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First Words and Summary China inc: Bull, Bear and Bottom line introduction: Why China Matters A Matter of Timing 3 4 6
Credit: too Much, too Quickly 8 The Great Credit Leap Forward Bad Debt? Just Roll It Over No Banker Will Come Clean This Year A Less Offensive Four-Letter Word real estate: Can a Bubble Be deflated? 13 Somethings Got to Give A Mens Shirtmaker Diversifies A Quiet New Year for Realtors Breaking a Vicious Circle investment and Consumption: looking for Balance 17 A Case of Diminishing Returns Go Buy a Refrigerator! A Blueprint for Rebalancing Success Bankers Are Shooting Fish in a Barrel Wanted: Carefree Spenders In Search of Luxury Goods Politics: Change is hard 23 The Emperor Is Far Away Vested Interests and Paralysis 300 Million Publishers From Small Piles of Rocks to Oil Shock Tit for Tat in Trade Wars Competiveness: Beyond Cheap labor Of Robots and Old People 27
Neeraj Seth Head of Asian Credit, BlackRock Fundamental Fixed Income Group
Jeff Shen, PhD Head of Asia-Pacific and Emerging Market Equity, BlackRock Scientific Active Equity Group
Markets: Counting on China 29 Equities and Corporate Bonds: A Growing Addiction Commodities: An Outsized Influence Government Bonds: A Big Overhang
The opinions expressed are as of April 2012, and may change as subsequent conditions vary.
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manufacturers. Domestic savers financed China Inc.s master plan by accepting savings rates below inflation, wage increases that lagged economic growth and a minimal social safety net. This is changing, but powerful interests are stacked against a true shift to a consumption economy: exporters, state enterprises and local governments. } Chinas new leadership could take the tough measures needed to engineer a shiftliberalizing interest rates, opening capital markets, market pricing of resources, and building out social services. But Beijing is not almighty; local governments tend to go their own way and a desire for consensus has often resulted in political paralysis. Risks of a popular revolt or foreign conflicts are low as the one-party state has kept a tight lid on dissent and is focused on fulfilling its domestic social contract. } Real wage growth, rising materials costs and environmental restrictions are changing the workshop of the worldfor the better. Some labor-intensive industries are moving elsewhere and automation is increasing. There is room for more productivity growth even as the easy gains have been harvested. Protection of intellectual property is still weak and global brands have yet to emerge, but we believe chances are China will remain competitive and confound the doomsayers.
Bull Case
It is easy to pave over financial problems in the short term, Beijing has plenty of firepower for bailouts. Growth in local government debt has come to a screeching halt. China has proved many times it can fix its banks when needed. The same team that engineered a doubling of annual credit to 14 trillion RMB during the financial crisis can pull the strings in a different direction.
Bear Case
Banks non-performing loans have fallen by 97% in the past decade, but this masks a poisonous reality: Unpaid loans are rolled over. Debts of state enterprises and, to a lesser extent, of local governments appear to be ticking time bombs. Banks are bleeding deposits and luring customers with asset-backed securities. (Hmmm, what kind of assets?) Banks are lending to all the wrong people: lumbering state giants and developers. Banks are bad at risk management. Local governments, banks and companies all bet prices would keep rising and are overexposed. Real estate has been the driver of economic growth. Homes are too expensive for average earners. Overbuilding has resulted in ghost cities and a huge inventory of unsold properties. Beijing may not be able to arrest a vicious cycle of lower prices and lower sales.
Urbanization and the desire for upgrades provide steady demand. Affordability is improving due to falling prices and rapid real wage growth. Buyers pay a majority of the purchase in cash, so price declines will not hurt the financial system. Savers have few other places to park their cash. A push on low-end social housing will keep the construction industry busy.
Is there such a thing as too much investment? Capital stock is not yet excessive by international standards, and China needs investments in infrastructure and automation to keep up productivity growth. Consumption is rising rapidly, and half of households will soon classify as middle income. Rural wages are growing faster than urban ones, making for more balanced development. Building out a social safety net would unleash a pile of precautionary savings for illness and old age. The Communist Party arguably is built for stability: It knows internal strife can result in Cultural Revolution-type horrors. Regimes historically have faced popular revolts only when incomes reach the worlds median: China has a long way to go there. Beijing has kept a tight lid on internal dissent and has not had a major overseas confrontation in the last 30 years.
Investment is a case of diminishing returns: It takes $5 to generate $1 of GDP growth. The model is based on an undervalued currency, low real wage growth and financial repressionfactors that policymakers are loath or unable to change. Chinas command economy appears ill-equipped to stimulate consumption. Much industry would collapse without below-cost energy and interest rates. Vested interests will work hard to torpedo a shift to a consumption model. Commodities demand is at risk. Watch out, Australia. All politics are local. It is an uphill battle to effectively steer the country toward a new course. China has not done enough to improve the environment, curb corruption, address the widening inequality gap and stimulate consumption. The leadership often is paralyzed because it is pulled in too many directions. Chinas military build-up could set up the world for a major confrontation down the road.
Political Risk
Competitiveness
Chinas value-added exports are increasing and industries are investing in automation to stay competitive and improve quality. China is filing more patents and is now dominating industries of the future such as solar power. The country has a first-class infrastructure. The migration of labor-intensive industries to Vietnam, Cambodia and elsewhere is a good thing.
Heavy subsidies have thwarted competitiveness and innovation. Violations of intellectual property rights still occur. The easy productivity gains have been harvested, and wage growth is a problem. China has yet to develop real brands.
