Braking China …Without Breakingthe WorldBlackRock Investment InstituteApril 2012
[ 2 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d What Is Inside Joel Kim Head of BlackRock Asia-Pacific First Words and Summary 3 Fixed Income China Inc: Bull, Bear and Bottom Line 4 Introduction: Why China Matters 6 – A Matter of Timing Credit: Too Much, Too Quickly 8 Mark McCombe – The Great Credit Leap Forward Chairman, BlackRock Asia-Pacific – Bad Debt? Just Roll It Over – No Banker Will Come Clean This Year – A Less Offensive Four-Letter Word Neeraj Seth Real Estate: Can a Bubble Be Deflated? 13 Head of Asian Credit, BlackRock – Something’s Got to Give Fundamental Fixed Income Group – A Men’s Shirtmaker Diversifies – A Quiet New Year for Realtors – Breaking a Vicious Circle Jeff Shen, PhD Head of Asia-Pacific and Emerging Investment and Consumption: Market Equity, BlackRock Scientific Looking for Balance 17 Active Equity Group – A Case of Diminishing Returns – Go Buy a Refrigerator! – A Blueprint for Rebalancing Success Ewen Cameron Watt – Bankers Are Shooting Fish in a Barrel Chief Investment Strategist, – Wanted: Carefree Spenders BlackRock Investment Institute – In Search of Luxury Goods Politics: Change Is Hard 23 BlackRock’s China Forum – The Emperor Is Far Away About 50 leading BlackRock portfolio managers and external – Vested Interests and Paralysis experts from around the globe recently exchanged views on China’s – 300 Million Publishers economic trajectory at the BlackRock Investment Institute’s China Forum. Many went in bullish and came out still bullish— – From Small Piles of Rocks to Oil Shock but with much less complacency and certainty. This publication – Tit for Tat in Trade Wars summarizes their ideas. Competiveness: Beyond Cheap Labor 27 The BlackRock Investment Institute leverages the firm’s – Of Robots and Old People expertise across asset classes, client groups and regions. Markets: Counting on China 29 The Institute’s goal is to produce information that makes – Equities and Corporate Bonds: BlackRock’s portfolio managers better investors and helps A Growing Addiction deliver positive investment results for clients. – Commodities: An Outsized Influence Lee Kempler Executive Director – overnment Bonds: A Big Overhang G Ewen Cameron Watt Chief Investment Strategist Jack Reerink Executive EditorThe opinions expressed are as of April 2012, and may change as subsequent conditions vary.
Blackrock investment institute First Words and SummaryChina is at a crossroads. Investment-driven growth has spun manufacturers. Domestic savers financed China Inc.’s masteran economic success story without equal since the country plan by accepting savings rates below inflation, wage increasesopened for business in 1978. This has come at a cost: Unbridled that lagged economic growth and a minimal social safety net.credit growth, overbuilding, environmental damage and a widening This is changing, but powerful interests are stacked againstdivide between the haves and have-nots. a true shift to a consumption economy: exporters, state enterprises and local governments.It has become clear China’s old playbook of “invest and grow” nolonger works so well. But a shift to a consumption-driven society } hina’s new leadership could take the tough measures needed to Cis tough for a command economy and wrought with pitfalls. The engineer a shift—liberalizing interest rates, opening capitalcountry’s upcoming once-a-decade leadership change brings markets, market pricing of resources, and building out socialboth opportunity and uncertainty. The downfall of “princeling” services. But Beijing is not almighty; local governments tendBo Xilai, the former charis-matic leader of Chongqing, shows to go their own way and a desire for consensus has often resultedtumult below the surface. This changing of the guard will in political paralysis. Risks of a popular revolt or foreign conflictsreverberate well beyond its own population, as China has are low as the one-party state has kept a tight lid on dissentbecome the globe’s growth engine. and is focused on fulfilling its domestic social contract.We are optimistic on China’s economic trajectory in the short term. } eal wage growth, rising materials costs and environmental RA nagging worry: Markets already factor in a “soft landing” this restrictions are changing the workshop of the world—for theyear, leaving potential downside risk. The leaders walk a tightrope, better. Some labor-intensive industries are moving elsewhereand have lowered the official growth target to 7.5% for 2012. We and automation is increasing. There is room for more productivityare concerned about China’s ability to keep up its economic march growth even as the easy gains have been harvested. Protectionin the long run. Challenges are big and solutions are not easy. of intellectual property is still weak and global brands have yet to emerge, but we believe chances are China will remainThis publication discusses key factors driving China’s economy competitive and confound the doomsayers.this year and beyond, signposts for change and implications forinvestors. Examining the financial system, the deflating realestate bubble, the tricky shift to a consumption economy, So What Do I Do With My Money?TMpolitics and competitiveness, our main findings are: } lobal consumer companies and high-end machinery G} n explosion in credit growth resulting from Beijing’s 2009 A makers are likely to be good long-term bets. stimulus has made the financial sector the economy’s Achilles } nergy, precious metals and agricultural commodities E heel and its biggest long-term threat. The country can pave prices should be underpinned by the country’s insatiable over problems this year, but the bills will come due. China will demand, and boost companies in those areas. have to charge borrowers real money and give savers a real } ost Chinese companies are likely to report poor M return to create a healthy financial system in the long run. earnings this year, but valuations look cheap.} he real estate slump is the biggest threat to economic growth T } hina’s demand for basic materials such as cement C and confidence this year. The sector is interwoven with the and steel should peak soon, hitting key suppliers and entire economy and has been a key growth driver. A government- resource currencies in those markets. engineered slowdown has brought down prices to more affordable levels, but also has created ghost cities. Urbanization } hina’s buying of US Treasuries may slow over time, C and growing incomes should balance supply and demand but a fire sale does not look to be in the cards. eventually. The question now is: Can Beijing break a vicious More investment implications on pages 29 to 31. circle of falling prices and sales (when it is ready to do so)?} hina’s economic miracle was built on an undervalued currency, C lots of investment, and subsidized energy and credit forThe opinions expressed are as of April 2012, and may change as subsequent conditions vary.
[ 4 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dChina Inc: Bull, Bear and Bottom Line Factor Bull Case Bear Case A Sickly Financial System It is easy to pave over financial problems in the Banks’ non-performing loans have fallen by 97% short term, Beijing has plenty of firepower for in the past decade, but this masks a poisonous bailouts. Growth in local government debt has reality: Unpaid loans are rolled over. Debts of come to a screeching halt. China has proved state enterprises and, to a lesser extent, of local many times it can fix its banks when needed. The governments appear to be ticking time bombs. same team that engineered a doubling of annual Banks are bleeding deposits and luring customers credit to 14 trillion RMB during the financial crisis with asset-backed securities. (Hmmm, what kind can pull the strings in a different direction. of assets?) Banks are lending to all the wrong people: lumbering state giants and developers. Banks are bad at risk management. A Deflating Urbanization and the desire for upgrades provide Local governments, banks and companies all bet Real Estate Bubble steady demand. Affordability is improving due to prices would keep rising and are overexposed. falling prices and rapid real wage growth. Buyers Real estate has been the driver of economic pay a majority of the purchase in cash, so price growth. Homes are too expensive for average declines will not hurt the financial system. Savers earners. Overbuilding has resulted in ghost have few other places to park their cash. A cities and a huge inventory of unsold properties. push on low-end “social” housing will keep Beijing may not be able to arrest a vicious the construction industry busy. cycle of lower prices and lower sales. Too Much Investment and Is there such a thing as too much investment? Investment is a case of diminishing returns: It Too Little Consumption Capital stock is not yet excessive by international takes $5 to generate $1 of GDP growth. The model standards, and China needs investments in is based on an undervalued currency, low real infrastructure and automation to keep up wage growth and financial repression—factors productivity growth. Consumption is rising that policymakers are loath or unable to change. rapidly, and half of households will soon classify China’s command economy appears ill-equipped as “middle income.” Rural wages are growing faster to stimulate consumption. Much industry would than urban ones, making for more balanced collapse without below-cost energy and interest development. Building out a social safety net rates. “Vested interests” will work hard to torpedo would unleash a pile of precautionary savings a shift to a consumption model. Commodities for illness and old age. demand is at risk. Watch out, Australia. Political Risk The Communist Party arguably is built for stability: All politics are local. It is an uphill battle to It knows internal strife can result in Cultural effectively steer the country toward a new course. Revolution-type horrors. Regimes historically China has not done enough to improve the have faced popular revolts only when incomes environment, curb corruption, address the widening reach the world’s median: China has a long way inequality gap and stimulate consumption. to go there. Beijing has kept a tight lid on internal The leadership often is paralyzed because it is dissent and has not had a major overseas pulled in too many directions. China’s military confrontation in the last 30 years. build-up could set up the world for a major confrontation down the road. Competitiveness China’s value-added exports are increasing and Heavy subsidies have thwarted competitiveness industries are investing in automation to stay and innovation. Violations of intellectual property competitive and improve quality. China is filing rights still occur. The easy productivity gains more patents and is now dominating industries have been harvested, and wage growth is a of the future such as solar power. The country problem. China has yet to develop real brands. has a first-class infrastructure. The migration of labor-intensive industries to Vietnam, Cambodia and elsewhere is a good thing.
