Is China Really Such a Great Investment?

China grew its industrial production by 12.3% last month. That is good or great in any environment. When the world is in a recession, it is undoubtedly great. China’s retail sales grew right along with it by 15+%. Could the economic world look any rosier for China?

The answer is apparently “yes”. People are questioning China. They are suspect of its banks. They are suspect of the numbers the government is providing. Why do they doubt it economic numbers? The answer would seem to be that the numbers just seem too good to be true. Are they?

My belief is that the numbers are a mixture of good and bad. There may be some number juggling by the government, but the US government has often been accused of that too. I believe the numbers are largely true. At the same time, the numbers give me doubts about the Chinese economy. How can that be?

The answer is in the fine print mixed with a little common sense. China has been growing in the high single digits to low double digits for about ten years now. They have been making incredible numbers of loans in order to sustain this high growth rate. As they have continuously grown quickly the “questionable” loans have not really come back to haunt them. If everything is going up, you don’t have to worry about real estate that is under water (or not for long). If China keeps growing its production, the extra money from the extra production keeps stoking the Chinese furnace. The whole thing would seem to feed on itself. So what is the problem?

The problem is that sooner or later the Chinese economy will grow beyond the demand levels of the importing countries (buyers). The demand growth rate in the other countries does not begin to approach the production growth rate in China. China is one of the most populous countries in the world. It cannot rely on the idea that the greater number of importing countries will prevent it from outgrowing the demand levels of its foreign customer base.

Just the opposite is true. In the current environment, we have seen China’s exports shrink in a consistent down trend for many months. Last month China’s exports were down 23% y-o-y. China’s trade surplus shrank 45%. With numbers like these how can China’s GDP continue to grow, especially at the rate it has been?

A possible/partial explanation may be that the retail sales were up 15+% last month. However, a lot of this has been stimulus driven. The government has given out vouchers, etc. The government has also funded many projects which needed materials (for example, steel products produced from iron ore). The stimulus part of the demand picture will disappear relatively soon. What will China do without stimulus demand? The inherent character of the Chinese consumer has not changed (Roubini).

China will increase production even more as more months go by in order to pull itself out of its slowdown (which posed the threat of exposing China’s banking woes). Yet China's markets will have shrunk. The Chinese export market is clearly trending downward. The US and Europe are slated to grow slowly if at all for the next two years. Unemployment in those countries is predicted to worsen before it gets better. US and European

Unemployment is predicted to stay high well into 2011. China's stimulus won't last that long. If China finds there is virtually no growth in the US and European markets over the next two years, where will it sell its ever increasing production? It cannot sell it to Europe and the US without serious dumping. This would bring retaliatory measures. In fact the US has imposed tire tariffs and the UK aluminum tariffs recently. China cannot sell its production completely internally because the Chinese are not going to change their spending habits that quickly. This means there will be a lot of left over production.

This means deflation. It means a Chinese slowdown or recession. It means a lot of commercial loans are going to be at risk. It means a lot of residential loans will be at risk. How can it mean anything else?

China has benefitted from being financed by western money via the Chinese trade surplus. If that surplus is reduced (or removed entirely), how will the Chinese growth continue to be funded? Will the Chinese even want to continue to try to grow that quickly without bigger markets for their products? Certainly there are nouveau riche Chinese as well as a growing middle class who will all spend more. However, China is still worker driven, and the workers are not likely to change their habits easily. They work too hard for what little they get.

Stop to admire what China has accomplished in the last ten years. The growth and development of the economy has been phenomenal. Then stop to consider where China is likely to go. China moving into slower industrial growth is tantamount to sending a child on a long journey alone. The child may survive, but there will be mistakes aplenty. There will be troubles all along the way.

China faces a slow down and/or recession. It faces deflation. It faces a possible high unemployment problem. In fact there are grumblings about this already. There will be trade wars if the Chinese decide to dump their excess production in the US and Europe. There may be civil unrest if the Chinese banking system develops problems similar to the ones the US banking system has recently experienced. There may be civil unrest upon a slowdown/recession or high unemployment. Some factory workers are already going back to farms.

