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That China needs to rebalance its economy goes without question. The manner in which it does so and the shock felt by its economy remain open topics of debate. Many prominent fund managers and investment bank analysts have taken the view that data coming out of China is sound, the authorities have it under control, and a soft landing will be engineered over the next decade or so.

One prestigious China bull, John Redwood, recently wrote an article in the Financial Times called "My Finger's on the 'Buy China' Button." I'd like to quickly show how his analysis (as well as his peers) misunderstands the effects of a slowdown in investment-led GDP growth on China's economy. So that you don't make Mr. Redwood's mistakes, I'll also quickly point out the effects that the inevitable rebalancing of China's economy will have on a Pan-Asian stock portfolio.

Before going any further, take a minute and read Mr. Redwood's original article here.

Redwood implies that the recent underperformance of the Chinese stock market is related to the inaction of the previous administration on shadow banking, while the new leadership will "admonish and reign in the shadow banking sector." This is contradicted by the State Council's own documents and actions. While many observers expected the shadow sector to be governed by the harsh terms laid out in the cabinet's Document 9, the reality of the country's reliance on shadow banking for GDP growth resulted in the watered-down if not outright permissive Document 107. Thus this administration, like its predecessor, is again turning a blind eye to the country's misallocation of capital.

Moreover, counter to Mr. Redwood's claims, money tightening has been limited at best. Weakening exports, a financially repressed household sector, and manufacturing overcapacity due to poorly allocated investment has created a massive supply and demand imbalance. It is this imbalance that has kept inflation in check both in China, as well as overseas.

While it is true that China has roughly $3.8tn "in the bank" it is of little use during a domestic debt crisis. Because the government has effectively borrowed renminbi to fund its foreign account holdings, the inevitable rise in interest rates will adversely affect the value of those reserves. Should the government decide to convert and deploy those reserves to fight a crisis not only will they lose control over the value of the renminbi, such devaluing effects will be exacerbated markedly.

For any successful rebalancing of the Chinese economy to occur, the household sector must increase its dreadfully low consumption contribution from 36% of GDP to around the global average of 60%. This means the state must contribute less; an objective that can only be achieved by a transfer of wealth from the state to the household. As the major beneficiaries of state-sponsored (and household-financed) subsidies, many large companies and SOEs will see their profits plummet if not disappear entirely.

Mr. Redwood would be wise to account for this inevitable rebalancing in China's economy as he rebalances his own portfolio. Hopefully, we can learn from his mistakes.

Source: Debunking China's Easy Rebalancing Myth In 500 Words Or Less