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in secondhand conversation with a very-high-profile private equity group here in the US, they report that they have four significant investments in China. None are in the manufacturing area; all are in the services sector. The slowest of their companies is growing at over 20% per year, and some are doing significantly better.
The China of today is not your father’s China. Fifty percent of the economy is now services. That part of the economy is growing – and evidently growing enough to offset the contraction in the manufacturing sector. And we must remember that China actually added twice as much to its GDP in either dollar or yuan terms in the past year than it did in 2003 when its growth was a “miracle.”
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China Good, China Bad, & China Ugly
Among the many letters and reports on China that I received over the last month, I’d like to single out an excellent research note that the team at
Gavekal Dragonomics published last week, called “What to Worry About and What Not to in China.” I appreciated this piece, because it really helped me structure my worrying. I dislike spending energy worrying about the wrong things. Further, worrying about the wrong things can be dangerous. It’s when you are paying attention to the wrong things that what you
shouldhave been paying attention to jumps up and bites you on the derrière.
In the spirit of the Gavekal note, here is the good side of China. We’ll get to the bad and the ugly below.
Chinese real estate prices will stabilize. We hear a lot about China’s massive infrastructure boom and the resulting “ghost cities.” These aren’t just rumors. The government mandated the construction of entire cities to house the formerly agrarian population as it shifts to industrial jobs. Provincial governments earned as much as 80% of their revenues from land sales. Essentially, this is a process where they take possession of rural land that has very little value in price terms, declare it to be available for development, and can make profits several orders of magnitude greater than their costs. Nice work if you can get it.
The ghost cities will not stay empty forever. They will fill with people over the next few years (in some cases more than a few). The recent housing bubble is more a function of young people wanting to cram into certain popular areas. The broader internal migration will support housing prices even as the bubble areas pop.
It might be helpful to think of the Chinese ghost cities as analogous to the overbuilt condos in Florida. Prices in Florida did in fact collapse, and places were selling for a fraction of their construction cost. I wrote at the time that I thought they would be very good investments, because the number of people wanting to retire to Florida is actually a fairly steadily growing figure. Low taxes, good weather, positive infrastructure, excellent medical care – what’s not to like, other than it’s not Texas? Just saying…
While it will take time, those ghost cities will eventually fill up. Further, most of that real estate was bought with significant capital, often 50% or more. Those apartments, which are essentially shells because they have not been finished out, function more like stores of value or bonds than they do as traditional apartments. While the original investors may not get the inflation-adjusted returns they want, inflation will eventually mean that they will get some return on their investments. While this may not make sense to most of us in the Western world, given the Chinese experience, owning something that is tangible might make sense. The reality is that there are hundreds of millions of people who are going to want to find a place to live in China over the next few decades. That seemingly endless source of buyers will eventually turn the ghost cities into real ones.
Note: that doesn’t that all of the ghost cities will be developed. Some probably won’t, as they are too far outside the path of growth. But most of them have excellent infrastructure and connectivity to the rest of China. Think of how satellite cities developed throughout the South and Southwest of the United States. Admittedly, in the US this was generally a demand-driven process. In China it was a way to prop up GDP and actually create something tangible, unlike the ephemeral transfer payments and other congressional pork that the US used as “stimulus.” I would argue the Chinese are better off putting their money into some kind of infrastructure than we were putting ours into temporary, nonproductive stimulus.
China is shifting from investment to consumption. The phase of China’s emergence led by exporting and infrastructure growth is ending. The next task is to build an economy that relies less on exports and more on consumer demand and services. This path was detailed in
our China e-book. It has been the plan for some time.
This process will continue to be ugly at times. Last week’s Purchasing Manager Index for Chinese manufacturing fell even deeper into contraction territory, where it has languished for six months. Services PMI also fell but not nearly as much; and more importantly, it continues to show a mild expansion.
I know this is anecdotal, but in secondhand conversation with a very-high-profile private equity group here in the US, they report that they have four significant investments in China. None are in the manufacturing area; all are in the services sector. The slowest of their companies is growing at over 20% per year, and some are doing significantly better.