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Bottom line
We expect a soft landing in 2012. Longer term, the financial system represents the biggest risk to the economy, we believe. The sheer magnitude and pace of credit growth does not pass our smell test.
Bull
Bear
} } } } } } } Inventories, sales volumes and price trends Ratio of new construction vs. sold floor space Debt and stock prices of major developers and consolidation in the sector Policy actions such as property taxes or, conversely, more curbs Sales of construction machinery and durable household goods Sales and volumes in secondary and tertiary cities Granting migrant workers urban residency permits so they can own homes
Real estate is the No. 1 threat to Chinas growth this year because the sector is so interwoven with the rest of the economy. Supply and demand should balance out in the long run. The lack of leverage is a big positive.
Bull
Bear
} } } } } } } } Monthly retail, auto and luxury sales Consumption share of GDP and GDP growth, and real wage growth Raw materials imports, energy subsidies and commodities prices Import/export trends (beyond one-month aberrations such as this February) Loosening the currency peg and opening capital markets Privatizing state enterprises and liberalizing interest rates New sources of local government financing Macau gambling revenues and capital flows
A pullback in consumption in the wake of falling real estate prices and slowing export growth is a major risk this year. Longer term, a big worry is that a rush to rebalance could lead to an economic implosion.
Bull
Bear
} } } } } } } Political unrest beyond local flare-ups Food price inflation, unemployment and rising inequality Efforts to curb corruption, protect the environment and ensure food safety High-profile casualties of the upcoming leadership change such as Bo Xilai Restrictions on social networks such as Weibo Confrontations in the East China Sea with other Asian countries or the US Increased secessionist and religious militancy
A one-party system is geared to retain its hegemony and ensure stability. The upcoming once-a-decade leadership change is hairy. Bo Xilais downfall is the tip of the iceberg, and one that is freezing policy for now.
Bull
Bear
} } } } } } Productivity and real wage growth High-end machinery orders R&D spending and patent applications Trends in returns of Chinese who have studied abroad Emergence of domestic and global Chinese brands Protectionist actions by Chinas trade partners
Loss of competitiveness is the lowest risk to the economy this year and beyond. China already is moving up the value chain.
Bull
Bear
A Heavy Burden
Chinas Share of expected 2012 global economic growth
China 40% Rest of Asia 24% Other Emerging Markets 17% US 17% Other Developed Markets 2%
a Matter of timing
Real reforms to rebalance Chinas economy are on hold this year because of the once-a-decade leadership change. An imminent collapse is unlikely, we think. The current leadership will not go out with a bang, but certainly does not want a train wreck during the final stages of stewardship. Business cycles exist in China as elsewhere but we expect a soft landing in 2012.
Source: Deutsche Bank (January 2012). Note: Assumes global economic growth of 3.2% in 2012.
Flattening Out
Sales of heavy Machinery and autos 100
UNITS (THOUSANDS)
250%
UNITS (THOUSANDS)
150% 120
Y-O-Y GROWTH (%)
Sources: Bank of America Merrill Lynch, China Construction Machinery Institute and China Association of Automobile Manufacturers. Notes: Machinery sales data through January 2012. Auto sales data through February 2012.
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In this interim period, it is important to read the economic tea leaves. Real estate prices, sales and construction are important ones. Politically sensitive food inflation is another one, as are manufacturing gauges such as the various purchasing manager indexes (PMIs). At the start of 2012, the data were both conflicting and skewed by the effects of the early lunar New Year holiday. Real estate and key consumption indicators pointed down, while other gauges pointed up. For example, sales of heavy machinery used in construction, such as excavators, crashed. Auto sales flattened, pointing to a general slowing in the wider economy. See the charts on the previous page. By contrast, transport volumes are strong. And a gauge of small business activity has been ticking up. See the chart below. This is important because small businesses employ 60% of Chinas workers and make up 90% of companies. The rebound could indicate the governments easing policy on liquidity has started to work. Bank credit enabled large companies to pay their supplier bills. Secondly, it could mean the bottom has not fallen out of exports because many small companies are exporters.
Like some corporate chieftains, China likes to manage expectations by under-promising and over-delivering.
Premier Wen Jiabao set a 7.5% annual growth target for 2012 in Marchthe lowest rate in almost a decade. Most China watchers, however, believe the country will want to achieve at least 8.5% a year. Official targets exist to be beaten. Like some corporate chieftains, China likes to manage expectations by under-promising and over-delivering. It is realistic to expect China to move toward economic growth of 6%-7% a year this decade versus the 10%-plus clip in the old days, we believe. Five reasons: } The political leadership appears to understand the drawbacks of too much credit. } Slow growth in the debt-ridden developed world likely means slack demand for exports. } The real estate boom has ended because tightening measures have taken hold. } Infrastructure spending is slowing as policy shifts from favoring bridges for the masses to pills for the people. } Savings ratesthe fuel of deposit and loan growthare likely to remain flat or drop from mind-blowingly high levels. Beijing is expected to arrest this years slowdown in growth
A Ray of Light
Chinas Small Business PMi, 2011-2012 60 58
SMALL BUSINESS PMI
with all sorts of administrative and fiscal measures, while at the same time trying to keep a lid on inflation and prevent more bad debts that eventually could overwhelm the banking system. Most people, perhaps too many, believe Beijing will walk this tightrope. At US investor gatherings in late February, one Wall Street firms China strategist polled the audiences and found just one bear among roughly 1,000 people. This lonely creature contrasted with a host of cubs the previous year. Beyond 2012, the picture becomes very different. It is now clear Chinas 2009 stimulus was too much, in too short a time. Beijing overestimated the US recessions fallout. The result is a pile of debtwhich looks ready to fall over in the next few years (or
Source: China Federation of Logistics and Procurement. Note: Data through February 2012.
