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Bullish or bearish on China? For me it depends on whether you're talking short or long term
11/13/2012 8:30 am EST
I understand the reasons provoking the question. It’s hard for me to write positively about Chinese stocks right now without a caveat or three. And I can’t, on the other hand, say that investors should shun all Chinese stocks.
So put me down as ambivalent. And my answer to the question of whether I’m a China bull or bear is a resounding Yes, I’m afraid. I’m bullish or bearish on China depending on what time period I’m looking at.
In the short-term, as China’s leaders re-accelerate the country’s economic growth rate, I’d have to say I’m bullish on China. I think September did mark a growth bottom in GDP. The economy looks likely to show a pickup in growth from 7.4% in the third quarter to something like 8% in the fourth quarter and then move modestly higher from there in the first quarter of 2013.
In the long-term, well, in the long-term I find it hard to ignore evidence that China’s economy is heading to some kind of readjustment. In the long-term logic argues that current big loans from state-owned banks to unprofitable state-owned enterprises at artificially low interest rates that are being used to finance projects that will not generate a positive return on investment will catch up with lenders, state-owned enterprises, and the government that is the final source of the funds. That readjustment could be relatively orderly if China’s leaders move on reforms to the banking sector and bloated state-owned enterprises. It will be chaotic indeed if the country’s leaders dig in their heels against all change and the country has to wait until a crisis forces either reforms or a crackdown on even the current pockets of market capitalism and patriotic dissent. So far, I’d have to say, the proceedings of the 18th Party Congress, which began on November 8, don’t show much in the way of reforms.
Let’s start with the short-term, okay?Data for October released on November 9 make a solid case—when piled on earlier numbers—that September did indeed mark the bottom of China’s growth slowdown.
The National Bureau of Statistics announced that industrial production rose 9.6% year-over-year in October. That was up from an annual increase of 9.2% in September and 8.9% in August.
Retail sales climbed at a 14.5% annual rate in October, up from an annualized 14.2% in September. Investment in fixed assets—infrastructure, industrial facilities, commercial and residential real estate—was up 20.7% in the first 10 months of 2012 when compared to the first 10 months of 2011. That’s a slight uptick from the 20.5% growth rate in the fist nine months of 2012. These numbers, Australia’s ANZ bank calculates, are consistent with 8% GDP growth in the fourth quarter. That would be a substantial step up from the 7.4% annual growth rate recorded in the third quarter and the 7.6% growth rate in the second quarter.
I’m of the firm belief that you can never be too cynical about government economic statistics anywhere in the world—and especially those from China. That these improved growth numbers are arriving just as the Communist Party is installing a new set of leaders isn’t a coincidence. But recent numbers don’t seem to be made up. They’re confirmed by big increases in the production of steel and cement (roughly doubling from levels during the summer) and of electricity (a rough triple.) Those statistics are tougher to fake—which is why non-governmental economists often use them to check on the government growth data. From this perspective, it looks to me like the picture of a Chinese economy accelerating—relatively modestly, to be sure—from a bottom in September seems to be true.
We’ve seen this pattern before, most spectacularly in the huge stimulus package put together by China’s national and local governments and its state-owned banks in a successful effort to keep the country’s economy growing right through the global financial crisis. This time around Beijing hasn’t announced a high profile stimulus package as it did in 2007—but the program has been the same. Lots of lending from China’s banks and lots of spending by China’s national and local governments. The lower profile has been a response to criticism both inside and outside China that the stimulus of 2007 led to an overheating of China’s economy and a spike in inflation that had to be brought under control by stomping on the economic brakes in 2011 and 2012. This time, the country’s new Five Year Plan said, growth would be more balanced: the country wouldn’t rely so much on infrastructure spending and exports but instead would work to increase domestic consumption. Big double-digit wage increases in every year of the plan and increased spending on health care, pensions, and education were part of that re-balancing.