The China of today is not your father’s China. Fifty percent of the economy is now services. That part of the economy is growing – and evidently growing enough to offset the contraction in the manufacturing sector. And we must remember that China actually added twice as much to its GDP in either dollar or yuan terms in the past year than it did in 2003 when its growth was a “miracle.” That helps to put their reduced growth in context. As I have pointed out, the law of large numbers requires that their growth will be slower in percentage terms in future years.
Room for More Stimulus. The Chinese government is spending big bucks to prop up the stock market and the renminbi through various interventions. Estimates vary, but $200 billion to date is a good guess. They will have to spend more. The good news, if you can call it that, is that they can afford it. There is, of course, reason to question the wisdom of trying to prop up a stock market – especially in the rather ham-handed (one is tempted to say “rookie”) way they have gone about it. More about this later.
Aside from its multi-trillions in FX reserves, the People’s Bank of China still has plenty of room for monetary stimulus. Short-term interest rates in China are over 4%, far higher than in most of the rest of the world. That means the PBOC can probably make several more small cuts without overly weakening its currency. Yes, I know that they devalued their currency a whole 2–3% recently. Given that the euro and the yen are down well over 30% against the dollar, I really find the overreaction in the West quite laughable.
The IMF says China has to float its currency in order to be included in the SDR (Special Drawing Rights). Okay, so they’re starting that process. As I have said repeatedly for the last four years, when they finally float their currency, the likely direction of the renminbi is down, not up. All the ranting of Donald Trump and US senators combined cannot push back the tide of what the market sees as the true value of the renminbi.
China’s banking system is also on a strong footing. Banks have little exposure to the stock market. Chinese brokers have very conservative (by Western standards) capital requirements. Gavekal says not to worry about a systemic crisis. (The Chinese shadow banking system is something else altogether. See below.)
Despite all this, China is enduring an economic slowdown that may get worse. We have plenty of legitimate worries. Now, here come the bad and ugly parts.
Idle Industrial Capacity. The transition from an investment-driven export economy to a consumption-driven service economy will take years. Further, it won’t be easy for those on the industrial side of the house. While it may be hard to believe, over the years China has lost more steelworkers than the US and Europe have. They overbuilt steel mills. It seemed that every province wanted its own mills, and their production capacity just grew too large. It likely still is too large.
The government hopes to reuse some of the idle capacity in its very ambitious (and quite expensive) “One Belt, One Road” or New Silk Road initiative. That strategy may help – as long as lower exports don’t slow down the plan. But that is a decades-long process and is unlikely to relieve much pressure over the next few quarters or years.
As every parent and employer knows, idle hands are never a good thing. You have to keep people occupied, or they will find suboptimal things to do. The last thing Beijing needs right now is a few million idle, i.e., unemployed factory workers. It is some somewhat ironic that China is facing the same problem as the US is: what do you do with excess manufacturing workers, and how do you help them transition to jobs in the service economy? I guess the best you can say for the Chinese is that the jobs in their manufacturing economy were not high-paying so the transition will not be as economically wrenching.
Chinese Stocks Are Still Overvalued. Calculating “fair value” is difficult for Chinese stocks. As mentioned above, many companies are subject to government interference. Data integrity can be a problem in others. We can’t always make apples-to-apples comparisons with non-Chinese stocks.
Whatever yardstick you use, Chinese stocks are still quite richly valued, even after recent losses. The losses, recall, are simply the undoing of a rally that was never justified in the first place. It was a momentum-based rally in a market of retail investors who come to the stock investing with a gambling mentality.
It’s also worth noting that some Chinese stocks haven’t traded a share in weeks. Further, the government has forbidden insiders from selling in other cases, so it’s hard to know whether the index values and share prices we see are trustworthy right now. I suspect many are not. Which leads to the “ugly” part…
We Don’t Know Whom to Trust in China. Until 2–3 months ago, most China watchers believed that the country’s leaders had a thoughtful, comprehensive economic plan. I don’t know many people who think so anymore. I should note that in our book I was very clear that I thought the Chinese government was not prepared to deal with the nature of the transitional economic crisis they were faced with. None of the leadership has any true experience in dealing with major economic issues in a modern economy.
