Misunderstanding ChinaPopular Western illusions debunkedSpecial report                 May 2012
China macro strategy                                                                                        Sinology      ...
Introduction                                   China macro strategy                              Introduction The biggest ...
Executive summary                               China macro strategy                                   Misunderstanding Ch...
Executive summary                                China macro strategy                              share of urban employme...
Executive summary                                China macro strategy                                  Local-government de...
Executive summary                               China macro strategy                               The turning point came ...
Executive summary                                China macro strategy                                   It is also importa...
Executive summary                                 China macro strategy                             The real worry: The rul...
1. China is not export-driven                                                             China macro strategy            ...
1. China is not export-driven                       China macro strategy                              Here are a few excer...
1. China is not export-driven                                                                              China macro str...
1. China is not export-driven                                 China macro strategy                             Figure 5   ...
1. China is not export-driven                                                   China macro strategy                      ...
2. World’s best consumption story                     China macro strategy                              2. World’s best co...
2. World’s best consumption story                                       China macro strategy                              ...
2. World’s best consumption story                          China macro strategy                             . . . supporte...
2. World’s best consumption story                                China macro strategy                                   Re...
2. World’s best consumption story                         China macro strategy                              Figure 15    E...
2. World’s best consumption story                China macro strategy                                This process is under...
2. World’s best consumption story               China macro strategy          A more repressive    China’s experiences in...
3. Entrepreneur-driven economy                                                                 China macro strategy       ...
3. Entrepreneur-driven economy                              China macro strategy                             Private firms...
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
China Popular Western illusions debunked
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  1. 1. Misunderstanding ChinaPopular Western illusions debunkedSpecial report May 2012
  2. 2. China macro strategy Sinology China Macro StrategyAndy Rothman ContentsChina Macro Strategistandy.rothman@clsa.com Executive summary ............................................................................ 4Julia Zhu This report debunks 16 Western misperceptions about China.julia.zhu@clsa.com Based on data and our own research, we assert the following: 1. China is not export-driven.......................................................... 10 2. World’s best consumption story ................................................. 15 3. Entrepreneur-driven economy ................................................... 22 4. Banking crisis unlikely, near term .............................................. 25 5. RRR cuts are not easing ............................................................. 27 6. Party plans 8-8.5% GDP growth ................................................ 29 7. Local-govt debt not a time bomb................................................ 31 8. Land sales are not key ............................................................... 36 9. Political instability very unlikely ................................................ 38 10. World’s best privatisation story ................................................. 40 11. Even the poor are homeowners .................................................. 41 12. There is no property bubble ....................................................... 42 13. No “shadow” banks .................................................................... 46 14. RMB is not grossly undervalued ................................................. 49 15. RMB not a key issue for USA ...................................................... 52 16. Manufacturing still competitive .................................................. 56 The real worry: The rule of law ........................................................ 61 References ....................................................................................... 65Need more understanding?2 andy.rothman@clsa.com May 2012
  3. 3. Introduction China macro strategy Introduction The biggest problem may Given how long China has been a focus of attention for global investors, be that the economy journalists, economists and government policymakers, it is amazing how is misunderstood poorly informed many remain. The Chinese economy faces many issues, but the biggest problem may be that it is misunderstood. Such misunderstandings Fortunately, the Chinese economy has not become depressed about being have hurt investors misunderstood. While moving a bit more slowly these days, it continues to outperform globally. But misunderstanding China has caused problems for many people. Take pity, for example, on the investors who mistakenly believed that the Chinese economy was export-led and would therefore crash as demand collapsed in the USA and Europe in 2009. China is the world’s best Have some sympathy for those who argue that consumption is weak, simply consumption story because the household spending share of GDP is low. China is actually the world’s best consumption story, with incredible growth in sales of everything from soft drinks to SUVs. Almost all new jobs are Do not be too harsh on the columnist who decries the “resurgence” of created by the country’s Communist Party control over the economy. He just misunderstands that the entrepreneurs share of urban workers employed by state firms has fallen to only 19%, from 60% two decades ago, and that almost all new jobs are created by the country’s entrepreneurs. Those who blame the Feel free, however, to taunt the public official (especially in America) who renminbi for their blames the renminbi for his country’s economic woes. He does not understand problems are that China’s currency has appreciated by more than 30% since 2005, or that ignoring reality its current account surplus/GDP ratio is now well below the US Treasury Secretary’s benchmark of 4%. And he fails to grasp that US exports to China rose by more than 500% during the past decade. We all know someone who misunderstands China. This report is for them. Andy Rothman China macro strategistMay 2012 andy.rothman@clsa.com 3
