Why might economic growth in China slow down, and what would be the effect on financial markets in China and beyond?

 

The Chinese economy has been growing at a rate of 8-10% per annum over at least the last two decades. Should this rate be maintained, as the majority of analysts and investors expect, China will overtake the USA as the world’s largest economy at some point in the 2030’s. However, signs of growing pains have emerged - contradictions in society, politics and the economy which need to be resolved with some urgency, and make continued growth at recent levels look increasingly unlikely. This blog will summarise recent reading and our current thoughts on China, with particular reference to investment.

 

Let’s put the positive case first.

 

Most people today remember Chairman Mao, who died in 1976, as a murderous ideologue whose lunatic initiatives, particularly the Great Leap Forward and the Cultural Revolution, caused the unnecessary deaths of around 40 million of his compatriots, and suffering for countless others. This is true, but at the same time there was a vast build-up of industrial production, extension of the rail network and agricultural irrigation, and a dramatic lowering of illiteracy. Life expectancy rose from 35 in the early ‘50s to 63 at Mao’s death. Women came to be seen as the equals of men, rather than as merely the property of their husbands, who could be bought and sold (‘Women hold up half the sky’ said Mao). When Mao died, China, now under the leadership of Deng Chao Ping, continued to be a one-party state, as it still is today. The party’s only realistic chance of survival was to introduce some form of capitalism, and, slowly at first, the process began that turned into today’s economic miracle.

 

China’s miracle has been built on exports. China has a land-mass equal to that of Europe, and a population of around 1.3 billion, twenty times that of the UK, and roughly a fifth of the entire world population. In the last twenty-five years, almost 200 million people have migrated to the cities from the land. Working in factories mainly in the East of China, they can earn as much in a month as they could in a year on the family farm. And yet, Chinese wages are only one-tenth of their US equivalent, which has given China a knock-out cost advantage in manufactures. China now dominates the world in the production of clothes, shoes, toys, and consumer electronics. 70% of the produce sold in the US’ largest retailer, Wal-mart, is made in China, and it is said that when President Bush celebrated his re-election in 2004, the Stars & Stripes flags behind him were of Chinese manufacture. In the process, China has become urbanised. The US has nine cites with over a million inhabitants. China has forty-nine. Having established dominance in exports, the next stage of China’s miracle, which is already well under way, is the creation of an affluent middle class, eager to consume a wide range of goods and services- cars, TVs, designer clothes, freezers and much else. Where the West is stagnating, China is growing fast. And where the West has debt, China has a vast and growing pool of savings, and a government committed to helping the country’s economic development to continue.

 

CHINA’s ECONOMY

 

The Chinese economy consists of three elements, export, investment, mainly in infrastructure- roads, airports and railways- and consumer spending. The first two of these elements appear to be running out of growth opportunities, at least in the short term, while the third seems unlikely to be able to fill the gap left by the other two.

 

EXPORT

 

Though China’s exports to other Asian counties are on the rise, the vast bulk still go to the US (around a third) and Europe. Much of this total goes from companies which have outsourced their manufacturing to China, rather than from Chinese-owned companies. Of the US’ Fortune 500 companies, 400 had already invested in China by 2006. We are close to the point of saturation. Indeed, the trend has been to some extent reversed recently. A report published at the end of December found that one fifth of UK companies with outsourcing operations in China had brought production back to this country, the main reason being better control and product quality.  The indebted Western consumer is unlikely to increase spending much over the next few years, so overall volumes are unlikely to increase much. Also, there is pressure on the Chinese government to allow their currency, the renminbi, to rise, in particular against the US dollar. The Chinese have held the rate down in order to retain export competitiveness, but the renminbi is artificially low, and if allowed to float might rise by around 25%, which would only make life harder for Chinese exporters. Finally, export has been for over a decade a very high proportion of Chinese total output, (figures for export vary between 60% and 70% of overall national output (GDP)), and historical comparisons with other developing nations suggest that export is more likely to shrink than to grow over the next decade.