The numbers for a continued Chinese expansion in the near term just do not add up. Barring some really insane behavior by US, European, and Japanese consumers, the Chinese economy will falter. It is currently standing on the precipice of a cliff! It is leaning out too far! I can see it falling easily. What could possibly stop it? The Chinese worker may be the only one with the power. My bet is that worker is not going to help. That worker is going to save for a rainy day -- not consume maniacally.

My bet is the Chinese banks will reap the disasters of too rapid expansion. They will reap the disasters of relying on 10+% GDP growth rate every year. Exactly when the Chinese system will begin to falter seems the only real question. The latest numbers are ominous.

One can no longer simply be awed by the industrial production growth number. One now has to ask, where is that production going? The answer seems to be no where (or I don't know). With the stimulus package, the Chinese have forestalled this problem for the near term.

However, this problem is coming. A second Chinese stimulus would forestall it a bit further. The growth / demand disaster is still coming. It was going to happen even without the worldwide recession. The Chinese have been expanding faster than the rest of the world's demand for their products. With the recession, the Chinese industrial production has in a single moment passed world demand for Chinese products.

China will survive. It is the same country that has grown phenomenally for ten years. However, the pain in the near future will be plain for all to see. China may well not be the best place to invest your money.

Admittedly it has been in the immediate past. It may continue to be for an uncertain amount of time into the future. However, China seems likely to take some hard knocks. Some high flying stocks will likely crash. There are other geographical areas that would provide safer and larger returns on your money. I would pick your China stocks carefully. I am sure there will still be some great ones, but I think the days of investing in “anything China” for great returns may be over for some time to come.

I am sure you are now asking where should I put my money instead? I have not really investigated this thoroughly. However, I am inclined to think Brazil may be a good place. Vietnam with the mega US interest due to US vets familiarity with the country may be another. Perhaps I will write another such article on this subject after some much needed research.

Comments

[David White:]

AP: "Profits at China's oil producers, steel makers and other major industrial companies fell 10.6 percent in the first eight months of 2009 from the same period a year earlier, the National Bureau of Statistics said Sunday. The data highlighted the impact of the global economic crisis on China's biggest companies, both private and state-owned, despite a multibillion-dollar government stimulus plan.

But it also marked an improvement from the last such survey in May, in which industrial profits fell 22.9 percent to 850 billion yuan ($124 billion) in the first five months of 2009 from the same period a year earlier.

Hardest hit were the iron and steel sector, where profits declined by 71.7 percent, and the petroleum and natural gas industries, which suffered a 68.5 percent drop in profits.

Profits in the power generation sector, however, increased by 194 percent. The report did not say why.

China's economic growth accelerated to 7.9 percent from a year earlier in the quarter ending June 30, up from 6.1 percent the previous quarter. The biggest improvements have been in state industry, while a private sector recovery has lagged.

Manufacturing and exports, mainstays of China's growth, have been battered by the downturn in global trade, but Beijing's 4 trillion yuan ($586 billion) stimulus program has helped to insulate the economy by fueling industrial demand through heavy spending on building new highways and other public works.

China's top economic official, Premier Wen Jiabao, has said the country's economic recovery is not stable yet and the government will continue its massive stimulus efforts despite recent improvements."

Sep 27 08:49 AM

[David White:]

AP today: "China on Sunday started investigating complaints that American chicken products are being dumped in China and are unfairly benefiting from subsidies, adding to a string of trade disputes with Washington.

The Commerce Ministry said the probe was launched Sunday on broiler products and chicken products, following requests by Chinese companies to investigate the U.S. imports they say are hurting the domestic industry.

The investigation comes at a time of mutual finger pointing with Washington and Beijing accusing the other of protectionism, which both say will hurt efforts to end the global economic crisis.

A U.S. labor union and three paper companies announced last week they had filed a new trade complaint over imports of Chinese paper. The move came a week after Beijing filed a World Trade Organization challenge to Washington's decision to raise tariffs on imports of Chinese-made tires.

The two governments also are involved in disputes over access to each others' markets for steel pipes, music and movies. On Tuesday, China appealed against a U.S. victory in a trade dispute over restrictions on the sale of U.S. music, films and books in the Chinese market."

Let the trade wars begin!!

Sep 27 09:11 AM

[CautiousInv...:]

All in all a good article.

The missing piece of the puzzle is internal spending or consumer spending; expanded consumer spending is the only possible offset to contracting exports. China fully realizes it must cultivate internal growth to compensate for flagging exports.

