China has shown up in the “Daily Intelligence Briefing” even more than usual in the last few weeks. This “Country Snapshot” groups together the key points into four areas: fiscal stimulus, monetary policy, economic rebalancing, and political frictions. While the latest data has been mixed, we think that China’s recent trajectory of slowing growth is turning back up, presenting renewed investment opportunities in currently unpopular sectors like materials and energy, although political tensions are edging up and the risk of market disruption is material.
Spiking the Fiscal Punch
A now famous WikiLeak quoted Li Keqiang when we was a regional party secretary and told the US ambassador that China’s GDP statistics are “for reference only.” Now that he’s the premier, Li is providing the references. He recently declared that 7.5% is the “lower limit” for growth this year and 7.0% is the “bottom line” that cannot be crossed. The chief central planner duly confirmed that 7.5% can be achieved this year with “arduous efforts.” Perhaps coincidentally, the Bloomberg consensus for China’s economic growth in both 2013 and 2014 is exactly 7.5%.
China’s leaders say they’re confident they will meet this year’s economic growth target of 7.5%. But they’re taking a few extra measures just to be sure, such as a mini-stimulus that includes another round of railway and infrastructure investment as well as tax cuts and credits to small businesses. Perhaps most important, local governments have been told to spend everything in their budgets this year (rather than carry anything over into next year). That kind of economic management is in the DNA of centrally-planned economies, as much of China still is: a burst of activity to meet the plan (even if it means borrowing from the next plan), a message for more than just the local governments.
The Baijiu Bowl
In China, monetary policy still plays second fiddle to government fiscal policies, more often than not implementing measures that reflect decisions already made by the political leadership. Even so, the People’s Bank of China’s role has certainly grown more prominent as China shifts from administrative directives to market levers in the economy. Credit reforms are advancing. Just recently, the PBOC removed a floor on lending rates as it moves to expand the role of markets in its economy, a change that will require banks to raise more capital. However, even the PBOC itself pointed out that the caps on deposit rates remain in place; those kinds of reforms are being put off, at least for now.
In the US, the Federal Reserve has the dominant role in shaping the business cycle. As former Fed chairman William McChesney Martin famously put it, the job of the central bank is to “take away the punch just as the party gets going,” and raise rates to prevent the economy from overheating. When China’s overnight lending rate spiked in June, the People’s Bank of China looked like it was finally taking away the baijiu bowl. For several days, a brief but brutal credit crunch reduced bank lending to a trickle, reverberating through global markets, before the PBOC released a statement pledging market stability. They’re not taking away the baijiu bowl after all, at least not yet.
While launching short-term fiscal stimulus and keeping the monetary policy settings on hold, China’s current economic policies fall into two main types: rooting out corruption to make the existing system work better and introducing reforms to the economic system itself. Last year, the Communist Party leadership set an example at the top by banning its cadres from gifting fancy watches and other luxury goods. Individual transgressions are being given prominence: the former railway minister, whose tenure was marked by bribes and a fatal high-speed train crash, was recently given a life sentence. Bo Xilai, the regional party ejected from office last year, was recently indicted for bribery in a country where 99% of cases end in conviction. China is now conducting an audit of all of its government debt. As the crackdown reaches deeper into the business community and widens to pharmaceuticals, dairy, and powdered milk, foreign firms in particular have been singled out and expatriates are now being detained.
Over the longer term, China’s leadership is seeking to reform and rebalance the economy to shift away from years of investment-led growth and place greater weight on household consumption. It is not a new goal, but it is now receiving far more attention by policymakers and is a centerpiece of the current five-year plan. How far they succeed depends on how quickly they can increase consumption as well as how effectively they can restrain investment, a process that will unfold over many years to come. On the consumption side, the most recent data from 2011 shows that household spending now accounts for 35% of the economy, which is little changed in five years and still half that of the US, at least according to the official statistics. But according to the Bank of China’s deputy governor, rebalancing is farther along because the official statistics are too low: since consumer goods are so cheap in China, the data should be adjusted for purchasing power parity, an exercise that boosts measured consumption to at least 43% of GDP. Be that as it may, consumption is contributing less to GDP growth in 2013 than it did at the same point last year and still lags investment.
