In Search of Justice

October 16, 2009

FT Insight: Is China due a reality check?

Filed under: Commentary — by loong5 @ 4:28 am
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Insight: Is China due a reality check?

By Andy Xie

Published: October 15 2009 16:32 | Last updated: October 15 2009 16:32

The United States had 1929, Japan 1989, and south-east Asia 1997. Will China face a similar moment of reckoning a few years from now?

The question is crucial, not just for those investing in Asia today, but for the wider global market. For as investors around the world reel from the recent financial crisis, many have clung to the idea of a Chinese boom, as the one bright spot of hope in an otherwise grim world. The trouble is that history suggests that much of this optimism may be misplaced.

Financial markets have a way of working themselves into a frenzy during rapid economic development, which ends up leading to disaster. It is the ultimate testimony to the gross inefficiency of markets. The problem is the unique mix of extreme optimism and rampant liquidity that occurs during periods of rapid economic development.

Economic development, especially in a large country like China, generates exceptional optimism for many reasons. Nothing brings out the animal spirits in humans like watching the economic pie expanding.  And it is natural to buy risk assets such as stocks to express one’s optimism over the future.

The problem is that market competition tends to depress capital returns and give the fruits of economic development to workers and consumers rather than investors. High asset prices incentivise companies to over-invest, which depresses returns on capital. This is why investors tend to do poorly during periods of rapid economic growth.

A low income base and favourable demographics help promote successful economic development.  Both tend to lead to excess liquidity due to a high savings rate on incremental income growth. When a population is urbanising, even though its productivity is shifting from the agricultural to the industrial level, consumption habits remain rural that is, anything beyond necessities is viewed as luxury and is minimised. The widening gap between the labour productivity increase and the consumption preference leads to the excess liquidity that feeds bubbles.

China’s one-child policy brings the ultimate demographic dividend but probably makes the country the most bubble-prone in modern times. The situation is made worse by the revenue dependency of local governments on the property market.  Local government officials who change every five years or so have strong incentives to juice up the property market to maximise their revenues. This political incentive sows the seed for a great property bubble.

Similarly, China’s stock market will remain overvalued, although it will deflate from time to time during panics and temporary liquidity shortages. The combination of low returns on capital and high share prices means businesses turn to the stock market rather than to their customers for profit.

But when businesses make profits from, rather than for, the stock market, it becomes a negative sum game.  It needs continuing liquidity inflows to sustain it. This is why high growth and a high savings rate are vital.

On the other hand, such a market essentially subsidises capital formation. The capital subsidy leads to overcapacity and low returns on capital. This is why poor profitability, high asset prices, and high economic growth rates can coexist. Indeed, they must exist together.

China’s economic development is undoubtedly going to be the most important economic event for the next decade or two. But the semi-permanent bubble situation makes it extremely difficult for financial investors to participate in this story.

“Buy and hold” simply won’t work. Value investing doesn’t work because value investors base their decisions on price/earnings ratios and price/book value ratios falling below certain levels.

Chinese stocks never get there.  If you are Warren Buffett, you can create your own bubble. He recently bought a stake in BYD, a maker of mobile phone batteries. The stock has since risen 8 times. If you are not Warren Buffett, I suggest “buy low, sell high”. The problem is working out what is high and what is low.

The day of reckoning will come when the high economic growth rate finally falters. This could happen either when the favourable demographic trend worsens or urbanisation ends. When either or both occurs, liquidity or savings do not grow any more. At that point, the stock market can not be subsidised anymore.

China’s final day of reckoning is probably 10 years away.

By that time, half of China’s babyboomers who were born between 1950 and 1978 will have retired. And the Chinese urbanisation rate will be about half what it is today. The good news is China will be a developed country by then. The bad news is there will be no cheap money for supporting overvalued asset prices any more.

The writer is an independent economist based in Shanghai and former chief economist for Asia-Pacific at Morgan Stanley

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