China watchers believe more of the stimulus program should have been focused upon areas essential to increasing consumer spending such as healthcare, unemployment benefits and retirement insurance. In addition to having ingrained tendencies to save, the Chinese enjoy few social safety nets which exacerbates the normal inclination to save.

The road to a consumption driven economy will be anything but smooth because of ingrained habits to save and the need for China to balance the social tensions between the prosperous coastal areas of the south with the poorer agricultural areas that make up much of the inland interior. As an aside, some China observers believe retail sales numbers are being fudged to make them look better than what they really are.

Sep 27 09:44 AM

[Alphameister:]

To the extent that US and European economies are able to stabilize and achieve modest growth, declining exports are likely to cease being a drag on China's economy. Moreover, China has wisely been cultivating increased trade with countries better situated to generate superior future growth, such as Brazil. It is developing programs beyond direct stimulus that are designed to yield gradual marginal improvements in domestic consumption, and it has abundant financial reserves with which to fund the transition stage. The human desire to improve one's standard of living is pretty deeply ingrained.

After suggesting that China's economy is about to plunge off a cliff, you at least had the good sense to conclude that China's superior growth could extend for some indefinite period into the future--a conclusion that gains credibility at the cost of considerable utility. I will continue to be selective, as you suggest, as to fundamentals of the Chinese companies in which I invest.

Sep 27 10:58 AM

[Mad Hedge F...:]

und For an iconoclastic, myth shattering, eye opening view of the true competitive threat posed by Asia, read the piece in the August issue of Foreign Policy magazine by Minxin Pei, a scholar at the Carnegie Endowment for International Peace. Power is not shifting from West to East; Asia is just lifting itself off the mat, with per capita GDP only at $5,800, compared to $48,000 in the US. We are simply moving from a unipolar to a multipolar world. China is not going to dominate the world, or even Asia, where there is a long history of regional rivalries and wars. China can’t even control China, where recessions lead to revolutions, and 30% of the country, Tibet and the Uighurs, want to secede. All of Asia’s progress to date has been built on selling to the US market. Take us out, and they’re nowhere. With enormous resource, environmental, and demographic challenges constraining growth, Asia is not replacing the US anytime soon. There is no miracle form of Asian capitalism; impoverished, younger populations are simply forced to save more because there is no social safety net. Ever heard of a Chinese unemployment office? Nor are benevolent dictatorships the answer, with the despots in Burma, Cambodia, North Korea, and Laos thoroughly trashing their countries. The press often touts the 600,000 engineers that China graduates, joined by 350,000 in India. In fact, 90% of these are only educated to a trade school standard. Asia only has one world class school, the University of Tokyo. As much as we despise ourselves and wallow in our failures, Asians see us as a bright, shining example for the world. After all, it was our open trade policies and innovation that lifted them out of poverty and destitution. Walk the streets of China, as I have done for nearly four decades, and you feel this. To read the story in its entirety, click here . I think I’ll reread it next time I think about doubling up my FXI and EEM positions.

Sep 27 11:08 AM

[ArtfulDodger:]

I say, irrespective of all the nugatory information, if you've invested well in proven Chinese companies, you should stay the course until you hear of monetary of fiscal policy changes coming from the Chinese government.

The bargains are mostly gone, indeed, but so are they elsewhere.

Would you rather have your money in a power company with the growth potential of Huaneng Power (HNG) or one in America that may face fierce Cap & Trade penalties?

Would you rather have the likes of Activision or Netease (NTES) and Power World (PWRD)?

Would you rather have an American coal company with an Administration in power that hates every type of natural fuel, especially coal, or Yanzhou Coal (YZC)?

The Shanghai Index has moved up 1500 points and during that time I've seen hundreds of articles on SA calling it a "bubble." They may be right one day, but if you're invested at reasonable prices, you'll have plenty of time to take profits and head elsewhere.

