The most common argument Our Man hears is a version of “don’t worry about it, China’s domestic consumption is low, and due to the formation of a middle class it’s going to increase so there’ll be loads of domestic demand”. Part of that argument is certainly true, at not even 33% of GDP Chinese consumption is low…very low, and in dollar terms (c$1.25trn) we’re talking about all of those Chinese consumer spending as much as British consumers! However, blithely assuming it’s going to go up (because you want it to) isn’t much of an answer, and Our Man has two major issues:
1). Chinese consumption has declined steadily since the 1980’s when it was consistently in the 50-54% of GDP range. Why should it suddenly rise? I’ve not yet heard anyone say that the Chinese just enjoy saving, more than the rest of us, so we can safely rule that out…though the arguments that they save because of the lack of welfare/social safety net and because investment “crowds it out” have merit. However, the underlying reasons why are important. Of the arguments, I think it’s certainly fair to say that a major reason that investment crowds out consumption is because government policy favors investment; through low interest rates, distorting the way in which credit is allocated (the benefits of being able to tell the banks who to lend to, and how much) and having no great penalty for misallocated investment (the benefits of being State-Owned Enterprises, and not having to survive a capitalist system). It’s pretty clear to Our Man that to change these things, and thus really encourage consumption, we’re not talking about the Chinese making small changes to their financial system but also to the growth engine that’s served them so well recently (and got the bulls so excited). That kind of change doesn’t come quickly and perfectly smoothly!
2). It’s the maths, stupid! For all Wall Street’s preoccupation with modeling and spreadsheets, numbers are tossed around with too little thought. For example, Our Man was having this discussion with a sell-side friend “Consumption fell from 50% in 1990, all I’m saying is that it gets back to 50%. That’s the same as most Asian countries (e.g. Korea, Malaysia, etc) and well less than Europe (c65%) and the US (c70$)”. On the surface it sounds like he has a reasonable point, but does he? Not particularly. For consumer spending to return to 50% of GDP by 2030 (fully 20 years away) would require consumer spending growth to outpace total Chinese GDP growth by 2-2.5% per annum and GDP (ex-Cons Spen) growth by 4-5% each year. How likely is that? Well, bear in mind that the bulls won't consider the quickest option for an increase in consumer spending as % GDP, namely that China's GDP growth rate slows dramatically (or goes negative). Thus we're left with a situation that immediately calls for both China to grow quickly & consumer spending growth to surge, despite the issues mentioned above...and that's not even considering the impact that things to aid consumer spending (like wage increases, or people moving to the cities but then garnering their wage from production of tradable/exportable goods, etc) may have on the rest of the economy. Maybe the Chinese government are just better at managing an economy, and transitioning it from one driver to another, than the rest of the world but that's a lot of faith to base an investment case on.
- Banking Sector & Credit
As mentioned above, one of the advantages the Chinese government has is that they can dictate the amount of bank lending. Like much of the Chinese model, this also subtly implies that the primary driver for financial enterprises (including those private ones) is not entirely profit-focused. Thus Our Man doesn't think it is a massive leap to suggest that if banks are extending credit because they are ordered to there's a decent probability that they're more likely to have more bad loans than if they were driven by considering whether these loans would be profitable. Furthermore, looking historically, the biggest guide to potential bubbles has been the presence of easy credit and while China's lending target of 7trn yuan for 2010 is a decrease from the exceptionally lax 10trn yuan in 2009, it represents a significant increase over any prior year (e.g. 4.9trn yuan in 2008). Additionally, China's been through a non-performing loan crisis before (c10yrs ago)...and the government's response was a glorified version of extend & pretend (in short: govt sponsored AMC's bought the debt, and issued the banks bonds paying 100% and 50% of face value of the debt. The problem being the debt isn't worth 50-100% of face value. So far, as the debt has been liquidated the interest on the bonds has been paid, allowing the banks to treat them as whole, but when the first bond came due in December it was rolled, as the AMC can't pay the principal(!), with a letter of support from the Ministry of Finance.).
- Investment and Resource Allocation
The skepticism Our Man has here is a continuation of those listed above; a significant number of the recipients of the banks' (government ordered) credit are government sponsored/owned entities (again with no focus on profitability). Thus you have creditors (with no focus on profit) lending to borrowers (with no focus on profit) -- a recipe for misallocation of resources and non-performing loans.