 

For exports to continue to grow exponentially, the vast pool of migrant labour would need to continue flowing from the country to the cities. A recent study suggests that this process may be more mature than had been thought. This is partly because the Chinese official definition of a ‘city’ (among other criteria, population density of 1500 people per square kilometre) is different to that used elsewhere. For example, using the Chinese definition, Houston ( population 2.2m people, density 1375 per square kilometre) would not be a city. China’s official urbanisation rate at 45% is lower than the world average (50%) and much lower than the developed world average (70-80%), but on a comparable basis is probably significantly higher than the reported 45%. (One recent study mentions the ‘village’ of Quiatou, population 64,000, which manufactures 60% of the world’s buttons and 70% of its zippers.)

 

The continued rapid growth of China’s exports appears to face increasing headwinds.

 

INVESTMENT

 

In the period 2000-8, the Chinese economy grew by around 10% p.a. Only 1.1% of the growth came from exports, but during the period the share of investment in the national output grew by 8%. However, the current rate of Chinese infrastructure development is already at an advanced stage, and growth at current rates can not be sustained. Progressively, the ratio of increased revenue for each new dollar invested has fallen, and new projects have become increasingly vast, hubristic and wasteful.

 

A comparison of the roads of China and the US might be useful at this point. The two countries are almost exactly the same size, but whereas the population of the US is more evenly spread, mainly round the coast, China’s is concentrated in the south and east. Currently, the US has 4.2 million kilometres of road, where China has only 2.7m kilometres, but the US has 250m cars to China’s 43m. In other words, the US has 58 cars per kilometre of road, where China has just 16. The US has 450,000 road bridges in current use, where China has 500,000. But the US has five times as many rivers as China, indicating that the Chinese authorities have built more bridges than were strictly needed.

 

Increasingly, the Chinese government’s infrastructure building appears to be aimed at political gains rather than economic ones. China is struggling to integrate the impoverished Western provinces such as Xinjiang and Tibet, which are racially and culturally separate, speak a different language, don’t think of themselves as Chinese and for the most part hate the Han Chinese of the wealthy east. 37 out of the 44 airports built between 2005 and 2010 have been in the sparsely populated areas of the west. The spectacular Qinghai to Tibet railway, the highest railway in the world, is unlikely ever to pay for itself.

 

Hubristic projects are being undertaken by private enterprise as well as by the state. An article in the magazine section of the weekend Financial Times (January 2/3^rd) entitled ‘Golf’s Secret Boom’ describes a multi-billion-dollar project on the island of Hainan, known as Project 791, which will incorporate 22 18-hole  golf courses, plus infrastructure. (‘Picture yourself playing into a waterfall, through a cave, around a volcano, or over a replica of the Great Wall. There will be multiple town centres with luxury homes and apartments, hotels and spas, shopping malls and streets lined with restaurants and bars.’) The reason for the secrecy is the awkward fact that there is an official moratorium on golf course development in China. However, it seems easy enough to get round it. ‘ “No one calls it a golf course now,” one industry insider told me. “Instead, it’s a green space or it’s equestrian or it’s an exercise field. They are creative. But the government knows. It’s just all about loopholes.” This reminds me of an anecdote in the excellent ‘China Road’ by Rob Gifford. Visiting a racecourse outside Beijing, he was astonished to find that people appeared to be placing bets on the horses, as gambling is illegal in China. The woman at the window told him that he couldn’t place a bet, but if he wanted to he could place a ‘guess’ on one of the horses. Gifford comments ‘A guess! I could place a guess on a horse! …That a race course (not some secret basement gambling joint but an out-in-the-open, everyone-can-see-you race course) was able to operate openly, taking bets on horses simply by calling the bets something else is quite fantastic.’ The golf course project may turn into the world’s premier golfing venue, or it may turn into a massive white elephant. However, an economy which relies on this type of project for its growth is at a late stage of its development cycle, and is vulnerable when the easy money disappears.

 

CONSUMER SPENDING

 

The Chinese economic miracle has lifted perhaps three hundred million people out of poverty, and their gradual enrichment will create an enormous pool of demand over the next few decades. Consumer demand is the most hopeful-looking growth driver from here on. However, there are caveats. During the period 2000-8, consumer spending declined from 46% to 35% of GDP. China has no social security. Individuals have to pay for education, healthcare and pensions. Greater prosperity adds to the cost of retirement provision in two ways. First, you can expect to live longer, so there are more years to be provided for, and as your income grows, the amount of pension you need to provide for grows too. In a society with a one-child policy, you can’t expect too much support from children. So, it is perhaps not surprising that the savings rate in China remains stubbornly high. Much of the savings go into the banks, where the returns are low - well below the rate of inflation.

