Note: This feature length cover story by Chris McMahon originally appeared in the November 2009 issue of SFO Magazine.
Link to original @ SFO Magazine
“At this critical juncture of countering the financial crisis, I called for perseverance, as perseverance will lead us to final victory. The dark cloud of the financial crisis will disperse. Let us work together for a more splendid future.”
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| The Year of the Ox: Is It a Bull for China? |
~ Chinese Premier Wen Jiabao
In Chinese astrology, 2009 is the year of the ox, a symbol of wealth created by strength, hard work and perseverance. Those born under the sign of the ox are thought to be quiet, patient and determined. That’s an auspicious sign for China’s stimulus plan and newly resurgent economy. But those born under the sign are also thought to be stubborn, eccentric and quick to anger.
As the global economic slowdown approaches the end of its second year, China’s economy appears to have pulled out of the downturn and to have done so with miraculous speed and strength, creating 6.7 million jobs, an enviable feat that the U.S. economic stimulus plan has yet to pull off.
“The evidence is overwhelmingly clear that China’s economy bottomed out in the fourth quarter [2008],” says Nicholas R. Lardy, senior fellow at the Peterson Institute for International Economics. On an annualized, quarter-over-quarter basis, Q4 growth was at about 4 percent. “It was 8 percent in the first quarter and 14.9 percent in the second quarter. So this is the earliest and most rapid recovery of any globally significant economy,” he explains.
Although some scoff at China’s reported economic statistics, Lardy says they are largely corroborated by other evidence, including industrial production and import numbers, which are growing relative to exports and their trade surplus, which has begun to shrink dramatically.
To fully appreciate the magnitude of China’s recovery, it is important to understand its recent history and how the economic crisis manifested in the country.
TO GET RICH IS GLORIOUS
Starting in the 19th century, China endured civil unrest, major famines, military defeats and foreign occupation, according to the Central Intelligence Agency’s World Factbook. After the Chinese Civil War and victory against the Chinese Nationalist Party in the early 1950s, China was unified under Mao Zedong, chairman of the Communist Party of China. Since then, the country has been ruled by a totalitarian government.
Chairman Deng Xiaoping succeeded Mao in the late 1970s, and the party began instituting market-oriented economic development in 1978, including liberalized prices, fiscal decentralization, increased autonomy for state enterprises, the foundation of a diversified banking system, development of stock markets, rapid growth of the nonstate sector, and the opening to foreign trade and investment. The county had quadrupled its economic output by the year 2000.
“What is going on in mainland China is what happened in the United States in the 1880s and 1890s. They are still in the middle of their industrial revolution,” says James Trippon, editor in chief of the China Stock Digest, adding that China is still a 60 percent agrarian economy; the rest have flocked to urban manufacturing centers. “When they are fully industrialized, they will be 80 percent urban.”
“China made a huge bet on interdependence on the United States, and it worked really well for them for a long time,” says David F. Gordon, head of research at Eurasia Group, a political risk research and consulting company. “They have been big beneficiaries, if not the biggest beneficiaries, of globalization and from the leading role that the United States has played in the world economy,” and especially benefiting from the U.S. consumer.
At the same time, that interdependence and the fact that the country’s gross domestic product is so heavily weighted in favor of exports made China highly vulnerable to external recession.
Now the distraught U.S. consumer class, which was responsible for consuming 17 percent of global GDP, has pulled back on spending as it contends with the negative wealth effects of a collapsing real estate market, an overhang of debt, tight credit markets and high unemployment. A massive drop in demand resulted in a massive overcapacity in China and a spike in unemployment.
“Their commitment to socialism, their commitment to equality, all that, was the legitimating principle for this regime,” Gordon says. “Over the last 20 years, they dropped all that ideology, and the main legitimating element of the regime has been improving the standard of living for the vast majority of the people living in China.”
China’s often-stated 8 percent GDP growth target is the rate required to absorb the rate of migration from farm to city and the nation’s birth rate, Gordon explains. “They have made this promise of a better life, which they have essentially delivered on for hundreds of millions of people, but they still have hundreds of millions more who are moving from the countryside into the city, and they have to keep up this extraordinary pace of job creation to satisfy them. That’s what the regime goes to sleep worrying about,” he says.
The 4 trillion renminbi Chinese economic stimulus package, valued at $585 billion, was the first major government stimulus program announced to counter the global economic downturn. In his Sept. 10 speech at Summer Davos in Dalian, held in the coastal city of China, Chinese Premier Wen Jiabao credited the stimulus package with returning 7.1 percent GDP growth in the first half of 2009 and creating 6.66 million new jobs. “Overall social stability was maintained,” he added.
Jiabao went on to explain efforts to expand domestic demand, which he described as a long-term strategic policy, and to increase growth through consumption and investment. Retail sales of consumer goods rose 15 percent, he said, and 7.31 million cars were sold in the first seven months of 2009.