  4. 4. Executive summary China macro strategy Misunderstanding China This report debunks 16 commonly held misconceptions about China. We also highlight the most serious risk to the country’s long-term outlook: its lack of the rule of law. In reality . . . China is not export-driven Everything does come This is the biggest misunderstanding about the Chinese economy, and it easy from China, but it isn’t to see why most people think the country is dependent on exports. After all, really made there and almost everything in your neighbourhood shop does come from China. But contributes relatively little to China’s economy many of those goods are just processed or assembled there, adding very little value and contributing very little to its GDP. During the decade prior to the global financial crisis, China averaged about 10% annual GDP growth, with only about 1ppt of that growth contributed by net exports. Today, China is even less export-dependent: last year net exports produced a -5.8% drag on GDP growth, and in the first quarter of this year, net exports provided a -9.4% contribution to growth. Our message is not that exports do not matter. They do, especially to the tens of millions of workers assembling iPads and other gadgets. But it is important to understand that China is a continental, domestic investment and domestic consumption-driven economy, where exports play only a supporting role. The overwhelming majority of goods made in China stay in China. It’s the world’s best consumption story Household consumption is China is already the world’s best consumption story: urban household a small share of GDP, but consumption rose 12.3% YoY in 1Q12, while rural household cash consumption that does not mean expenditure rose 17.6%. Chinese consumers don’t spend Unprecedented income growth is the most important factor supporting consumption. Over the past decade, real urban income rose 151%, while real rural income rose 111%. Much of the increase was driven by government policy: the minimum wage in Shanghai, for example, rose 171% over the past 10 years. But for those who are waiting for the day when the household consumption share of GDP begins to rise and the investment share begins to fall, that day has arrived. China’s transition away from investment-led growth will begin this year, as fixed-asset investment growth will slow a bit below the roughly 25% YoY pace of the past nine years. With an entrepreneur-driven economy The role of state- The Communist Party maintains significant control over China’s economy, controlled firms has been but this control is exercised primarily via macro policy rather than through steadily shrinking, while state-owned enterprises (SOEs). SOEs and state-controlled firms continue private companies create almost all new jobs to dominate the financial industry and many of the capital-intensive sectors, such as telecoms, aviation, oil & gas and petrochemicals, but state firms are far less important than they once were. China’s economic growth is increasingly driven by entrepreneurial small- and medium-sized enterprises (SMEs). Back in 1958, 86% of urban workers were employed by state firms, and that share remained above 70% through 1989. But between 1995 and 2001, the Party laid off 46 million state-sector workers - equal to sacking the entire combined workforces of France and Italy in six years. As a result, the state4 andy.rothman@clsa.com May 2012
  5. 5. Executive summary China macro strategy share of urban employment fell from 60% in 1994 to 28% in 2002. In recent years, almost all new job creation came from private firms. Similarly, the state-firm share of fixed asset investment has fallen from 58% in 2004 to 32% in 1Q12. A banking crisis is unlikely in the near term China’s banking system is The economy may be largely in private hands, but the Party still controls the not Mexico of 1994, largest industrial firms and the financial sector. While the Party no longer Argentina of 1999, or today’s Greece micromanages financial institutions on a day-to-day basis, it continues to control the personnel process, including at banks where the majority of shareholders come from the private sector. And Party control of the financial system extends well beyond the banks. Party control does not, on its own, mean that China’s banks are incompetent or insolvent, but it means that the Party does not have to rely on open- market operations to manage the economy. Interest rates and reserve requirements are somewhat symbolic tools when the Party can pick up the phone and assign a monthly loan quota to every bank. Aside from trade finance, China does not borrow money overseas and, because of the non-convertibility of the renminbi, offshore investors are overwhelmingly excluded from the domestic capital markets. There is simply no way that offshore speculators, investors, hedge funds or others can get at China’s domestic debt obligations and challenge the Party’s valuation of these obligations. In short, the closed nature of China’s financial markets suggests a deliberate strategy based on a particular understanding of past international debt crises. China’s financial system is an empire set apart from the world. RRR cuts are not easing In a banking system In a real banking system, regulators use the required reserve ratio (RRR) to where lending is manage growth of lending and money supply. But China does not have a real controlled by quota, banking system. All Chinese banks are controlled, via the personnel system cutting the RRR has a neutral impact on credit (even down to the branch level), by the Communist Party. This enables the and liquidity Party to set loan quotas for each bank, governing the level of lending above and beyond the RRR limitations. In China, the RRR is primarily a tool for the central bank to sterilise foreign- exchange inflows. The RRR will continue to come down from historically high levels, but this has, on its own, a neutral impact on monetary policy and will not result in a material change to credit and liquidity in China. The Party is planning for 8-8.5% GDP growth Premier Wen didn’t really Premier Wen Jiabao, in his March speech to the National People’s Congress, mean it when he said his said that his target for GDP growth this year is 7.5%. But he didn’t really mean target for 2012 is 7.5% it. During each of the previous five years, Wen said he expected 8% annual GDP growth. But full-year growth rates never slowed to anything close to Wen’s target. During that period real annual GDP growth actually averaged 11.2%. Wen’s lower targets reflect that the Party is comfortable with slower growth. This year, we forecast 8.5% GDP growth, and we believe the Party will be comfortable with anything in the 8-8.5% range (down from 9.2% last year and 10.4% in 2010).May 2012 andy.rothman@clsa.com 5