 

By how much does consumer spending need to rise to replace the growth from exports and infrastructure spending, should these two cease to grow for a while? Using simple arithmetic, let’s say that the economy is 100 and we want it to be 110 by the end of the year. Consumer spending is 35, and the other factors are 65. If the 65 doesn’t grow, we’ll need the 35 to become 45 during the year, to make 110 - in other words it needs to go up by 28%. This doesn’t look likely. From 1997-2007, domestic consumption grew at a steady 8.2% p.a. above inflation. Should the economy hit a period of turbulence, as we suspect, Chinese households would be likely to save more rather than less.

 

Finally, there is a massive real-estate boom going on in Chinese cities. In one of the more fashionable suburbs of Beijing, the house price to average income ratio has reached 40 times, far beyond anything we have seen in the UK. The reason - an excessive supply of cheap money - is the same as in the West, but the difference is that the bubble hasn’t popped - yet. When it does, consumer spending will do well to grow at all.

 

PROBLEMS OF THE CHINESE GOVERNMENT

 

Chinacontinues to be a one-party state. The party controls the legal system, so there is no such thing as a fair trial. There is no freedom of speech or of the press. However, the main reason for the government’s unpopularity is corruption, which affects the whole system from top to bottom.

 

CORRUPTION

 

Mao’s revolution aimed to liberate the peasant farmers, who still comprise two-thirds of the population of China, numbering around 750 million. This silent majority has not benefited in any way from the economic miracle, except to the extent that their relatives send cash back home from the cities. Chinese farmers rent land on a long-term basis, but officially all Chinese land belongs to the state. So local officials, as representatives of the state, have the final say in what happens to the land within their jurisdiction. Now they are taking the land by force from the farmers and selling it to developers. The central government is opposed to the practice, knowing that it creates anger towards the party among rural people. But without any checks and balances in the system, it is hard for them to rein in the predatory local officials. Despite the spasmodic efforts of the Beijing government to control it, land seizure continues on the outskirts of almost every city in China. The farmers are offered compensation for their land, but usually far below market rates, and if they object, local officials and developers hire thugs to beat them up and force them off the land.

 

Corruption is everywhere in China. You may remember the earthquake that devastated an area of south-west China a couple of years ago. Watching the reports on TV, I was struck by the anger of the locals in a village where the school had collapsed. It had been built inadequately because the officials had pocketed a good part of the money which should have gone to build it. The reservoir walls had collapsed because not enough cement had been used - for the same reason. A similar thing had clearly happened in the case of the golf-island, Hainan (see above). The FT article continues ‘Nearly three years ago, a local pressure group believed it had secured 825 acres of this land to establish a forest park that would help promote environmental awareness. Its members worked on the project for two years, winning the support of the government, attracting investors and brokering a land deal with local villagers. But suddenly, in 2007, the villagers ended talks. And that is when the group’s organisers first heard of Project 791. “They didn’t even notify us,” a member of the group told me over a pot of tea. “The government just told the villagers not to work with us any more. It broke our hearts, and we felt so small and insignificant.” The group was warned not to do anything that might disrupt Project 791. In Hainan, a good relationship with the authorities is necessary for survival, and going against golf, an industry thought to be lining the pockets of many a government official, would not be a wise move.’

 

Corruption is an old problem. Leading Chinese economist Hu Angang calculated that in the 1990s the cost of corruption to the Chinese economy was between 13% and 17% of total output. The government knows all about the problem, but appears powerless to do anything about it. In his last report to the National Congress in 2002, premier Jiang Zemin declared ‘If we do not crack down on corruption, the flesh-and-blood ties between the party and the people will suffer a lot, and the party will be in danger of losing its ruling position, or possibly heading for self-destruction.’ As we have seen, little has changed since that speech was made, except that perversely, the illegality of corruption, and the risk of discovery and punishment, appear to have had the effect of increasing the going rate for bribes.

