Does It Make Sense to Be Bearish on China?

by: Econ Grapher

The China bear story is overdone. Through most of this year and much of last year, it has been popular to write stories about how China’s real estate market is about to crash, and how there’s countless ghost cities, and how it will be such a struggle for China to shift to a domestic demand-led economy. Sure, there have been some interesting signals and data emerging, but in all, concerns about an imminent market crash are likely premature.

Is property really the Achilles heel that everyone makes it out to be?

I would guess that most of the people writing the most doom and gloom-filled articles on China have never been there. I traveled to China again early this year, and though I did see construction on a scale I could hardly imagine (coming from a small developed economy), I also saw a bustling economy. I counted about 13-odd cranes on construction sites just when I looked out of the window of the place we were staying. There’s no denying that they are doing a lot of building, but does that mean they’re doing too much? My quick guess would be no.

Without studying the data too closely, but based on an informed view, it is likely that China can support such large-scale construction. The population argument alone can provide a degree of justification, but so too can things like debt capacity and income growth. Historically, Chinese property markets have seen residential units financed with LVRs (loan to value ratios) of less than 50%; some of this is down to culture (e.g. high rates of saving), but also coming into play are the practices and culture of the banks.

Residential housing credit

Banks in China will tend to look first and foremost at the security backing the loan and the amount of down payment, emphasizing deposit/equity over cash flow. This is different from the U.S. and other countries where cash flow is the most important part of the loan assessment, and where LVRs can reach 95% or more. I would hazard that some of this emphasis on a low LVR is due to the state of development of the banking sector in China. I wouldn’t be surprised to see banks using more sophisticated lending policies and more aggressive financing over time.

This is also interesting from the perspective of investing in the banking sector in China (in terms of how well secured their loans likely are – at least in the residential sector), but also in terms of the capacity for property financing to grow. At the moment it’s safe to say that China’s property boom is not predicated on credit; this is another reason why China is not "sub-prime on steroids" or Dubai X1000.

So that’s one (admittedly relatively weak) argument, i.e. “credit use is relatively low at the moment, therefore in the future there is capacity to increase use of credit” – thereby creating buying liquidity. But the other side is the income argument.

Rising incomes and urbanization

Over the past five years, China’s per capita income for urban households has almost doubled, and it’s hard to see why it won’t continue a strong upward trajectory. Even looking at wage statistics and employment hiring intentions, there are notable upward trends underway. The key for the property market is how fast and broadly incomes rise. In its annual five-year plan, the Chinese government has put a priority on increasing incomes, as well as tackling some of the issues in income distribution.

One of the measures is likely to take the form of a higher minimum tax threshold aimed at the lowest income earners – with the current threshold of 2,000 expected to be lifted to as high as 3,000 yuan. Oh and while we’re on the topic of the lower end, the Chinese government is planning to build 10 million units of social housing (affordable), in order to help lower income earners into their own house, which will also help keep the economy stoked over the medium term.

Thus, while economic growth, rising corporate earnings, and government policy (including raising minimum wages) will result in higher earnings on average, much of the policies noted above are targeted at the lower end ... which more or less refers to rural China, that vast population that inhabits inner China (as opposed to the coastal cities). Indeed, such measures are likely to assist in efforts to shift development inland, and boost rates of urbanization.

In fact, the urbanization and inward development trend is probably one of the important economic and investment themes in China. You need only look at some basic stats to get an idea of the potential: In the past five years, rural incomes rose 65% to 5,919 yuan, with average spending on food comprising 41.4% of income. Meanwhile, urban incomes rose 63% to 19,109 yuan, with average spending on food comprising 35.7% of income.

To throw some numbers around, let's say of about 700 million (or 900m?) rural Chinese, 30% enjoy "urbanization" over the next five years, their incomes rise to the current level for urban citizens (19,109), and call non-food spending 65%. That would equate to a very roughly-estimated rise in potential consumer spending of about 2 trillion yuan, as a result of a structural shift, which would be additional to organic growth.