Most people, perhaps too many, believe Beijing will walk this tightrope.
Chinas hard-pressed consumer and unprecedented investment boom later. In this chapter, we review the credit boom these savings helped create.
Armed with a reliable supply of cheap deposits, banks went on a lending binge. The biggest beneficiaries were state-owned enterprises (SOEs) and local governments.
99
01
03
05
07
09
11
The first group revved up exports and capital expenditures even more, supported by cheap credit and subsidized energy costs. It was a lifeline to many enterprises that had no business staying in business.
Source: Peterson Institute for International Economics. Note: Data through December 2011.
50%
CREDIT GROWTH TO GDP (%)
40 30 20 10 0 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Other
3,000 0
Sources: Carl Walter, Su Ning, China Bank Statistics and Peoples Bank of China.
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The second group financed infrastructure works, office towers, conference centers and an array of faux landmarks, from Chengdus Dorchester-inspired British town to Venetian canals and a replica of St Marks bell tower at the New South China Mall in Dongguan. This helped inflate an emerging real estate bubble. Credit grew and grew ... until a great leap forward in 2009. Worried the world financial crisis and subsequent US recession would hit China hard, Beijing engineered a huge monetary stimulus. Credit doubled to a clip of at least 14 trillion RMB a year. See the chart on previous page. Credit grew at an compounded annual growth rate of 36% in the period 2004 to 2010. As a result, the total value of bank loans and bonds quickly exceeded GDP. See the chart below.
It is unlikely China will let the market collapse. Nobody wants to see a local government default or a big state firm go belly up.
A bank CEO in a coastal city may say his operation is lending 100% of deposits, no problem. He gets away with it because his bank is part of a national network that (still) has enough deposits in the interior to make up for shortfalls on the coast. The government may abolish this cap because it has many other ways to control loan growth, notably its stranglehold on interbank market. Everything appears just hunky-dory for Chinas banks: Nonperforming loans (NPLs) fell by 97% over the past decade and now average just 1% of the loan book. See the chart below.
35%
NON-PERFORMING LOANS (%)
120 100 80 60 40 20 0
30 25 20 15 10 5 0
Bonds
98 99 00 01 02 03 04 05 06 07 08 09 10 11 Sources: UBS, Peoples Bank of China, China Banking Regulatory Commission and CEIC. Note: Data before 2002 only cover the Big-4 state-owned banks.
This is where the problem lies: Take a machine that runs along at a steady pace, suddenly inject adrenaline and order: Go lend. The sheer magnitude and pace of this unbridled credit growth does not pass our smell test. It suggests to experienced investors there has to be trouble somewhere, sometime.
This is dangerous, especially because both local authorities and SOEs are already deep in debt. It is unlikely China will let the market collapse, though: Nobody wants to see a local government default or a big state firm go belly up. There is nothing subtle about the government guarantees of these entities. High-profile bankruptcies just do not fit into China Inc.s master plan of economic growth and employment. And banks are very much part of the plan. Banks are, after all, an extension of the fiscal policy. This is also the reason they trade at such low valuations.
Take a machine that runs along at a steady pace, suddenly inject adrenaline and order: Go lend.
[ 10 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
have deteriorated across the industry in the past three years, with many second-tier banks already facing shortfalls, according to ratings agency Fitch Ratings. Do not expect any banks to come clean this year. Bank chieftains angling for government positions in the leadership change will want their records to remain squeaky clean. Put yourself in the position of a bank CEO. You have been presiding over five years20 quartersof profit increases. Now you are gunning for that position in the State Council. Are you going to bring down your profits this year by increasing provisions? Just to be prudent? Chances are you will not. You leave it for the next guy to deal with.
Looks Familiar?
investment in asset-Backed Securities Quadrupled, 2007-2011
ASSET-BACKED SECURITIES (RMB MILLIONS)
To be sure, there are plenty of deposits. They are just not for lending. One example: To recycle the inflows of foreign exchange and prevent the RMB from appreciating, the central bank obliges banks to hold vast quantities of reserve bonds yielding only 1.5%. This deflates the money multiplier and kicks sand into the engine of a credit-led economy.
8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2007 2008 2009 2010 2011
Bank chieftains angling for government positions in the leadership change will want their records to remain squeaky clean.
In all, the Triple R (Required Reserve Ratio) and other measures tie up some 10 trillion RMB of deposits. This has given the central bank the means to provide stimulus when the economy needs it. Every cut in the Triple R pumps some 380 billion RMB into the system (provided the cuts are not offset by capital outflows). This doesnt mean SOEs and other politically connected players have a tough time getting credit. Not at all. They are issuing bonds like there is no tomorrowforced down banks throats at slightly higher rates than one-year deposit rates. The result is a huge debt capital market where very few trades take place. Why? If a bank sells these bonds, it is almost guaranteed to take a loss because nobody wants them at the price the bank paid for them. Bottom line: The corporate bond market is bank lending in disguise. The bulls believe China has proved again and again it can fix these problems. The basic argument goes like this: Chinese banks go bust every decade, but the country has just found a much better way to deal with it than the West. Conclusion: Any weakness in the financial system will be dealt with quietly.
Sources: Carl Walter, Wind Information and Fitch Ratings. Note: Data through June 30, 2011.