  6. 6. Executive summary China macro strategy Local-government debt is not a timebomb . . . In China, local debt is, Local-government debt represents a significant financial burden for the Party, ultimately, national (or but it is far being from a ticking timebomb for the following reasons: Communist Party) debt  Local debt is, ultimately, national (or Party) debt, so it needs to be considered in a national fiscal context.  Prior to 2009, the growth rate of local government debt was roughly in line with growth in national fiscal revenue.  The huge leap in local debt in 2009 was a one-off response to the global financial crisis, and was withdrawn as quickly as it was implemented.  The use of bank loans to local governments to finance public infrastructure, particularly the huge 2009 stimulus, has created a serious fiscal burden for the Party. But because we expect continued strong revenue growth, and because all local debt is backed by the Party and is held by Party-controlled banks (no private institutions, no foreigners), this is not a looming disaster.  Local debt of Rmb10.7tn (US$1.7tn) is not pocket change, even for Beijing, but it is far from a fiscal crisis given the strong revenue growth and healthy fiscal position we described earlier.  Infrastructure-spending growth is decelerating and local borrowing has slowed, while fiscal revenue is likely to continue growing faster than nominal GDP. This should enable the Party to grow out of the local debt burden. In sum, the Party has the political will and the fiscal resources to ensure that local governments do not default on their bank loans. . . . and land sales are not key to local-government revenue Net revenue from land Revenue from land transfers is a fairly small part of local government sales account for only 9% budgets. Last year, local governments were ultimately only able to keep 28% of local budgets of the revenue they collected from land transfers, and some of those funds must be set aside for low-income housing. Gross revenue from the sale of land-use rights was equal to 25% of local-government revenue last year, but on a net basis, after accounting for all of the costs associated with clearing and transferring land, land revenue accounted for only 9% of total local- government revenue. Political instability is very unlikely The sacking of Bo Xilai The dismissal in March of a senior Chinese official is unlikely to have a will not derail day-to-day concrete impact on the country’s economic or political policies, and was management of the not the result of a struggle within the Communist Party over the direction economy or longer term reform prospects of reforms. This is a transition period for the Communist Party leadership, but given than the two new leaders have been part of the small group running the country for the past five years, this is not a lame-duck government. It’s also the world’s best privatisation story The Communist Party has The development of China’s commercial housing market is one of the world’s been willing to make greatest and least recognised privatisation success stories. In just 20 years, bold moves the country went from one of the world’s lowest urban homeownership rates to one of the highest.6 andy.rothman@clsa.com May 2012
  7. 7. Executive summary China macro strategy The turning point came in 1998, when the Party ended the practice of government work units (danwei) providing public housing for their workers, in tandem with the momentous decision to radically shrink the state workforce. Over a six-year period, 46 million state-sector workers were laid off - the equivalent of sacking the entire combined workforces of France and Italy. Many state workers, including some of those who lost their jobs, were allowed to buy their government-provided flat at a steep discount to the market value (which was, at that point, very low). This was the largest one-time transfer of wealth in the history of the world, as most of China’s urban-housing stock was handed over to its occupants, and it helped create the liquidity to fuel China’s brand-new commercial-housing market. Even the poor are homeowners . . . Over 80% urban Almost all income groups have benefited from the privatisation of China’s homeownership rate housing market. The overall homeownership rate was 82% in 2007 (compared with 68% in the USA), and while the rich were more likely to own their own home, even the lowest 10th percentile of income groups had a 73% homeownership rate. We note that with 40% of homeowners living in housing stock built by government work units - typically small and of poorer quality than commercially built flats - this population will continue to drive new home upgrades. . . . and there’s no property bubble Homeowner leverage is From 2006 to 2011, new home prices in China rose at an average annual low and residential prices pace of 9.7%, while urban income rose by an average of 13% per year. have risen in line with income China’s home market is driven by owner-occupiers, not speculators. Our own study of sales managers at new residential projects across the country found that in March, only 7% of buyers were investors. Our study also reveals that in February, 17% of first-time homebuyers paid all cash, down from 23% a year ago, as mortgage availability has improved and interest rates have declined. Among investors, 20% paid all cash. Buyers who use mortgages have a lot of skin in the game: the minimum cash downpayment is 30% for owner-occupiers and 60% for investors. Chinese banks have not been permitted to offer subprime mortgages. The fact that the average residents of Chinese cities, like the average residents of most major cities around the world, cannot afford to buy a downtown home does represent a significant social problem, which is why the Party has embarked on a major programme to build low-income housing. But this social problem is not evidence of a bubble, or of a shortage of buyers who can afford what is currently on the market. There are no “shadow” banks The Communist Party still The Party still controls all of China’s financial institutions, including all controls all Chinese commercial banks and the 70 trust companies. financial institutions It may also be useful to put the scale of China’s trusts into context. In 2011, the total assets of the trusts was Rmb4.8tn (US$764bn), equal to only 5.9% of total deposits (or 8.8% of total loans outstanding) in the formal banking system. This is in sharp contrast to the US shadow-banking system, which in March 2008 had a gross size of nearly US$20tn - significantly larger than the liabilities of America’s traditional banks.May 2012 andy.rothman@clsa.com 7