Sep 27 03:40 PM

[Paul Harper:]

Looking at demographics in China, the traditional savings bent will fade away & domestic consumption will shoot. The new "middle class" is young tech & design savvy & I can see this offsetting any drop in exports, as the market is so large.
Another area to look at is where China has been forging bilateral agreements, these are mostly "new" markets in Asia, but they are also expanding their reach into S America, where again the demographic is changing to a consumption model.
Lastly, China is very active in Africa right now sponsoring infrastructure projects, specifically in countries rich in mineral resources. Am sure they are also developing in-depth trade ties with these nations & developing new consumer markets for their manufacturies.
None of this is going to change overnight, but the Chinese are past masters at playing the long game & are flexible with it, no matter what Western mainstream media would like to have us think.

Sep 28 02:16 AM

[Peter Medved:]

Interesting article & premise. I travel to China on a fairly
regular basis working on telecom projects in Shandong
for China Telecom.
From what I observed over the last 18 months, there is
certainly more consumer spending on what would be called luxuries a few years ago.
Shanghai seems to me to be leading the trend, with the
25-40 year old age group spending on property, electronics
& automotive.
I Think Alphameister & Paul H have assessed the situation
quite well, am no old hand, but from experience, the Chinese certainly plan well ahead & the bilateral agreements in Brazil, Argentina & SE Asia, would seem to point to the govt actively
trying to define new markets.
On Africa, I think this is a little speculative, but am ready to be corrected on this.

Sep 28 02:42 AM

[ArtfulDodger:]

Very good points Alpha. I agree totally. Thank you.


On Sep 27 10:58 AM Alphameister wrote:

> To the extent that US and European economies are able to stabilize
> and achieve modest growth, declining exports are likely to cease
> being a drag on China's economy.

Sep 28 04:22 AM

[ArtfulDodger:]

Good info, PH. Thanks!


On Sep 28 02:16 AM Paul Harper wrote:

> Looking at demographics in China, the traditional savings bent will
> fade away & domestic consumption will shoot. The new "middle
> class" is young tech & design savvy & I can see this offsetting
> any drop in exports, as the market is so large.

Sep 28 04:23 AM

[EX-AD-MAN:]

Outstanding commentary. Agree with Mad Hedge - we have 2/3 of the world simply rising. Meanwhile, I predict our own conservative media will begin beating the war drum, albeit subtly. Before you scoff, tune your ears and listen. It has already started.

Sep 28 09:31 AM

[David White:]

I should point out that a good part of this article is meant solely to deal with the economic situation in China over the next 2-3 years. The stimulus has so far helped China to avoid many of the banking problems the US has experienced. However, it is unlikely the stimulus (i.e. a second stumulus and possibly a third) will last long enough to cover the recovery of the world from the current recession. The extra spending by the middle class, etc. will also take many years to develop. It won't happen over night. This means it is very likely in the next few years that China will experience a significant slow down or even a recession. Plus there will likely be defaltion because their production level is quite obviously too high already (see first comments). This production level is still climbing -- helped along by the stimulus. When this slow down and deflation hits (as the stimulus is withdrawn), it will have a lot of the consequences of the US housing market crisis. Loans that were made based on 10+% growth every year will turn sour (or at least a high enough proportion of them to cause significant pain). I wouldn't have wanted to be invested (long) in the US markets as they went down (I did lose some money on long positions). For the same reason I think you need to be careful with your China investments until this situation becomes a lot clearer. Big industrial production numbers are simply not going to be enough.

Yes, I do like the Chinese long term view. It will likely help them get through this. However, there will still likely be near to intermediate term pain. Plus longer term growth will likely be at a slower pace than that of the immediate past.

Sep 28 10:01 PM

[blonde molly:]

mr. white, your article reads more negative than this last post.

thanks for clarifying. i too am invested in china.

bm

Sep 28 10:46 PM

[bsharvy:]

Country Yield PE Ratio
Japan 2.1 30.4
India 1.0 22.8
USA 1.9 19.0
China 2.6 16.9
UK 3.4 12.1
Brazil 3.5 11.8
Russia 1.2 7.1

Interesting that the UK is so cheap.

Disclosure: Short Japan (with EWV)

Sep 29 02:21 PM

[coreopsis:]

Class non-sequitur. Welcome to America.


On Sep 28 10:01 PM David White wrote:

>
> The stimulus has so far helped China to avoid many of the banking
> problems the US has experienced.

You haven't got a clue as the problems of the US banks, have you, and yet you think you can write as a specialist?

Oct 01 10:23 AM