 

China’s failure to get to grips with corruption makes all the other problems harder to tackle. There are serious environmental problems. China has a severe water shortage - it has 21% of the world’s population, and 6% of its water. This problem is especially acute in the populous north-east, where the Yellow River regularly runs dry in the summer.  There just isn’t enough water, and the water table is falling by seven feet every year, as the water companies extract it from ever deeper levels. The government has announced a huge project to divert water from the Yangtse river to the north by means of a vast system of three canals, each running over a thousand kilometres. Intensive agriculture is causing soil erosion, and the deserts are advancing steadily. Air pollution is a chronic problem - much discussed at the time of the Beijing Olympic Games. Sixteen of the world’s twenty most polluted cities are in China. Around 400,000 people a year die early in China as a result of respiratory problems related to air pollution.

 

There is also a demographic problem. Mao encouraged large families, and in his time, despite the deaths of perhaps 35 million people through starvation in the Great Leap Forward, the population of China almost doubled. In 1979, three years after the death of Mao, the government introduced the one-child policy, which is still rigidly enforced. Many peasant families abort their girl babies, which has led to a heavy preponderance of men, up to 1.4 to 1.0 in some areas. In other societies, an excess of men over women has often gone together with increased levels of violence.

 

The government has presided over the economic miracle, and has brought China back to a position of power and respect in the world after the century of humiliation (1840-1949) followed by three decades of dictatorship. Many Chinese citizens support the regime, or are prepared to tolerate it, for these reasons. However, the majority, including the Tibetans, the Uighurs, and the other ethnic groups (altogether 47) within China’s borders dislike the regime intensely. There is a vast well of anger simmering below the surface, with no legal outlet. Should the economic juggernaut slow down, it seems to us unlikely that the regime would be able to avoid confrontation with its critics.

 

WHAT MIGHT HAPPEN?

 

After three decades of breakneck economic growth, China is wealthy and powerful again. In the process, though, it has become one of the most unequal and unfair societies on earth. The regime which has presided over this extraordinary period of history knows that its survival depends on keeping the good times rolling - that’s why in proportion to the size of its economy, China’s stimulus package has been even bigger than those of the US and the UK. Much of this new money has gone into trophy infrastructure projects with only marginal economic benefit, and into stoking up the already overheated housing market.

 

Up till recently, my reluctance to invest in China has been based on two hunches, neither which has so far been proved right. The first was that 10% per annum growth doesn’t last - as evidenced by the growing social and environmental problems referred to above. The second was that China’s superior growth rate, and the assumption of its sustainability, have been the unchallenged consensus view for several years. This means that the idea of sustainable rapid growth, and the forecasts which follow from it, are completely priced in to every asset class, to the point where the outcome has to match your best expectations to avoid disappointment. More detailed recent reading has confirmed these two hunches. China is unique – it has some unique advantages, and also some unique problems. Investors are overlooking the problems.

 

Chinese shares aren’t too expensive - so long as the economy carries on growing at or around 10%, as the consensus expects. A comparison with the technology bubble of the late 90’s may turn out to be entirely misplaced, and if so I apologise. However, my clear impression of the time was that the signs of over-valuation were there, but they were ignored because those shares had been going up by more than the market for fifteen years, a very long time, and continued to do so at an accelerating pace. Warning signs exist aplenty in China, but the economy is still growing at 10% p.a., and the stock market is going up, and has risen and is rising faster than the markets of the developed world. Most investors won’t consider the risks till the market has fallen significantly, because until that time they won’t appear to be relevant.

 

It’s necessary to put some sort of timescale on predictions. Based on all the above, we expect there to be a significant slowdown in Chinese economic growth in the next year or so, perhaps to 5-6%p.a., or even lower. People often say that you can’t rely on the official GDP numbers, and that the figures for electricity demand are much more reliable. One way or the other, a slowdown of that magnitude would not go unnoticed. It seems unlikely for such an event to take place without the government facing serious, and probably violent challenges. In 2005, there were 80,000 recorded instances of rural unrest (Communist Party figures) Take away the economic miracle, and that number could multiply.

