Invigorated China: there's still a tough road ahead
I've just returned from a wonderful two-week trip to China and I defy anyone who visits this vast country not to return brimming with confidence in the future. I did – even though the local stock markets tanked during my stay.
While I was there, I wanted to look at the wider macroeconomic picture – and for this my guide was US economist Michael Pettis. He is a finance professor at Peking University's Guanghua School of Management, as well as being chief strategist at Shenyin Wanguo Securities in Hong Kong, and author of the China Financial Markets blog at www.mpettis.com.
At the core of his argument is this simple idea. China is expanding at a rapid rate, fuelled by cheap credit and massive government spending on infrastructure. This massive increase in output and capacity must be paid for in some way – and the real cost is to consumers who don't receive a fair return on their savings because interest rates are kept artificially low. So every time you travel on one of China's impressive new high-speed trains, you're actually travelling on a fiscal black hole! )
Pettis believes China is experiencing a major mis-allocation of capital to a range of massive projects, which have the net effect of repressing household income and consumption at the expense of the country's rampant export sector. He finds little evidence that this is about to change soon – exports are booming again and the government continues to invest like there's no tomorrow. But Pettis suggests a crunch is not far away and we'll see it first in what he calls “debt capacity”. He argues that government debt is much higher than the official 20 per cent of gross domestic product because it needs to include all the debt at municipal and provincial level, which is guaranteed by central government. He thinks this is nearer 70-80 per cent of GDP and growing quickly.
This alternative take on China's economic vulnerability leads to some difficult conclusions for equity investors.
First, Pettis reckons that investing in China will be a roller-coaster ride. “The government is very worried about the real estate bubble and is trying to hammer it down, but they're not addressing underlying liquidity, so it's going to go somewhere else,” he argues. “My guess is, that after a period of stability in the equity markets in China, they're going to surge”. Then, Pettis reckons, we'll see another bust, followed by years of below par economic growth as domestic consumption starts to recover.
Second, Pettis is deeply suspicious of fund managers who reckon they can find value stocks in China. “To be a fundamental investor, you need good macro data. We don't really have it. You need good financial statement data. Impossible. When you take fund managers out to drinks, they tell you what matters: underlying liquidity, and government policy!”
Third, he is cynical about fund managers tracking down fast-growing small and mid-cap companies “If you assume we've reached an end to that [exporting] process and we now need Chinese consumption, then we've got a really big problem – because in order to get consumption to grow?.?.?. you've got to [stop] the household sector subsidising manufacturers. If you remove those subsidies, what happens to the growth of those companies? We don't really know.”
So, how should investors react? “If I were going to invest in China, I would want to invest in good, solid companies that will benefit from consumption growth,” Pettis told me. “Stay in the best, most liquid stuff at least for a few more years because we've got a really tough road ahead of us. Then at some point, it makes sense to go back into
the risky assets like developing countries and consumer orientated companies in China.”
I hope to be going back to visit both, very soon.