Blackrock investment institute Bottom Line Signposts (What to Look for)We expect a soft landing in 2012. Longer term, } Reserve ratio changesthe financial system represents the biggest risk } Deposit outflows and sales of wealth management productsto the economy, we believe. The sheer magnitude } Bank cash flows and operating cash levelsand pace of credit growth does not pass our } Credit growth and non-performing loan trendssmell test. } Corporate bond issuance and trading } Gradual moves toward market-driven deposit and lending rates } Demand for gold and other “hard” assetsBull BearReal estate is the No. 1 threat to China’s growth } Inventories, sales volumes and price trendsthis year because the sector is so interwoven with } Ratio of new construction vs. sold floor spacethe rest of the economy. Supply and demand } Debt and stock prices of major developers and consolidation in the sectorshould balance out in the long run. The lack of } olicy actions such as property taxes or, conversely, more curbs Pleverage is a big positive. } Sales of construction machinery and durable household goods } Sales and volumes in secondary and tertiary cities } Granting migrant workers urban residency permits so they can own homesBull BearA pullback in consumption in the wake of falling } Monthly retail, auto and luxury salesreal estate prices and slowing export growth is } Consumption share of GDP and GDP growth, and real wage growtha major risk this year. Longer term, a big worry } Raw materials imports, energy subsidies and commodities pricesis that a rush to rebalance could lead to an } Import/export trends (beyond one-month aberrations such as this February)economic implosion. } Loosening the currency peg and opening capital markets } Privatizing state enterprises and liberalizing interest rates } New sources of local government financing } Macau gambling revenues and capital flowsBull BearA one-party system is geared to retain its } Political unrest beyond local flare-upshegemony and ensure stability. The upcoming } Food price inflation, unemployment and rising inequalityonce-a-decade leadership change is hairy. Bo } Efforts to curb corruption, protect the environment and ensure food safetyXilai’s downfall is the tip of the iceberg, and one } High-profile casualties of the upcoming leadership change such as Bo Xilaithat is freezing policy for now. } Restrictions on social networks such as Weibo } Confrontations in the East China Sea with other Asian countries or the US } Increased secessionist and religious militancyBull BearLoss of competitiveness is the lowest risk to the } Productivity and real wage growtheconomy this year and beyond. China already is } High-end machinery ordersmoving up the value chain. } RD spending and patent applications } Trends in returns of Chinese who have studied abroad } Emergence of domestic and global Chinese brands } Protectionist actions by China’s trade partnersBull Bear
[ 6 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dIntroduction: Why China MattersChina matters—a lot. The country has rapidly become the second- The big questions are how the current government will navigatelargest economy in the world. It will likely contribute two-fifths the domestic real estate slump and the global economic slowdown,to global growth this year, twice as much as the United States. and whether the future leaders will be able to solve a tickingSee the chart below. Resource-hungry China has an outsized bad debt time bomb and deliver on promises to rebalance theinfluence on most commodities markets, and is the largest economy toward consumption and sustainable growth.foreign holder of US Treasuries. Add in challenges of maintaining a “harmonious society” in aGDP per capita jumped more than 20-fold to $4,400 in the 30-year place with rapidly growing expectations, corruption, a long historyperiod ended 2010. Ports, bridges, airports, expressways and of regionalism and world-beating income inequality, and you haveentire cities have been built in record time. China is now the largest a troublesome brew. This is before you even consider artificialmarket in the world for cars, computers, mobile phones—the pricing of money and a financial system that subsidizes borrowerslist is endless. Wine sales have more than tripled in just five years. at the expense of lenders. Or ponder environmental despoilment, deteriorating demographics, water shortages and a growing addiction to imported energy. It is a wonder the place works A Heavy Burden so well—or at all. There is enough fodder for a fierce debate China’s Share of Expected 2012 Global Economic Growth between panda haters and panda huggers. Now read on… China 40% Rest of Asia 24% A Matter of Timing Other Emerging Markets 17% Real reforms to rebalance China’s economy are on hold this US 17% Other Developed Markets 2% year because of the once-a-decade leadership change. An imminent collapse is unlikely, we think. The current leadership will not go out with a bang, but certainly does not want a train wreck during the final stages of stewardship. Business cycles exist in China as elsewhere —but we expect aSource: Deutsche Bank (January 2012).Note: Assumes global economic growth of 3.2% in 2012. soft landing in 2012. Flattening Out Sales of Heavy Machinery and Autos 100 250% 2,000 150% 200 120 80 UNITS (THOUSANDS) UNITS (THOUSANDS) 1,500 Y-O-Y GROWTH (%) Y-O-Y GROWTH (%) 150 90 60 100 60 1,000 40 50 30 0 500 0 20 -50 -30 0 -100 0 -60 2008 2009 2010 2011 2012 2002 2004 2006 2008 2010 2012 Monthly Machinery Sales YoY % Monthly Auto Sales YoY %Sources: Bank of America Merrill Lynch, China Construction Machinery Institute and China Association of Automobile Manufacturers.Notes: Machinery sales data through January 2012. Auto sales data through February 2012.
Blackrock investment institute In this interim period, it is important to read the economic tea Like some corporate chieftains, China likes to manageleaves. Real estate prices, sales and construction are important expectations by under-promising and over-delivering.ones. Politically sensitive food inflation is another one, as aremanufacturing gauges such as the various purchasing manager Premier Wen Jiabao set a 7.5% annual growth target for 2012indexes (PMIs). in March—the lowest rate in almost a decade. Most China watchers, however, believe the country will want to achieve atAt the start of 2012, the data were both conflicting and skewed least 8.5% a year. Official targets exist to be beaten. Like someby the effects of the early lunar New Year holiday. Real estate and corporate chieftains, China likes to manage expectations bykey consumption indicators pointed down, while other gauges under-promising and over-delivering.pointed up. It is realistic to expect China to move toward economic growthFor example, sales of heavy machinery used in construction, of 6%-7% a year this decade versus the 10%-plus clip in the oldsuch as excavators, crashed. Auto sales flattened, pointing to days, we believe. Five reasons:a general slowing in the wider economy. See the charts on the } he political leadership appears to understand the Tprevious page. drawbacks of too much credit.By contrast, transport volumes are strong. And a gauge of small } low growth in the debt-ridden developed world likely means Sbusiness activity has been ticking up. See the chart below. This slack demand for exports.is important because small businesses employ 60% of China’sworkers and make up 90% of companies. } he real estate boom has ended because tightening T measures have taken hold.The rebound could indicate the government’s easing policy } nfrastructure spending is slowing as policy shifts from Ion liquidity has started to work. Bank credit enabled large favoring bridges for the masses to pills for the people.companies to pay their supplier bills. Secondly, it could meanthe bottom has not fallen out of exports because many small } avings rates—the fuel of deposit and loan growth—are Scompanies are exporters. likely to remain flat or drop from mind-blowingly high levels. Beijing is expected to arrest this year’s slowdown in growth A Ray of Light with all sorts of administrative and fiscal measures, while at the China’s Small Business PMI, 2011-2012 same time trying to keep a lid on inflation and prevent more bad debts that eventually could overwhelm the banking system. 60 58 Most people, perhaps too many, believe Beijing will walk this 56 tightrope. At US investor gatherings in late February, one Wall SMALL BUSINESS PMI 54 Street firm’s China strategist polled the audiences and found 52 just one bear among roughly 1,000 people. This lonely creature 50 contrasted with a host of cubs the previous year. 48 46 Beyond 2012, the picture becomes very different. It is now clear 44 China’s 2009 stimulus was too much, in too short a time. Beijing 42 overestimated the US recession’s fallout. The result is a pile of 40 debt—which looks ready to fall over in the next few years (or Jan ’11 Mar ’11 May ’11 Jul ’11 Sep ’11 Nov ’11 Feb’ 12 stay shaky forever).Source: China Federation of Logistics and Procurement.Note: Data through February 2012. Most people, perhaps too many, believe Beijing will walk this tightrope.
[ 8 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dCredit: Too Much, Too QuicklyFor a poster child of “financial repression,” pick any of China’s What changed in 2004? China had started to rack up huge accountone-billion-plus consumers. They have been bankrolling the surpluses because of bumper exports and an underappreciatedcountry’s infrastructure boom and manufacturing machine— RMB currency. The surplus hit an unprecedented 10% of GDP atand have lost money in real terms in the process. (A cynic would its peak in 2007. The central bank started to offset, or sterilize,say the West now is importing this made-in-China concept.) the flood of foreign currency by selling bills at very low rates.Consumers who park their savings at banks have received For bankers, these were “bills you can’t refuse.”negative returns after factoring in inflation, an average loss To keep the banks profitable, authorities set deposit rates low.of 0.54% a year since 2004. See the chart below. Low deposit rates and high reserve ratios also would put a brake on inflows of “hot money” speculating on appreciation of the Don’t Take It to the Bank! RMB. The result: an effective tax on consumers who kept their Real Return on Household One-Year Deposits, 1997-2011 savings at banks. 8% Financial repression worked well because consumption took 7 a back seat in China’s investment-driven master plan. More on 6 China’s hard-pressed consumer and unprecedented investment REAL INTEREST RATE (%) 5 Average Interest 4 Rate = 3.04% boom later. In this chapter, we review the credit boom these 3 2 savings helped create. 1 0 -1 The Great Credit Leap Forward -2 Average Interest Rate = -0.54% Armed with a reliable supply of cheap deposits, banks went on -3 -4 a lending binge. The biggest beneficiaries were state-owned -5 enterprises (SOEs) and local governments. ’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11 The first group revved up exports and capital expenditures evenSource: Peterson Institute for International Economics. more, supported by cheap credit and subsidized energy costs.Note: Data through December 2011. It was a lifeline to many enterprises that had no business staying in business. Debts Have a Way of Piling Up—Even in China Credit Growth in Billions of RMB and as a Percentage of GDP, 1993-2011 15,000 50% CREDIT GROWTH (RMB BILLIONS) CREDIT GROWTH TO GDP (%) 12,000 40 9,000 30 6,000 20 % GDP 3,000 10 0 0 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 New RMB Loans New Foreign Currency Loans New Entrusted Loans New Trust Loans New Bank Acceptances Corporate Bonds New Stock Issued by Non-Financial Enterprises Insurance Claims Paid Insurance Company Real Estate OtherSources: Carl Walter, Su Ning, China Bank Statistics and People’s Bank of China.