Ignorance or myth – the lack of a consumer sector in China

Another argument I’ve frequently seen batted around is the great challenge of reorienting China’s economy to a consumer-led, rather than a manufacturing/export-led economy, as if to suggest there is no consumer sector. Sure, the Chinese prefer to save a large portion of their income, rather than spend. But again, a look from the ground over there will reveal just how vibrant the consumer sector is.

There is something you notice when you go to China: The people there get the idea of entrepreneurship, and the class struggle is alive and well in this Communist nation. I’ve hardly seen a greater divide between the rich and the poor. China is a great place to be wealthy. Going from the cities into the countryside, you can see the difference between the rural peasants and the city-folk. But even within the cities, the wealth divide is palpable. But when you see it (and I’m sure I’m not the only one), if anything, it makes you feel inspired to achieve or raise your position in the world, given what riches and privileges await those successful in fame and fortune.

Perhaps the best illustration of the divide and the depth of the consumer sector is the clothes shopping.The bottom tier is the street markets, with vendors making do in tents or simply with a blanket on the ground and their wares on display; that is where you find the lowest prices (and quality).

The next tier is in some sense the indoor equivalent: A large multi-story building with each floor filled with grids of dozens and dozens of small vendors, their shops perhaps about 5-10 square meters. The quality can vary, but at least you can bargain with the store owners.

The next tier is what I would call the standard malls, which are basically your stock-standard malls, full of Chinese brands (and there are a lot); the quality is a bit better, the environment a little more comfortable.

The final tier is the premium malls: Filled with all the brands you would see anywhere in the world, especially the luxury brands(pdf): L’Oreal, Armani, Hugo Boss, Dior, CK, Versace, etc. These places are much more pleasant, designed for the shopping experience for the wealthy; all the amenities are high quality; it’s a place you wouldn’t mind spending time in. The prices are not/less negotiable – and it is not uncommon to see a price in yuan that, translated, works out to be higher than that in your own country.

The point is, consumerism is alive and well in China. Brand awareness, self-image, and status are important things, especially for the younger generations. So if anything, I would see the consumer sector growing and growing. With both Chinese brands and western brands (like the highly successful KFC) flourishing, and the wide variety of shops and services continuing to prosper.

A time to be bearish and a time to be bullish

As far as I can tell, the future for China is fairly bright. There is still a long way to go for modernization (you won't find all of the comforts of home if you go there as a tourist from a western country), and as the nation has made leaps and bounds in this respect over the past decade, there are still opportunities for the Chinese in terms of catch-up. It is also true that there is a lot of potential in the form of urbanizing rural inner/western China – with growth spreading from the coast to inland.

In short, it’s easy to present the case for China as a long-term investment. But as stupid as it is to be always bearish, it is also stupid to be always bullish. You need only look at the Chinese stock market over the past few years to see the unfathomable stock bubble: A rise of about 700% and subsequent 80% crash (rough numbers). In terms of the China allocation, it will pay to take a medium-term outlook, reducing exposure when valuations get out of hand, and buying on the dips (or crashes).

Basically, as long as the long-term story stacks up, it will make sense to buy when future crashes occur. I don’t think there is a crash due in the near term; the market needs to make a lot more ground in terms of valuations and rolling return levels before a major stock bubble arises again. But of course there are short-term risks like a policy overreaction to inflation, or a significant deterioration of banks’ loan books.

But even if China did sink its economy into recession by tightening too much, it’s pretty plain to see that it has a lot of ammunition in its clip: The required reserve ratio is at all-time highs, and the interest rate is also still relatively high. The technocrats in China could easily stimulate the economy out of most recession scenarios.

In the immediate term

The question is: Is the hard-landing/slow-down story over-done? The time to answer this question for the China asset allocation is before the middle of this year. By that time, we will probably know whether China has won the inflation battle. Much of the near-term outlook for Chinese equities depends on inflation in the second half of this year. Currently, valuations and rolling returns are fairly stable and stuck in a range – but as soon as the signals emerge, either way, the market will move ... so get ready.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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