Wednesday, April 11, 2012

China: The long and short term views

Michael Pettis has a must-read piece on the long-term growth trajectory for China, in which he says that China will inevitably change its growth pattern, either voluntarily or otherwise. Pettis contends that China will rebalance by shifting away from investment driven growth to a growth model based on domestic consumption.

He goes on to say that the government has to stop the financial repression of the household sector and lays out a number of options:

This is the key prediction, and it implies that one way or the other Beijing will engineer a transfer of wealth from the state sector to the household sector. As I see it, the various ways in which this transfer can take place can all be accounted for by one or more of the five following options:

  1. Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.
  2. Beijing can quickly reverse the transfers in the same way.
  3. Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.
  4. Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt.
  5. Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
He went on to discuss the implications of any potential rebalancing and the implications on the growth trajectory for China:

Notice also that the changing share of GDP tells us little or nothing about the actual GDP growth rate, or about the growth rate either of household wealth or of state wealth. It just tells us something very important about the relative growth rates. For example we can posit a case in which GDP grows by 9% annually while household income grows by 12-13% annually. In that case the rest of the economy would grow by roughly 5-6% annually (household income is approximately half of GDP), and the distribution of this growth would be shared between the sate sector and the business sector. This might be considered the “good case” scenario of rebalancing...

It is worth making three points about these different scenarios. First, in both cases China rebalances, but the way in which it rebalances can have very different growth implications. Second, notice that even in the bad case, household income growth can be quite robust, which means that fears of social instability as Chinese growth slows are very exaggerated if a slowdown in Chinese growth occurs with real rebalancing.
He went on to outline the pros and cons of each policy option, which is well worth reading in detail.

I mostly agree with Pettis. I recently wrote an essay entitled China: the first Axis of Growth for my firm, Qwest Investment Fund Management, which approaches the issue from a slightly different point of view:

This month, we begin the first of a three part series examining the effects of this deleveraging process as it affects the three major trade blocs, in the world, namely China, Europe and the United States. We discuss the challenges that affect each Axis of Growth and the likely growth trajectory that each region will have over the next ten years.
I arrived at a similar conclusion [emphasis added]:

Our analysis begins with China. China faces three challenges over the next ten years. Most immediate is the excessive debt built up from white elephant infrastructure projects on the government side, and a property bubble on the private side. Longer term, China is facing an aging population (see our May 2011 publication entitled China’s long-term growth headwinds) and the prospect of reaching a “Lewis turning point”, where labour productivity falls because China is running out of cheap labour from the rural regions, which pushes up wages and gains from rising labour productivity falls.

We believe that the Chinese leadership is well aware of these issues and are taking steps to address these one by one. Our base case calls for continued Chinese growth as it transforms itself from a growth model based on low cost-labour driven exports and infrastructure investment to one based on higher value-added exports and domestic consumer spending.
In other words, expect the drivers of China's economic growth to change slowly over time, but growth will continue. What is admirable about Pettis' analysis is he goes into the implications of different policy options that the government has in order to effect these changes.

What's the trade?
As interesting as this long-term analysis is, my trader friends will ask me, "What's the trade?"

Today, China and Chinese related investment plays are showing weakness indicating that slowing growth expectations. While some China bulls have emerged, I see no technical signs of a bottom has been put in place. This Bloomberg TV interview with Patrick Chovanec, an associate professor at Tsinghua University's School of Economics and Management in Beijing, tells the story of what's happening on the ground in China. His most important quote was:

When I talk to companies throughout China, there isn't a single one that's seeing an increase in profits or revenues.
Here’s the trade: Should China experience a hard landing or commodities crash, my inner investor tells me to be prepared to buy commodity related investments with both hands, largely because commodity intensity rises when incomes rise and consumers want more stuff (cars, TVs, fridges, etc.) [emphasis added]:

The winners of this transformation remains the commodity complex, as rising incomes mean greater resource intensity, and companies focused on the Chinese consumer. We would avoid companies and countries exporting capital goods to China. Japan, in particular, appears vulnerable over the next few years because of its high debt level and reliance on Chinese exports as a source of economic growth.
A slowdown in China should not be viewed as a disaster, but an opportunity to buy into a secular growth theme at better prices.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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