Walt Whitman Rostow wrote a book back in 1960 called The Stages of Economic Growth: A Non-Communist Manifesto. He outlined five stages that mark the transformation of traditional agricultural societies into modern mass-consumption societies. The first three stages are actually suited to top-down command-control governments. The fourth and fifth stages – at least according to him, and he has been proven right over the ensuing 55 years – can’t happen under the same type of government. There must be a bottoms-up, consumer-driven economy.
So when I say that China’s leadership has no experience in dealing with a modern economy, I mean it in that context. They’ve done a heck of a job for the last 35 years, especially given where they started. What they have done is unprecedented. So hats off. But just as we keep reminding investors that past performance is not indicative of future results, so should we be skeptical about the future quality of government decisions. And frankly, I did not expect the truth of that assertion to become apparent so quickly and so blatantly in China.
If the leadership did have a plan going into the stock market tumble, it must have gone out the window. The on-again, off-again interventions and conflicting statements could not have been part of any rational plan, unless the plan was to confuse everyone. They succeeded, if that was the case. They are clearly making up their game plan in the middle of the game.
In the space of about two months, Beijing reversed years of statements that had almost convinced the world that China really believes in market discipline. That PR campaign is now in shambles. The best-case interpretation is that the leadership is in disarray amid Xi Jinping’s corruption crackdown and unable to coordinate its messaging and intervention strategies – which is obviously not good, either.
Many people thought that at least the central bankers at the PBOC were competent and as immune from political interference as it is possible to be in China. No more. The PBOC may well have tried to assert its independence; but if it did, it failed.
The Chinese government is once again a “black box,” at least in terms of its economic policy. We don’t know who is making the decisions, nor can we be sure what they want to accomplish.
Just a few weeks ago, we all thought China wanted to float the renminbi so it could go in the IMF’s reserve currency basket. The IMF has bent over backwards trying to help China do this, even extending the review period by a year so China would have more set-up time. Beijing is not taking the hints. Either they have abandoned that goal or they don’t understand what they need to do to accomplish it.
As Worth Wray and I wrote in
A Great Leap Forward?, China is engaged in a transition from which it cannot turn back. Well over a billion Chinese are in various stages of joining the modern world. Our planet has never seen anything like this, so it’s no surprise that the process is rocky. The transition will continue regardless, because China has no other option. If you want to know more about China, you really should get a copy of this book now. I priced it at a very reasonable $8.99 as an electronic book. It now appears that my regular book publisher, Wiley, is going to bring the book into print and will take over the e-book marketing, so prices will go up.
Investors want to know about China’s stock market and currency. Even after all of this year’s stimulus, the Chinese leadership still has plenty of ammunition. They can prop up the markets for a long time if they are willing to spend the money. Of course, that will drain reserves.
Beijing has always prioritized stability over free markets, and I think they will continue to do so. The risk they run is that shoving problems under the rug simply stockpiles them instead of solving them. Eventually they become unmanageable, and you have to throw back the rug and confront them. What that will look like in a Chinese context, I don’t know; but I bet it won’t be pretty.
Before we Yankees get too smug, let’s remember that we have our own black box over here, called the Federal Reserve. Its independence is also questionable at times, and it just spent the last six years interfering in our own economy via multi-trillion-dollar QE programs. What would we say if the PBOC did the same thing in China? And now we can say the same thing about Japan and Europe.
In the short term, I think the major risks lie not with China itself but with China’s energy and raw materials suppliers. Countries like Australia, Brazil, Chile, Angola, Saudi Arabia, and Russia are all going to lose as China continues shifting to services and away from infrastructure building and manufacturing. China is not going to turn off the spigot, but it will reduce the flow of materials into the country. Those commodity-exporting countries will, in turn, reduce their purchases of US, Canadian, and European goods and services.
We’ll all feel China’s pain to some degree. That, ironically, is the main reason I think China will get through this. By virtue of its sheer size, it has spread its impact over practically the whole globe. Just as we all shared in China’s growth, we will all share in its contraction.
