Is there any value to be found in China?
SOUTH African investors can get direct exposure to Chinese assets through avenues like the Prescient China Balanced Fund or through Imara’s relationship with Quam Asset Management.
But as Chinese president Xi Jinping tries to put the brakes on his country’s economic slide, is there any value to be found in China? How much will failure in Beijing affect our economy?
In South Africa to speak at RE:CM’s Shifting Perspectives investment conference in Johannesburg, former Wall Street trader, economic theorist and Peking University professor Michael Pettis thinks that although the Chinese surge has all the hallmarks of previous emerging-market investment booms, the magnitude of the supercycle is unprecedented — and so will be the bust to follow.
“Post-2008, the adjustment in consumption in the US should have slowed the global economy, but China and hard commodity producers continued to grow. China’s GDP is radically overstated, but it continued to embark on massive projects. It shouldn’t have happened — the level of consumption had dropped and would not recover.
‘‘The increase in investment, for example in South Africa, is fragile and cannot be sustained. So, investment levels will ultimately have to adjust to significantly lower demand.”
The dissipation of demand for hard commodities, which Pettis said had been artificially propped up, would mean less investment here. While the price of iron ore, for example, has rallied recently and most predictions have the price staying above $110 a ton in 2014, Pettis believes the worst is yet to come. He said iron ore could fall to $50 a ton, with copper and other hard commodities to follow as China rebalances its economy.
Why must it end in a debt crisis?
“For decades China systematically underinvested in infrastructure. When it began to move, at first there were efficient projects that increased the capital stock of the country and generated real returns, but it eventually reached a point where consumption’s ability to absorb that investment is reached.”
According to Pettis, the real problem was a failure to pass on social benefits which accrued as benefits of economic growth — in short, the Chinese elite became obsessed with rent-seeking behaviour.
“Eventually investments are no longer efficient and they can no longer service the debt repayments. Investments become unproductive and it keeps growing the country’s debt levels. If you reach that stage, either the borrower goes bankrupt or someone else is paying.”
The Chinese workers were footing the bill, he said. “There is evidence of the transfer of re- sources from one part of the economy to another to keep this programme going. It came from household consumption. The average contribution of consumption to world GDP is 65%, and in the 1980s China’s consumption accounted for about 50% of GDP, but in the 1990s it dropped to 46%; by 2005 that level was 40%. In 2010 it was 35%. This is an unbalanced economy and it needed to reduce its reliance on investment.”
This didn’t happen, and investment continued to be misallocated on a massive scale. The reason consumption has not surged to take up the slack is that the national savings figures are misleading.
“It’s a structural problem. People are not actually saving money. There is no social security and medical costs are high. The explanation behind the figures is that consumption is so low because income is so low,” Pettis said.
He said China had systematically undervalued its currency to raise the cost of imports and subsidise the tradeable goods sector, had relied on a huge rural resource of unemployed labour to drive down costs and had failed to grow wages in line with productivity. Productivity tripled, but wages only doubled.
China restricts offshore investments by its citizens; few invest in the Chinese stock market. “It’s essentially an insider’s market. Instead, it drives Chinese to invest in bank savings, but its leaders have set inap- propriately low interest rates.”
As a result, the average Chinese worker is seeing a negative real return on savings, which means money is moving from net savers to net borrowers — the producers and employers.
“China is reaping 5% to 8% of its GDP from these moves alone. It pushes up GDP growth by radically lowering borrowing costs while putting downward pressure on household income.”
Pettis said all these factors needed to be addressed, but not without considerable pain for the country’s elite. “If the currency increases in value, the risk is erosion of the tradeable goods sector. If wages rise, labour-intensive sectors will be decimated, and that will likely involve a lot of SME bankruptcies — the only efficient part of China’s economy. And, even at low interest rates, the government can barely service its debt. If rates rise, state-owned enterprises and municipalities would go bankrupt.”
While the average Chinese worker would benefit from changes, Pettis said the leadership had not provided direction, or an adjustment strategy.
Pettis thinks the US will emerge from the global crisis first, but this doesn’t mean value in China will disappear. “In China there will still be some cheap assets and opportunities to buy because consumption may still grow even while overall GDP slows.”