When you tune out all the recent white noise surrounding China’s growth prospects and internal debt challenges, an altogether more positive narrative emerges, says Jonathan Wu.
I recently attended a conference where the key topic was asking advisers and investors alike to stop chasing shadows; to look past the issues the media likes to focus on to generate fear and look at the substance behind this cloud of fear.
This is exactly the issue with China, because in the last six months people have consistently focused on issues that are not central to the development of China. So let us look at the substance by focusing on three key areas:
- China needs to and will have slower growth levels to ensure sustainability;
- The debt situation within China is under control; and
- The true issue facing China is its middle class.
- Slower growth vital for sustainability
If you look at the growth figures in recent years since the GFC, you can see a steady reduction from 2010 until now.
Whereas the figures have been 10.4 per cent, 9.3 per cent and 7.8 per cent by the World Bank’s estimation, it is 7.5 per cent for 2013 and 6 per cent for 2014.
Ultimately, however, if China is now comfortably the second largest economy in the world, it simply is not reasonable to expect it to be growing at 10 per cent per annum rates as it did before.
The last time we saw this occur was prior to 2008 (and also in the 2010 figure), which both proved to create either bottlenecks in the system or stimulated parts of the economy which could cause problems down the track (property / loans, which will be touched on later).
We should not be focused on the headline figure of growth: China is a developing economy, and the figures will jump around as it balances itself out at the ends.
The ideal would be a relatively sustainable rate of growth that would meet the needs of providing employment for new people entering the workforce, but also would not bring about the issues that a 10 per cent p.a. GDP growth level has generated.
As the new government started its leadership in March 2013, both Li keqiang and Xi jinpin were the first leaders since the “re-opening” of China who came from an economics background.
Prior to this they were all engineers and hence the focus was on output. With this next 10-year leadership cycle, however, rebalancing the economy is the key.
On 5 July, the State Council issued a paper entitled Guidelines on Financial Support for Economic Restructuring and Transformation.
We simply should not worry if growth does fall to the forecasted 6 per cent as China has a long way to go in structural reforms. Keep in mind that the service economy is still in its infancy and far below the Western level.
The official July 2013 Purchasing Managers’ Index (PMI) for China was also released at 50.3, beating the consensus of 49.8.
This improvement was seen across the board on all three indicators that make up the PMI – industrial output, inventories of raw materials and employment.
This shows some stabilising of the appropriate growth level, which the leaders have set at 7.5 per cent with 3.5 per cent inflation.
The other wonderful asset that China has compared to most other economies is its command status.
The country itself has 1.35 billion people. If the leaders see that the economy does weaken quickly, they will engineer a new form of stimulus to bring growth back up.
They have proven it can be done in 2008-2009, but are cautious in that they don’t want a repeat of “over-stimulus”.
There has been far too much chatter on the news waves criticising the leaders for not taking action via fiscal stimulus since they took power as growth has been softening.
But one must remember that it is far too easy to criticise without looking at what stimulus is actually of a sustainable kind. The US$3 trillion-plus of reserves that the central Government in China controls is a war chest which can be used to fight a serious slowdown in growth, so there is no need to despair.
Debt within China is under control
The market has raised plenty of concerns about China’s “shadow” banking system, describing it as a monumental debt bubble just waiting to burst at the seams.
This fear has clearly fed on itself in the last six weeks or so, and hence has seen another weight of money leaving the emerging markets – including China – and being placed back into developed market equities.
First and foremost, is China’s credit growth an issue? The answer is yes and no. If this is a true bubble, then historically people would not have seen it coming.
Many examples prove this from the first tulip bubble in 1637 in the Netherlands to the GFC of 2007; it was simply a fact that no one saw them coming. Yet in the case of China, everyone has identified it.
This in fact has allowed the Chinese leadership to address the issue straight away. If only the same reports had come out in 2005 or 2006 regarding the risks that the unprecedented levels of lending evident in the US could cause, the crisis that then ensued would not have been so serious.
So how is the Chinese leadership addressing the challenge?
They effectively froze liquidity in late July within the interbank system, causing the SHIBOR (Shanghai Interbank Rate) to shoot up from 4 per cent normalised levels to circa 15 per cent. At the same time the CSRC (China Securities Regulatory Commission) gave the banks a stern warning regarding their lending standards and the way they are lending out the money.
Some history and context needs to be provided here. Since the 2008-09 US$4 trillion stimulus in China, the Chinese Government has been very encouraging with regards to M2 or loan growth.
A lot of this money has since gone into the investment side of the GDP equation, some of which went into social financing and not into productive sectors of the economy. This is where the problem lies.