On the investment side, China is burdened with overcapacity in everything from steel to solar panels and from paper to cement. China has ordered more than 1,900 industrial plants to curtail excess production by the end of 3Q and shut down altogether by the end of the year, but even that’s still a drop in the bucket. Having helped create the global solar panel glut, China now plans to cut polysilicon production in half. Overcapacity in the shipping industry left China’s largest shipbuilder on the verge of collapse and needing support from the state. Meanwhile, while some prominent large-scale projects have lost steam, including a stalled $91 billion industrial project near Beijing, other sectors continue to add new capacity: pig iron consumption is slowing but output was still up in the first half of the year (against the backdrop of record steelmaking overseas).
While some analysts forecast a trillion dollar deleveraging of the largest housing bubble of all time, so far the data is still going the other way. On the supply side, the housing sector remains strong despite a raft of measures to curb prices and restrict ownership. House prices went up in July for the eighth month in a row. Local government revenues from land sales surged 46% in the first half of the year. Skyscraper construction is still strong. And there is still plenty of potential demand: In a radical departure from decades of collective ownership, farmers could soon rent or even sell their land, many of whom will move to the cities. That’s in addition to the 250 million people China is planning to relocate from the countryside into new towns and cities in the next dozen years.
While the Communist Party has been careful to limit spillover of economic reform into the political realm, China’s rapid growth has come with greater dissent at home and more disputes abroad. Internally, some of the protests come with the tacit approval of the authorities, such as protests outside factory gates owned by Japanese and other foreign firms. In other cases, protests are focused on broader issues, notably pollution, and are having some policy impact. The first known protest against nuclear power prodded the local government to cancel a processing plant. There are clear limits to these protests, however, and some forms of protest remain beyond the pale altogether. Chinese police opened fire at Tibetans during a birthday celebration for the Dalai Lama. In the northwest region of Xinjiang, clashes with police and outside immigrants are on the rise. Ethnic unrest shows that Beijing’s efforts to re-educate and relocate ethnic minorities are not going smoothly.
Abroad, China has extensive territorial claims in the South China Sea and the East China Sea that are in conflict with nearly every country in the region. Tensions between China and Japan again flared up recently as China started the construction of a new natural gas rig in contested waters. Ships in China’s new coast guard now conducts incursions into waters controlled by Japan almost every day. Japan’s defense ministry recently issued a white paper that included remarkably terse language to say that Beijing was using “force” and was in violation of international law. Japan’s prime minister says he would like to revise Japan’s pacifist constitution and take a more active role in the area, an idea that the Philippines has already endorsed. China also has a similar territorial dispute with the Philippines, as well as Brunei, Vietnam, South Korea, Malaysia, and Indonesia. There are plenty of potential flash points in the region to disrupt critical sea lanes as well as upset markets. But as regional disputes continue to fester, some trade frictions are getting ironed out: China and the EU reached an agreement resolving their solar panel trade spat, preventing it from spilling over into a broader trade war.
China’s new leadership has signaled that it is prepared to tolerate slower growth to rebalance the economy from investment to consumption. They have simultaneously deepened a crackdown on discipline to root out corruption. Balancing those goals while keeping economic growth on track will be a challenge, particularly in the context of rising discontent domestically and greater frictions regionally. While there is no shortage of long-term challenges, our view is that policymakers are opting once again to boost growth in the short-run.
Within emerging markets, China has started to outperform since the mini-stimulus was announced. The best investment opportunities, however, might be less in China itself than in the global sectors that have been slumping along with China and are tied to a renewal of economic growth. Industrials are a good place to start since the sector also benefits from stronger industrial production in the US and improved prospects in Europe. Within commodities, base metals are also firming and have been outperforming precious metals for some time, a trend that would only be strengthened by an upside surprise in China through the rest of the year. But some industry groups, notably steel and shipbuilding, should continue to lag as overcapacity in China persists. There are also rising risks to other industry groups that China has singled out in the crackdown on corruption, notably pharmaceuticals and dairy.
Over the longer run, China’s need for energy has yet to be met; while coal might enjoy some rebound, the eventual winner is likely to be nuclear: China has bigger plans on the drawing board today than before Fukushima. The Party’s efforts to improve its image by cutting down on fancy gifts will also run its course, as the combination of urbanization and rising incomes continues to create opportunities in luxury goods and automobiles.
Over the even longer run, China faces deep problems, many of which are well familiar: huge government debt, endemic corruption, wealth inequality, overinvestment, internal dissent, and external frictions. Others will undoubtedly emerge. There are enough internal contradictions to keep any Marxist busy, and not all of them will be resolved easily. Eventually, China itself will be one massive short. But not yet.
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Warren Hatch, PhD, CFA
Portfolio Management and Global Investment Strategy
McAlinden Research Partners