  8. 8. Executive summary China macro strategy It is also important to note that China’s trusts are not permitted to leverage their investments, a far cry from the seemingly unlimited leverage available, pre-crisis, to the five big American broker-dealers. Leverage is quite limited across China’s financial institutions and is available only for a few activities. In 2Q11, our national study of SME manufacturers found that only 6% of their capex was funded by informal borrowing, down from 13% three years ago. The RMB is not grossly undervalued The renminbi has One thing that is clear is that the renminbi has appreciated significantly since appreciated by more than Beijing broke its currency peg in the summer of 2005. According to the Bank 30% against the US dollar for International Settlements (BIS), between January 2005 and March 2012, since 2005 . . . the yuan appreciated 32% on a real basis and 24% on a nominal basis. . . . and the current- US policymakers have emphasised one metric for evaluating China’s account surplus/ exchange-rate policy: the current-account balance/GDP ratio, and Treasury GDP ratio is now Secretary Geithner has argued that a 4% ratio is a ‘benchmark for the future’. below Geithner’s benchmark level Based on this metric, the US should be satisfied that the renminbi is close to its equilibrium rate, as China’s current-account surplus/GDP ratio fell last year to 2.8% from the 2007 peak of 10.6%. Nor is the RMB a key issue for USA Chinese goods make up Goods labelled “Made in China” make up 2.7% of US consumer spending, but less than 3% of US only 1.2% actually reflects the cost of the imported goods. Thus, on average, consumer spending - of every dollar spent on an item labelled “Made in China,” 55 cents go for and half of that goes on services produced services produced in the United States. In other words, the US content of in the US “Made in China” is about 55%. The fact that the overall import content of US consumer goods has remained relatively constant while the Chinese share has doubled indicates that Chinese gains have come, in large part, at the expense of other exporting nations. US exports to China rose Another common misconception is that China is closed to US exports, and over 500% during the that an undervalued currency has kept Chinese from buying American goods. past decade In fact China is the third-largest buyer of US exports after Canada and Mexico. And China is, by a huge margin, the fastest-growing market for US goods. Between 2000 and 2011, US exports to China rose 542%. In contrast, its exports to the rest of the world rose only 81% during that period. Manufacturing is still competitive Strong wage growth has Chinese manufacturing wages have been increasing at an amazing rate for a been matched by rapid very long time - 14% annually since 1987. Much of the increase has been productivity gains driven by government policy: over the past decade, the minimum wage rose 152% in Shenzhen, and 171% in Shanghai. How did Chinese manufacturing remain competitive, despite the rapid wage growth? The answer is that productivity also rose at a very fast pace. China’s industrial value-added rose by 13.4% annually in real terms between 1997 and 2010, while real manufacturing wages rose by an average of 11.2%. China continues to have a structural labour surplus with significant unemployment and underemployment. At an aggregate level, it still appears that wage pressures are mostly being absorbed by productivity gains; manufacturing unit labour costs are rising only slowly and corporate profit margins are not being compressed by rising costs.8 andy.rothman@clsa.com May 2012
  9. 9. Executive summary China macro strategy The real worry: The rule of law The most important Having suggested what not to worry about, in this final section we discuss the longer-term risk to most important longer-term risk to China’s continued economic growth and China’s continued economic growth social stability: its legal system. This is also, not coincidentally, the biggest long-term risk to any investment in China. This is already the source of many of problems. Corruption, weakness in commercial sectors dependent on intellectual property rights, and the widespread theft of farmers’ land - the main cause of protests across the country - are all consequences of the lack of the rule of law. In the near term, China can continue to thrive, as people continue to find ways to navigate corruption and the opaque system. But, as the pace of economic growth slows over the coming decades, can China’s unique form of authoritarian capitalism continue to support the rising standard of living Chinese citizens have come to expect? This problem is already increasingly visible in rural China, where local officials often violate farmers’ property rights, leading to protests and sometimes to violence. Changing China’s legal system and institutions to prevent this problem from becoming more widespread, and to support continued economic growth, is the Party’s chief challenge in the coming decades.May 2012 andy.rothman@clsa.com 9
  10. 10. 1. China is not export-driven China macro strategy 1. China is not export-driven Everything does come from China, but it isn’t really made there and it contributes relatively little to China’s economy The biggest This is the biggest misunderstanding about the Chinese economy, and it easy misunderstanding about to see why most people think the country is dependent on exports. After all, the Chinese economy almost everything in your neighbourhood shop does come from China. But many of those goods are just processed or assembled there, adding very little value and contributing very little to its GDP. Although the share of China’s exports that are just processed there has been declining, it still accounts for 44% of the total, down from 55% in 2001. Figure 1 Processed exports still Structure of China’s exports account for 44% of total (%) Processed exports Other exports 100 90 80 70 60 50 40 30 20 10 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: CEIC Apple’s iPad is a good A good example of processed exports is Apple’s iPad, which, famously, is example of China’s assembled in China but creates little value there. Last year, the Personal processed exports Computing Industry Center (PCIC) of the University of California, Irvine took apart an iPad and worked out its value chain. Figure 2 China takes a very thin Distribution of value for Apple’s iPad slice of the Apple pie Input costs: non-China labour Input costs: 5% China labour 2% Apple profit 30% Input costs: materials 31% Distribution Unidentified and retail profit 15% 5% Non-Apple S Korea profit US profit 7% Japan profit Taiwan profit 2% 1% 2% Source: PCIC, UC Irvine10 andy.rothman@clsa.com May 2012
