“Let me have men about me that are fat, sleek-headed men and such as sleep a-nights,” says Shakespeare’s Caesar. Caesar thought that men who were happy with their lot were less likely to threaten his grip on power.
Sadly, this assembly of portly allies failed to stop the lean and hungry Cassius from slipping a knife between his shoulders. Perhaps Caesar would have been better to collect people that he disagreed with, troublemakers who would keep him on his toes.
There’s a lesson for investors here. Comforting opinions that you agree with are far less useful than those that make you question your ideas and your biases. Most days, my email inbox is full of comments on China’s inexorable rise to dominate the world. Few say anything new or memorable.
Far more valuable are analysts such as Albert Edwards of Société Générale, who as usual pulls no punches in his latest note. “In a few years’ time, I believe we will look back on the China economic miracle as the sickest joke yet played on investors,” says Edwards. That’s a pretty bleak forecast from a man with a good track record – he predicted this crash, the dotcom bubble and the Asian crisis of 1997-1998. Could he be right again?
Exports are not as important as you think
It’s indisputable that China has one key ingredient of a mania. Almost everyone is a believer in this new era, just as they were (or pretended to be) in every other great bubble.
At times like this, it’s very easy to succumb to ‘group think’ and stop looking critically at the fundamentals. So let’s take a look at some criticisms of China’s economy.
The most common complaint is that China’s too export-dependent. But this is essentially a myth. Exports are far less important to China’s GDP than to most of its Asian peers: export value-added in GDP is around 18%, according to Jonathan Anderson of UBS (higher figures based on the exports-to-GDP ratio overstate the contribution, because China imports a significant amount for assembly and re-export).
However, the situation is more complicated than that. The chart below shows Chinese industrial profits, which are down around 30% year-on-year. Corporate profits are usually more volatile than GDP, but as Edwards asks, how can the economy be in okay shape if profits have fallen this far?
There are two likely answers. One is that companies are writing down investments in the stock market, property and derivatives sold to them by banks for ‘hedging’ (for which, read ‘speculation’).
But the other reflects an oddity about China’s export growth. While export profits boomed in recent years, this didn’t really make its way through into wages. As you can see below, wages apparently declined as a share of GDP while profits rose.
In other words, the lion’s share of export profits were kept by companies. Right now, that’s good news, because if the export bubble had caused a wages bubble and fed through into a consumption bubble, China would be in more trouble. But, as you can see below, consumption growth lagged behind GDP growth (and measured in real terms, it didn’t grow much faster than in previous cycles).
The upshot is that exports seem to have sat ‘on top’ of the Chinese economy. They added a few percentage points to growth, but haven’t become as deeply rooted in it in the same way as some other economies. A collapse in exports is hurting corporate profits – but it isn’t hitting the rest of the economy quite as much as you might think from the top chart (although obviously, higher unemployment and lower business investment is feeding through). This suggests that even if Western demand for exports remains weak for a long time, China can still grow at 8%-10% once things stabilise.
Don’t bet on the consumption story yet
The second criticism is that China’s economy is too heavy on investment and too light on consumption. And here the numbers look a bit more convincing. Fixed asset investment is around 40% of GDP, while household consumption is around 35%. Investment is the key driver of the economy; it was a dip in this – rather than exports – that first set off the sharp slowdown last summer.
However, developing economies need to invest at a much higher level than developed ones. Analysts who argue that China must immediately reduce investment and boost consumption are off-track. In many cases, their arguments are driven by the belief that higher Chinese consumption will increase demand for imports and help bail out the West, which simply isn’t going to happen.
Long-term growth involves a trade-off. Investment today enables higher consumption tomorrow. China is investing for the future; other, high-consumption countries have failed to do so and are now suffering the consequences. We can hope to see China increase consumption a bit over the next few years, but investment is going to remain more important for a long time.
But what matters is how this investment is deployed. Will it create better infrastructure and useful capacity or mal-investment and asset bubbles? This brings us on to the third criticism: the lending boom that China has unleashed to help it through the downturn is bound to end in trouble.