Jiabao claimed that 52.4 percent of the stimulus package has gone to subsidized housing and social expenditures, such as education, health and social security, 24.7 percent to “independent innovation, economic restructuring and energy projects,” and that only 22.9 percent was to be spent on investment for infrastructure.
“I don’t know how he calculates 23 percent,” says Stephen S. Roach, chairman of Morgan Stanley Asia. “But in looking at the package, whether it’s rail construction, roads, bridges or reconstruction in the Sichuan province after the earthquake a year ago, we call all that infrastructure, and it accounts for a little less than $3 trillion of the $4 trillion package.”
Roach says the design of China’s stimulus package indicates the regime is opting for the quick fix that plays into the country’s existing imbalances, which he believes is also true of the United States’ stimulus package.
“In America, it’s ‘Cash for Clunkers,’ which is creating an artificial boost to consumer demand—America’s most unbalanced sector that has gone to excess. In China, it’s ‘cash for bridges,’ using an extraordinary burst of bank lending to fuel infrastructure-led investment, which is China’s most top heavy and unbalanced sector.”
COMMODITIES IN DEMAND
China’s necessary focus on constructing infrastructure, such as roads, bridges, rails, factories, ports, cities, housing, etc., is driving demand for natural resources, including base metals, industrial materials, oil and other energy products. In addition, China also has old technologies, which use energy inefficiently and, thus, require higher energy and natural resources per unit of GDP than would a more technologically advanced economy.
Roach characterizes China’s demand for commodities as high and rising. He says that trend is likely to continue until China can shift growth from exports to investments, which would automatically lower the resource content.
That high and rising demand has been a floor created under commodity prices, in particular metals, which are required for everything from buildings to consumer electronics.
“The demand for steel is running at 460 million to 470 million tons of steel per year; and you need a lot of iron ore to make that much steel,” observes Lardy. “Maybe they overstocked a bit on some of these commodities, but they will get worked down, and they will be back for more.”
Steel production is quickly rising in China. According to the World Steel Association, China’s crude steel production for August 2009 was 52.3 million metric tons, 22 percent higher than August 2008 and the highest level of monthly production. Compare that to the United States’ production, which was 5.2 mmt in August 2009, a 40 percent decrease from a year ago. Total world steel production in 2008 was 1.33 billion metric tons.
With less mature market infrastructure, Chinese pig farmers, who are among the nation’s most established entrepreneurs and investors, are speculating on their country’s boom by stockpiling copper and other physical metals.
Copper, which is used in both consumer items and infrastructure for everything from electrical systems to plumbing, is a crucial commodity for the country, and production and imports of the metal are considered important indicators of economic activity. In 2008, China imported 1.46 million tons of copper. In the first seven months of 2009, it imported 2.4 million tons.
In July, copper imports fell to their lowest levels in six months, and the consensus is that stockpiling is slowing. But that simply creates another opportunity, Trippon says. “They don’t have to build warehouses; they can just buy the stock.” And they are.
While China’s efforts to acquire mining giant Rio Tinto were rebuffed, China is still buying interests in mining companies. Among the many deals announced in recent months, OZ Minerals Ltd. is selling assets to China Minmetals Group.
Just days later in July, China Investment Corp. (CIC), a sovereign wealth fund that also owns interest in Blackstone Group LP and Morgan Stanley, acquired $1.5 billion of interest in Canada’s Teck Resources Ltd. and PT Bumi Resources of Indonesia, Indonesia’s largest producer of thermal coal. And in an indication that it could become more active and sophisticated in international markets, CIC bought an $850 million, 15 percent, stake in Noble Group Ltd., a Hong Kong-based commodities trading company.
In addition to discount buying of mining stocks, there is another factor spurring China’s commodity buying binge. “The Chinese are looking for an excuse to get rid of their U.S. dollars anyway. What better way for them to get rid of those dollars before they get hurt by inflation than to buy commodities at discount prices?” Trippon asks.
DOLLAR STORE
The interdependence between China and the United States goes far deeper than that of the symbiosis of China’s exports and U.S. consumers. The Chinese have invested enormously in U.S. financial markets and hold $800 billion in U.S. Treasuries as of July 2009, slightly more than President Barack Obama’s $787 billion stimulus plan, which represents roughly 5.5 percent of U.S. GDP in 2008. In September 2008, arguably at the height of the financial crisis for the United States, China superseded Japan as America’s largest creditor (see Figure 1).
China is understandably concerned about the astronomical amount of U.S. debt and the very real possibility that runaway inflation could erode the value of its U.S. dollar-denominated assets.
“One reason they are so frustrated is because they don’t have a lot of choices in what to do with that money,” Gordon says. “They are very uncomfortable having to purchase $20 billion a month in Treasury paper. That’s a lot! And they are hooked on it,” he says, likening the interdependency to drug addiction: To continue buying U.S. Treasuries increases their vulnerability, but discontinuing it undermines the value of their assets.
