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bears in the china shop

While China’s long-term rise looks unstoppable, the ‘growth miracle’ has slowed somewhat recently, and debate on whether its eventual landing will be soft or hard remains ongoing. With powerful fundamentals still in place, consensus is tipped towards the soft, but there are equally compelling arguments for a hard landing, particularly against a backdrop of slumping property prices and rising anxiety. 

After a long period of broad bullishness on China – at least from a macro perspective – it is worthwhile considering the consequences for investors if the country disappoints. At the most bearish end of the spectrum is local economist Jim Walker from Asianomics, who believes China has made so many mistakes over the past few years that a hard landing is inevitable. “China has taken on the notion of credit at all costs to fuel growth at all costs,” he says. The Government is trying to control the adverse effects of its credit expansion in 2008, but Walker thinks misallocation of capital will lead to a property crash.

He also questions the reliability of China’s figures – citing the example of the banking crisis in the late ’90s, when 40% of assets in the system were nonperforming and simply moved into asset management companies. Elsewhere, chief Asian economist at Capital Economics Mark Williams believes property is key, and questions whether a strong economic recovery is possible in China without solid growth in real estate.

He points out: “China has built over 90 million properties in the past 15 years – enough to house the combined populations of Germany, France and the UK. Along the way, construction activity has boosted economic growth and been a key source of jobs for migrant workers.”

Primacy of property

According to Williams, a return to rapid economic growth in China is extremely unlikely as long as property is struggling. He adds: “Roughly 2 million properties were sitting empty at the end of July and a further 30 million are under construction. That is enough to meet property demand for the next three or four years, and in these circumstances, only the bravest developers will embark on new projects. In other words, a property sector rebound seems unlikely, and so a sluggish economic recovery looks the most probable scenario whatever the Government decides.”

China has built over 90 million properties in the past 15 years – enough to house the combined populations of Germany, France and the UKalt=''

Mark Williams
Cheif Asian economist, Capital Economics

Yet Capital Economics actually sees sluggish recovery as the best outcome, citing unsustainable growth on the property side. Williams says: “Urban residential real estate investment accounts for double the share of total spending in the economy than it did a decade ago and a period of below-trend growth is needed to put the sector back on a sustainable path.

“If that means the economy ends up growing slower than China has been used to, this is something worth putting up with. Another wave of property investment would bring short-term benefits, but result in an even bigger economic downturn a few years down the line.”

Walker says it is possible to make money from the China theme, primarily by playing on the country’s mistakes.

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“Australia, for example, has benefited from China’s misallocation of capital, which led to a huge demand for commodities,” he says. Walker cautions against owning Chinese companies and suggests investors are better off buying into economies where the cost of capital is commensurate with the growth rate.

Chinese exposure

A look at activity among multi-managers is also instructive, with many paring back Chinese exposure.Cazenove’s head of multi-manager Marcus Brookes is among those making such changes, seeing the region’s growing problems as under-appreciated. “Even without assuming a hard landing, there remain enough impediments to current levels of growth that are not yet fully priced into many markets,” he says.

“The strangely common belief that the Chinese Government can control every aspect of growth in all its minutiae, where most have struggled through history, still seems somewhat questionable to us.” Brookes says that while Chinese growth will continue to outpace the West, 7% GDP will feel slow compared with recent years and 6% would potentially be approaching recession territory.

Like many China watchers, he is particularly concerned with developments in the property market. “In a global context, the Chinese market has only been open for around a decade and with its currency fixed to the dollar, the authorities have had to print huge amounts of the currency to keep up,” he says. “Much of that has gone into forming a huge construction bubble and in the most expensive city, mortgages now require massive multiples of salary.”

Hedging portfolios

To hedge his portfolios – and potentially benefit if the country continues to struggle – Brookes has bought noted China sceptic Hugh Hendry’s Eclectica Fund.

Summary

• The impact of a property crash cannot be underestimated – China has built over 90 million properties in the past 15 years.
• Many fund pickers have stripped back their exposure to China or prefer to use broader global emerging market funds rather than China-specific vehicles.
• Some fund selectors are hedging their China exposure with strategies which seek to benefit from over-optimism on the country’s economic outlook.

“Hendry’s fund is built on a similar view to ours – namely that several markets around the world are still pricing in a fairly rosy scenario for China,” he adds. “If you look at Japanese steelmakers, for example, they are some of the most leveraged companies in the world but have thrived in recent years because they sell to China. A small decrease in their turnover would have a huge effect on operating profits and credit servicing and continued Chinese strength is built into so many assumptions.”

 

tom@ybc.tv

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