Compounded with this is China’s ultra-conservative banking system, where loan-to-deposit ratios are capped at 75 per cent (in Australia we are far above 120 per cent and deregulated), making them net borrowers as opposed to net lenders.
Where most banks have to obtain interbank funding for short, medium and long-term loans, Chinese banks historically only meaningfully dip into the short-term market when they are well capitalised.
With such a strict limit, the banks started to become somewhat creative and created short duration Wealth Management Products (WMPs) and trusts, which has led to credit misallocation and inefficiency. This is the “yes” part of the credit growth problem.
The “no” part has focused on the Government’s actions to date, which include strict rules forcing WMPs to readjust their asset allocations to publicly listed assets and away from small-time property developers and local government financing vehicles.
Further to this, China’s Ministry of Finance has banned local governments from placing public assets, such as schools or hospitals, into trusts or WMPs.
There are also increased levels of deposit requirements for provincial governments on property purchases, and in some cities outright bans on multiple property purchases. So the action taken by the Government to date has been strong and heavy handed.
China’s middle class the real issue
As the broad public focus their attention on slowing growth, a debt-fuelled credit crisis and human rights issues, everyone seems to be missing the most important issue facing China over the next decade: its population.
If one reflects on social unrest and uprisings in the last few years, there are only two reasons that caused these: a population’s living standards are very low, or they were very high and now their standards are being lowered. Cases in point includes Spain, Greece, Egypt and Tunisia.
For China, the country has come a long way by bringing over 500 million people above the poverty line over the last three decades. The challenge it faces now is how to ensure the largest part of its population is the middle class.
The way to achieve this (and it is a challenge) is to increase the urbanisation rate. This is the first step of many. As part of the urbanisation process, the Government is also extending reforms into providing universal healthcare coverage.
The previous leadership in 2012 achieved 96 per cent coverage of urban residents in China (themselves 50 per cent of the total population), who are now receiving basic coverage.
On top of this, the Government is creating a pension/superannuation system as well as providing free universal education.
These three initiatives over the next 10 years will provide the population with increased living standards and hence mitigate the risk of social unrest. This in turn will also mean the population will spend more.
Consumer confidence in China at the moment is very strong, which is reflected through the Nielsen China Consumer Confidence index which rose to 110 for the second quarter, up from 108 in the first quarter.
A reading above 100 signals optimistic expectations. In comparison, the Nielsen global consumer confidence index was still at 94 for the second quarter.
Consumer confidence in China means an increased willingness to spend on improving their own quality of life.
The average disposable income of an urban resident was US$2,201 in the first half of 2013, up 9.1 per cent compared to a year earlier, while rural residents had a boost to their disposable income of 13 per cent compared to a year earlier.
Retail sales also reflect this sentiment, with an increase of 12.7 per cent in the first half of 2013. As urbanisation overall in China increases, so will the population’s view of consumption and spending. When it does hit a certain point, then you will have a sustained middle class and subsequent sustainable growth for China.
As with any urbanisation process, with rising income levels there comes a range of opportunities for investment.
If the population achieves higher levels of disposable income, then spending increases on such things as luxury goods, motor vehicles and medicines – which are currently at incredibly low penetration rates – will become the norm (as we experience here in Australia).
Cars, for example: there are still only less than 50 cars per 1000 population in China compared to 650 cars in Australia. Universal healthcare has only reached the urban residents and medicines are still not mass marketed as in the West.
Luxury goods such as phones, laptops, handbags are all still in their infancy. This is where growth is headed and certainly not the export market, which so many now fail to realise.
A total of 1.35 billion people are currently striving for a better living standard, and as the labour force itself becomes more productive over time, this will also fuel growth.
The urbanisation “prophecy” for China is bulletproof in the sense that its predecessors are Europe, the UK, the US and Japan, who have all achieved it with tremendous success.
China now has the benefit of hindsight to see what worked well and what didn’t work in previous mass urbanisation shifts, and to generate a more stable and sustainable growth path for China.
With so many China bears drowning the market, the China bulls (of which we are just a few) are calling for the market to recognise how cheap it is on a P/E basis.
As this weight of capital has left China of late, P/E’s are now sub 8x (and even local investors are still calling the Australian market cheap at 12-13x).
As earnings continue to increase at approximately 5-10 per cent for the rest of the year, these P/E’s may still fall, but there will come a point where people recognise value and what will be a once in a lifetime investment opportunity (ie, to buy into a market with such potential, yet trading on negative sentiment).
So overall, we hope people refrain from jumping at shadows and focus on the real issues in China. Forget the shadows, and focus on substance.
Jonathan Wu is the associate director and head of distribution and operations at Premium China Funds Management.
