Postcard from China

Writing a piece like this after a trip to (a part of) a country is always somewhat difficult. The reason is that you have to be very careful not to extrapolate to the entire country what you have seen in the cities you have just visited. In this particular case, I will try to share with you some thoughts on my recent stay in Shanghai and obviously, what is going on in Shanghai is not really representative for what goes on in Fujian or other provinces. Moreover, whenever you are talking about the People’s Republic of China, it automatically makes things much more complicated as it seems almost everybody has an opinion on China nowadays. Most people have never even been there but still most feel compelled to have a (in most cases black or white) opinion on the one trillion dollar question: will we have a hard or soft landing in China?

I will first tell you a little bit on my experiences in and around Shanghai and then will share some comments on the Chinese economy in general.

THE CITY OF SHANGHAI

The rise of cities in China has been unprecedented and Chinese Tier-1 or Tier-2 cities can be overwhelming. Some facts: in 1990 about 26% of China’s population lived in urban areas. By 2011 it was 51% and by 2025 it is expected to be 65% or about 920 million people. Today, China already has 18 cities with populations of more than 4 million! Shanghai obviously is China’s largest city (by population) with around 23 million people. It is also China’s largest destination for college-educated talent and a magnet for foreign direct investment. As the national financial and industrial hub, it is probably the best positioned metropolis in China, if not the world, to benefit from an expanding global economy.

A picture often says more than a thousand words and I’m sure you have already seen some these pictures, but they are nonetheless pretty remarkable. The first picture below was taken in 1990 and the second was taken at the same spot in 2010. This is what transformational growth looks like in a city (Shanghai) whose GDP grew by double-digits every year for more than 20 years in a row.

When driving around Shanghai, you can see with your own eyes that private car ownership has more than tripled over the past five years. According to the Shanghai Daily downtown car ownership went from 5 cars per 100 families only five years ago to 18 cars per 100 families at the end of 2011. See some of the pictures above if you don’t believe me… (taken at 13h45 on a Thursday afternoon).

MEETINGS

One of the meetings we had in Shanghai was with the Chief Knowledge Officer of Ogilvy & Mather China. He told us the following interesting facts & figures:

• China’s 12th Five Year Plan includes US$110 billion every year on urban connectivity (every city with more than 500.000 people should be connected and 45.000km is to be connected by high-speed rail)

• The Chinese online gaming industry grew by 21% last year to a total of US$5,8 billion

• About 60% of luxury cars sold, is in Tier-2 and Tier-3 cities

•About 70% of luxury sales in general are from outside Tier-1 cities

•There are 1 million Chinese households with assets worth more than US$1 million

• 10 of the 100 most valuable brands in the world today are from China; however, not one of those brands is of a manufacturing company

• 2/3 of Chinese households with internet connections bought an everyday item online during the past 6 months

We also had a meeting with a Senior Researcher at the China Center for Public Economics and Governance (Renmin University of China in Beijing). He talked to us at length about how to get a better understanding of the Chinese economy and some of his more interesting statements are as follows:

•The population/farmland relation has been the most fundamental factor for dynasty changes since the Han Dynasty

•In 2011, China ranked only n° 126 globally in terms of the arable land/capita, so food security remains a very hot item

• Every PRC top leader is haunted by “catching up with the US and UK”

•The reliability of the data published by the National Bureau of Statistics is zero; one should not believe these data

• A high, though not higher, investment rate will be maintained: agriculture, environment, new energy revolution,… each will require trillions of Yuan

•Agricultural products prices have been in an accelerated, long-term rising cycle which is a structural irreversible trend

• Energy prices will not go down

• Officially half of the population has been urbanized, but of the urban population, at least 250 million peasant-workers are employed in the informal economy (meaning less stable employment, no welfare system and very hard work for a low pay)

•China is bound to reduce its energy intensity and change its energy structure in the years directly ahead

• China cannot and does not have the plan to build a European or North American level of social security system

GENERAL COMMENTS ON CHINA

Every year for the past ten years or so, experts have predicted the impending crash of China’s economy because of its huge imbalances and policy mistakes. They would point to non-performing loans, bad banks, inefficient state-owned enterprises and huge real estate bubbles. However, none of these have derailed China’s growth so far, which has averaged almost 10% annually for more than two decades. To be fair, there is absolutely no question that China has its fair share of problems. But it should be clear that China is very much aware of the challenges it is facing. Following the conclusion of the National People’s Congress in March 2007, China’s Premier, Wen Jiabao, talked about that very clearly. He acknowledged that the Chinese economy looked extremely strong on the surface, especially in terms of GDP and employment growth. Yet, beneath the surface, he cautioned, such strength was far more questionable. In the case of China, he warned of an economy that was increasingly “unbalanced, unstable, uncoordinated and unsustainable”.

