September 2009

CHINA: it's lonely being a (China) bear

There are concerns about how China is spending its increased debt. But respect for the country’s economic handlers bolsters confidence, finds Fiona Rintoul
panda.jpgThe MSCI China has surged by more than 50% since its low in March and everyone is agreed, pretty much, on what that means: the Chinese government’s RMB 4 trillion (€400bn) stimulus package, rolled out in September 2008, is working – or, at least, appears to be working.

“Investors have bought the economic policy decided by the government,” explains Claude Tiramani, fund manager of Parvest China, part of BNP Paribas Asset Management.

The numbers seem to speak for themselves. Everyone thought GDP would be up 4% this year, says Mark Edwards, portfolio manager responsible for Asia at T. Rowe Price, but the government had a target of 8%. “They’ve achieved that,” Edwards says.

This 8% GDP growth – described as the magic number for China by one analyst – has largely been achieved by stimulating domestic consumption to make up for the drop-off in exports to developed countries occasioned by the global financial crisis. In that sense, the headline RMB 4 trillion stimulus package is the tip of the iceberg.

“The total stimulus package is RMB 10 trillion,” says Pinakin Patel, client portfolio manager at JP Morgan Asset Management. “It’s a lot more than what most people think has been spent.”

The headline RMB 4 trillion has mainly gone on infrastructure projects, but it’s the remaining RMB 6 trillion worth of myriad smaller initiatives that are credited with stimulating all-important consumer spending. These include measures to encourage consumers to trade in old cars and TVs and buy new ones, a 13% subsidy for farmers who buy certain white goods, interest rate and tax cuts for property transactions, and raised procurement prices for various grains.

It’s partly as a result of measures such as these that China’s new car sales of 6.09m units topped those of the US through the first half of the year, says Frank Yao, senior portfolio manager, Greater China Investments, at Neuberger Berman.

The backdrop to this stimulus package – which, as Jason Hepner, investment director, global strategy, at Standard Life Investments, points out as a percentage of GDP is the largest enacted globally – is the $2 trillion (€1.4 trillion) in reserves that the Chinese government has built up. This combined with its low debt/GDP ratio meant it was better placed than most to spend its way out of the global financial crisis.

“China is capable of shoring up its own growth,” says Hepner. “The signs are it has the capacity to keep the economy growing relatively strongly until the rest of the world shows decent signs of recovery.”

Efficiency and stability
Another advantage China has is that, not being a democracy, it could agree and roll out its stimulus package quickly and efficiently without the need for any boring parliamentary debates. Patel calls this China’s “efficient transmission mechanism”. One person’s efficient transmission mechanism, is, of course, another person’s dictatorship, but the markets don’t seem to care as long as there is stability – and stability appears to be a function of the continuing economic prosperity the stimulus package was designed to achieve.

“The biggest challenge to the government is to maintain social stability which is obviously linked to economic stability, income growth and employment,” says Christina Chung, manager of the Allianz RCM China fund.

There are more stimuli to come, which may help to ensure that what Patel calls the “harmonious society” remains in place. Yang Liu, chairman and chief investment officer at Atlantis Investment Management, points, for example, to a draft package designed to stimulate investment.

“The promotion of private investment is an important measure in sustaining China’s long-term recovery,” she says. “A second stimulus package from the Chinese government – currently in the draft stage – will kick start this process, lifting restrictions to allow private investors to enter into the state-owned enterprise sectors and encouraging banks to increase lending to small and medium sized enterprises.”

But, however, deep the Chinese government’s pockets, China presumably can’t go on spending forever. What then?

“The risks of the China growth story include a further deterioration in the global economy which will place significant pressure on the export sector leading to massive unemployment that could be socially destabilising,” says Chung.

If the global economy went into a depression that could present serious challenges to China’s future growth. As Hepner puts it: “China cannot drag the entire world back on to its feet.”

However, some commentators express frustration with a view of China that always has one eye on the US. Tiramani even dares to use the ‘d’ word.

“There is a kind of decoupling in terms of economic growth,” he says. “But as far as the market is concerned it’s too early to say. At the moment there is a kind of asymmetrical decoupling: emerging markets outperform developed markets substantially, but if the US market crashes emerging markets will follow suit.”

Many feel that it would take something close to complete economic meltdown in the developed world to derail China now. “If further deterioration in the global economy occurs I would expect the Chinese government to implement a very aggressive policy to maintain economic stability,” says Chung.

The scope for domestic economic expansion is huge. The Chinese have been busily saving at record-breaking rates and are now being encouraged to consume.

“Consumption only represents 25-30% of Chinese GDP,” says Patel. “China needs to increase the proportion of GDP coming from consumption in line with developed economies where it typically stands at 60-70% of GDP.”

There are also vast areas of Chinese potential not even broken into yet. Many second-tier cities with populations in the millions (Patel notes there are 250 cities in China with a population of one million plus) have yet to be substantially developed – to say nothing of the country’s vast rural hinterland. China is also moving up the food chain: less T-shirts and more electrical goods.

“China’s rapidly growing middle class will continue to drive domestic consumption growth,” says Yao. “As a point of reference, the US represents roughly 30% of global GDP with the US consumer contributing 70% of this number. China represents 7% of global GDP with the Chinese consumer comprising only 35% of China’s contribution. China retail sales have increased by +20% year over year for the past few years and this should continue to be the case as cities in more rural areas increase their domestic consumption rate.”

Growling noises
However, even if growth can be maintained at the crucial 8% level there are other potential clouds on the horizon. One is the potential roll-out from what Allianz RCM’s Chung describes as “the exceptionally loose credit year to date” which was handmaiden to the stimulus package.

“New bank loans during H1 2009 totalled RMB 7.4 trillion, compared with RMB 4.9 trillion during the whole of 2008, however concern is rising about a potential credit bubble, the quality of banking assets and future policy tightening,” says Liu.

Concern is heightened by lack of transparency. “It’s very difficult to get accurate information on where exactly the money is going,” says Hepner. “We’d like to know what percentage is going into productive projects and what into speculative projects.”

Lack of reliable information can be a problem in other areas too. Citing the risk that rising unemployment would represent, Edwards says it’s hard to be sure if you’re getting the full picture from the data with regard to, for example, graduate employment.

This also begs the question: can the economic data be relied on? “The bears say it’s all smoke and mirrors and that there isn’t that much demand,” says Edwards.

A related issue is corporate governance. In many ways, having had the advantage of starting with a blank sheet of paper, China has leapfrogged Western markets in terms of regulation, says David Jiang, CEO of BNY Mellon Asset Management Asia. But corporate governance still isn’t all it could be.

“The reality is how it functions isn’t developed,” says Jiang. “The regulators know it needs to be done, but there is a lack of people to implement it.”

Some of these issues, particularly those concerning transparency, bring us back to the tedious problem that just won’t go away: China is a command economy – and a communist country, as the forthcoming 60th anniversary of the founding of the People’s Republic of China can but serve to underline. However, Edwards probably speaks for most analysts when he commends the Chinese government for the way it has handled the economy.

“It’s very well run,” he says. “It’s not a democracy, but the top guys are there because they’re extremely capable.”

Whatever the problems, being a China bear is basically a lonely job at the moment. Most commentators view the five-year outlook for the Chinese market very optimistically.

“We are structural long-term bulls on China,” says Patel. “China will move along the S-curve quicker than any other economy [see chart].” “China superseded Germany last year, three years ahead of when it was expected. Japan is now in sight. If things continue as they are it won’t be long until China is the second-largest economy.”

©2009 funds europe

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