  11. 11. 1. China is not export-driven China macro strategy Here are a few excerpts from the UC Irvine study:  In the case of the iPad, Apple keeps about 30% of the sales price of its low-end US$499 16GB, Wi-Fi only model (and more if the unit is sold through Apple’s retail outlets or online store). Koreans the biggest  The next biggest beneficiaries are Korean companies such as LG and gainers after Apple Samsung, who provide the display and memory chips, and whose gross profits account for 5% and 7%, respectively, of the sales price for the iPhone and iPad. US, Japanese and Taiwanese suppliers capture 1-2% each. But overall, the story remains the same, with Apple’s success benefiting its shareholders, workers, and the US economy more generally.  It is a common misconception that China, where the iPad is assembled, receives a large share of money paid for electronics goods. That is not true of any name-brand products from US firms that we’ve studied.  First, our assignment of profits (which exclude wages paid) to first-tier suppliers is based on the location of their corporate headquarters. There are no known Chinese suppliers to the iPhone or iPad. The iPhone and iPad are assembled in mainland China factories owned by Foxconn, a Taiwan-based firm. Main financial benefit to  That means that the main financial benefit to China takes the form of China is wages wages paid for the assembly of the product or for manufacturing of some of the inputs. Many components, such as batteries and touchscreens, receive their final processing in China in factories owned by foreign firms. Although hard facts are scarce, we estimate that only US$10 or less in direct labor wages that go into an iPhone or iPad is paid to China workers. So while each unit sold in the US adds from US$229 to US$275 to the US- China trade deficit (the estimated factory costs of an iPhone or iPad), the portion retained in Chinas economy is a tiny fraction of that amount.  What these data illustrate is that the US-China trade deficit reflected in the trade statistics for electronic goods is comprised of China’s small direct labor input plus large inputs of parts and components (including the labor) from the US, the EU and other countries in Asia. Trade statistics can  This study also confirms our earlier finding that trade statistics can mislead mislead as much as much as inform. Earlier we found that for every US$299 iPod sold in the as inform US, the US trade deficit with China increased by about US$150. For the iPhone and the iPad, the increase is about US$229 and US$275 respectively. Yet the value captured from these products through assembly in China is around $10. You will remember from Econ 101 that GDP equals investment plus consumption plus exports minus imports. This formula, which applies to all economies, is designed to ensure that GDP excludes, for example, the value of a hard drive that is made in Japan, imported into China and snapped into an iPod which is then sold overseas. That hard drive costs US$73 and accounts for half of the factory value of an iPod, but it was not made in China and did not contribute directly to the Chinese economy. (The indirect contribution - including the jobs assembling and testing the iPod - adds up to US$7.50 and is counted in the net export calculation.) During the decade prior to the global financial crisis, China averaged about 10% annual GDP growth, with only about 1ppt of that growth contributed by net exports. Today, China is even less dependent on exports. In 2007, prior to the last slowdown, net exports accounted for 18% of GDP growth. Last year, however, net exports contributed a -5.8% drag on GDP growth, and in the first quarter of this year, net exports provided a -9.4% contribution to growth.May 2012 andy.rothman@clsa.com 11
  12. 12. 1. China is not export-driven China macro strategy Figure 3 China is even less Contribution to GDP growth by expenditure approach dependent on exports now Final consumption Gross capital formation Net exports of goods and services 16 (%) 14 12 10 8 6 4 2 0 (2) (4) 12F 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1Q12 Source: CEIC, CLSA forecast From the perspective of GDP, as opposed to GDP growth, net exports also play a relatively small role. In 2007, net exports accounted for 8.8% of China’s GDP, but this share fell to only 4% in 2010. (The 2011 details are not yet available.) Figure 4 Net exports accounted for Share structure of China’s nominal GDP by expenditure approach only 4% of GDP in 2010 120 (%) Household consumption Government consumption Gross capital formation Net exports of goods and services 100 80 60 40 20 0 (20) 1980 1985 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: CEIC Manufacturing FAI slowed Along similar lines, Figure 5 illustrates the relatively small role that exports far less dramatically play in China’s manufacturing sector. During the last global recession, China’s than exports in the last exports collapsed, from a 26% YoY growth rate in 2007 to 17% in 2008 and global recession -16% in 2009. But fixed-asset investment growth in the manufacturing sector slowed far less dramatically, from 35% YoY in 2007 to 31% in 2008 and 27% in 2009. This is because most Chinese manufacturers are targeting domestic demand, not exports.12 andy.rothman@clsa.com May 2012
  13. 13. 1. China is not export-driven China macro strategy Figure 5 Growth rates of FAI in manufacturing and total exports 50 (% YoY) FAI in manufacturing Total exports 40 39.2 34.7 30.7 31.8 29.1 31.3 26.6 30 24.8 28.4 27.2 26.0 27.0 20 20.3 17.2 10 7.6 0 (10) (20) (16.0) 2005 2006 2007 2008 2009 2010 2011 1Q12 Source: CEIC More recently, as export growth has once again slowed, manufacturing FAI has declined, but at a much gentler pace. This is consistent with the statistic that the delivery value of China’s exports accounted for only 12% of its total industrial sales revenue in 2011. China’s consumers also Figure 6 shows that China’s consumers also do not pay too much attention to do not pay too much the health of the nation’s exports. attention to exports Figure 6 Growth rates of retail sales and total exports 40 (% YoY) 30 20 10 0 (10) Exports Retail sales of consumer goods (20) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1Q12 Source: CEIC China is a domestic Our message is not that exports do not matter. They do, especially to the tens investment and of millions of workers assembling iPads and other gadgets. But it is important domestic consumption- to understand that China is a continental, domestic investment and domestic driven economy consumption-driven economy, where exports play only a supporting role. The overwhelming majority of goods made in China stay in China.May 2012 andy.rothman@clsa.com 13