Deposits from corporations under cash flow pressure (and with the ability to export capital by padding overseas invoices) dwindled to near zero in the first nine months of 2011, compared with growth of 3.7 trillion RMB in 2010. In the third quarter alone, corporate deposits of an estimated 1 trillion RMB vanished into thin air. Combined with the strangle of rising reserve ratios, growth in the M1 money supply has dwindled to a clip of 3%-4%. Moreover, deposit outflows have triggered a slow-motion cash crunch. Smaller banks in particular are vulnerable, partly because their loans are coming due earlier. Operating cash reserves
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23 Provinces 5 Autonomous Regions 4 Municipalities (Beijing, Shanghai, Chongqing, Tianjin) 2 Special Administrative Regions Incorporated 6,500-8,200 LGFVs
Equity/Loan Injection
Cash Investments
2,858 Counties
40,858 Townships
time bomb, especially at a time a main source of local government revenuesland saleshas dried up amid falling real estate prices.
The bulls believe China has proved again and again it can fix these problems.
LGFVs have taken out trillions of RMB in loans backed by land sales. China bears have long argued this represents a ticking
[ 12 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
35%
2,500
RMB BILLIONS 600 TOTAL DEBT (RMB BILLIONS)
3,000
24.5%
30
2,000 1,500 1,000 0 Local Govt. Revenues Asset Sales Over-Provision for NPLs Recoveries on Projects Potential NPLs Local Govt. Bond Central Govt. Support
600
2,500
25
PERCENT DUE (%)
2,000
17.2%
20
1,500
11.4% 9.3% 7.5%
15
Write-Offs
1,000
10
500
Source: Deutsche Bank estimates. Notes: Assumes 30% of LGFV loans default. Assumes local governments sell 10% of assets and divert 2% of revenue.
Sources: Deutsche Bank and National Audit Office. Note: Data as of year-end 2010.
Even if 30% of all LGFV loans default, the problem is manageable, according to Deutsche Bank. Local government bond issues, asset sales and diverting 2% of government revenues would solve most of the problem in its view. See the chart above.
In addition, most LGFV debt is spread out after scaling a renewal hump last year, with almost a third due only after 2016. See the chart above.
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100%
Shenyang SHARE OF POPULATION (%) Beijing Tianjian Xian Nanjing Shanghai Chengdu Wuhan Chongqing Guangzhou Hangzhou
80
745 mln
467 mln
60
490 mln
790 mln
40
960 mln
20
62 mln 172 mln
562 mln
1950
1978
2005
Rural
2025
Urban
Sources: ISI Group, CEIC and National Bureau of Statistics. Note: Numbers in millions of people.
Rapid urbanization drove Chinas housing boom for much of the 2000sand is likely to do so in the future. China is expected to have almost one billion urbanites by 2025. It already has 214 metropolitan areas with more than one million people, four times as many as the United States. See the chart above. Many Chinese already owned their homes, but often these were shacks or rural dwellings. There was definitely a need to upgrade, and many households did just that. Then savers desperate for yield and hard assets started to snap up apartments. Where else could they go? Banks offered negative real interest rates. The stock market was perceived as a big high-roller table at best. And offshore markets wereand arepretty much shut.
Other speculative bubbles built in jade, art and gold prices, but there was nothing like real estate.
[ 14 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
Local governments did their part to support the boom by providing infrastructure and sponsoring grandiose projects. They bought farmland at artificially low prices and sold it for a profit to developers. Over time, local governments became addicted to these land sales as a source of revenues. And the practice to appropriate land became the root cause of periodic local outbreaks of social unrest. Real estate has been a great wealth creator, for companies, local governments and individuals alike. The top source of wealth among Chinas richest 1,000 people is real estate, according to the latest ranking by Hurun Report Magazine (which was appropriately sponsored by the Hainan Clearwater Bay luxury development). No wonder those feasting want the banquet to continue.
The risk to housing in China is not so much its imminent collapse, but how ubiquitous other segments of the economy are exposed to it.
Sales volumes and prices fell after government measures to dampen speculation and prevent prices from spiraling beyond the reach of the emerging middle class. There are some tentative signs of bottoming (see the charts below), especially in secondand third-tier cities where people buying homes for themselves are a more important source of demand than investors.
Sales volumes and prices fell after government measures to dampen speculation and prevent prices from spiraling upward.
Bubbles involving real estate are quite common. This seemed to have all the signs, including the endemic involvement of local governments and the corporate sector. It is clear the boom cannot last. (Nor does Beijing want it to last.) Consider: } Chinas residential housing construction equaled almost 10% of GDP in 2011, compared with 6% for the US economy during the height of the boom in 2005. } Real estate accounted for 40% of urban household wealth in 2010, double the proportion in 1997, according to Peterson Institute. It is hard to imagine it doubling again in the next decade.
150% 120 90 60 30 0 -30 -60 -90 2007 2008 2009 2010 2011 2012 2010 2011 2012
Volume Growth Weekly Sales Prices
Sources: Deutsche Bank and Soufun. Notes: Price and sales volume trends in 39 major cities. Volumes represent year-over-year growth in four-week periods. Data through March 2012.
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11
FACTOR OF HOUSEHOLD INCOME
10
+1 Standard Deviation
Source: Deutsche Bank. Note: Weekly data through March 18, 2012.
One example: The CEO of a mens shirtmaker says he expects 100 billion RMB in revenue in three years, with the core shirt business making up just 1%. It is tough to make money in the apparel business, so the CEO is building a 400-meter office towerthe highest in his cityand outlet malls. This particular CEO is not alone. He illustrates how real estate runs through the entire economy. It is not about a few developers going bust. It is about local governments. It is about the entire corporate sector. It is hard to see a happy ending here. We struggle to find a precedent in history where the bursting of a property bubble did not lead to financial distress.
