The summer trading months are behind us, volatility begins to creep back into the markets during the nervous months of fall, and all eyes are on the Fed tapering at the end of the year and the debt crisis in Europe. Every year analysts begin the chatter of a hard landing for China's economy, the doom of their housing bubble, and the end of their perpetual growth. Every year this Tiger economy defies the "China" experts and analysts. Having visited China for the first time in 2001 and worked in the financial service market for the past year in the PRC, I've experienced the rapid growth and transformation of its economy during the past decade. What does this mean for the investor looking for returns? Let's take a look at the long game vs. the short term.
Looking at the long term, the picture does not bode well for China's economy. Comparing the growth of modern China to post WWII Japan, there are many similarities. The opening up and reforms of the economy in China during the 1980's and continued progress of the 1990's focused on manufacturing growth as the driving force of its economic engine. This was similar to Japan after WWII in the 1950's and 60's. Both countries took drastic measures when faced with the brink of collapse before the start of their economic miracle cycles. Although both economies are vastly different in nature, there are many similarities to the two growth cycles. The development of China since 2000 and over this decade can be seen as Japan in the 1970's and 80's, rapid growth, maturing of financial markets, growth of asset bubbles, etc. The long game for China could be the same fate as Japan in 1991, a potential lost decade for China beginning in 2020 with the needle popping the asset bubble. This may happen with any of the asset classes, from the rapid rise of real estate prices or the enormous domestic shadow banking sector, leading to a debt deflation trap.
As for the short term, there will still be buying opportunities over the next several years. Will the housing market collapse this year or next like many analysts have been predicting (every year) for the last several years? Most likely not, though we've been seeing the rise of housing prices cool off moderately this year in tier 1 cities like Shanghai and Beijing. Property prices have not had a rapid rise in tier 2 and 3 cities throughout China, so the threat of a housing collapse in the next two years are slim. Beijing will put a floor on the decline in housing prices either with lowering mortgage rates and easing conditions for buying multiple properties or lowering borrowing cost for developers to encourage more rapid development of ghost cities across the country. The real estate party will eventually come to an end in China, just not anytime soon.
The shadow banking sector will continue to grow and loom as a concern over the commercial banking industry and private lending in China. The total credit in the Chinese financial system may have reached as high as 220% of GDP according to some estimates, and China has increased its credit from $9 trillion to $23 trillion since late 2008. Half of the $2 trillion in wealth management products, a hidden balance sheet by the Chinese banks, must be rolled over continuously on a 3 month basis. Any systemic risk will be avoided in the short term by rolling over the debt each year until it reaches a breaking point with possible defaults by banks and local governments.
(Source: World Bank, low income countries are in orange)
Due to the falling European demand of Chinese exports due to the austerity measures and the refusal of the ECB to initiate some form of quantitative easing, Beijing has sought to keep growth above the 7% threshold the past couple of years by massaging the GDP growth figures with expensive public spending projects like the domestic high speed rail, matching and subsidizing funding for investment projects especially real estate developments, and encouraging domestic consumption to fuel future growth. The outlook for China into the end of the year and through 2014 will be its growth model being tested by the markets, but ultimately Beijing will pull out all the stops, and with a relatively low public debt level to GDP, the central planners have enough reserves to fuel a fresh round of stimulus for railway, broadband, social housing, green energy, and infrastructure spending.
For investors, there are still opportunities in China equities. The Shanghai composite has been sluggish since late 2010, underperforming like the other BRIC members. There's still attractive value and growth potential even with the doomsday headlines about the economic miracle growth of China coming to a stop. The Shanghai composite could still test the lows of 1,922 back in June by the end of the year, but I don't see the index breaking too far below to test the financial crisis lows of '08-'09. If Beijing were to announce another round of massive fiscal stimulus, expect a similar outbreak like 2009, allocate some positions based on risk tolerance for growth during a 6 month to 1 year period to capture the uptrend. Otherwise, look for valuation and growth funds with proven track records such as Value Partners High Dividend Stock and First State China Growth. Both funds invest in higher yielding equities and debt securities in Greater China. If there's a stress on the shadow banking in China, reduce allocation to both funds due to the high level of exposure to the banking industry in China. For individual plays on stocks, large cap companies with good growth and dividend over the long term are PetroChina (PTR), China Mobile (CHL), Tencent Holdings (0700.HK), and Baidu (BIDU). The other option is to look for multinational corporations with a large exposure to the domestic consumption market in China, YUM! Brands (YUM), Starbucks (SBUX), General Motors (GM), McDonald's (MCD), mid range clothing retailers, etc. An investment with an international brand may have less exposure to the country compared with a pure play like Tencent or PetroChina, but there will be more transparency with accounting standards and less volatility and risk. Keep an eye on another round of massive stimulus from Beijing, otherwise look to enter positions gradually toward the end of the year and beginning of next year when BRICS indexes might finally come out of their slump and start catching up to the global markets. This might be the last great buying opportunity before the aging crisis hits China and the end of cheap labor for the PRC in the second half of this decade.