  14. 14. 1. China is not export-driven China macro strategy Finally, it is worth noting the key role foreign firms play in China’s exports. While the share of total exports coming from foreign-owned companies has declined from the 2005-06 peak of 58%, last year more than half (52%) of China’s exports were produced by foreign firms. Figure 7 Last year more than half Exports by foreign-funded enterprises as a share of China’s total exports of China’s exports were produced by foreign firms 2,000,000 (US$m) Total exports (%) 70 1,800,000 Exports by foreign enterprises Share of exports by foreign enterprises (RHS) 65 1,600,000 1,400,000 60 1,200,000 1,000,000 55 800,000 50 600,000 400,000 45 200,000 0 40 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: CEIC14 andy.rothman@clsa.com May 2012
  15. 15. 2. World’s best consumption story China macro strategy 2. World’s best consumption story Household consumption is a small share of GDP, but that does not mean Chinese consumers don’t spend. Household consumption accounts for a small share of China’s GDP: 34% in 2010, down from 46% in 2000. This is quite low when compared to the USA, where household spending is 71% of GDP, or the UK, where the share is 64%. The OECD average is 63%, and in India, household consumption is 58% of GDP. Although China’s consumption numbers are not fully accurate - private spending on services and housing is clearly undercounted - we are happy to stipulate that the household consumption share of China’s GDP is very low. The misunderstanding concerns the reasons that the share is low, the impact on the Chinese economy and listed companies, and the policy steps that Beijing should take to raise that share. These misunderstandings have led a parade of world leaders and prize-winning economists to urge China to “rebalance” its economy. Consumption is already strong . . . By most metrics, private consumption in China is already exceptionally strong. In 1Q12, retail sales rose 15.2% YoY, after rising 17.1% last year. During the period from 2005 to 2010, retail sales increased at an average annual rate of 17.6%. Figure 8 The Chinese are spending Nominal and real retail sales growth 25 (% YoY) 20 15 10 5 Nominal retail sales growth Real retail sales growth 0 Jan 01 Nov 02 Sep 04 Aug 06 Jun 08 May 10 Mar 12 Source: CEIC National Bureau of China’s retail sales data is not directly comparable to that in developed Statistics provides a countries because it includes purchases by government offices and excludes better picture consumer spending on services such as healthcare, education and entertainment. Urban household consumption expenditure, based on a quarterly survey by the National Bureau of Statistics, provides a better picture by excluding purchases by government offices and other organisations, as well as construction materials bought by individuals, and by adding spending on many services that are not covered by retail sales.May 2012 andy.rothman@clsa.com 15
  16. 16. 2. World’s best consumption story China macro strategy Urban household consumption rose 12.3% YoY in 1Q12, up from 10.7% a year earlier. Rural household cash consumption expenditure, driven by increasing nonfarm wages and farmgate prices, rose 17.6% in 1Q12, compared to 22% a year earlier. Figure 9 Urban household Urban and rural retail sales/consumption consumption rose Urban retail sales Rural retail sales in 1Q12 . . . Urban household consumption expenditure Rural household cash consumption expenditure 30 (% YoY) 30 (% YoY) . . . and rural spending saw bigger increases 25 25 20 20 15 15 10 10 5 5 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 Source: CEIC Fast-food sales rose This strong spending trend is also visible when we look at specific categories 19% last year of goods. Computer sales, for example, rose 15% YoY last year and by a 15% Cagr during 2007-11, according to data from Access Asia-Mintel. Fast-food sales rose 19% last year (13% Cagr), while sales of white goods rose 9% (11% Cagr) and cosmetics increased by 10% (9% Cagr). China is the world’s fastest growing market for everything from carbonated soft drinks (14% last year) to SUVs (100%).Figure 10Urban and rural household consumption by category (Rmb) 1992 20105,0004,5004,0003,5003,0002,5002,0001,5001,000 500 0 Urban Rural Urban Rural Urban Rural Urban Rural Urban Rural Urban Rural Urban Rural Urban Rural Food Clothing House facility Healthcare Transport and Recreation Residence Miscellaneous communicationsSource: CEIC. Note: ‘Household facility’ includes appliances and services; ‘residence’ refers to spending on housing and utilities.16 andy.rothman@clsa.com May 2012
  17. 17. 2. World’s best consumption story China macro strategy . . . supported by strong income growth Healthy consumer This strong growth in consumer spending is driven by several factors: healthy confidence consumer confidence; the absence of household debt; rapid income growth; moderate inflation; and growing demand for goods and services from the large number of Chinese who have only recently earned enough money to move into the consuming class - in part through the urbanisation process, which allows millions of people to make the transition from subsistence farming to salaried jobs. The proportion of Chinese living in urban areas has risen from 11% in 1949 to 51% in 2011, and we expect another 15 million people to make the migration annually for the next few years. Figure 11 The march from China’s urbanisation rate subsistence farming to salaried jobs 50 (m) Annual net increase in urban population (%) 60 Urbanisation rate (RHS) 40 50 30 40 20 30 10 20 0 (10) 10 (20) 0 1949 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Source: CEIC Unprecedented income Unprecedented income growth is the most important factor supporting growth a major factor for consumption. Real (inflation-adjusted) urban income rose 8.4% YoY last year, consumption up from 7.8% in 2010 and representing the 11th consecutive year of 7%-plus real growth. Real urban income rose 9.8% in 1Q12. Figure 12 Rural incomes are now Real growth of per capita urban household disposable income and rural net growing faster income 16 (% YoY) Urban disposable income Rural net income 14 12 10 8 6 4 2 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1Q12 Source: CEICMay 2012 andy.rothman@clsa.com 17