Blackrock investment institute The second group financed infrastructure works, office towers, It is unlikely China will let the market collapse.conference centers and an array of faux landmarks, from Nobody wants to see a local government defaultChengdu’s Dorchester-inspired British town to Venetian canals or a big state firm go belly up.and a replica of St Mark’s bell tower at the New South China Mall in A bank CEO in a coastal city may say his operation is lending 100%Dongguan. This helped inflate an emerging real estate bubble. of deposits, no problem. He gets away with it because his bankCredit grew and grew ... until a great leap forward in 2009. Worried is part of a national network that (still) has enough deposits in thethe world financial crisis and subsequent US recession would interior to make up for shortfalls on the coast. The governmenthit China hard, Beijing engineered a huge monetary stimulus. may abolish this cap because it has many other ways to controlCredit doubled to a clip of at least 14 trillion RMB a year. See loan growth, notably its stranglehold on interbank market.the chart on previous page. Everything appears just hunky-dory for China’s banks: Non-Credit grew at an compounded annual growth rate of 36% in the performing loans (NPLs) fell by 97% over the past decade andperiod 2004 to 2010. As a result, the total value of bank loans now average just 1% of the loan book. See the chart below.and bonds quickly exceeded GDP. See the chart below. A Likely Sad Ending Too Good to Be True Outstanding Loans and Bonds, 1996-2010 Non-Performing Loan Ratios of Major Banks, 1998-2011 60,000 140% 35% LOANS AND BONDS (RMB BILLIONS) LOANS AND BONDS TO GDP (%) 50,000 120 30 NON-PERFORMING LOANS (%) 100 40,000 25 80 30,000 20 60 20,000 15 40 10,000 20 10 0 0 5 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 0 Bank Loans Bonds ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 Loans/GDP Loans and Bonds/GDP Sources: UBS, People’s Bank of China, China Banking Regulatory Commission and CEIC.Sources: Carl Walter, People’s Bank of China and Wind Information. Note: Data before 2002 only cover the Big-4 state-owned banks.This is where the problem lies: Take a machine that runs along This is dangerous, especially because both local authoritiesat a steady pace, suddenly inject adrenaline and order: “Go and SOEs are already deep in debt. It is unlikely China will let thelend.” The sheer magnitude and pace of this unbridled credit market collapse, though: Nobody wants to see a local governmentgrowth does not pass our smell test. It suggests to experienced default or a big state firm go belly up. There is nothing subtleinvestors there has to be trouble somewhere, sometime. about the government guarantees of these entities.Bad Debt? Just Roll It Over High-profile bankruptcies just do not fit into China Inc.’s masterChina has plenty of rules to keep credit growth in check. But plan of economic growth and employment. And banks are very muchthey are loosely enforced. For example, Chinese banks are part of the plan. Banks are, after all, an extension of the fiscalsupposed to lend up to 75% of deposits. But banks need to show policy. This is also the reason they trade at such low valuations.a 75% loan-to-deposit ratio only at the month’s end—givingthem about 30 days each month when they can lend more. Take a machine that runs along at a steady pace, suddenly inject adrenaline and order: “Go lend.”
[ 10 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dNo Banker Will Come Clean This Year have deteriorated across the industry in the past three years, with many second-tier banks already facing shortfalls, accordingThe practice of rolling over loans works—as long as banks have to ratings agency Fitch Ratings.enough deposits to play with. It is like a bath filling up fasterthan it empties out. Do not expect any banks to come clean this year. Bank chieftains angling for government positions in the leadership change willBut companies and consumers—faced with cash flow needs want their records to remain squeaky clean.and fed up with negative real returns—are starting to vote withtheir feet and are pulling deposits. Banks, especially in coastal Put yourself in the position of a bank CEO. You have been presidingareas, are trying to fight these outflows by offering asset-backed over five years—20 quarters—of profit increases. Now you aresecurities that carry higher interest rates. About 10% of deposits gunning for that position in the State Council. Are you going tohas flowed into these “wealth management” products. See the bring down your profits this year by increasing provisions? Justchart below. to be prudent? Chances are you will not. You leave it for the next guy to deal with. Looks Familiar? To be sure, there are plenty of deposits. They are just not for Investment in Asset-Backed Securities Quadrupled, 2007-2011 lending. One example: To recycle the inflows of foreign exchange and prevent the RMB from appreciating, the central bank obliges 8,000 ASSET-BACKED SECURITIES (RMB MILLIONS) banks to hold vast quantities of reserve bonds yielding only 1.5%. 7,000 This deflates the money multiplier and kicks sand into the engine 6,000 of a credit-led economy. 5,000 Bank chieftains angling for government positions 4,000 in the leadership change will want their records to remain squeaky clean. 3,000 2,000 In all, the Triple R (Required Reserve Ratio) and other measures 1,000 tie up some 10 trillion RMB of deposits. This has given the central bank the means to provide stimulus when the economy needs 0 it. Every cut in the Triple R pumps some 380 billion RMB into the 2007 2008 2009 2010 2011 system (provided the cuts are not offset by capital outflows). Index-Linked Asset-Backed Other Asset-Backed Bills Asset-Backed Loans This doesn’t mean SOEs and other politically connected players have a tough time getting credit. Not at all. They are issuing bondsSources: Carl Walter, Wind Information and Fitch Ratings. like there is no tomorrow—forced down banks’ throats at slightlyNote: Data through June 30, 2011. higher rates than one-year deposit rates. The result is a huge debt capital market where very few trades take place. Why? If a bankDeposits from corporations under cash flow pressure (and with the sells these bonds, it is almost guaranteed to take a loss becauseability to export capital by padding overseas invoices) dwindled to nobody wants them at the price the bank paid for them. Bottomnear zero in the first nine months of 2011, compared with growth of line: The corporate bond market is bank lending in disguise.3.7 trillion RMB in 2010. In the third quarter alone, corporatedeposits of an estimated 1 trillion RMB vanished into thin air. The bulls believe China has proved again and again it can fixCombined with the strangle of rising reserve ratios, growth in these problems. The basic argument goes like this: Chinese banksthe M1 money supply has dwindled to a clip of 3%-4%. go bust every decade, but the country has just found a much better way to deal with it than the West. Conclusion: AnyMoreover, deposit outflows have triggered a slow-motion cash weakness in the financial system will be dealt with quietly.crunch. Smaller banks in particular are vulnerable, partly becausetheir loans are coming due earlier. Operating cash reserves Deposit outflows have triggered a slow-motion cash crunch.
Blackrock investment institute [ 11 ] Acronym to Watch: LGFV Structure and Mechanics of Local Government Financing Vehicles (LGFVs) How LGFVs Come To Be Typical LGFV Structure Central Government Local Government Equity/Loan Ownership of Local Enterprises, 23 Provinces Injection Land and Tax Subsidies 5 Autonomous Regions 4 Municipalities (Beijing, Shanghai, Chongqing, Tianjin) Repayment 2 Special LGFV Bank Administrative Regions Cash Loan Incorporated 6,500-8,200 LGFVs Profit Cash Investments 333 Prefectures 2,858 Counties Activities (Infrastructure, Utilities, Transportation, Land Development) 40,858 TownshipsSources: Deutsche Bank and China Statistical Yearbook 2010.A Less Offensive Four-Letter Word time bomb, especially at a time a main source of local government revenues—land sales—has dried up amidLocal governments cannot borrow unless they have specific falling real estate prices.approval from the State Council, the country’s highest executiveadministrative body chaired by the premier. This doesn’t happen Where there is a will, there is a way—especiallyvery often. It is not meant to happen often. Think of it as a in China.company requiring CEO sign-off for all travel and entertainment.TE costs will go down very quickly. Others are optimistic. LGFV net debt barely increased in 2011 because regulators discouraged banks from making new loans,Where there is a will, there is a way, though—especially in according to research firm CLSA. This compared with a 19% riseChina. Local authorities have set up special entities to pay for in LGFV net debt in 2010 and a 62% stimulus-fueled jump in 2009.infrastructure and other projects. This is perfectly legal. The CLSA says. Local governments can pocket an increasingly smallerchart above shows the mechanics of these so-called local share of land sales because of higher spending on compensationgovernment financing vehicles (LGFVs). and relocation. As a result, local revenues from land fees The bulls believe China has proved again and again equaled just 9% of total national spending on infrastructure it can fix these problems. in 2011, CLSA notes. In any case, all local debt is an explicit liability of the centralLGFVs have taken out trillions of RMB in loans backed by land government—which saw a 30% jump in tax revenues in 2011.sales. China bears have long argued this represents a ticking Beijing can pay a lot of bills.
[ 12 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d Get Out of Debt Tomorrow Over the Refinancing Hump A Possible Solution for Bad LGFV Debts Maturities of Local Government Debt 3,000 3,500 35% 30.2% 2,550 600 2,500 3,000 30 600 24.5% RMB BILLIONS 2,000 TOTAL DEBT (RMB BILLIONS) 2,500 25 600 1,500 PERCENT DUE (%) 2,000 17.2% 20 260 1,000 120 245 1,500 15 125 0 11.4% 9.3% Local Govt. Revenues Asset Sales Recoveries on Projects Potential NPLs Local Govt. Bond Central Govt. Support Over-Provision for NPLs Write-Offs 1,000 7.5% 10 500 5 0 0 2011 2012 2013 2014 2015 2016 and BeyondSource: Deutsche Bank estimates.Notes: Assumes 30% of LGFV loans default. Assumes local governments sell 10% of assets Sources: Deutsche Bank and National Audit Office.and divert 2% of revenue. Note: Data as of year-end 2010.Even if 30% of all LGFV loans default, the problem is manageable, In addition, most LGFV debt is spread out after scaling a renewalaccording to Deutsche Bank. Local government bond issues, hump last year, with almost a third due only after 2016. Seeasset sales and diverting 2% of government revenues would the chart above.solve most of the problem in its view. See the chart above.
Blackrock investment institute [ 13 ]Real Estate: Can a Bubble Be Deflated? The City Beckons Urbanization and Migration 22 Cities 5 Million = 180 Million 71 Cities 2-5 Million = 216 Million 552 962 1,307 1,427 121 Cities 1-2 Million = 175 Million mln mln mln mln 100% 214 Cities = 571 Million Harbin 467 Shenyang 80 mln Beijing 745 SHARE OF POPULATION (%) mln Tianjian 60 790 490 mln Xi’an mln Nanjing 40 Shanghai 960 mln Chengdu Wuhan Hangzhou 562 20 mln Chongqing 172 62 mln Guangzhou 0 mln 1950 1978 2005 2025 Rural UrbanSources: ISI Group, CEIC and National Bureau of Statistics.Note: Numbers in millions of people.Rapid urbanization drove China’s housing boom for much of the Something’s Got to Give2000s—and is likely to do so in the future. China is expected to Some 40%-45% of all residential properties sold in early 2009have almost one billion urbanites by 2025. It already has 214 were for investment purposes, according to think tank Petersonmetropolitan areas with more than one million people, four Institute. Other speculative bubbles built in jade, art and goldtimes as many as the United States. See the chart above. prices, but there was nothing like real estate. Beijing inadvertentlyMany Chinese already owned their homes, but often these were made it the preferred asset class, egged on by powerfulshacks or rural dwellings. There was definitely a need to upgrade, interests that cashed in on this state-sponsored freebie.and many households did just that. Other speculative bubbles built in jade, art and goldThen savers desperate for yield and “hard assets” started to prices, but there was nothing like real estate.snap up apartments. Where else could they go? Banks offerednegative real interest rates. The stock market was perceived asa big high-roller table at best. And offshore markets were—andare—pretty much shut.