Keep an eye on lending – but don’t be too worried for now
This concern is a real one. Lending is up 30% year-on-year as you can see below. Some of this money is undoubtedly making its way into the stock market and property, running the risk of creating more bubbles.
Meanwhile, fixed asset investment is exploding, up 33% year-on-year in the first five months. Realistically, such rapid growth is bound to lead to some mal-investment.
But these trends need to be seen in context. China has been deleveraging in recent years, in sharp contrast to most of the world. Increased lending can now help to ride out a downturn rather than accelerate a boom.
The government deliberately clamped down on the property market in late 2007 to stop bubbles from getting out of hand. While there’s certainly a risk of them re-emerging in some sectors, there is still a huge untapped demand for better mass-market property at the right price.
More generally, there’s no shortage of investment opportunities in China. Undoubtedly some money will flow into extra capacity in industries that really don’t need it such as steel (although if it’s new, more efficient capacity, it may still bring benefits). But when it comes to transport links, the power grid, the healthcare system – the more money that flows into these, the better.
That said, it’s unlikely that fixed asset investment is accelerating as sharply as the figures suggest; such rapid growth would need huge amounts of construction materials, yet indicators such as steel, electricity and industrial production remain weaker. It seems likely that local governments are booking planned projects before the shovel hits the ground, in order to be seen to be doing their bit. And this is to the good – a gradual pick-up will be better for the economy than an unsustainable splurge.
China is doing fine – but don’t bank on a V-shaped recovery
There are problems and risks in China, but we’re not talking about the castles in the air of the dotcom era. Neither is this the Asian crisis – which rose out of huge foreign investment flows and gaping current account deficits (like Eastern Europe in this cycle). It won’t all be smooth going – but in the long run, potholes don’t matter as long as the wheels stay on.
That said, I firmly agree with Edwards on one thing. Investors are immensely rash to bank on a V-shaped rebound, even in China. I think Asia will emerge from the global recession faster than anywhere else in the world – the much-derided ‘decoupling’ theory may actually have some truth on the way up, as I’ll argue in a future article. But we still need a period of stabilisation and adjustment. And that means a high chance of another big sell-off before this bear market can be declared over.
In other news this week…
| Market | Close | 5-day change |
|---|---|---|
| China (CSI 300) | 3,083 | +3.9% |
| Hong Kong (Hang Seng) | 18,060 | -2.4% |
| India (Sensex) | 14,326 | -3.7% |
| Indonesia (JCI) | 1,975 | -4.6% |
| Japan (Topix) | 922 | -2.6% |
| Malaysia (KLCI) | 1,046 | -4.1% |
| Philippines (PSEi) | 2,412 | -7.7% |
| Singapore (Straits Times) | 2,267 | -2.7% |
| South Korea (KOSPI) | 1,400 | -0.9% |
| Taiwan (Taiex) | 6,341 | +1.9% |
| Thailand (SET) | 582 | -4.8% |
| Vietnam (VN Index) | 458 | -7.2% |
| MSCI Asia | 92 | -2.1% |
| MSCI Asia ex-Japan | 377 | -2.7% |
Japan’s prime minister Taro Aso is under pressure after a key ally, internal affair minister Kunio Hatoyama, resigned over a dispute about privatising parts of the national postal system. Aso’s Liberal Democratic Party (LDP), which has ruled Japan for all but 11 months since 1955, looks likely to lose a general election in the autumn; consequently, some members of his party are reportedly aiming to push him out before the polls. If successful, this would be the troubled LDP’s fourth change of leader in three years.
China’s stock market is likely to see its first IPO for 10 months within the next few weeks. Although Chinese A-shares – which can be owned by Chinese citizens and a handful of foreign institutions – have been one of the world’s best performers this year, the market has been closed to new issues since September 2008 as the government attempted to bring an end to the bear market. However, a pharmaceutical firm has been approved for an RMB630m ($90m) issue, while at least 30 other firms who received initial approval before the ban are also hoping to list in the near future.
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