Anecdotal evidence abounds: Coffers with cash in Macau and Hong Kong. Record real estate prices in Vancouver. Australian mines and vineyards snapped up by Chinese buyers. Once people start believing prices will keep falling, they stop buying. Just 19% of people expected housing prices would go up in the first half of 2012, down from around 45% in 2009, according to a December Peoples Bank of China quarterly survey. The same survey showed 21% expected prices to fall and 46% anticipated a flat market. Things looked pretty grim in the first quarter. For example, not one transaction closed in Beijing, a city of 20 million, during the entire Chinese Year of the Dragon celebrations, according to JPMorgan. Overall, transactions have plummeted and inventory has risen to 15 months worth of sales. See the chart above on the left. The inventory may be understated as the gap between floor space under construction and the amount sold is huge: 1.9 billion vs. 1.1 billion square meters in 2011. The gap is slowly closing, but there is a big overhang. And new construction usually lags six months behind trends in real estate sales.
Once people start believing prices will keep falling, they stop buying.
[ 16 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
Commercial real estate is hit hardest, especially in second-tier cities. Chongqing, for example, will have nearly 800,000 square meters of new commercial space in 2012, whereas the annual take-up has been just 150,000 square meters. The government has started to offer incentives for first-time home buyers, including lower mortgage rates combined with guidance to banks to lend to this group. It could ax deed taxes and even cut mortgage down paymentsalthough it would not resort to the latter measure lightly.
The question we ask ourselves is: Suppose the government took its foot off the brake; could it reignite demand in housing?
population, or 200 million people, live in cities but do not have a proper registration. Another avenue is the push toward low-end social housing. This will not do much for prices of high-end private homes, but it does serve the dual purpose of creating affordable housing for the masses and keeping the construction industry going. Expect social housing construction to almost double to more than seven million units this year, according to Bank of America Merrill Lynch. The market is starting to believe the magic of policy. Bonds and shares of Hong Kong-listed developers rose sharply at the start of the year. One company even raised new equity. The triumph of hope over experience? Only time will tell. It is clear the government is not ready yet to reverse its housing policy. Premier Wen Jiabao in early March emphasized house prices were still too high and that relaxing existing curbs could cause chaos. This dampened investor hopes for a policy reversal and caused stocks to post their biggest daily loss in months. The questions we ask ourselves are: Suppose the government took its foot off the brake; could it reignite demand in housing? And suppose the paralysis in policymaking lasts long enough to destroy confidence in real estate as an inflation hedge?
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The country is becoming less efficient in turning credit growth into economic growth. It needs ever more gasoline in the tank to make the car go down the highway at the same speed.
You might ask: Is there such a thing as too much investment? (Especially if you live in a place in desperate need of an infrastructure upgradeand many of us do.) The answer is: Yes. It has taken China $5 of investment to generate $1 of GDP growth since 2001, 40% more than Japan or South Korea in their takeoff periods, according to the International Monetary Fund. The country is becoming less efficient in turning credit growth into economic growth. It needs ever more gasoline in the tank to make the car go down the highway at the same speed. We believe this is unsustainableand a real worry. This is even truer if you accept some analyst views that Chinas subsidies and production input advantages represent more than half of the return on invested capital. Demand for raw materials, especially cement and steel, may peak earlier than many expect. See the table below. China is now using 590 kilos of cement for every $1,000 of capital formation, compared with 155 kilos in South Korea and just 29 for the United States, according to Deutsche Bank.
45
Accumulated Chinese consumption to 2010 Accumulated consumption peak in Japan and United States
40
Average = 37.1%
Projected peak consumption year Projected peak year consumption Projected increase from current levels to peak year (%) Source: Deutsche Bank. Note: All data in kilos per capita except where noted.
35
30 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Sources: Peterson Institute for International Economics and National Bureau of Statistics.
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Year 2005 2006 2007 2008 2009 2010 Total (2006-2010) Growth Rate (2006-2010)
Sources: ISI Group and CEIC. Notes: Conventional rails exclude rolling stocks & locomotives. High-speed rails include new capital construction. Airports exclude aircraft and other special vehicles. Growth rates are compounded.
To be sure, investment in infrastructure is still needed to secure energy, conserve water and connect Chinas interior to the coast and the world. In the past decade, about 50% of investments have gone into transport. Expect less spending on transport in the future, especially on high-speed trains after recent mishaps, and more on nuclear power and water conservation. See the table above for past spending trends.
In addition, Chinas capital stockthe countrys highways, ports, rail tracks, airports and factoriesis still far below that of the United States, Japan and South Korea on a per capita basis. Even as a percentage of the relatively small economy, capital stock has not been excessive. See the charts below.
325
CAPITAL STOCK PER CAPITA ($) CAPITAL STOCK TO GDP (%)
120,000
300
90,000
275
60,000
250
225
30,000
200 78 82 86 90
China
0 94
US
98
02
06
10
1995
China
2000
US
2005
Japan
2010
South Korea
South Korea
Sources: HSBC, CEIC, Bureau of Economic Analysis and Japans Cabinet Office. Note: Per capita figures in constant 2005 US dollars.
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go Buy a refrigerator!
The mirror image of the investment boom is subdued consumption. Consumption has grownwe have all heard about the excesses but not as fast as GDP. As a result, it made up barely a third of the economy in 2010. To many economists, this number is surrealit is something you just never see. The contribution of consumption to GDP growth also remains extraordinarily low. See the chart below.