[ 14 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dLocal governments did their part to support the boom by providing The risk to housing in China is not so much itsinfrastructure and sponsoring grandiose projects. They bought imminent collapse, but how ubiquitous otherfarmland at artificially low prices and sold it for a profit to segments of the economy are exposed to it.developers. Over time, local governments became addicted to Sales volumes and prices fell after government measures tothese land sales as a source of revenues. And the practice to dampen speculation and prevent prices from spiraling beyondappropriate land became the root cause of periodic local the reach of the emerging middle class. There are some tentativeoutbreaks of social unrest. signs of bottoming (see the charts below), especially in second-Real estate has been a great wealth creator, for companies, local and third-tier cities where people buying homes for themselvesgovernments and individuals alike. The top source of wealth are a more important source of demand than investors.among China’s richest 1,000 people is real estate, according to thelatest ranking by Hurun Report Magazine (which was appropriately A Men’s Shirtmaker Diversifiessponsored by the Hainan Clearwater Bay luxury development). The real estate market is the biggest risk to China’s economicNo wonder those feasting want the banquet to continue. growth this year. The tipping point will likely come in the second quarter, when downside risks to the entire economy will start to Sales volumes and prices fell after government measures to dampen speculation and prevent outweigh inflation and affordability considerations. Or will they? prices from spiraling upward. Our assumption is Beijing wants to take real estate prices down 25%-30% from their highs. With a 10% fall already, there is a painfulBubbles involving real estate are quite common. This seemed to additional 15%-20% to go. This is dangerous. The biggest riskhave all the signs, including the endemic involvement of local is stagflation—when activity drops off a cliff while prices stay high.governments and the corporate sector. It is clear the boom In that case, the government may stick to its tightening policy.cannot last. (Nor does Beijing want it to last.) Consider:} hina’s residential housing construction equaled almost 10% C How big is the real estate sector? It makes up 20% of fixed of GDP in 2011, compared with 6% for the US economy during investments, translating into a 10% share of GDP. But the sector the height of the boom in 2005. looms much larger in reality. We suspect land is collateral for more than half of loans. Real estate is interwoven with the} eal estate accounted for 40% of urban household wealth R entire economy. In other words: The risk to housing in China is in 2010, double the proportion in 1997, according to Peterson not so much its imminent collapse, but how ubiquitous other Institute. It is hard to imagine it doubling again in the next decade. segments of the economy are exposed to it. That Sinking Feeling Real Estate Prices and Sales Volumes in Major Cities 12,000 150% 120 Y-O-Y SALES VOLUME GROWTH (%) 10,000 RMB PER SQUARE METER 90 8,000 60 6,000 30 0 4,000 -30 2,000 -60 0 -90 2007 2008 2009 2010 2011 2012 2010 2011 2012 Weekly Sales Prices Volume GrowthSources: Deutsche Bank and Soufun.Notes: Price and sales volume trends in 39 major cities. Volumes represent year-over-year growth in four-week periods. Data through March 2012.
Blackrock investment institute [ 15 ] Clearing Out Inventory Can We Finally Afford It? Months to Clear Real Estate Inventory at Current Sales Rates Housing Prices as a Factor of Annual Household Incomes 40 12 35 11 FACTOR OF HOUSEHOLD INCOME 30 MONTHS TO CLEAR INVENTORY 10 25 20 9 15 8 10 7 5 6 0 2007 2008 2009 2010 2011 2012 2008 2009 2010 2011 2012 Housing Affordability Inventory +1 Standard Deviation -1 Standard DeviationSource: Deutsche Bank. Source: Deutsche Bank.Note: Weekly data through March 18, 2012. Note: Estimated data through end 2012.One example: The CEO of a men’s shirtmaker says he expects Anecdotal evidence abounds: Coffers with cash in Macau and100 billion RMB in revenue in three years, with the core shirt Hong Kong. Record real estate prices in Vancouver. Australianbusiness making up just 1%. It is tough to make money in the mines and vineyards snapped up by Chinese buyers.apparel business, so the CEO is building a 400-meter office Once people start believing prices will keep falling, they stoptower—the highest in his city—and outlet malls. buying. Just 19% of people expected housing prices would goThis particular CEO is not alone. He illustrates how real estate up in the first half of 2012, down from around 45% in 2009,runs through the entire economy. It is not about a few developers according to a December People’s Bank of China quarterlygoing bust. It is about local governments. It is about the entire survey. The same survey showed 21% expected prices tocorporate sector. It is hard to see a happy ending here. We fall and 46% anticipated a flat market.struggle to find a precedent in history where the bursting Things looked pretty grim in the first quarter. For example, notof a property bubble did not lead to financial distress. one transaction closed in Beijing, a city of 20 million, during the entire Chinese Year of the Dragon celebrations, accordingA Quiet New Year for Realtors to JPMorgan. Overall, transactions have plummeted andA slowdown or, worse, a crash in the real estate market inventory has risen to 15 months worth of sales. See thealso would hurt consumer spending. If the US experience chart above on the left.is any guidance, ever-increasing real estate prices can driveconsumption. Take them away, and consumption plummets. The inventory may be understated as the gap between floor space under construction and the amount sold is huge: 1.9 billion vs.Some money is already fleeing the country. China had capital 1.1 billion square meters in 2011. The gap is slowly closing, butoutflows in the fourth quarter of 2011—the first time since the there is a big overhang. And new construction usually lags sixAsia crisis in the late 1990s. Speculative inflows betting on an months behind trends in real estate sales.RMB revaluation dried up as it became clear China’s economywas slowing. This put the spotlight on the wealthy taking money Once people start believing prices will keep falling,abroad. they stop buying.
[ 16 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dCommercial real estate is hit hardest, especially in second-tier The question we ask ourselves is: Suppose thecities. Chongqing, for example, will have nearly 800,000 square government took its foot off the brake; could itmeters of new commercial space in 2012, whereas the annual reignite demand in housing?take-up has been just 150,000 square meters. population, or 200 million people, live in cities but do notThe government has started to offer incentives for first-time have a proper registration.home buyers, including lower mortgage rates combined with Another avenue is the push toward low-end “social housing.” This“guidance” to banks to lend to this group. It could ax deed taxes will not do much for prices of high-end private homes, but it doesand even cut mortgage down payments—although it would not serve the dual purpose of creating affordable housing for theresort to the latter measure lightly. masses and keeping the construction industry going. Expect social housing construction to almost double to more than sevenBreaking a Vicious Circle million units this year, according to Bank of America Merrill Lynch.Some fear it is already too late to re-engineer a real estateturnaround—even in a command economy such as China’s. The market is starting to believe the magic of policy. Bonds andThese bears predict a vicious circle of lower real estate prices shares of Hong Kong-listed developers rose sharply at the startand lower activity. of the year. One company even raised new equity. The triumph of hope over experience? Only time will tell.On the positive side, China has had much shorter real estatecycles than the West. Policy measures reversed a downturn It is clear the government is not ready yet to reverse its housingat the end of 2008 in six months, for example. In the current policy. Premier Wen Jiabao in early March emphasized houseclimate, affordability is improving fast. If prices were to fall 20% prices were still too high and that relaxing existing curbs couldfrom their peak and real wages were to grow 13%, affordability cause “chaos.” This dampened investor hopes for a policy reversalwould improve by one third in one year. In the US market, this and caused stocks to post their biggest daily loss in months.would take about a decade. See the chart on the previous page. The questions we ask ourselves are: Suppose the governmentOne way to boost the housing market—and consumption—is took its foot off the brake; could it reignite demand in housing?reforming or doing away with the hukou system that bars migrant And suppose the paralysis in policymaking lasts long enoughworkers without proper urban registration from essential services to destroy confidence in real estate as an inflation hedge?such as schooling and healthcare. As much as 15% of the
Blackrock investment institute [ 17 ]Investment and Consumption:Looking for BalanceChina is about investments. Ports, multi-lane highways, dams, The country is becoming less efficient in turningbridges, high-speed trains, nuclear reactors, office towers, entire credit growth into economic growth. It needs evercities pop up seemingly overnight. The world’s workshop has more gasoline in the tank to make the car go down the highway at the same speed.renewed its plumbing, has redone its floor plan and is betterconnected with customers around the world than ever before. You might ask: Is there such a thing as too much investment?The result is an export juggernaut with productivity growth (Especially if you live in a place in desperate need of anmore than three times that of competitors. infrastructure upgrade—and many of us do.) The answer is: Yes.China is not unique in following an investment model. Germany It has taken China $5 of investment to generate $1 of GDP growthdid it in the 1930s; the USSR in the 1950s and 1960s; Brazil in since 2001, 40% more than Japan or South Korea in their take-the 1960s; and Japan in the 1970s and 1980s. Most of these off periods, according to the International Monetary Fund. Theefforts produced short booms but ended on ugly notes: war, country is becoming less efficient in turning credit growth intodebt drama and stagnation. economic growth. It needs ever more gasoline in the tank to make the car go down the highway at the same speed.A Case of Diminishing Returns We believe this is unsustainable—and a real worry. This is evenLike Japan and others, China enabled investment through truer if you accept some analyst views that China’s subsidiesrepression of consumption in three main ways: and production input advantages represent more than half of} An undervalued currency essentially taxed imports the return on invested capital.} Increases in real wages lagged GDP growth Demand for raw materials, especially cement and steel, may} Deposit rates were artificially low peak earlier than many expect. See the table below. China is now using 590 kilos of cement for every $1,000 of capitalWhat is extraordinary is investments are still increasing their formation, compared with 155 kilos in South Korea and justshare of China’s economy. In most places, consumption kicks in 29 for the United States, according to Deutsche Bank.and investment tapers off because of diminishing returns. Notso in China. See the chart below. Topping Out Expected Peak Demand for Selected Raw Materials Investment: Too Much of a Good Thing? Investment Share of GDP, 1997-2010 Material Cement Steel Copper 50% 2010 Chinese consumption 1,396 448 4.8 (in kilos per capita) Accumulated Chinese 13,939 3,348 37 INVESTMENTS TO GDP (%) Average = 44.1% consumption to 2010 45 Accumulated consumption peak 23,382 9,449 147 in Japan and United States 40 Projected peak consumption year 2015 2017 2025 Average = 37.1% Projected peak year consumption 1,633 657 10.8 35 Projected increase from current 17% 47% 125% levels to peak year (%) 30 Source: Deutsche Bank. Note: All data in kilos per capita except where noted. ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10Sources: Peterson Institute for International Economics and National Bureau of Statistics.
