China’s Outlook Seems Darkest From a Distance
Distance seems to make investors’ views of China grow, shall we say, less fond.
(Bloomberg) -- When it comes to analyzing China, distance seems to make investors’ views of the world’s second-largest economy grow, shall we say, less fond. Whether it’s George Soros (who’s likened China to the U.S. before the 2008 subprime mortgage crisis) or Kyle Bass (who’s said the Chinese economy is built on sand) or Jim Chanos (who’s said, memorably, that China is on a “treadmill to hell”), there’s no shortage of gloomy outlooks. Over-investment, too much debt, bubbly markets, faked data, Ponzi-like financial structures—the litany of looming pitfalls seems inescapable to many investors, especially hedge funds, based in financial hubs from Connecticut to Canary Wharf.
That negativity is a sharp contrast to the majority opinion held closer to Beijing or Shanghai. There, booming consumption, a pickup in global trade, and an increasingly innovative private sector are fueling bets that China’s generation-long economic miracle still has plenty of room to run, albeit at a slower rate than the average gross domestic product growth of almost 10 percent a year since the early 1980s. “I find it scary how many self-proclaimed US based China experts w real influence have barely lived in China, barely speak Chinese and barely have a clue …” tweeted Shaun Rein, Shanghai-based founder and managing director of China Market Research Group and author of The War for China’s Wallet, on Dec. 26. Later he was on Twitter again, wagering that the “same tired group of China’s watchers will predict China’s collapse for the 40th year in a row… and they’ll be wrong for the 40th time but western media will keep quoting them breathlessly as experts.”
Rein may have a point, but there are plenty of investors across the Pacific who take a longer view on China. Corporate America, for one, has long seen through the fog of gloom. Chicago-based Boeing Co. is building its first overseas “completion center” for 737 aircraft on Zhoushan Island south of Shanghai. In 2016 Walt Disney Co. opened a $5.5 billion theme park in Shanghai—its biggest-ever foreign investment. Tesla Inc. says that within the next several years it plans to begin making automobiles in China, where surging demand for electric cars contributed 15 percent of the company’s revenue in 2016. Meanwhile, in December, the world’s biggest Starbucks—all 30,000 square feet of it, about half the size of a soccer field—opened in Shanghai.
Western banks, which have long coveted the vast Chinese market but had mixed success entering it, are looking at new opportunities now that President Xi Jinping promised to open up the sector to greater foreign competition. UBS Group AG is in discussions to acquire a majority stake in its Chinese securities joint venture, and Morgan Stanley and Goldman Sachs Group Inc. have signaled a desire to take majority stakes in their own Chinese ventures. BlackRock, Fidelity International, UBS Asset Management, and Man Group are among global fund managers expanding in China.
If much of the commentary on China from the West remains bearish, blame Japan. Some analysts and investors base their assessments on the assumption that China is destined to share the fate of Japan, whose three-decade boom hit a wall in the early 1990s. This supposition is questionable. China is still at a much lower stage of development than Japan; on a per-capita basis, China’s GDP in 2016 was less than 40 percent of where Japan was in 1970, according to World Bank Group data. What’s more, China is a vast, multiregional economy—not an island. That means it can keep posting world-beating growth even when some regions do turn down, as happened in 2016 and early 2017 when the industrial northeast slowed as the government pushed through an economic rebalancing that promotes consumption and services.
As China enters the lunar Year of the Dog, the gloomy bears say it’s unlikely that plans to curb loans and credit expansion can succeed without denting growth. Mark Williams, chief Asia economist at Capital Economics Ltd. in London, for instance, thinks government statistics have inflated GDP readings. He reckons China’s GDP growth will slow to 4.5 percent this year, whereas the more than 100-strong research team at China International Capital Corp., the country’s first Sino-foreign investment bank, thinks the economy will actually accelerate to 7 percent.
CICC downplays the negative impact of total borrowing, which has risen to more than 2.5 times China’s GDP and is generally seen as the No. 1 risk factor facing the economy. The investment bank argues that both the state sector and households have more than enough cash on hand should trouble strike. In addition, CICC says, the most indebted sector—corporates—is sitting on cash equivalent to about 40 percent of current debt. That, according to Liang Hong, the company’s chief economist, means that while government reforms to cut debt levels in China are important, they needn’t translate into negative growth.
Another point missed by the Connecticut-set mentality is this: China’s debt is largely self-funded and will remain that way as long as the country hangs on to a healthy current account surplus, according to Michael Spencer, global head of economics at Deutsche Bank AG in Hong Kong. “Hedge funds in New York have been saying for seven years it’s going to be a crisis, but it clearly hasn’t been the case,” he says. “China is not investing New York hedge fund money. It is investing Chinese home savings.”