  18. 18. 2. World’s best consumption story China macro strategy Real rural income grew even faster, rising 11.4% in 2011, up from 10.9% in 2010 and representing the fifth consecutive year of 8%-plus growth. Rural wage growth outpaced urban last year, and wages for the 160 million migrant workers rose 21% YoY in nominal terms. In 1Q12, real rural income rose 12.7%. Real urban income rose Over the past decade, real urban income rose 151%, while real rural income 151% in the past decade rose 111%. Much of the increase was driven by government policy: the minimum wage in Shanghai, for example, rose 171% over the past 10 years. Figure 13 Minimum-wage growth 30 (% YoY) Average from 2001-12 2010 2011 2012 25 20 15 10 5 0 Beijing Shanghai Tianjin Shenzhen Jinan Source: CEIC Consumption is rising By some metrics, private consumption is growing more rapidly in China than in other countries. Figure 14 China leading Household consumption growth in local-currency terms the charge in private 30 (% YoY) China USA Japan Germany UK consumption . . . 25 20 15 10 5 0 (5) (10) (15) 1997 1999 2001 2003 2005 2007 2009 2011 Source: CEIC, CLSA estimates . . . far outpacing that of And if we convert China’s private consumption into US dollars, the growth American consumers in rate far outpaces that of American consumers in recent years. recent years18 andy.rothman@clsa.com May 2012
  19. 19. 2. World’s best consumption story China macro strategy Figure 15 Eclipsing growth in US Private-consumption growth in US-dollar terms private consumption 30 (% YoY) China USA 25 20 15 10 5 0 (5) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: CEIC, CLSA estimates So what’s the problem with consumption? Analysts who worry Analysts who worry about consumption do not pay much attention to the data about consumption do not we have just described. They focus instead on the low share of household pay much attention consumption in the overall economy, emphasising that this accounts for only to the data about 34% of China’s GDP - a very low level, as we noted at the opening of this section. Household consumption is But we do not believe this is the most important metric for the consumption a small share of GDP story. The reason that household consumption is a small share of China’s GDP because investment is not because consumption is weak. On the contrary, as we have just accounts for so much outlined, Chinese consumers are experiencing dramatic income growth and spending freely. Private consumption is a small share of GDP because the Communist Party has over the past decade dramatically ramped up its spending on public infrastructure. Infrastructure has accounted for about one- third of overall investment, which has been a major driver of GDP growth. Building in a decade what By building out in one decade the modern infrastructure that now-developed took other countries countries required many decades to create, the Party pushed GDP growth up many decades into double digits, with most of that growth coming from investment, squeezing out the share of GDP (or GDP growth) that could come from private consumption. In other words, the “problem” was not due to weak household consumption: it was because fixed-asset investment boomed as the Party built basic infrastructure, manufacturers modernised and privately owned housing was permitted. FAI rose at an average annual pace of 25.8% from 2003-11, compared to a 12.5% rate from 1995-02. Fixing the “problem” Strengthening the social In our view, there is little the government can or should do to accelerate the safety net will broaden rate of household-consumption growth (which is already rising at a double- the base for household digit pace). The government can, however, broaden the base for household consumption consumption by strengthening China’s social safety net, which will lead to a gradual reduction in the relatively high savings rate.May 2012 andy.rothman@clsa.com 19
  20. 20. 2. World’s best consumption story China macro strategy This process is underway. Last year, government spending on education rose 28% YoY, healthcare spending increased by 33%, social security was up 22% and spending on low-income housing jumped 61%. Over the past five years, healthcare spending increased 382% and education spending rose 237%. What about rebalancing? The Chinese government is often pressed by pundits and politicians to “rebalance” its economy. Usually “rebalancing” is simply a code word for currency appreciation - a topic we address in Section 14. China’s transition from But for those who are waiting for the day when the household consumption investment-led growth share of GDP begins to rise and the investment share begins to fall, that day will begin this year has arrived. China’s transition away from investment-led growth will begin this year, as fixed-asset investment growth will slow a bit below the roughly 25% YoY pace of the past nine years. The FAI slowdown will be led by a significantly slower rise in spending on public infrastructure, reflecting that the Communist Party does not want to build bridges to nowhere and is comfortable with slightly slower GDP growth. Slower FAI growth (we forecast 21-22% this year) is a positive development, not cause for alarm. There are several consequences of slower FAI growth. First, GDP growth will slow to about 8.5% from 9.2% last year and 10.4% in 2010. This marks the end of double-digit growth in China. Second, with GDP growth and FAI both slowing while consumption remains robust, the long-awaited rebalancing process will begin as, by default, the consumption share of GDP will gradually increase. Are Chinese consumers repressed? Household savings in Chinese consumers clearly suffer from financial repression, because the Party China are greater than the controls interest rates and has deliberately kept real returns on bank deposits combined GDPs of Russia, negative or very low. Throughout 2010 and 2011 - and during half of the Brazil and India prior decade - interest on one-year deposits was less than the rate of inflation. This has a significant impact given the size of household savings deposits in China: the renminbi equivalent of US$6.1tn, greater than the combined GDPs of Russia, Brazil and India. But if real deposit rates had been modestly positive in recent years, as they are today in most Asian markets, would urban household consumption have risen significantly faster than the 9-12% experienced in China (a much faster pace than seen in countries where real deposit rates were higher)? We are not suggesting that continued financial