“This is a source of big-time frustration for them, especially when they look at what the United States is spending on its stimulus program,” he says, listing health care, green technology and the potential for serious inflation. “That’s why they have begun to hector and lecture us about these things. But what they are not doing is pulling their money out.”
China has started speaking publicly about moving away from the U.S. dollar and has floated the idea of starting a new global reserve currency. In September, China petitioned the International Monetary Fund to issue $50 billion in notes denominated in special drawing rights as a way to begin diversification and make a point to the public.
“It’s a much more symmetric relationship. They are no longer taking advice from us. They have some for us,” Lardy says. “China has gained enormous international confidence through this crisis for a number of reasons.”
For years the Chinese resisted the advice of U.S. Treasury Secretary John Snow and his predecessor Hank Paulson to liberalize financial markets and introduce supposedly more sophisticated financial products, which would theoretically result in a much more efficient engagement of capital, such that China could grow even faster.
“They were skeptical of that,” Lardy says. “And now they see that was clearly a brilliant decision. They are no longer going to sit around and listen to the United States lecture them about how they ought to operate their economy and their financial system in particular.”
Further, the Chinese are concerned that the U.S.’s monetary policies are not set up to solve the problem and could make it worse, Trippon says. For example, one of his worries is that the U.S. credit market, despite a massive infusion of government money, remains frozen as banks shrink their balance sheets and raise additional capital (see Figure 2).
“[Banks] used it to purchase Fannie Mae mortgages. They are still not lending,” Trippon says, explaining that banks are collecting money under the Troubled Asset Relief Program (TARP) at 1 percent and can then effectively loan it back to the government at 4 percent or 5 percent. “Why would we loan it to you, your small business or anybody else?” he asks.
As a result, the U.S. stimulus package is not reaching small or mid-sized businesses, which create almost 50 percent of new jobs. A stagnant job market will result in fewer tax revenues and the greater expense of unemployment benefits, as well as lower corporate earnings, all of which could hurt consumer sentiment and spending and, by extension, further depress demand for China’s exports.
China’s stimulus plan, in contrast, has spurred a lending orgy, which is reportedly up 70 percent year over year.
“China never allowed financial institutions to operate with as high a degree of leverage as we did in the United States,” Lardy says. “They have very little exposure to subprime and toxic assets. They have had to write off practically nothing.” As a result, the central bank has not had to inject capital into the banking system or guarantee any bank liabilities.
“Banks had massive amounts of money on deposit at the central bank in reserves, which earned almost no interest,” Lardy says. Beginning in September 2008, they cut the reserve requirements four times, which freed up liquidity; and rather than earning a pittance at the central bank, they could make loans at 6 percent or more. As a result, China is free to use the entirety of its stimulus package to develop domestic consumption and infrastructure, thus creating jobs.
AFTER THE FLOOD
Although China’s economic recovery to date has been impressive and has had an important positive effect on the psychology of the global markets, it is telling that even Premier Wen Jiabao remains tentative.
At Summer Davos in Dalian, he said, “The stabilization and recovery of the Chinese economy is not yet steady, solid and balanced. With many uncertainties remaining in the prospects of the world economy, we still face tremendous pressure of the decline in external demand. And we are under the various constraints in expanding domestic demand in the short term.”
Should China succeed in developing its domestic market and moving away from an over-reliance on cheap exports, a recovered and thriving China would continue creating competitors to international firms that serve both the domestic Chinese and other markets. The winners for investors, however, are not necessarily going to be the foreign firms in China (see Figure 3).
“It could very well be domestic firms in China,” Gordon says. However, expectations that China’s growth will reinvigorate the world economy and that the Chinese are poised to take leadership in international economics are wrong.
“Investors have been talking about the Chinese consumer for 20 years,” Gordon points out. Domestic consumption as a percentage of GDP is incredibly small, and while he says that will change, it will not affect the world economy immediately.
China, while obviously a globally significant economy, still contributes slightly less than 10 percent of worldwide GDP, Lardy says. “It’s not the U.S., which is 25 percent of global GDP. It’s a nice contribution, but it’s not going to pull the world economy off the bottom,” and it won’t change things dramatically for the United States.
Further, if China’s recovery and strengthening are based on less reliance on low-cost exports, that shift would obviously increase the cost of goods for consumers in the United States and elsewhere. In a worst-case scenario, a stronger domestic Chinese economy could put upward pressure on commodity prices and choke off a recovery in the rest of the world’s economies, Gordon says.
Roach shares that opinion. “It’s going to take longer than I originally thought, but when it happens, it will be one of the biggest megatrends in the global economy, and have huge and important implications for investors—retail and institutional alike.”
Note: This feature length cover story by Chris McMahon originally appeared in the November 2009 issue of SFO Magazine.
Link to original @ SFO Magazine