12 9 6 3 0 -3 -6 96 98 00 02 04 06 08 10
Exports
12
estate taxes pioneered by Shanghai and Chongqing. } arket pricing of resources: electricity prices are M artificially low to protect manufacturing, which uses the brunt of electric power. expectations for reform are massive, but do not hold your
Consumption
Investment
Highly unusual? Yes. Damaging? Probably. The internal imbalances are reflected externally, with Chinas trade surplus and foreign currency pile ever increasing. Leaving prescriptions for debtor nations such as the United States aside, everybody agrees China has to rebalance its economy toward consumption. Can a command economy successfully make such a shift? It is tough. A command economy is very good at investing. The order build a highway comes down, and it gets done. It is much harder to say go buy a refrigerator, and get much traction. Any moves toward a consumption society are likely to be gradual and slow. This is a good thing. Suddenly taking away industrial subsidies such as below-cost loans and electricity, for example, would create a train wreck. Similar to how a July 2011 deadly accident near Wenzhou upended Chinas ambitious plans for a high-speed rail network, a big economic downturn could set back the clock on any moves made to favor consumers over manufacturers.
breath this year. the once-a-decade leadership change is putting the big decisions on hold. it is more about what Beijing wont do than what it can do for now. the February 2012 China 2030 World Bank report hits many of the right buttons. Many recommendations have been on the agenda for years, but nothing has happened. the main reasons are twofold: Powerful forces, including local governments, exporters and banks, support the investment model. and a consensus-driven leadership tries to placate too many interests.
Similarly, a rush to rebalance could trigger a spike in inflation around the world. For years, China exported deflation by providing consumers elsewhere with goodies that became cheaper and better over time. The secret sauce consisted of low wages, a low exchange rate and investment-driven jumps in productivity, such as better and cheaper transport. Change the sauces ingredients, and the world is looking at a very different dish.
[ 20 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
food price inflation triggered by surging pork prices. The CPI short for Consumer Pork Index in Chinahit 6% last year but has receded since. The governments 2012 inflation target of 4% on March 5 beat expectations, leaving more room for fiscal and monetary stimulus. In other areas, China is slowly making progress. For example, Beijing has deliberately been punching (small) holes in its Great Wall of capital controls. All companies authorized for foreign trade can now settle payments in RMB; qualified foreign investors can invest in Chinese securities; and central banks from Japan to Nigeria are adding RMB and Chinese bonds to their reserves.
This is a huge middle income class with money to spend. Supposedly, the most popular phrase in China is: New Louis Vuitton opening soon. There may be some truth to this.
350,000
300,000
ANNUAL HOUSEHOLD INCOME (RMB)
250,000
200,000
12 9 6 3 0
150,000
Total income of households in top bracket by 2015
100,000
50,000
0 0% 20
2005
40
2010
60
80
2015 (Forecast)
100
97
99
01
03
05
07
Urban
09
Rural
11
POPULATION (%)
Sources: CLSA and CEIC. Note: Income growth rates in real terms. Rural is growth in net income. Urban is growth in disposable income.
[ 21 ]
Incomes are now growing faster in rural areas, reversing a long trend of faster rising urban wages. See the chart on the previous page. This caused many coastal employers this year to anxiously await the return of migrant workers from visiting family over the New Year holiday. Some never did. Nearby family, low costs of living and now faster wage growth are big attractions of the interior. This trend bodes well for a more geographically balanced economy.
Income is one thing. Getting people to spend is another. China has become a lot richer, but savings have gone up even more. See the chart on the left. Financial repression is one reason for the high savings rates, as we have seen. In addition, people set aside buckets of money to pay for retirement and illnesses. The lower the interest rate on deposits, the greater the amount of savings needed to create a selfdirected social safety net. Building out social security programs would reduce the need for these precautionary savings.
There are plenty of other reasons to establish provisions for the elderly. China is grayingfast. The country will have 300 million people aged 65 and over by 2050. See the table below.
40
Average = 36.4%
35
30
2050
40%
30
110
20
100
10
90 95 97 99 01 03 05 07 09 11
0 94 96 98 00 02 04 06 08 10 12
Sources: ISI Group and National Bureau of Statistics. Notes: Retail sales consist of all purchases by individuals, organizations and government. Consumer confidence data through January 2012. Retail sales growth through December 2012.
[ 22 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
LuxuryAt a Price
tax rates on luxury goods in Selected Countries China Coach Handbag Porsche 911 Rolex Watch Lancme Perfume 27% 82% 47% 57% uS 8% 11% 15% 8% hong kong 0% 90% 0% 0% Singapore 7% 134% 7% 7%
Sources: Deutche Bank and Central University of Finance and Economics. Note: Tax rates include import consumption tax, VAT/GST and import tariffs.
Chinese tourists mob upscale department stores around the world because prices are cheaper overseas (and you have a better chance of buying the real thing). Some 70 million mainland Chinese traveled outside the country in 2011, spending about $70 billion, according to the China Outbound Tourism Research Institute. Duty cuts on luxury goods would serve to boost consumption, give domestic retailers a shot in the arm and reduce the trade surplus. It is a bit of a political football, though, as duty cuts are seen as only benefiting the very wealthy.
The economic bar is high in China. Sales are still rising at a rate retailers in the developed world would kill for.
