As the debtor economies of the developed world sputter, the health of China grows ever-more central to the fate of the global economy. Yet, the debate on China’s prospects remains polarized and often superficial, with commentary either baselessly bullish or derisively bearish.
Reality, of course, is usually more nuanced. China’s model is unbalanced and its economy has misallocated capital, but its policy makers are using the country’s plentiful reserves and policy tools to keep inflation under control and growth on a sustainable path. China’s growth will probably slow, as its model evolves from depending on exports and investment to relying on greater consumption, but the economy is unlikely to implode.
The financial crisis in the West marked the end of the export-dependent phase of China’s growth. As the U.S. and Europe deleveraged, China compensated by plugging its export deficit with internal fixed-asset investment, largely in housing, which has represented the majority of the country’s GDP growth since 2008. With its population now about 50 percent urban (the comparable figure for the U.S. is roughly 80 percent), China is still building the infrastructure it needs to keep urbanizing over a million people a month. However, the Chinese can’t rely on investment much longer without running the risk of inflation and a treacherous bubble.
Consequently, China has recently been raising interest rates and restricting credit to slow things down. Credit growth has stabilized at 17 percent from a year earlier, down from 32 percent in post-crisis 2009. It’s ironic that the China bears who worried about inflation a few months ago now characterize the government’s calculated moderation as an “unwinding bubble.” Managing growth without arresting it is the very definition of a “soft landing.”
China can continue to grow, although probably at a slower rate, if it reduces investment dependence, but consumption will need to pick up some of the slack. Consumption’s share of GDP has fallen as investments have increased in recent years, but Chinese leaders hope to promote more sustainable growth by strengthening consumers and services, in part by deregulating energy and wages and by revaluing the yuan. The yuan is up more than 6 percent against the U.S. dollar this year, and officials are targeting full convertibility by 2015. Nominal wages are rising 17 percent annually, and consumption has increased 12 percent, according to China’s National Bureau of Statistics.
Chinese consumers are in better shape than those in the U.S., with a household debt-to-income ratio of 18 percent, compared with 95 percent in the U.S. Bank of America points out that Chinese households have $5.1 trillion in savings, more than the GDPs of India, Brazil and Russia combined. The Chinese middle class is almost as large as the entire U.S. population and will be twice as large (as will its share of global GDP relative to the U.S.) in 10 years.
Real consumption is already growing briskly at the high end, where luxury retailers have seen explosive growth. Analyst Aaron Fischer of CLSA projects that China’s share of the global luxury market will rise from 14 percent in 2010 to 44 percent by 2020. The next step is for China to broaden the base of consumption as household incomes rise across the middle class.
Market bears point to China’s “ghost cities,” instant residential developments bereft of citizens, as proof of a major misallocation of capital resulting in a housing bubble. However, Chinese policy makers have been working to reduce the excess with a range of regulations, including restrictions on multi-property ownership, rising interest rates and mortgage limitations.
As a result, growth in the most speculative markets has moderated (and the deserved financial problems of the most exuberant builders serve as a deterrent to further misallocations). Today, according to CLSA analyst Andy Rothman, 89 percent of new homes are purchased by owner-occupiers making down payments that average 44 percent of purchase price; the majority of the rest are bought with cash. This looks more like prudence than a bubble.
Bears are overly focused on supply, basically disregarding the demand dynamics driving the housing market. Amid the greatest urban migration in history, the concept of “just in time” inventory management simply doesn’t apply. Five years ago, the Pudong district of Shanghai was reckoned to be the biggest urban real estate bubble of all; today, it’s fully occupied. In China, if you build it, they will come.
There has indeed been substantial misallocation of capital in the financial system. My team at Xerion estimates that up to 25 percent of Chinese bank loans may be bad, implying potential losses as high as $1 trillion. That’s a huge bailout number, but not beyond China’s capacity.
Fortunately, the financial system is highly liquid thanks to the high rate of savings, which equal 80 percent of bank capital. Lacking investment alternatives, China’s depositors are victims of financial repression, receiving only 2 percent interest on bank deposits while suffering an inflation rate of more than 6 percent. China’s ratio of loans to deposits is about 68 percent, according to Paul Schulte of the China Construction Bank International, much lower than in most developed economies, which average 100 percent.
As long as bank deposits stay high and inflation stays low enough to permit the continued flow of credit, problem loans can be refinanced as they mature. In a worst case scenario, China could deploy some of its $3.2 trillion in foreign reserves to recapitalize its banks. China’s foreign credit status creates a stark contrast with the weak balance sheets of many nations in the West.
Much to Dislike
There is plenty to dislike about China’s state capitalism, but its strong external accounts and tight control of policy levers give it huge practical advantages relative to the politically divided, overleveraged democracies of the developed world. Balancing growth, solvency and inflation while simultaneously overhauling China’s economic engine from investment to consumption will require considerable policy skill. But the track record of the past 30 years should earn Chinese policy makers the benefit of the doubt. The rest of us should view bearish criticism with skepticism and table the counterproductive protectionist resolutions in Congress. It should be clear by now that China’s success will be ours, too.
(Daniel J. Arbess is a partner of Perella Weinberg Partners LP and portfolio manager of the Xerion investment strategy. The opinions expressed are his own.)
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