This post was edited by markwu at 2018-3-28 18:28|
Seeing The Chinese Forest, Not The Trees
Charles Gave\Gavekal\February 25 2016
I do not know as much as I should about China, but I would beg readers’ indulgence as I have some general knowledge of how economies work, and some particular insights into economic history.
My fairly unoriginal starting point is that the first phase of China’s development, starting in about 1990, required a focus on building infrastructure and this caused particular rules to be adopted.
Since the essential roads, bridges, power plants and airports necessary for a modern economy are now largely built, China is moving to adopt a new set of rules. As a result, it is in a transition phase, which may or may not succeed. What is clear is that the outcome would have been worse if this attempted shift had not been undertaken.
My first visit to Guangdong took place in the late 1980s when I spent a night in one of Guangzhou’s few available hotels; after a fairly lousy dinner I opened my bedroom window and was struck by both the noise of the city at night (that has not changed in China) but also the almost complete absence of electrical lighting. By this point China had failed to add modern infrastructure for at least 100 years, and the dire reality was all too clear.
To address the issue the Chinese government opted for a policy of “financial repression” that relied on:
(i) an undervalued currency, leading to huge current account surpluses, and
(ii) capital controls by the government and central bank, which allowed the “capture” of these savings for use in building infrastructure.
Since the return on invested capital from infrastructure at this time was higher than the ROIC that the private sector could hope to earn, such a policy made sense and resulted in massive positive “externalities”.
This development approach required the building from scratch of an “infrastructure industry” (cement, steel, metals etc...). And the logic of such a development approach means that this industry must be oversized versus the “current” demand.
Why so? A steel mill must satisfy current demand, but also the demand from building the next steel mill, which will be needed to satisfy future demand, and so on. What matters is that final demand keeps growing.
Problems emerge when this demand tapers off and it becomes clear that there is a 20% overcapacity in steel production. Simply put, there is no known way to effectively forecast required production capacity when nobody can predict final demand.
Hence, those who intone gravely that China has engaged in a “massive misallocation of capital, as if this could have been avoided, have little knowledge of economic history.
In the US the 1873-80 depression followed the topping out of the railways and construction boom, and following the post-WW2 reconstruction of Western Europe a similar downturn occurred in 1962. Looking back, I’m guessing something similar unfolded in ancient Rome after the imperial road network was completed.
At such moments there is no other solution than to close at least 20% of the unneeded industrial capacity and take the losses through bankruptcies or debt reorganisation. One simply has to move on, recognizing that nothing will ever again make that excess capacity profitable.
But the question is move on to what? So long as the ROIC on the infrastructure industry exceeds the ROIC in the rest of the economy there are good reasons to maintain “financial repression”.
Once that situation is reversed, something must change. The problem is that for the rest of the economy to grow in a sustainable fashion it relies on a proper allocation of capital and so market-dictated interest rates and exchange rates.
Such a transition cannot be achieved with the flick of a switch as it requires property rights, a proper credit system and competitive banks. While not easy, it is—to paraphrase Margaret Thatcher—a TINA scenario (meaning, there-is-no-alternative).
Heading in the right direction
Viewed from afar, my judgement is that the Chinese authorities are moving, albeit with great hesitation, in this TINA direction.
It started with the partial floating of the exchange rate and deregulation (and reregulation) of the financial sphere and the credit markets. It is China’s good luck that unlike the US in 1880 it does not need to invent new products in order to grow.
It has a huge population which seeks a higher standard of living and a share of the goods and services consumed in the developed world.
This process is already well underway as can been seen by the fact that Chinese tourists today represent 13% of global tourist spending versus zero 30 years ago.
The only thing that the Chinese government has to do is to manage the decline of the infrastructure industries.
At this point, what do I know?
1) Big losses will be taken by state-owned banks on losses made by mostly state-owned companies. As such, who really cares if losses are transferred from the banking system to Chinese government debt?
2) Those Chinese banks seem to have lent a very low multiple of their deposits, so there is no danger of a run on the banks.
3) If one part of China owes money to another part of China, then on a consolidated basis China has no debt. This was a lesson learnt the hard way by the fellows who for years shorted Japanese government bonds.
4) Devaluing the currency will not help as there is no demand at any price for the excess capacity (Chinese steel producers are quickly realizing the limits to offloading supply in overseas markets as anti-dumping probes are escalated).
It would be better for the local currency to appreciate resulting in an improvement in the terms of trade, and as a result robust consumer demand.
There is one nasty precedent for the country with the world’s biggest current account surplus devaluing and that was the US in 1934. This transformed a nasty recession into a worldwide depression. I cannot imagine the Chinese making such a mistake (unless, of course, they ask American economists for advice!).
5) The current decline in China’s currency has nothing to do with fundamentals, but rather the unwinding of a skew between natural buyers and sellers of the unit.
Of US$4.5trn of reserves held in 2014, US$3.5trn were “earned” and US$1trn were “borrowed”. So what if these borrowed reserves are now being repaid to their legitimate owners?
6) The countries which have refused to bite the bullet and make the economic transition to a genuinely modern economy have not had a happy time of it.
Think of Argentina since 1945, Japan since the early 1990s which is still building bridges to nowhere or France (for far too long) where government spending keeps going through the roof regardless of who is elected. Compare this to Sweden which in 1992 presided over a broken banking system or Germany in the late 1990s which had become a byword for industrial sclerosis.
China is in the middle of its transition from an investment-based economy to a consumption-based economy, and politically, this is a dangerous time for any regime.
I also know that every such successful economic transition has been followed by huge bull markets. Both Sweden and Japan were at a similar crossroads in 1992. Sweden succeeded, Japan did not even try. Look at the relative performance of the two stock markets ever since.
Hence, I would contend that if a new bull market is about to start somewhere, it will be in China, and probably within the next two years. What will need to be bought is “new China” and not “old China”.
If the Chinese decide to go the Japanese or the British way (at the start of the 1970s) then all bets are off and the world will be a pretty miserable and dangerous place.
Given the silliness of economic policymaking in the US and Europe, for the time being I am happy to watch from the side lines. But should signs start to appear that the Chinese transition is a success then investors should begin to make a structural shift towards Asia.
I am starting to watch the Asian markets on a relative performance basis and if my contention on China is remotely right, then they should soon start to outperform.
And the first place where I will start buying is the Chinese domestic bond market. It helps of course that yesterday the Chinese government made a significant move by announcing an opening of the domestic bond market to foreign investors.
Not only does this provide market access but it is an encouraging sign that also serves to support my thesis.