Why does this matter? Historically, as noted in part A, China benefited from its investment in capacity by increasing its share of global exports. Now however, China already punches well above its weight in the export markets (it represents a greater percentage of global exports, c15%, than it does global GDP, c8%), but it continues to focus on building yet more capacity with the aim of increasing its exports (irrespective of the marginal returns on such investments in capacity). A recent public research piece from Pivot Capital (here) talks a lot about the fixed capital formation in China, both how it's broadly unprecedented and how it drove a significant portion of 2009's growth.
- Global Trade & Mercantilist Model
It's often said that pictures are worth a 1,000 words, hence Our Man will attempt to curtail his loquaciousness by showing you his favourite Financial picture (from Charles Kindleberger's book "World in Depression") showing what happened to Global Trade during the Great Depression.
Now, take into account the recent rumblings about protectionism and imposition of tariffs on Steel, Tires and Chicken (!), and consider what the impact on China would be if global trade did anything even mildly similar today. Our Man suspects that it's not going to be good for the world's largest exporter, who already has an oversized slice of the pie and is building (potentially rampant) over-capacity.
As an aside, it seems slightly bizarre to Our Man that China seems intent to proceed (at a vastly faster rate) down a similar mercantilist model to Korea & Japan before it, by seeking to become the supplier to the world and generate current account surpluses as a tool/proxy for national power. (In much the same way, as it seems odd to Our Man that the US Fed/Treasury seems keen to mimic Japan's policies of the 90's, in the hope that by doing so in greater size will bring about a different result).
- Reserves and Current Account Surpluses
A recent argument that Our Man encountered is that one should never bet against a country with substantial reserves. This argument is muppetry, at it's finest! Firstly, Our Man has no idea what reserves have to do with anything (with regards to the investment positions mentioned in part C), especially as reserves are a result of the imbalances (i.e. those big current account surpluses over time, from being an exporter) that have helped caused some of the issues. Secondly, even if reserves had anything do with anything, then Our Man would point out that China's reserves are 5-6% of global GDP and the only 2 other times that a single country has had anything similar as a % of Global GDP are.......late 1920's USA and late 1980's Japan! While this doesn't mean that China is guaranteed to face the same market crashes that Japan or the US did at that time, it certainly should debunk the counter-argument that one should never bet against a country with substantial reserves!
- Urbanisation
Another argument that Our Man has heard is that the migration of people from rural areas to the city's justifies the continued increase of real estate (both residential and commercial) in Chinese cities. Our Man has two observations on this; 1). It presumes that the migrant worker can afford the housing being built (which emprically seems somewhat questionable) and 2). building in anticipation of migration of people, by itself, is a weak argument as trends can quickly reverse (or stagnate) causing massive oversupply -- you'd think that the examples of Spain and Florida in the last 3 years would make this palpably obvious, but apparently not.
- Demographics
Look at the 2 pyramids below; China's population in 2010 and 2030 -- what should become immediately apparent is that China's going have a lot more older people (60+) in 20 years time and a lot less young adults (20-35yrs). In numeric form, in 2030: 31.8% of the adults will be 60+ (vs. 17.8% today), only 21.1% will be 20-35yrs old (vs. 32.3% today) AND the adult population will decline by c10%.
That's the result of China's 1-child policy! The impacts of those changes are significant, since it's the 20-35yo cohort that add the most to GDP (think buying first car/house/etc) and one of China's apparent advantages is endless supply of labour. Instead Our Man fears that China will get old before it gets rich.
- Stimulus & Data
The Chinese stimulus in 2009/10 at $1trillion was far larger than the US stimulus, especially when considered as a % of GDP (China's stimulus was 25% of GDP!). Given the impact this had on GDP, it should be no surprise that China showed great growth last year! However, just like the US, the impact of stimulus turns from a positive to a negative on GDP growth rates unless the stimulus is continued/renewed OR private demand steps up to replace it. Separately, there seems to be much teeth-gnashing over the quality of US data (e.g. the BLS revisions on Friday to the payrolls numbers for 2009) yet no such qualms exist over China (despite very strange data, like auto sales up 80% through October...yet gas sales up only 8%).
Next Up: The warning signs Our Man is watching, and trade ideas
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