 

What China needs is a bit of democracy. Unfortunately, the necessary institutions don’t exist. Before the communists were the weak Nationalist government, which struggled to re-unify the country while fighting and losing a war against the Japanese. And before that, two millennia of imperial dynasties. The regime can’t reform itself without handing over too much power to the reformers. There is the example of Russia, where Gorbachev introduced reforms in the mid-80s, and unleashed an unstoppable momentum which led to the collapse of the Soviet Union a few years later. Eventually, when faced with challenges, the regime will respond with repression - as happened at Tiananmen Square in 1989. It is hard to forecast the outcome, but the outlook appears difficult, and we would prefer to continue avoiding China for the moment.

 

The argument that we often make about the UK, that the fact that there are many weak and over-indebted companies shouldn’t put you off investing in the good ones, no doubt holds true of China as well, but we don’t know the market well enough to be sure what to hold and what not to hold.

 

WHAT MIGHT THE CONSEQUENCES OF A SLOWDOWN BE?

 

The deflating of an investment bubble in China could lead to gains in other areas as capital was re-allocated, but it could cause another bout of general risk-aversion, which could affect all or most asset classes.

 

A sharp slowdown in Chinese economic activity would almost certainly lead to a sharp sell-off in the Chinese and Hong Kong stock markets, and we are well prepared for both those outcomes. Another likely outcome would be a sharp fall in house prices in the cities of the east and south, which is unlikely to affect any of the investments Wise Investment clients hold. However, a fall in Chinese house prices could result in a growth in bad debt, which would affect UK-listed lenders such as HSBC and Standard Chartered, and any funds which invested in those two banks.

 

An economic slowdown in China would lead to a drop in imports as well as exports. China is a major importer and many UK-quoted companies are beneficiaries. Any company which exports to China would be affected, and the price of commodities and the companies that mine them would almost certainly fall.

 

A possible result of a slowdown might be a fall in China’s trade surplus, and a consequence of that would be a reduction in the amount of foreign reserves China had available to buy US treasury bonds, of which the Chinese government is a major holder. Treasury prices could fall, and their yields rise, which would make money more expensive and harder to borrow worldwide.

 

Should such a situation develop, our preferred asset classes would be defensive shares, mainly UK-listed, good quality corporate bonds and property, with a much higher than usual allocation to cash.

 

Longer term, China may move to a more democratic form of government, though many Chinese don’t consider this outcome possible. In the first chapter of Rob Gifford’s book, he hitches a ride with a lorry driver, Liu, in the remote north-west of China, and gets him on to the subject of politics. ‘I ask Liu if he thinks China can make the transition from a one-party state to a democracy. ‘No, I don’t think China can ever become a democracy’ he says without hesitation. ‘Look at Chinese history. There have always been changes in government, but it’s just the history of one emperor being replaced by another. The system never changes, just the people at the top. That’s how China is.’’

 

We are patient investors at Wise Investment. In 1992-4, we missed the spectacular rally in house building shares, but resolved not to miss them next time round. Our opportunity - a very good one-came in 2000-7. Having missed the last couple of years of the technology bubble, in 1998-9, we were determined not to miss the next technology up-cycle. It has begun, and we are in it. Having missed the last three years or so of the bull market in China, we believe that the opportunity has gone in this cycle. We are saying ‘China-next time round’ -  we think there may be a few years to wait.

 

BOOKS AND ARTICLES

 

There is a wealth of good books and articles on the subject of modern China. I have read several excellent books on life under Mao - including Wild Swans by Jung Chang, China Witness by Xinran, Red Azalea by Anchee Min, and Life & Death in Shanghai. Understanding what life was like in Red China helps to understand what follows - and also why some survivors of the Mao era say that in some respects it was better than life under the current regime. But for this article, I have drawn heavily, and quoted extensively from two books and three articles. The books are China Road by Rob Gifford, and The Writing on The Wall by Will Hutton. Gifford’s very readable book describes a journey he made across China in 2006, in which he was trying to sum up his views of the country after twenty years as a journalist and expert China-watcher based in Beijing. Will Hutton’s more theoretical book attempts to put China’s relationship with the West into context. The articles were an excellent report by Pivot Capital Management on China, from which I have quoted the statistics about roads, ‘Golf’s Secret Boom’ from the FT, and also from the FT, an Insight article by John Plender, called Savings Boom Raises Questions About Growth & Decoupling.

 

This blog represents Tony Yarrow’s views as at 6-7^th January, and does not constitute financial advice.

 

Tony manages TB Wise Investment and TB Wise Income