[ 23 ]
The leadership change is a complex game of musical chairs that is likely to last well into 2013.
municipal politics such as the events in Chongqing discussed earlier can take on national and international significance. The leadership change is a complex game of musical chairs that is likely to last well into 2013. The clear aim is to have the process take place with caution and consensus building rather than prolonged and public tree shaking. That said the markets will watch closely to see if this morphs into policy delays and subsequent changes in investment risk.
An Almighty Party
Chinas Political and leadership Power Structure
Discipline Committee
Politiburo
Party Elders
State Council
Armed Forces
Influence
Control
[ 24 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
China may not be a formal democracy, but the Communist Party has a clear social contract with the population to deliver growth.
[ 25 ]
In the immediate term, two risks loom large: First and most important is a potential oil price shock. Sustained high oil prices would kill global growth and simultaneously drive up Chinas production costs and energy subsidies. A trigger could be an Israeli attack on Irans nuclear installations. Or it could be something we have not yet thought about.
Expect trade brawls to flare up more often, and China to stand alone more often.
The rest of Asia is viewing Chinas military built-up warily, however. Chinas military budget is expected to double to $238 billion a year by 2015, according to HIS Janes Defense weekly. This is still less than half the (shrinking) US defense budget, but Chinas increasing military prowess is causing anxiety among its neighbors. In addition, US President Barack Obama recently turned his focus to the Pacific, potentially setting the superpowers up for conflict. The longer-term risks are competing adversarial power blocks in the region, warns one of the architects of the opening of China, Henry Kissinger, in a 2012 article in Foreign Affairs. This need not beif both countries set aside rivalries and make genuine efforts at cooperation, Kissinger believes. Another long-term risk is conflict with India over water. Both countries derive much of their fresh water from the Himalayas.
[ 26 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
exports to
$68,088 $49,717 $31,143 $27,659 $18,177 $14,306 $5,507 $3,959 $2,514 $1,993 $1,959 $1,854 $1,843 $1,385 $1,348 $988 $677 $233,118 $311,342 4.3% 3.1% 2.0% 1.8% 1.2% 0.9% 0.3% 0.3% 0.2% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.0% 14.8% 19.7% Germany France Italy Belgium
imports From
$74,391 $17,107 $14,006 $7,828 $6,479 $6,227 $4,237 $4,034 $3,409 $1,790 $754 $569 $390 $258 $177 $177 $17 $141,851 $168,484 5.3% 1.2% 1.0% 0.6% 0.5% 0.4% 0.3% 0.3% 0.2% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 10.2% 12.1% Germany
total trade
$142,480 $56,196 $45,149 $44,766 $24,403 $22,134 $9,541 $6,091 $5,402 $4,350 $3,749 $3,268 $2,413 $1,562 $1,366 $1,246 $854 $374,969 $479,826 4.8% 1.9% 1.5% 1.5% 0.8% 0.7% 0.3% 0.2% 0.2% 0.1% 0.1% 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 12.6% 16.1%
Balance With
Netherlands Italy Spain France Belgium Greece Portugal Finland Cyprus Malta Slovenia Luxembourg Estonia Slovakia Ireland Austria Germany Eurozone EU $43,239 $17,137 $11,950 $10,552 $6,478 $3,569 $1,760 $1,473 $1,331 $1,274 $1,209 $730 $500 $168 ($1,417) ($2,383) ($6,303) $91,267 $142,858 23.4% 9.3% 6.5% 5.7% 3.5% 1.9% 1.0% 0.8% 0.7% 0.7% 0.7% 0.4% 0.3% 0.1% -0.8% -1.3% -3.4% 49.5% 77.4%
Netherlands Italy France Spain Belgium Finland Austria Ireland Greece Slovakia Portugal Malta Slovenia Cyprus Luxembourg Estonia Eurozone EU
Netherlands Spain Austria Finland Ireland Slovakia Portugal Malta Greece Luxembourg Slovenia Estonia Cyprus Eurozone EU
exports to
$283,375 $218,380 $121,156 $68,818 $40,920 $38,790 $32,374 $29,693 $29,615 $27,234 $890,355 18.0% 13.8% 7.7% 4.4% 2.6 % 2.5% 2.1% 1.9% 1.9% 1.7% 56.4% Japan Korea Taiwan US Australia Malaysia Brazil Thailand
imports From
$176,785 $138,423 $115,649 $102,060 $60,340 $50,396 $38,038 $33,201 $32,862 $25,814 $773,569 12.7% 9.9% 8.3% 7.3% 4.3% 3.6% 2.7% 2.4% 2.4% 1.9% 55.5% US Japan HKG Korea Taiwan Australia Malaysia Brazil India SGP Total China
total trade
$385,435 $297,941 $230,650 $207,241 $145,341 $87,575 $74,216 $62,504 $61,787 $57,053 13.0% 10.0% 7.8% 7.0% 4.9% 2.9% 2.5% 2.1% 2.1% 1.9% HKG US UK India UAE Malaysia Australia Japan Korea Taiwan
Balance With
$206,109 $181,314 $27,481 $20,053 $16,863 ($26,577) ($33,106) ($55,629) ($69,605) 111.7% 98.3% 14.9% 10.9% 9.1% (14.4%) (17.9%) (30.1%) (37.7%)
($85,956) (46.6%)
$1,578,447 100.0%
$1,393,909 100.0%
Sources: ISI Group; CEIC; General Administration of Customs. Notes: Figures in millions of US dollars. Percentages are the share of Chinas total.
[ 27 ]
55 50 45 40 35 30 00 01 02 03 04 05 06 07 08 09 10 11
Value-Added Exports Processed Exports
In all, chances are China will overcome competitive pressures. It may even emerge stronger. Competitiveness is very much part of the China storyand likely more sustained than doubters opine.