[ 18 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d Building, Building … Building Spending on Infrastructure in Billions of RMB, 2005-2010 Total High- Highways Urban Water Spending Conventional Speed Express- Transit Waterways Pipelines Electricity, Conserva- Environ- (RMB Year Rails Rails ways Subways Airports Ports Storage Gas Water tion ment Billions) 2005 93 17 548 53 21 69 39 725 82 33 1,680 2006 110 64 623 80 31 87 51 820 95 42 2,004 2007 98 98 649 107 46 89 79 907 109 60 2,242 2008 130 231 688 127 57 99 112 1,048 142 73 2,707 2009 246 377 967 203 59 106 177 1,348 216 120 3,820 2010 294 442 1,148 236 65 117 224 1,454 275 153 4,407 Total 878 1,212 4,075 754 258 497 643 5,577 837 449 15,180 (2006-2010) Growth Rate 26% 92% 16% 35% 25% 11% 42% 15% 27% 36% 21% (2006-2010)Sources: ISI Group and CEIC.Notes: Conventional rails exclude rolling stocks locomotives. High-speed rails include new capital construction. Airports exclude aircraft and other special vehicles. Growth rates are compounded.To be sure, investment in infrastructure is still needed to secure In addition, China’s capital stock—the country’s highways, ports,energy, conserve water and connect China’s interior to the coast rail tracks, airports and factories—is still far below that of theand the world. In the past decade, about 50% of investments United States, Japan and South Korea on a per capita basis.have gone into transport. Expect less spending on transport in Even as a percentage of the relatively small economy, capitalthe future, especially on high-speed trains after recent mishaps, stock has not been excessive. See the charts below.and more on nuclear power and water conservation. See thetable above for past spending trends. … And Building More China’s Capital Stock to GDP and Per Capita 350% $150,000 325 120,000 CAPITAL STOCK PER CAPITA ($) CAPITAL STOCK TO GDP (%) 300 90,000 275 60,000 250 30,000 225 200 0 ’78 ’82 ’86 ’90 ’94 ’98 ’02 ’06 ’10 1995 2000 2005 2010 China US South Korea China US Japan South KoreaSources: HSBC, CEIC, Bureau of Economic Analysis and Japan’s Cabinet Office.Note: Per capita figures in constant 2005 US dollars.
Blackrock investment institute [ 19 ]Go Buy a Refrigerator! A Blueprint for Rebalancing SuccessThe mirror image of the investment boom is subdued consumption. Rebalancing the economy is a multi-year project. NobodyConsumption has grown—we have all heard about the excesses— wants to upset the delicate equilibrium holding China’sbut not as fast as GDP. As a result, it made up barely a third of economy together now.the economy in 2010. The ingredients of rebalancing are well known:To many economists, this number is surreal—it is somethingyou just never see. The contribution of consumption to GDP } iberalizing interest rates: Given the economy’s torrid L growth also remains extraordinarily low. See the chart below. growth, interest rates should be in the double-digit range to allocate capital efficiently and offer savers real rewards. The trick is to go slowly: Local governments and state enter- Consumption Growth Is Surreal—In Its Modesty Composition of GDP Growth, 1996-2012 prises would go bankrupt if rates became real overnight. } xchange rate flexibility and opening of capital E 15% accounts: Another multi-year project, but one that CONTRIBUTION TO GDP GROWTH (%) 12 is very necessary to address global imbalances. 9 } rivatizing state-owned companies: Would cut bad P 6 debts and reduce reliance on exports. Assets could go into the underfunded social security fund. 3 } uilding out a social safety net: Would help turn at B 0 least some precautionary savings into consumption. -3 } ew sources of local financing: Would lessen the N -6 reliance on land sales. A possibility is recurring real ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12 estate taxes pioneered by Shanghai and Chongqing. Consumption Investment Exports } arket pricing of resources: Electricity prices are M Sources: CLSA and CEIC. artificially low to protect manufacturing, whichNote: 2012 data is estimated. uses the brunt of electric power. Expectations for reform are massive, but do not hold yourHighly unusual? Yes. Damaging? Probably. The internal imbalances breath this year. The once-a-decade leadership change isare reflected externally, with China’s trade surplus and foreign putting the big decisions on hold. It is more about whatcurrency pile ever increasing. Leaving prescriptions for debtor Beijing won’t do than what it can do for now.nations such as the United States aside, everybody agrees The February 2012 “China 2030” World Bank report hits manyChina has to rebalance its economy toward consumption. of the right buttons. Many recommendations have been onCan a command economy successfully make such a shift? the agenda for years, but nothing has happened. The mainIt is tough. reasons are twofold: Powerful forces, including local governments, exporters and banks, support theA command economy is very good at investing. The order “build investment model. And a consensus-drivena highway” comes down, and it gets done. It is much harder to leadership tries to placate too many interests.say “go buy a refrigerator,” and get much traction.Any moves toward a consumption society are likely to be gradualand slow. This is a good thing. Suddenly taking away industrial Similarly, a rush to rebalance could trigger a spike in inflationsubsidies such as below-cost loans and electricity, for example, around the world. For years, China “exported” deflation bywould create a train wreck. Similar to how a July 2011 deadly providing consumers elsewhere with goodies that became cheaperaccident near Wenzhou upended China’s ambitious plans for and better over time. The secret sauce consisted of low wages,a high-speed rail network, a big economic downturn could a low exchange rate and investment-driven jumps in productivity,set back the clock on any moves made to favor consumers such as better and cheaper transport. Change the sauce’sover manufacturers. ingredients, and the world is looking at a very different dish.
[ 20 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dBankers Are Shooting Fish in a Barrel food price inflation triggered by surging pork prices. The CPI— short for Consumer Pork Index in China—hit 6% last year butIn our view, rebalancing the economy should start with a gradual has receded since. The government’s 2012 inflation target of 4%interest rate liberalization. The 11th and 12th five-year plans on March 5 beat expectations, leaving more room for fiscal and(2006-2015) stressed this … but nothing has happened. One monetary stimulus.way to make progress would be to slowly expand the band ofdeposit rates. Banks would not like it, but they are in much In other areas, China is slowly making progress. For example,better shape than a decade ago. Beijing has deliberately been punching (small) holes in its Great Wall of capital controls. All companies authorized for foreign tradeFat lending spreads helped banks ring up a combined profit of can now settle payments in RMB; qualified foreign investors1 trillion RMB in 2011—which is close to half of all private sector can invest in Chinese securities; and central banks from Japanprofits. They are shooting fish in a barrel! This has created tensions to Nigeria are adding RMB and Chinese bonds to their reserves.between bankers and the “real economy.” Banks make moneyhand over fist while small businesses are cut off from credit Wanted: Carefree Spendersand consumers lose money on deposits. We have talked a lot about under-consumption in relativeThis situation has raised the possibility of an asymmetrical rate terms. As a part of a fast-growing economic pie, its size iscut: reducing the lending rate while leaving deposit rates alone. miniscule. In absolute terms, it is breathtaking.Until recently, the government’s sole focus was to keep a lid on The growth in the number of China’s wealthy— and their spending power—is huge. Half of China’s households will have income of Middle Kingdom of Middle Income 100,000 RMB or more a year—close to Mississippi’s GDP per Households With Annual Income Over 100,000 RMB, 2005-2015 capita—by 2015, up from less than 15% in 2010, according to 400,000 Deutsche Bank. See the chart on the left. Total income of This is a huge middle income class with money to spend. households in top 350,000 bracket in 2005 Supposedly, the most popular phrase in China is: “New Louis Vuitton opening soon.” There may be some truth to this. 300,000 Total income of households in top ANNUAL HOUSEHOLD INCOME (RMB) bracket in 2010 A Sweeter Home on the Farm 250,000 Income Growth in Rural vs. Urban Growth Areas, 1997-2011 15% 200,000 Y-O-Y INCOME GROWTH RATE (%) 12 150,000 Total income of 9 households in top bracket by 2015 100,000 6 50,000 3 0 0 ’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11 0% 20 40 60 80 100 POPULATION (%) Urban Rural 2005 2010 2015 (Forecast) Sources: CLSA and CEIC. Note: Income growth rates in real terms. Rural is growth in net income. Urban is growth inSource: Deutsche Bank. disposable income.Note: Income figures are nominal.
Blackrock investment institute [ 21 ]Incomes are now growing faster in rural areas, reversing a long Income is one thing. Getting people to spend is another. Chinatrend of faster rising urban wages. See the chart on the previous has become a lot richer, but savings have gone up even more.page. This caused many coastal employers this year to anxiously See the chart on the left.await the return of migrant workers from visiting family over the Financial repression is one reason for the high savings rates, asNew Year holiday. Some never did. Nearby family, low costs of we have seen. In addition, people set aside buckets of money toliving and now faster wage growth are big attractions of the pay for retirement and illnesses. The lower the interest rate oninterior. This trend bodes well for a more geographically deposits, the greater the amount of savings needed to create a self-balanced economy. directed social safety net. Building out social security programs would reduce the need for these precautionary savings. Spending Is Not a National Duty Yet There are plenty of other reasons to establish provisions for the Household Savings to Disposable Income, 1997-2008 elderly. China is graying—fast. The country will have 300 million 45% people aged 65 and over by 2050. See the table below. SAVINGS TO DISPOSABLE INCOME (%) 40 A Country of Old People Population by Age Bracket, 1995-2050 Average = 36.4% Population 0-14 years 15-64 years 65+ years 35 1995 1,211 327 808 76 2000 1,260 328 845 87 Average = 29.4% 2010 1,353 293 956 104 30 2020 1,449 287 989 173 2030 1,481 278 989 214 2040 1,489 287 950 252 25 2050 1,473 211 962 300 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 Source: World Bank.Source: Peterson Institute for International Economics. Note: Population figures in millions of people. Sagging Confidence = Sagging Sales Consumer Confidence Index and Retail Sales Growth 120 40% MONTHLY Y-O-Y RETAIL SALES GROWTH (%) MONTHLY CONSUMER CONFIDENCE 30 110 20 100 10 90 0 ’95 ’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12Sources: ISI Group and National Bureau of Statistics.Notes: Retail sales consist of all purchases by individuals, organizations and government. Consumer confidence data through January 2012. Retail sales growth through December 2012.