repression is a good thing. It is clearly unsustainable over the long run. But it is also clear that providing Chinese savers with the same real rate of return offered to households in neighbouring countries would be unlikely to spark significantly faster growth in consumption or lead to “rebalancing” of the Chinese economy. Findings on financial It is worth noting the findings of Peking University economists Huang Yiping repression in China and Wang Xun, in a paper on financial repression in China published last year by the Oxford Bulletin of Economics and Statistics:  Despite more than 30 years’ economic reform, the Chinese economy still possesses typical characteristics of financial repression: heavily regulated interest rates, state-influenced credit allocation, frequently adjusted reserve requirement and tightly controlled capital account. In the meantime, China achieved very strong gross domestic product (GDP) growth, averaging 10% during the reform period. These at least suggest that China’s repressive financial policies did not seriously jeopardize its growth performance.20 andy.rothman@clsa.com May 2012
  21. 21. 2. World’s best consumption story China macro strategy A more repressive  China’s experiences inject further controversy into this discussion. financial system but Compared with its East Asian neighbours, China has a more repressive stronger growth financial system but enjoys stronger growth. China successfully avoided financial meltdown and economic recession during the Asian financial crisis and the US subprime crisis, mainly on account of its repressive financial policies and closed capital account.  We concur that repressive financial policies are generally efficiency- reducing. Equally important, however, financial repression or financial restraint could probably promote growth through maintenance of financial stability and resolution of market failure. The net impact, therefore, depends on the relative importance of these two opposing effects, which may change over time. China has come a long  First, despite continued financial repression in China, the financial way in financial repression index fell from 1.0 in 1978 to 0.6 in 2008. This decline is liberalisation strong evidence that China has come a long way in financial liberalization, although China’s financial liberalization lagged behind that in many other emerging market economies but also behind reform of its own goods market. A possible model for other  China’s cautious reform approach - avoiding premature financial developing countries liberalization - probably provides an appropriate model for other developing countries. However, our evidence suggests that China should now pursue financial liberalization more forcefully, including, in particular, improving credit allocation between state and non-state sectors, abandoning frequent reserve requirement adjustments, introducing market-based interest rates and liberalizing the capital account.May 2012 andy.rothman@clsa.com 21
  22. 22. 3. Entrepreneur-driven economy China macro strategy 3. Entrepreneur-driven economy The role of state-controlled firms has been steadily shrinking, while private companies create almost all new jobs The Communist Party maintains significant control over China’s economy, but this control is exercised primarily via macro policy rather than through state- owned enterprises (SOEs). Macro policy includes everything from control of monetary and fiscal policy to loan quotas, the minimum wage and subsidised access to land and utilities. SOEs and state-controlled SOEs and state-controlled firms continue to dominate the financial industry firms still dominate the and many of the capital-intensive sectors, such as telecoms, aviation, oil & financial industry gas and petrochemicals, but state firms are far less important than they once were. China’s economic growth is increasingly driven by entrepreneurial small- and medium-sized enterprises (SMEs). Private firms employ 81% of urban workers In six years, 46m state Back in 1958, 86% of urban workers were employed by state firms, and that workers were sacked share remained above 70% through 1989. But between 1995 and 2001, the Party laid off 46 million state-sector workers - equal to sacking the entire combined workforces of France and Italy in six years. As a result, the state share of urban employment fell from 60% in 1994 to 28% in 2002. Figure 16 Employment by firm ownership 400 (m) State employment Other urban employment 350 300 250 200 150 100 50 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: CEIC Even in 2009, when most of the massive economic stimulus was channelled through state firms, their share of employment fell to 19%, versus 20% in 2008. As of 2010, the state share of total urban employment remained only 19%, leaving 81% of Chinese workers at private companies. Almost all new job In recent years, almost all new job creation in China came from private firms. creation in China came Between 2005 and 2010, employment at state firms rose at an average from private firms annual rate of 0.1%, while employment by private firms rose 6.2% per year.22 andy.rothman@clsa.com May 2012
  23. 23. 3. Entrepreneur-driven economy China macro strategy Private firms drive corporate investment We can also see the declining role of state firms when we look at fixed-asset investment. In 2004, the first year where we are able to break out FAI data by firm ownership, SOEs and other state-controlled firms accounted for 58% of total FAI. That share fell to 43% in 2008 and rose only slightly to 45% in 2009 as a result of the stimulus. But with the stimulus quickly withdrawn, the state-firm share of FAI fell to 42% in 2010 and 36% last year. In 1Q12, private firms accounted for 68% of total FAI. Figure 17 Most FAI by private firms FAI by firm ownership 35,000 (Rmbbn) SOEs Non-SOEs 30,000 25,000 20,000 15,000 10,000 5,000 0 2004 2005 2006 2007 2008 2009 2010 2011 Source: CEIC Figure 18 illustrates that for the 25 consecutive months through March 2012, investment by private firms grew faster than investment by SOEs. Figure 18 Private investment YoY growth rate of monthly FAI by SOEs and non-SOEs growing more rapidly 80 (% YoY) FAI SOEs Non-SOEs 70 60 50 40 30 20 10 0 (10) (20) Feb 05 Apr 06 Jun 07 Sep 08 Nov 09 Jan 11 Apr 12 Source: CEIC Private firms drive industrial production and exports The SOE share of China’s industrial production has also declined steadily, from 80% in 1999 to 44% in 2005 and 34% in 2011. And the SOE share of China’s exports has shrunk from 56% in 1997 to 18% in 2007 and 14% in 2011 (although 52% of all exports are produced by foreign-owned firms).May 2012 andy.rothman@clsa.com 23

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