Vietnam, Indonesia and Bangladesh are just not in the same league.
[ 28 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
1,500
870 1,050
Sources: ISI Group, Ministry of Human Resources and Social Security, and National Bureau of Statistics. Notes: All wages in urban areas. Annual disposable income is per capita. Urban populations are in millions as of 2009. * Excluding Shenzhen.
JAPAN YOUNG AND OLD TO WORKING POPULATION (%) YOUNG AND OLD TO WORKING POPULATION (%)
CHINA
2010
2030
2050
2010
2030
2050
65 Years or Older
65 Years or Older
[ 29 ]
China Inc. can quickly wipe out whole sectors by mass producing high-quality goods.
Medical device and agricultural equipment makers are likely beneficiaries from a population that is getting richer and living longerbut not necessarily healthier. Spending on these sectors, as well as on water conservation, should grow at twice the rate or more of Chinas overall budget spending, we believe. Chinas cement makers, aluminum smelters and building materials companies saw business implode only in the fourth quarter. Full-year 2011 results mask this implosion, and more pain is likely to come in 2012. Even successful womens shoemaker Belle International reported a slowdown in same-store sales to the high single digits. The only companies that report sales growth in the 20% range are mass consumer plays such as Yum!, the owner of the KFC fast food restaurants. Chinas banks remain cheap for (good) reasons described earlier. Chinas companies will likely see profits hit this year, we believe. SOEs already reported an 11% drop in profit in the first two months of the year. That said, Chinese equities look cheap by historical valuations. It is reasonable to expect gains of 25% or more this year after a horrible 2011.
Source: Deutsche Bank. Note: Estimated fiscal 2012 sales for Coach, Burberry and Tiffany.
[ 30 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
60
40
30%
37% 20%
20
7% 7% 7% 1% 4%
18%
Nuclear 0% 10 20 30 40 50 60
Hydro
Nat. Gas
China
Oil
Coal
World ex-China
Sources: ISI Group and BP World Energy Outlook. Note: Data as of 2010.
where these energy sources can start to compete with oil, gas and coal. A shift to a consumption-driven economy could imperil this. Similarly, a credit contraction or financial bust would likely result in the drying up of Chinese project financing that has supported the global market. The countrys commodities appetite goes beyond the obvious. China has become the second-largest importer of gold, after India. It now makes up around one fifth of world gold demand for jewelry, according to ISI Group. Gold is seen as a hedge against inflation. Policy also may drive demand for precious metals such as platinum and palladium, which are used in car catalytic converters.
Expect the iron ore boom to fizzle out as China nears peak consumption in steel and cement.
[ 31 ]
Chinas buying of US Treasuries illustrates the power the country holds over the US bond market. The US Federal Reserve crowded out all other buyers in the year ended June 20, 2011, so Chinas share was just 18%. Excluding Fed purchases, however, China had a 73% share. See the chart below on the right. A shift to a consumption economy would mean less Chinese buying of US Treasuriesas opposed to absolute reductions. Assuming the US government is not closing the budget gap any time soon, conventional wisdom says fewer Chinese purchases would drive up yields and pummel bond prices. Fewer buyers equals lower prices. Conventional wisdom is always dangerous, so here is an opposite view: Rates actually could go down in a sort of flight-to-safety bond rally. Why? If foreign buying dries up, simple math says private savings will have to pick up the slack (assuming the US government doesnt cut the deficit markedly). To do this, investors would have to sell risk assets. This would hammer equities, high-yield bonds, commodities and emerging market assets, in turn triggering a dash for safety. As China opens to the world, more of its debt may become available for international trading. This may coincide with a bailout of its financial system and a jump in its debt-to-GDP ratio.
A shift to a consumption economy would mean less Chinese buying of US Treasuriesas opposed to absolute reductions.
This appears a likely scenarioand does not bode well for Chinas ranking in the BlackRock Sovereign Risk Index. The country advanced three spots in the fourth quarter to rank 15thahead of the UK and France. Commodity currencies such as the Australian and Canadian dollars could take a hit as China reaches peak consumption in key industries such as steel. The currencies are a good signpost for whether Chinas economy is perking up in the short term and shifting toward consumption in the long run. Exporters and countries closely linked to the booming resources trade, such as Australia and Chile, could suffer. The Aussie dollar and bond market are just as much China plays as LVMH and Daimler. More insulated economies such as Brazil could power along, driven by domestic consumption. Asian investors appear more upbeat than those in the developed world. For US and European investors, things are about as bleak as they have been in decades. Asians, on the other hand, have overcome three economic crises in recent memory: the 19981999 Asia crisis, the 2003 SARS crisis and the 2008-2009 world financial crisis. Plus, the sheer scale of consumption and wealth is breathtaking when you are on the spot.
50%
$400
PURCHASES IN BILLIONS ($)
2,500 2,000 1,500 1,000 10 500 0 2001 2003 2005 2007 2009 0 2011 30
60
300
40
200
20
20
100
0 2011
China Buying of Net Issuance (%) China Buying of Publicly Available Net Issuance (%) China Buying ($ Billions)
Sources: US Department of Treasury and BlackRock. Note: Data as of June 30 of each year. 2011 data based on preliminary survey data.
Sources: US Department of Treasury and BlackRock. Notes: Data as of June 30 of each year. Publicly available Treasuries are those not purchased by the US Federal Reserve. 2011 data based on preliminary survey data.
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