Dissecting The Bull Case For China

Regular readers will know that I have been relatively cautious on the outlook for China. But despite recent dire headlines such as China, beyond the hard/soft landing debate ). Here are the basics:

The roots of China's growth
The China miracle was fueled mainly by two factors:

1. Access to a cheap source of labor and the willingness to use it as a source of competitive advantage to grow the economy; and
2. The CNY/USD currency peg.

While the currency peg allowed Chinese labor to be highly competitive, it also created all sorts of nasty side effects. First and foremost, China was stuck with America's monetary policy, which was inappropriate for China. As the Chinese economy heated up and inflation rose, Chinese interest rates could not rise with inflation and inflationary expectations because of the currency peg. Thus, real interest rates went negative.

Negative real interest rates created winners and losers. The winners were the companies with easy access to capital, which were mostly the SOEs at the expense of private businesses, which are often referred to as Small and Medium Enterprises (SMEs). An academic paper called Wikipedia :

Reinhart and Sbrancia characterise financial repression as consisting of the following key elements:

1.Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2.Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market.
3.Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
4.Government restrictions on the transfer of assets abroad through the imposition of capital controls.

John Hempton at Bronte Capital outlined the dilemma of the Chinese household well:

The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country. So they can't invest in any foreign assets.

Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.

What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.

For those ordinary Chinese citizens who could afford it, the only logical place for savings is in real estate. Real estate became a form of money and savings poured into it. In effect, the CNYUSD peg was indirectly responsible for China's property boom.

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Where we are today
Fast forward to today. China's growth has hit a slow patch. One of the objectives in the Party's latest five-year plan calls for a re-balancing of growth away from heavy infrastructure spending, which has benefited SOEs, to the consumer (read: household sector). Andy Xie described the slowdown and how the authorities have managed to contain the worst effects of the downturn:

There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.

SOEs, the vehicle of wealthy Party insiders, have been hit hard:

State-owned enterprises (SOEs) reported 4.6% net profit margin on sales and 7.4% return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4% decline in profits but 11.3% increase in sales.
SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.

Xie also echoed Hempton's kleptocracy claims, though in a less dramatic fashion:

Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20% to 30% more than that for private companies and take about 50% longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China.

In addition to the problems presented by slowing growth, the financial system is teetering because of an over-expansion of the shadow banking system (see my previous comment If any China bulls were to make a bet on China, then PGJ is probably the better vehicle as it is more exposed to the consumer sector (though I would add the caveat that it is very technology and internet heavy and therefore exposes the investor to a high degree of sector concentration risk).