But it looks like when push came to shove, when growth threatened to fall below 7%, the government went back to the tried and true. The railway ministry, for example, got a big increase in its debt ceiling so that it would increase its spending on China’s railroads not one or twice but three times in 2012. Beijing announced that China would build dozens of new airports. Local governments went back into the business of competing to see who could build the most miles of new subways or give the biggest subsidies to companies in targeted industries such as wind and solar.
The big winners have been China’s 145,000 state-owned enterprises. These companies have had access to plenty of capital at low interest rates from China’s big state-controlled banks even as privately owned companies have been starved of capital. Because those low interest rates are essentially a subsidy that pumps up the bottom line, state-owned companies are significantly more profitable—on paper anyway—than private companies. (It doesn’t hurt either that the government has ensured that big sectors of the economy are off-limits to private competitors. That lets state-owned enterprises charge higher prices for their products than that could if they faced market-based competitors.) State-owned enterprises make up about 35% of China’s economic activity and, officially, generated 43% of the economy’s profits.
If you look at the costs of this current round of stimulus, it’s clear why some of China’s leaders were reluctant, initially, to go down this path. Just take a look at the balance sheets of China’s big state-controlled banks. Those banks have been on a lending spree in recent months that puts the cherry on top of the mountain of loans that these banks have extended over the last five years. On current trend, by the end of 2012 Chinese banks, according to Fitch Ratings, will have expanded their balance sheets by an amount equal to the combined balance sheets of ALL U.S. commercial banks. Quite a heavy load for an economy that, on purchasing power parity measures is only half the size of the U.S. economy.
There is good reason to believe this loan-powered growth isn’t sustainable because the returns being earned by the investments financed by this borrowing are falling. According to Fitch Ratings the ratio of loans outstanding to the size of China’s economy held steady at about 1.2 in the years before the global financial crisis. But that ratio has been on an upward march since that crisis until this year loans equal 1.9 times China’s GDP.
Officially, the bad loan ratio at China’s banks is extraordinarily low at an estimated 2%. The official rate is 0.97%, but no one believes that. That figure seems unlikely to be accurate now—and it certainly is headed higher in the future.
China has dealt with a bad loan crisis before in the aftermath of the 1997 Asian currency crisis. Then the government set up new financial companies that bought bad loans from the big banks using a combination of government money and capital raised by selling bonds backed by these bad loans back to the state-controlled banks. Ten and 15 years down the road those bonds themselves were buried through the reorganization of those financial companies or, in some cases, when those financial companies went public.
I’m not sure that same solution would work again because 1) there’s too much leakage in the financial system and 2) banks are significantly more leveraged than they look.
China has kept the interest rates its big banks pay to depositors extremely low so that the big banks can make money on the not-quite-so-low interest loans they make to state-owned enterprises. In effect China’s savers subsidize those loans because they earn so little on their deposits.
Because of that a second financial market has grown up for wealth management products, managed by banks, that pay more than bank accounts do. The amount of money in bank managed wealth management accounts had climbed to 6 trillion yuan ($895 billion) by the end of June from just 1.7 trillion yuan ($254 billion) in December 2009.
You can certainly understand why China’s savers would want to move to higher paying wealth management accounts. But why would banks want to encourage a product that cost them more in higher interest payments? Because, the answer goes, China’s banking regulators have created a massive incentive for banks to push the new products. Banks, the regulators have said, don’t have to put aside any reserves against potential defaults in wealth management accounts. So banks can invest the money in these accounts in loans to risky corporations, to speculative real estate investments, to the favorite projects of local governments—as well as in money market funds and other theoretically “safe” vehicles—that on paper will earn back the higher rates and more paid to wealth management accounts without having to put aside reserves against the possibility that the investments in wealth management accounts will go bad. With loan loss reserve ratios set by regulators in the neighborhood of 20% that’s a big incentive. (Another incentive is that regulatory scrutiny of what is in the pools where wealth management accounts are invested is very minimal—although it does seem to be increasing.)
Rather than answering the question, though, the incentive created by regulators for wealth management accounts really only pushes the question back a level. Why would regulators, some of whom have got to know the dangers in the system they’ve created, put those incentives in place?