That’s not to say the China bears don’t have legitimate concerns. The country’s total debt from the government, households, and nonfinancial companies reached 256 percent of GDP in June 2017, already surpassing that of the U.S. (250 percent), according to the Bank for International Settlements. That’s up from 146 percent a decade ago, and it marks a faster pace of debt accumulation than occurred in the U.S. during the period leading to the housing crisis. Even officials in Beijing are taking the possibility of asset-price collapse seriously: Outgoing People’s Bank of China Governor Zhou Xiaochuan in October warned of the risk of a debt-induced Minsky Moment, and Xi has prioritized financial stability through his second term in office.
Confidence in the ability of China’s policymakers to manage the economy wavered in 2015, when an epic stock market crash and bungled exchange rate reform sent global markets into a tailspin. But more than two years on, the clear takeaway from that episode is the need to distinguish market ructions from real economic activity: Economic growth largely held up through that crisis as authorities used levers such as capital controls to stem the fallout.
For all the talk of reform, the central government retains a firm grip on the economy. The heavy fist of the state still often trumps the invisible hand of markets, credit is still channeled from state-owned lenders to state-owned firms, and local governments can still ramp up infrastructure investment at the first whiff of a slowdown. That sort of investment rationale is behind one of Xi’s signature policy initiatives—the Belt and Road initiative that Beijing says will pump $1.3 trillion into roads, ports, and other construction projects designed to connect China to trading partners across Asia and into Europe. While the state and local involvement is a plus for near-term stability, it could also be a tax on the future if capital is misallocated.
Banks are often identified as China’s weakest link. A deep-dive analysis by the International Monetary Fund in 2017 recommended that the nation’s lenders should increase their capital buffers to protect against any sudden economic downturn. Kevin Smith, Denver-based chief executive officer and founder of Crescat Capital LLC, says a banking implosion is inevitable; the only question is when. Smith has held short yuan bets since at least 2014, a position that helped his global macro fund gain 16 percent in 2015 when the PBOC surprised the world with its minidevaluation.
Smith was less fortunate last year when China’s economic recovery and tightening capital controls helped the yuan to rally. His fund lost 23 percent in 2017. The loss cut the fund’s annual return since its 2006 inception to 11 percent, which still outpaced the S&P 500 index’s gain of 8.8 percent during the period. Smith is undaunted. “We remain grounded in our analysis,” he says. “Credit bubbles burst. Ponzis implode. In the end, we believe China will be forced to print trillions of U.S. dollars equivalent of new money to recapitalize its banking system and bail out its depositors.” In that scenario the currency will crash, Smith says, who’s also short on various Chinese equities.
He wasn’t alone in getting the yuan bet wrong last year. Consensus estimates at the start of 2017 forecast the dollar would buy 7.15 yuan by yearend; it ended at 6.50 yuan. Headline economic data don’t tell the story of trends and developments actually taking place on the ground, from the industrial northeast to the high-tech south and the agricultural interior, says Frederic Neumann, co-head of Asian economics research at HSBC Holdings Plc in Hong Kong. And the government’s firm hand on the tiller, he says, needs to be closely watched. “The further away students of China are located, the more easily such nuances get lost, leaving many to focus more on the risks than on the promises of the country’s economic future,” Neumann says.
Because changes across China’s extensive economy tend to be subtle and gradual, it’s often hard to get a feel for the pace of development, according to Mo Ji, Hong Kong-based chief economist for Asia ex-Japan at Amundi Asset Management, who called a bottom to China’s slowdown in late 2015, well before it was a consensus view. She’s been working for the past 13 years with the Nobel laureate economist Joseph Stiglitz on analyzing China’s economy, having first met him when she studied under him for a doctorate at Columbia University. “The further away from China, the more difficult to feel all the real changes,” Mo says.
Stephen Roach may spend a lot of time in Connecticut—he’s a senior fellow at Yale in New Haven—but he’d never be accused of being part of the Connecticut set. A former nonexecutive chairman of Morgan Stanley in Asia, Roach first went to China in 1985 and still travels there four or five times a year. He says there’s a tendency to project the West’s crisis-prone outcomes onto China. “Connecticut-based hedge funds and Washington-based politicians,” he says, “are equally guilty of this long-standing bias.”
Curran is chief Asia economics correspondent in Hong Kong. Xie is a market blogger in New York.
To contact the editor responsible for this story: Stryker McGuire at smcguire12@bloomberg.net.
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