[ 22 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l dIn Search of Luxury Goods Luxury—At a PriceIt is clear the real estate downturn has spread throughout the Tax Rates on Luxury Goods in Selected Countrieseconomy. Consumer confidence plummeted in late 2011, triggering China US Hong Kong Singaporea decline in the growth of retail sales. See the charts on the Coach Handbag 27% 8% 0% 7%previous page. Porsche 911 82% 11% 90% 134%Remember the economic bar is high in China. Sales are still Rolex Watch 47% 15% 0% 7%rising at a rate retailers in the developed world would kill for. Lancôme Perfume 57% 8% 0% 7%Overall retail sales increased almost 15% in the first two Sources: Deutche Bank and Central University of Finance and Economics.months of this year, although this was less than forecast Note: Tax rates include import consumption tax, VAT/GST and import tariffs.and less than the previous clip of 18%.One way to jumpstart consumption is to cut duties. China has Chinese tourists mob upscale department stores around therelatively high duties, especially on luxury goods. See the table world because prices are cheaper overseas (and you have a betteron the right. chance of buying the real thing). Some 70 million mainland Chinese traveled outside the country in 2011, spending about $70 billion, The economic bar is high in China. Sales are still according to the China Outbound Tourism Research Institute. rising at a rate retailers in the developed world Duty cuts on luxury goods would serve to boost consumption, would kill for. give domestic retailers a shot in the arm and reduce the trade surplus. It is a bit of a political football, though, as duty cuts are seen as only benefiting the very wealthy.
Blackrock investment institute [ 23 ]Politics: Change Is HardChina is in the midst of a once-a-decade leadership change. The leadership change is a complex game ofThe change starts at the top, where seven of nine members of musical chairs that is likely to last well into 2013.the all-powerful Standing Committee of the Politburo are slated municipal politics such as the events in Chongqing discussedto change in October or November this year. The newcomers will earlier can take on national and international significance.likely include political scientists and economists, making it a morediverse crowd than the engineering-dominated current group. The leadership change is a complex game of musical chairs that is likely to last well into 2013. The clear aim is to have theA system of patronage causes the changes to trickle down, process take place with caution and consensus building rathernot just to ministries, provinces, mega cities and the armed forces, than prolonged and public tree shaking. That said the marketsbut to the humblest townships and courts. In a country where will watch closely to see if this morphs into policy delays andpolicy and government influence every walk of life, the subsequent changes in investment risk.leadership handover is the topic du jour. This explains why An Almighty Party China’s Political and Leadership Power Structure Communist Party of China Discipline Committee Politiburo Party Elders Military Affairs National People’s State Council Commission Congress Ministries Provinces Armed Forces Courts Prosecutors Agencies Townships Influence ControlSource: ISI Group.
[ 24 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d Nobody ever really knows the whole picture in China. Vested Interests and Paralysis If all politics are local, it makes sense central government initiativesThe party, which claims some 80 million members, controls take time to gain traction and in some cases never do. Localevery level of society, including the People’s Liberation Army officials will take their concerns to Beijing, adding to a cacophonyand the State Council, which oversees ministries and provinces. of voices proclaiming what needs to be done. The result can beIt was split by internal strife in the 1970s with the Cultural political paralysis—especially if the leadership’s penchant is toRevolution as a disastrous result. These days, it appears it seek consensus rather than to rock the boat.is built for stability. At least, most investors like to believe so. Some measures are opposed by the same groups across theThe Emperor Is Far Away nation. The drive to rebalance the economy, for example, isIs the political leadership all-knowing? Far from it. For one, opposed by “vested interests,” industries and people who havethe country is too big and too diverse. There is an old saying in the most to lose. The investment model is supported by exporters,China that roughly translates as: “The mountains are high and heavy manufacturing, banks and many local governmentthe emperor is far away.” chieftains. The powerful People’s Liberation Army has commercial interests, too. All this makes change a poor second choice, andThe country has a long history of provincialism, and the central is one reason reform happens slowly.government has always looked to tighten its grip on the regions. Beijing always overdelivers on five-year plan goals that relate toNobody ever really knows the whole picture in China. This is investments. And why not? Investment is easy to command andwhy the national statistics bureau uses satellite pictures: It there are no budget constraints. It is a different story when itis to understand land use and double-check data from local comes to objectives that cannot be achieved by investing alone:governments. Another example: Some people believe GDP is things like tackling corruption, increasing consumption andunderestimated by 30% due to a huge black market, whereas improving the environment. This is where Beijing barely passesothers contend it is overestimated by 30% because investments or is at risk of getting a failing grade.have generated a pile of non-performing loans.There is actually an upside to this opaqueness: Policymakers 300 Million Publishershave more time to adjust to whatever picture emerges. This is Internal conflicts are unlikely to spin out of control. Beijing haspartly why China’s political system has had resiliency. kept a tight lid on religious, ethnic and secessionist sentiments.Keep in mind regional differences: Every province, city and And protests typically only turn into social unrest when atownship is competing for resources in the top-down economy—or country’s income hits the world’s median level—whichtrying to stave off changes that may upset its business model. will take at least another decade for China.The government in Guangdong, for example, is deeply uninterested At the same time, corruption, illegal land appropriations andin incentives to develop the inland provinces if it comes at the growing inequality are flash points for popular anger. The surplus ofexpense of Guangdong. young males resulting from the one-child policy can aggravateAnd every cadre owes his or her position to the ability to pursue these simmering tensions, especially if unemployment werea growth agenda. China may not be a formal democracy, but the to mount. The latter would be a breach of the country’s socialCommunist Party has a clear social contract with the population to contract: employment and rising wages in return for obedience.deliver growth—and a deep institutional memory of what happens The recent stand-off at the fishing village of Wukan illustrateswhen this is broken, as in the Tiananmen Square protests of 1989. the point—and is the tip of the iceberg. It is difficult to see anDo not underestimate local officials. They often are smart and Arab Spring-type scenario for China, though, especially ifwell-informed—and in a position to move the needle. The vice Beijing plays it smartly and tackles corruption.mayor is a must-see stop for investors visiting one of China’s The web allows activists unprecedented means to broadcast their200 lesser-known cities with more than one million inhabitants. messages. SINA’s Weibo (or microblog), a cross between Facebook and Twitter, has 300 million members. This means China has China may not be a formal democracy, but the 300 million publishers. The government works very hard to control Communist Party has a clear social contract the web, but is likely fighting a losing battle in the long run. with the population to deliver growth.
Blackrock investment institute [ 25 ]From Small Piles of Rocks to Oil Shock In the immediate term, two risks loom large: First and most important is a potential oil price shock. Sustained high oilThe risks of external conflicts appear small at this time, we prices would kill global growth and simultaneously drive upbelieve. The re-election of President Ma Ying-jeou in Taiwan China’s production costs and energy subsidies. A trigger couldin early 2012 lessened the risk of a Cross-Straits flare-up and be an Israeli attack on Iran’s nuclear installations. Or it could bewill likely strengthen ties between the “renegade province” something we have not yet thought about.and the mainland.Ma’s re-election also adds fuel to China’s project to develop Tit for Tat in Trade Warsa Greater China economic zone, taking in not just Taiwan and The second risk is trade wars brought about by new protectionistSouth Korea, but an entire “String of Pearls” of ports across the and populist politics in the run-up to elections in key countries.Indian Ocean. This would link China to growing interests in Africa French President Nicolas Sarkozy, for one, has dusted offthat are a crucial part of the incoming tide of natural resources. a “Buy European” slogan (which really means: Buy French)Stand-offs between China and Japan, Vietnam and South Korea as the election campaign heats up.over small islands in the East China Sea are likely to remain China’s exports have been slowing in the wake of the Europeanjust that: flare-ups over small piles of rock that mostly involve debt crisis. The country’s biggest trading partners are thefishing boat captains. European Union, United States, Japan and Hong Kong, with the latter mostly a half-way station for goods on their way Expect trade brawls to flare up more often, and to US and European markets. See the table on the next page. China to stand alone more often. Expect trade brawls to flare up more often, and China to standThe rest of Asia is viewing China’s military built-up warily, however. alone more often. The rare earths dispute is a good example. ItChina’s military budget is expected to double to $238 billion a year pitted China against the United States, European Union and Japanby 2015, according to HIS Jane’s Defense weekly. This is still all at once. This tells us three things: 1) China’s trade adversariesless than half the (shrinking) US defense budget, but China’s are finding the political will to act together. 2) China cannotincreasing military prowess is causing anxiety among its neighbors. have a trade war with all three simultaneously, so it must startIn addition, US President Barack Obama recently turned his focus to provide concessions while trying to save face (not easy).to the Pacific, potentially setting the superpowers up for conflict. 3) The World Trade Organization and other global bodies meantThe longer-term risks are “competing adversarial power blocks” to resolve trade disputes remain a sideshow: Governmentsin the region, warns one of the architects of the opening of China, engage in hand-to-hand combat while regulators look on.Henry Kissinger, in a 2012 article in Foreign Affairs. This need Tit-for-tat strategies will cause casualties. Case in point: Chinanot be—if both countries set aside rivalries and make genuine recently struck back at Europe by suspending a large Airbusefforts at cooperation, Kissinger believes. order (supposedly because of emissions standards). In suchAnother long-term risk is conflict with India over water. Both an environment, the risk of policy miscalculations driven bycountries derive much of their fresh water from the Himalayas. domestic needs is high. And some companies will end up as collateral damage.
