of them make quality products selling at 30% cheaper yet still makes a double digit net profit margin. They won't take over the world, for sure, but the rest of the world have reasons to be worried about their presence and progress. It is no co-incident that Buffett bought into BYD, and look no further than Munger's comments in this year's Berkeshire annual meeting for recognizion that "Chinese will be very hard to compete against"

That is the ultimate drive of China's economic wonder - a nation of billion humble, poor and reasonably smart people who are willing to work their ass off (how many Americans today can say that?) to improve the lives of their family. The government has done a fine job, but really what it did is simply not getting in the way of its people. No political or economic system is perfect but the Chinese government at least is willing to learn and adopt to what it sees as right and what has worked in US.

Deng Xiaoping used to say that "a cat,no matter black or white, that can catch mice is a good cat". And that, my friend, is the wisdom underlying the pragmatism in China. And I got to think that most will agree that the result speaks for itself. If enriching the nation from deep poverty to world power is wrong, I just don't want to be right


DaveinHackensack
DaveinHackensack - 5 years ago
The challenge of the Congress Party in India highlights how China's lack of democracy may be a big advantage in pursuing pro-growth policies. The Congress Party leadership (including the current PM, who is an economist) realizes the utilitarian benefits of high economic growth for India: high growth is good for everyone, including the poor. But since India is a democracy, the Congress Party has to pander to its constituents, among whom are the poor, who -- like poor people in most other parts of the world -- tend not to be very future-oriented or willing to delay gratification. So instead of just enacting pro-growth economic policies, India's governing coalition will have to buy off the poor with make-work jobs, redistribution, etc., in order to pursue some pro-growth policies. China isn't similarly handicapped by a need to pander to its rural poor.

That doesn't mean that China won't have an economic correction at some point -- it probably will. But it's a reasonable possibility that it will continue to grow strongly for now, because, as the FT article notes, internal growth may offset the decline in exports.

That said, I have a question for Sivaram and other China bears: given the world of hurt (and debt, both government and household) that the first world economies are in, if you are bearish on China (and India), what can you be bullish on?
Sivaram
Sivaram - 5 years ago
ISIAH: "If enriching the nation from deep poverty to world power is wrong, I just don't want to be right"

That's not what I'm saying at all! I am not saying it is wrong for China to prosper. China used to be the #1 civilization and gave us a lot of new technologies and inventions so I don't think it's bad if it did well.

But having said that, I'm speaking as an amateur investor. I don't work in the industry, don't have a lot of money, and am not an "expert". All I'm concerned about is investing properly so that I, or others, don't lose money. Also, everything I say is my opinion and may turn out to be wrong.

I do not doubt most of what you say about what is happening on the ground. The question though is whether it is sustainable. I believe the market has priced in all the positives you are describing. The question is whether it is sustainable, which I do not believe it is for the reasons I mentioned before. Remember, Japan grew very fast in the 70's and 80's but ended up with a massive bust in the 90's. I'm not saying China is Japan (they are very different) but the point is that someone looking at Japan in the 70's or 80's would have said something similar to what you are saying.

To go back to my main problem, no country has grown near 10% per year (real GDP) for a long time. Yet, China's numbers indicate that. That doesn't make sense to me.
Sivaram
Sivaram - 5 years ago
Dave: "The challenge of the Congress Party in India highlights how China's lack of democracy may be a big advantage in pursuing pro-growth policies."

I'm not a fan of India either. The government is inefficient but that's kind of the price you pay for democracy. I was talking about the Chinese govt misallocating resources and, well, India does that too. On top of what you have described, the government has other policies that distort the economy. For instance, if I'm not mistaken, the government forces banks to buy its own government bonds. This increases the cost of capital for the banks (hence consumers and businesses will pay more), and lets the government be a bit more reckless with its budget deficits.

Dave: "That said, I have a question for Sivaram and other China bears: given the world of hurt (and debt, both government and household) that the first world economies are in, if you are bearish on China (and India), what can you be bullish on? "

I wouldn't say I'm extrmely bullish on any region right now. I'm mostly neutral and am not deploying capital into anything (except special situations.) But in terms of mild bullishness, I'm bullish on America. The theory that I follow--this may turn out to be completely wrong for all I know--is that the current situation is somewhat similar to the 1930's. If we go with that view, the economies that did better were, as hard as it may to believe, the current account deficit countries (Britain and Europe). The ones running the surplus and seeing strong growth (America, and Japan too I believe) were hit really hard. Presently, the role of 1930's America is occupied by China/Germany/etc; and Europe/Britain back then is presently USA/Britain/etc. I think American equities are probably safer than that in many other regions. (Some of the periphery countries like Canada, Australia, Mexico, etc, may be ok too but returns will likely be driven by currency fluctuations and that creates uncertainty.)

On top of this economic thesis, one needs to look at valuations. American valuations are reasonable, but not extremely cheap, and that is the case in most other places as well. Because valuations are not extremely low--although others like Buffett et al think they are--I'm mostly staying out of the market.


(The risk to me view is if, instead of a long slump, we get strong growth. In such a case, America would probably be the worst place since growth will be lower and the US$ can decline significantly.)
isiah
Isiah - 5 years ago
Sivaram

Sustainablity, as you rightly pointed out, is the key question. I don't profess that I have the crystal ball to see what's coming in the next decade. But just a few points for you to ponder

- Secular growth trend driven by urbanization. Despite all the progress, urbanization ratio is still something like 50%. To catch up with the average of 60%+, there is lots of house to build, job to create, money to make, given the 1.3 bn population

- Off a very low base. No doubt the number of 10% CAGR for 3 decades sounds too good to be true. But we are off a very low base. It is totally expected that the growth rate will slow down going forward. But even you cut it by half, it is still a massive number given the scale we currently have

- Domestic market just starting: for all the points we made on the slowly but surely strengthening of Chinese domestic market (as opposed to the export markets that have been the pivotal driver for the prosperity in the past), we indeed have a long way to go. A simply way to interprete this is to compare the "stuff" that an average household American take for granted, and think about how many Chinese family is going to have the same in the future. Cars, houses and vocation houses, trip abroad, legal gambling adventures, multiple credit cards, marginal trading facility, etc... The truth (as I witness in person) is that in wealthier cities like Shanghai/ Beijing, people are now getting all those things. But there are other large cities in different layers, eager and able to follow suits over time

- Export: despite the current turmoil, the strong competitive advantage is still with the Chinese manufacturers. To the extent that that the world will continue to consume (less luxury items but more Walmart nature) and westerns remain too proud and too expensive to physically make the products, the Chinese will continue to rake in money (although with only a meager profit). What's more promising is the Chinese are now gradually moving up the manufacturing chain and start getting into areas that are more value-added and hence with a fatter margin (e.g. Huawei in telecom, MR in medical devices, etc.). In short the Chinese as a dominating export force is not going away

I do mean to say that we should go all-in on China market. Not at all. I am just tired of hearing the doomsayers without real understanding of the issues. Hiccups are of course inevitable along the way, but I am glad to be in this part of the world at this juncture and next decade.

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