Although recent Chinese economic indicators worsened across the board, we should not forget that slower growth was the government’s intention in the first place. However, it does seem that China’s slowdown has been somewhat sharper than expected. But here comes the interesting part. How do we define a ‘serious slowdown’? April readings included industrial production (up 9,3%), nominal fixed asset investment growth (up 19%) and retail sales (up 14%). All of these figures are indeed lower than had been expected by the market, but they still represent a lot of growth and this from an increasingly larger base.

One could also assume that as long as inflation stays low, more easing will be coming down the road. In some ways the Chinese have a very long-term approach (seizing up companies and buying real assets all over the world), but on the other hand China’s policymakers exhibit the same short-term approach as their Western counterparts. The massive stimulus program of 2008-2009 for example succeeded to the extent that it made things look better in the short term, but that is now considered as a big mistake as the economy almost overheated. Still, if we pay attention to what Wen Jiabao said over the weekend, he clearly repeated the stance of “maintaining stable and relatively fast growth, restructuring the economy and managing inflation expectations” by carving out “proactive fiscal policy and prudent monetary policy”, but he added that he would put more emphasis on stabilizing growth. This means that China is now more concerned than before and that they are ready to pull the trigger on further measures to boost growth. More reserve requirement ratio cuts are probably going to materialize sooner or later this year and credit supply could be further eased, as well as more spending on new infrastructure projects, social welfare and social housing. All of this is just a matter of willingness.

The slowdown in China is obviously also linked to the current Eurozone crisis and the ongoing problems in the US. Both the Eurozone and the US remain a very important customer of the Chinese manufacturing sector. Asian exports to Europe have been contracting since the last quarter of 2011. China’s domestic and intra-Asian trade is not (yet) sufficient to fully offset the poor demand from Europe and the US.

SHOW ME THE MONEY

So on the one hand China wants a slower, more qualitative and sustainable growth, but on the other hand they want to avoid a hard landing. This is the balancing act the Chinese government is involved in right now. Slower growth would of course be negative for commodities demand, corporate profits and the global recovery in the short term, but it would be much healthier for everybody in the medium to longer term.

Because what have we learned from Japan, South Korea and Taiwan in the past? These countries also grew close to 9% annually for about two decades and then started to slow. And what caused these slowdowns? Success! In each case, the economy had produced a large economy and a middle class society from where it becomes much more difficult to grow at the same breakneck pace. So China’s growth story is not as unprecedented as first meets the eye.

Another way to look at China is in terms of the valuation of the Chinese stock markets. Below is a chart of the Hong Kong Stock Exchange Hang Seng China Enterprise Index (representing the H-shares in Hong Kong which are included in the Hang Seng Mainland Composite Index), where the 12-month trailing price/earnings ratio is around 7 right now.

What makes me less happy about China’s future, is that many years of fixed asset investment driven growth have created excesses and overcapacity across the country. A couple of years ago many Western companies faced the problem that they could not meet demand in the Chinese market and they started adding more local capacity. However, many Chinese companies have been doing the exact same thing. Sany Heavy Industries for example has been building more capacity, but so has Caterpillar (both are active in the same industry). At some point, especially in the transformational phase whereby fixed asset investments grow at a slower pace than before, this overcapacity is definitely going to be a problem and it could be detrimental for growth for quite some time.

In conclusion, the Chinese economy will certainly begin to slow in the next few years after three decades of almost 10% average annual growth. Exports will be constrained by depressed Western markets and fixed asset investments will produce diminishing returns. However, China’s economy will probably continue to grow at a rate which makes us all blush, even if it will be markedly lower than the average rate of the past decades. This “new normal”, will be less pronounced if the Chinese government succeeds in boosting consumption as the new growth engine. order to achieve that, a gradual transition to a more consumer-led economy does need to begin NOW. The longer it takes for this transition to start, the more painful the adjustment period will be.

Sources: CLSA, Foreign Policy, The Economist, MRB, Stephen Roach, GaveKal Dragonomics, The Atlantic, Morgan Stanley, Bank of America Merrill Lynch, China Daily