[ 26 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d A Global Trade Web China’s Trade Partners in 2010 Chinas Trade With the Eurozone Rank Exports To Imports From Total Trade Balance With 1 Germany $68,088 4.3% Germany $74,391 5.3% Germany $142,480 4.8% Netherlands $43,239 23.4% 2 Netherlands $49,717 3.1% France $17,107 1.2% Netherlands $56,196 1.9% Italy $17,137 9.3% 3 Italy $31,143 2.0% Italy $14,006 1.0% Italy $45,149 1.5% Spain $11,950 6.5% 4 France $27,659 1.8% Belgium $7,828 0.6% France $44,766 1.5% France $10,552 5.7% 5 Spain $18,177 1.2% Netherlands $6,479 0.5% Spain $24,403 0.8% Belgium $6,478 3.5% 6 Belgium $14,306 0.9% Spain $6,227 0.4% Belgium $22,134 0.7% Greece $3,569 1.9% 7 Finland $5,507 0.3% Austria $4,237 0.3% Finland $9,541 0.3% Portugal $1,760 1.0% 8 Greece $3,959 0.3% Finland $4,034 0.3% Austria $6,091 0.2% Finland $1,473 0.8% 9 Portugal $2,514 0.2% Ireland $3,409 0.2% Ireland $5,402 0.2% Cyprus $1,331 0.7% 10 Ireland $1,993 0.1% Slovakia $1,790 0.1% Greece $4,350 0.1% Malta $1,274 0.7% 11 Slovakia $1,959 0.1% Portugal $754 0.1% Slovakia $3,749 0.1% Slovenia $1,209 0.7% 12 Austria $1,854 0.1% Malta $569 0.0% Portugal $3,268 0.1% Luxembourg $730 0.4% 13 Malta $1,843 0.1% Greece $390 0.0% Malta $2,413 0.1% Estonia $500 0.3% 14 Slovenia $1,385 0.1% Luxembourg $258 0.0% Slovenia $1,562 0.1% Slovakia $168 0.1% 15 Cyprus $1,348 0.1% Slovenia $177 0.0% Cyprus $1,366 0.0% Ireland ($1,417) -0.8% 16 Luxembourg $988 0.1% Estonia $177 0.0% Luxembourg $1,246 0.0% Austria ($2,383) -1.3% 17 Estonia $677 0.0% Cyprus $17 0.0% Estonia $854 0.0% Germany ($6,303) -3.4% Eurozone $233,118 14.8% Eurozone $141,851 10.2% Eurozone $374,969 12.6% Eurozone $91,267 49.5% Eu $311,342 19.7% Eu $168,484 12.1% Eu $479,826 16.1% Eu $142,858 77.4% Chinas Trade Outside the Eurozone Rank Exports To Imports From Total Trade Balance With 1 US $283,375 18.0% Japan $176,785 12.7% US $385,435 13.0% Hkg $206,109 111.7% 2 Hkg $218,380 13.8% Korea $138,423 9.9% Japan $297,941 10.0% US $181,314 98.3% 3 Japan $121,156 7.7% Taiwan $115,649 8.3% Hkg $230,650 7.8% UK $27,481 14.9% 4 Korea $68,818 4.4% US $102,060 7.3% Korea $207,241 7.0% India $20,053 10.9% 5 India $40,920 2.6 % Australia $60,340 4.3% Taiwan $145,341 4.9% Uae $16,863 9.1% 6 UK $38,790 2.5% Malaysia $50,396 3.6% Australia $87,575 2.9% Malaysia ($26,577) (14.4%) 7 Sgp $32,374 2.1% Brazil $38,038 2.7% Malaysia $74,216 2.5% Australia ($33,106) (17.9%) 8 Taiwan $29,693 1.9% Thailand $33,201 2.4% Brazil $62,504 2.1% Japan ($55,629) (30.1%) 9 Russia $29,615 1.9% Saudi Arabia $32,862 2.4% India $61,787 2.1% Korea ($69,605) (37.7%) 10 Australia $27,234 1.7% Russia $25,814 1.9% Sgp $57,053 1.9% Taiwan ($85,956) (46.6%) Total $890,355 56.4% Total $773,569 55.5% Total $1,609,744 54.2% China $1,578,447 100.0% China $1,393,909 100.0% China $2,972,356 100.0% China $184,538Sources: ISI Group; CEIC; General Administration of Customs.Notes: Figures in millions of US dollars. Percentages are the share of China’s total.
Blackrock investment institute [ 27 ]Competitiveness: Beyond Cheap LaborA visitor to the port city of Ningbo soon after Chinese New Of Robots and Old PeopleYear was struck by how little traffic this large port city had. The easy productivity gains have been harvested, but there isEmployers were anxious to see if migrant workers would return room for more. The work of Tsinghua University professor Gavrielfrom visiting their families in the interior. The city’s mayor had Salvendy, for example, shows it is easy to rack up double-digitcalled an emergency meeting with local business leaders productivity increases by introducing basic managementbecause exports had plunged in January. This illustrated the techniques to minimize waste and stop staff churn.plight of China’s coastal region. New highways and rail tracks have opened up the country’sWage growth is currently outpacing productivity. This is good interior. Companies have moved inland to take advantage of lowerfor consumption, but hurts China’s competitiveness in labor- wage and real estate costs. Apple supplier Foxconn, which employsintensive industries. Many of the latter, including garment more than one million in China, has already made a big pushmakers, have already moved to cheaper countries such as into Chengdu from its “Foxconn City” base in Shenzhen. It isVietnam and Cambodia. going one step further: Chairman Terry Gou plans to put to workThis is a good thing for China. The country wants to move up one million robots in the next three years, up from 10,000 in 2011.the value chain, and this is one way to achieve it. It is starting Vietnam, Indonesia and Bangladesh are just not in the sameto work, evidenced by the share of processed exports slowly league. These are smaller economies without the enterprise,diminishing. These are exports of basic products using mostly scale and infrastructure of China. With productivity growth(imported) raw materials or simple assemblage where China running at a much higher clip than that of the developed world,adds little value. See the chart below. China is not about to lose world trade share. Also remember there is no average in China: Income levels and Up the Value Chain minimum wages vary greatly by city and province. See the table Value-Added Exports vs. Processed Exports, 2000-2011 on the next page. This means relocating to the interior can lead 70% to easy productivity gains. 65 Productivity will need to keep growing to make up for the effects of a graying population: The number of people older than 65 will 60 surpass the group of people younger than 19 by 2030. Bottom EXPORTS (%) 55 line: China’s demographic dividend—a huge working population supporting a relatively small number of dependents—is 50 disappearing fast. See the charts on the next page. 45 The real estate boom has arguably thwarted innovation because 40 the government, businesses and consumers alike focused 35 on making quick profits. On the other hand, China surpassed Japan and the United States in patent filings in 2011, according 30 to Thomson Reuters research. ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 In all, chances are China will overcome competitive pressures. It Value-Added Exports Processed Exports may even emerge stronger. Competitiveness is very much part ofSource: Deutsche Bank. the China story—and likely more sustained than doubters opine. Vietnam, Indonesia and Bangladesh are just not in the same league.
[ 28 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d There Is No Average in China Minimum Wages by Province in RMB per Month Monthly Minimum Wages Annual Ratio of Urban % of Disposable National Province 2005 2006 2007 2008 2009 2010 2011 2012 Population Total Income Average Shanghai 690 750 840 960 960 1,120 1,280 1,450 17 2.7 31,838 1.67 Beijing 580 640 730 800 800 960 1,160 1,260 15 2.4 29,073 1.52 Zhejiang 490 645 750 960 960 1,100 1,310 30 4.8 27,359 1.43 Tianjin 570 660 670 820 820 920 1,160 10 1.5 24,293 1.27 Guangdong* 352 604 780 860 860 1,030 1,300 61 9.8 23,898 1.25 Shenzhen 635 755 755 950 950 1,100 1,320 1,500 Jiangsu 400 630 750 850 850 960 1,140 43 6.9 22,944 1.20 Fujian 320 542 650 750 750 900 1,100 19 3.0 21,781 1.14 Shandong 350 490 610 760 760 920 1,100 46 7.4 19,946 1.04 Liaoning 350 497 590 700 700 900 1,100 26 4.2 17,713 0.93 Inner Mongolia 380 485 560 680 680 900 1,050 13 2.1 17,698 0.93 Chongqing 330 500 580 680 680 680 870 15 2.4 17,532 0.92 Guangxi 320 417 500 670 670 820 820 19 3.1 17,064 0.89 Hunan 350 475 600 665 665 850 1,020 28 4.4 16,566 0.87 Hebei 420 510 580 750 750 900 1,100 30 4.9 16,263 0.85 Yunnan 350 480 540 680 680 830 830 16 2.5 16,065 0.84 Hubei 280 364 460 700 700 900 1,100 26 4.2 16,058 0.84 Henan 320 400 480 650 650 800 1,080 36 5.8 15,930 0.83 Anhui 290 443 520 560 560 720 1,010 26 4.1 15,788 0.83 Shaanxi 400 480 540 600 600 760 860 16 2.6 15,695 0.82 Shanxi 400 490 550 720 720 850 980 16 2.5 15,648 0.82 Hainan 350 497 580 630 630 830 830 4 0.7 15,581 0.82 Jiangxi 270 315 360 580 580 720 720 870 19 3.1 15,481 0.81 Sichuan 280 485 580 650 650 850 850 1,050 32 5.1 15,461 0.81 Jilin 300 460 510 650 650 820 1,000 15 2.3 15,411 0.81 Ningxia 320 417 450 560 560 710 900 3 0.5 15,344 0.80 Tibet 445 470 495 730 730 950 950 1 0.1 14,980 0.78 Guizhou 320 500 550 650 650 830 930 11 1.8 14,143 0.74 Heilongjiang 235 476 620 680 680 880 880 21 3.4 13,857 0.73 Qinghai 330 450 460 580 580 750 750 2 0.4 13,855 0.73 Xinjiang 300 536 670 800 800 960 1,160 9 1.4 13,644 0.71 Gansu 300 378 430 620 620 760 760 9 1.4 13,189 0.69 National Average 376 507 586 715 715 874 1,013 YoY Growth 39% 16% 24% 0% 23% 16%Sources: ISI Group, Ministry of Human Resources and Social Security, and National Bureau of Statistics.Notes: All wages in urban areas. Annual disposable income is per capita. Urban populations are in millions as of 2009. * Excluding Shenzhen. Going the Way of Japan Young (0-19) and Old (over 65) to Working Age Population, 1950-2050 JAPAN CHINA 100% 100% WORKING POPULATION (%) WORKING POPULATION (%) YOUNG AND OLD TO YOUNG AND OLD TO 80 80 60 60 40 40 20 20 0 0 1950 1970 1990 2010 2030 2050 1950 1970 1990 2010 2030 2050 0-19 Years Old 65 Years or Older 0-19 Years Old 65 Years or OlderSources: ISI Group and United Nations.