Here I’m clearly entering the realm of speculation, but see if this explanation makes sense to you. China’s banking authorities have a big and growing problem. China’s rich are increasingly taking their money out of China. (Guesstimates range from $50 billion to $215 billon. There are no reliable figures, I’m afraid, but the flows seem to be increasing.) Such export of cash is illegal but the rules are easily evaded by anyone with political connections (or the price of a ticket to Hong Kong.) That leakage of China’s wealth is a problem now and will become a bigger problem as the country ages and it needs more and more of its wealth for its own domestic needs. Wealth management accounts are a way that China’s banks can compete to keep some of this money at home. Regulators could, of course, try to stem the flow of money abroad by tightening regulations and enforcing them more strictly, but I think most government regulators understand that taking steps like that against China’s wealthy elite would hardly constitute a career-enhancing move.
If you think this sounds like it all has the makings of a gigantic Ponzi scheme, you won’t be the first to have such thoughts. Even some of China’s banking regulators have voiced worries that the lack of transparency in the investment pools in which wealth management accounts are invested invites that kind of fraud. If no one knows what the pool is invested in, no one can tell if the fund’s reported returns are reasonable or fictions created by paying out part of what new investors put in as investment “returns” to older investors. Regulators are trying to increase transparency to reduce this possibility but I think they’ve got a long road to travel.
So here you come down to the crux of my ambiguity about China. Faster economic growth—even if it’s engineered by unsustainable bank lending and government spending—will produce significant returns to holders of stocks linked to China’s exporting and infrastructure sectors. I’ve mentioned some of those stocks, both inside and outside of China: Jiangxi Copper and Aluminum Corporation of China (ACH) in China, for example, and Vale (VALE) and Freeport McMoRan Copper & Gold (FCX) outside of China. I think you can see the beginnings of that trend over the last couple of weeks or so.
But at some point the lending and spending that sustains this economic growth isn’t sustainable. At some point, the Ponzi-like elements in China’s wealth management accounts do blow up. At some point the cash flows out of the country do become a significant drag on growth.
I think the catalyst for “When?” is demographic. A recent Organization for Economic Cooperation & Development (OECD) report, “Looking to 2060: Long-term Global Growth Prospects,” projects that by 2045 China will have the same dependency ratio as the United Kingdom (39.) The dependency ratio compares the compares the number of people either too young or too old to work with the working age population. A higher dependency ratio is bad since it means fewer workers and more dependent youngsters and oldsters. In 2045, the OECD projects the dependency ratio in the United States will be a relatively lower 35.
History shows that, all else being equal, a higher dependency ratio goes along with a lower economic growth rate. On the basis of demographics, the OECD argues that India and Indonesia will be growing faster than China within the next decade. And that China’s growth rate will slow to 2.3% a year from 2030 to 2060. (The U.S. growth rate will be 2% a year in that period.)
How does this relate to an answer to “When?” It certainly doesn’t say that “When?” won’t arrive until 2030 or 2045 or 2060. If China’s current risky economic policies are in large part a reaction to fears that growth might fall below 7% in 2012, think what pressure China’s leaders will feel as they have to fight against demographic trends that are pushing the country toward 2.3% growth by 2030? The risk of a mistake with big consequences will certainly increase as will trends, such as the flow of money out of China, that make the problem worse.
That doesn’t suggest that “When?” is 2013 or 2014 or even 2015. But it does suggest that China’s growth rate and the potential investment returns are likely to get more volatile as the demographic clock ticks.
Even after the first bounce to “stimulus” stocks fades later in 2012 or in early 2013, I’m still bullish enough on China to want to own the best of the country’s domestic companies such as Home Inns and Hotels Management (HMIN) or Tencent Holdings (TECHY).
But the increasing volatility that I see as China’s leaders struggle with a truly tough set of problems means that I don’t want to treat even those stocks as “buy and forget.”
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund owned shares of Freeport McMoRan Copper & Gold, Home Inns and Hotels Management, Jiangxi Copper, and Tencent Holdings at the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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