Blackrock investment institute [ 29 ]Markets: Counting on ChinaEquities and Corporate Bonds: Specialized machinery makers should do well as China movesA Growing Addiction up the value chain. The country is starting to become very competitive in capital goods with big improvements in quality.Makers of luxury goods around the world have become dependent Giants such as GE, Siemens and Caterpillar are worried abouton China’s ravenous appetite for their goodies. See the table China stealing their secret sauce, but should be okay for now asbelow. Don’t expect this to change in the near term. In the long they are capturing share in a booming market.run, we believe, it is crucial for China to take steps to encourageconsumption to keep up the torrid growth rates. At the same time, disasters such as the high-speed rail crash and mining accidents have dented China’s ambitions in someThe luxury goods boom goes beyond exports to Greater areas. And hazardous industries with heavy capital equipmentChina. A jump in Chinese travel and the hiring of Mandarin- needs and high potential for disasters (the oil and gas industry,and Cantonese-speaking staff is keeping department stores for example) are becoming less likely to take risks on China’sbusy from Tokyo to New York. quality control.Basic materials companies are likely to suffer as China hits the China Inc. can quickly wipe out whole sectors by mass producingceiling for cement and steel consumption. The country is still high-quality goods. Case in point is the solar industry. European,far from reaching peak demand in other commodities, including US and Indian companies cried foul over unfair subsidies foroil and copper as well as agricultural products such as corn and Chinese makers, but the coup still happened. This doesn’tpotash used in fertilizer. This has a big impact on UK, Australian mean emerging Chinese players in these industries are goodand Canadian equities because of the heavy weighting of mining investments. Just check the implosion of stock prices of (loss-companies in those markets. Shale and other new sources of making) Chinese solar makers.energy have become a focus given China’s supply vulnerability.Investors and other stakeholders have taken note. For China Inc. can quickly wipe out whole sectors by mass producing high-quality goods.example, the Reserve Bank of Australia studies China given itsimportance to the large farm-cum-mine surrounded by beach Medical device and agricultural equipment makers are likelyknown as Australia. The European Central Bank studies China beneficiaries from a population that is getting richer and livingbecause it needs growth. We all are China watchers. longer—but not necessarily healthier. Spending on these sectors, as well as on water conservation, should grow at twice My Best Customer Is China the rate or more of China’s overall budget spending, we believe. Percentage of China Sales of Selected Luxury Companies in 2011 China’s cement makers, aluminum smelters and building Mainland China Greater China materials companies saw business implode only in the fourth Burberry 5% 8-10% quarter. Full-year 2011 results mask this implosion, and more Coach 3% 6% pain is likely to come in 2012. Even successful women’s shoemaker Hermès 15% 23% Belle International reported a slowdown in same-store sales LVMH 7-8% 12% to the high single digits. The only companies that report sales Luxottica 3% 5% Prada Group 15% 21% growth in the 20% range are mass consumer plays such as Richemont 33% 40% Yum!, the owner of the KFC fast food restaurants. China’s Safilo 1% 3% banks remain cheap for (good) reasons described earlier. Salvatore Ferragamo 17% 27% Swatch 15% 22% China’s companies will likely see profits hit this year, we believe. Tiffany 10% 18% SOEs already reported an 11% drop in profit in the first two Tod’s 5% 12% months of the year. That said, Chinese equities look cheap by Yoox 2% 2% historical valuations. It is reasonable to expect gains of 25%Source: Deutsche Bank. or more this year after a horrible 2011.Note: Estimated fiscal 2012 sales for Coach, Burberry and Tiffany.
[ 30 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d Hunger for Commodities Addicted to Coal—For Now China’s Share of Global Commodities Consumption in 2010 China’s Energy Supply Sources Compared With the World’s Cement 80% Pigs 70% Iron Ore COMMODITIES CONSUMPTION (%) Steel Lead 60 ENERGY USAGE (%) Copper Zinc Aluminum Nickel 40 Platinum 37% Coal 30% Soybeans Autos 20% China’s Population 20 18% Corn Palladium 7% 7% 7% Wheat 4% 0 1% China’s GDP in PPP Oil Sugar Nuclear Hydro Nat. Gas Oil Coal Uranium China World ex-China 0% 10 20 30 40 50 60 Sources: ISI Group and BP World Energy Outlook.Source: Deutsche Bank. Note: Data as of 2010.Commodities: An Outsized Influence where these energy sources can start to compete with oil, gas and coal. A shift to a consumption-driven economy could imperilChina has an outsized influence on commodities markets. this. Similarly, a credit contraction or financial bust would likelyThe country has one fifth of the world’s population and result in the drying up of Chinese project financing that hasaccounts for 11% of world GDP. Yet it accounts for about half supported the global market.the world’s cement and iron ore consumption. See the chart above. The country’s commodities appetite goes beyond the obvious.We expect the iron ore boom to fizzle out as China nears peak China has become the second-largest importer of gold, afterconsumption in steel and cement. The country’s demand for India. It now makes up around one fifth of world gold demandcopper, which has many uses beyond construction, should for jewelry, according to ISI Group. Gold is seen as a hedgehold up better, we believe. against inflation. Policy also may drive demand for preciousEnergy demand should also hold steady, we believe. Oil demand metals such as platinum and palladium, which are used in cartypically runs at 0.6 times GDP growth. So even with the economy catalytic converters.slowing down to 7% a year, oil demand increases by 4% a year.China’s import dependence is rising at an annual clip of 500,000 Government Bonds: A Big Overhangbarrels a day (b/d), from an import bill of 5 million b/d in 2009, China is the single largest holder of publicly traded US Treasuries,according to research firm ISI Group. excluding the US Federal Reserve. It has a $1.3 trillion share, orChina is already the world’s biggest energy consumer, with a one-sixth of the total. It has slowed buying but is still a major20% share in 2010, up from a tenth in 2000, according to BP. It player (the Fed trumps it). The reasons: China wants to keepstill relies on coal for the brunt of its energy supply. See the chart its own currency in check, doesn’t have many alternatives forabove right. Expect a shift to natural gas and nuclear energy parking the flood of export-generated dollars and would hate to(Japan’s Fukushima accident in 2011 only temporarily halted see the value of its existing holdings implode. See the chart onconstruction). This bodes well for uranium prices in the long run. the next page on the leftThe story is different for alternative energy. Chinese manufacturers China, which has additional US assets in its foreign reserve kit,have brought down prices for wind and solar energy to levels has been diversifying into the euro, yen and other currencies as well as gold. It is transferring funds to sovereign wealth fund Expect the iron ore boom to fizzle out as China China Investment Corp, which in turn is spreading its bets across nears peak consumption in steel and cement. the globe and across asset classes. Talk of investment in Europe to mitigate the debt crisis is likely real.
Blackrock investment institute [ 31 ]China’s buying of US Treasuries illustrates the power the country A shift to a consumption economy would mean lessholds over the US bond market. The US Federal Reserve crowded Chinese buying of US Treasuries—as opposed toout all other buyers in the year ended June 20, 2011, so China’s absolute reductions.share was just 18%. Excluding Fed purchases, however, China This appears a likely scenario—and does not bode well for China’shad a 73% share. See the chart below on the right. ranking in the BlackRock Sovereign Risk Index. The countryA shift to a consumption economy would mean less Chinese advanced three spots in the fourth quarter to rank 15th—aheadbuying of US Treasuries—as opposed to absolute reductions. of the UK and France.Assuming the US government is not closing the budget gap any Commodity currencies such as the Australian and Canadian dollarstime soon, conventional wisdom says fewer Chinese purchases could take a hit as China reaches peak consumption in keywould drive up yields and pummel bond prices. Fewer buyers industries such as steel. The currencies are a good signpost forequals lower prices. whether China’s economy is perking up in the short term andConventional wisdom is always dangerous, so here is an opposite shifting toward consumption in the long run.view: Rates actually could go down in a sort of flight-to-safety Exporters and countries closely linked to the booming resourcesbond rally. Why? If foreign buying dries up, simple math says trade, such as Australia and Chile, could suffer. The Aussieprivate savings will have to pick up the slack (assuming the US dollar and bond market are just as much China plays as LVMHgovernment doesn’t cut the deficit markedly). and Daimler. More insulated economies such as Brazil couldTo do this, investors would have to sell risk assets. This would power along, driven by domestic consumption.hammer equities, high-yield bonds, commodities and emerging Asian investors appear more upbeat than those in the developedmarket assets, in turn triggering a dash for safety. world. For US and European investors, things are about as bleakAs China opens to the world, more of its debt may become available as they have been in decades. Asians, on the other hand, havefor international trading. This may coincide with a bailout of its overcome three economic crises in recent memory: the 1998-financial system and a jump in its debt-to-GDP ratio. 1999 Asia crisis, the 2003 SARS crisis and the 2008-2009 world financial crisis. Plus, the sheer scale of consumption and wealth is breathtaking when you are on the spot. A Case of Too Many Greenbacks China’s US Treasury Holdings and FX Reserves, 2001-2011 $3,500 50% A US Bond Market Force China’s Buying of Newly Issued US Treasuries, 2002-2011 3,000 80% $400 CHINA’S FX RESERVES IN BILLIONS ($) 40 SHARE OF TREASURY BUYING (%) 2,500 PURCHASES IN BILLIONS ($) SHARE OF RESERVES (%) 60 300 30 2,000 40 200 1,500 20 1,000 20 100 10 500 0 0 2002 2004 2006 2008 2011 0 0 China Buying of Net Issuance (%) 2001 2003 2005 2007 2009 2011 China Buying of Publicly Available Net Issuance (%) China’s US Treasury Holdings China’s Total FX Reserves China Buying ($ Billions) US Treasuries to FX Reserves (%) Sources: US Department of Treasury and BlackRock.Sources: US Department of Treasury and BlackRock. Notes: Data as of June 30 of each year. Publicly available Treasuries are those not purchasedNote: Data as of June 30 of each year. 2011 data based on preliminary survey data. by the US Federal Reserve. 2011 data based on preliminary survey data.