China's Intermediate And Long-Term Outlook

 |  Includes: EWH, FXI
by: Bo Peng

China is a big country, inhabited by many Chinese.

-- Charles de Gaulle

Recently I took a long trip to China. It was quite an eye-opening experience. That's how I generally describe all of my China trips that I have taken every two years or so for the past 10 years. To paraphrase a famous saying, 'the more things change in China, the more they stay the same in the U.S.'

Make no mistake, China is still a developing country. But things are just more exciting over there. Take driving for example. Driving in China is the next best thing after going to war; you get 80% of the adrenaline rush with only 40% of the risk. Your average American chicken would never make it across the road. In fact, it'd be run over so fast, the question "why" wouldn't even come up. But once you figure out the game, you begin to see rules and etiquette of the road and it's not nearly as crazy and dangerous as it seems to an outsider. (Please bear with me on the winding route but I will get to investing before the end of this article.)

Actually, driving is a good metaphor illustrating the differences between the two societies. Things have been changing so fast in China that no codified rules or 'institutionalized' institutions could possibly keep up. It would be stupid for Chinese society to be too rigid and literal on rules. Instead, people keep their eyes open and improvise. On the other hand, the U.S. has been much more mature and stable in many ways, where the cost of improvisation on the go generally exceeds the benefit of flexibility.

This leads to my explanation why China experts in the west have been mostly wrong about China for centuries. Chinese society operates under very different circumstances that are rarely ever in sync with the west. This calls for a different set of assumptions and norms. One really must be very conscious about leaving behind preconceptions and judgmental tendencies in order to understand how things work there. Then one would see there's nothing mysterious or strange about the Chinese way. Everything actually makes sense, well, for the most part, sort of.

There has been a lot of attention focused on the Chinese economic outlook lately. Most of it is bearish, to say the least. Housing bubble, inflation, bad debt, soft global demand, hard landing. All of these are true; I saw/heard plenty of anecdotal evidence during my trip. And even China cannot escape the laws of economics. Except that the laws of economics in China are somewhat different.

Housing bubble? No question. But how badly can it go bust when the country of 1.3 billion people is at most 30% through the urbanization transition? Furthermore, there's no mortgage securitization, so the contagion effect is much simpler to track and control. The LTV [loan-to-value] range of mortgages is much higher, with much shorter duration and generally stringent lending. And there's a strong cultural bias towards paying off loans ASAP; people commit suicide for not being able to repay loans as a matter of cultural tradition and honor.

Some investors may lose some money, some banks may face some difficulty, that's about the worst it can get. It is emphatically not a systemic failure point. And you can safely ignore all the hysteria about ghost cities in China. No, they're real. But what's the problem? They're empty because the developers and banks choose them to be so. And they choose it to be so because there are little to no carrying costs. If life gets bad enough, people would just move in. As I said, what's the problem? Damn westerners, they whine about every little thing.

Inflation? Of course. And China's tolerance to inflation is lower than in the west because it's a saver's society. Wage pressure is definitely there: My anecdotal observation indicates a magnitude of 100% for skilled blue-collar labor since 2008. But mainstream media have been talking about the rising Chinese wage pressure since at least 2005. As to those talking about Chinese wages reaching parity with U.S. in a few years, I can only advise them to venture out of Beijing and Shanghai on the next trip. They might be surprised at how big and diverse the country is. Let's put things in perspective, shall we? We're talking about 6%, or maybe 10% if you refuse to believe official figures (higher in some regions for sure). Tell me about a crisis when it hits 20%.

Bad debt? Plenty, especially those guaranteed by local governments. But here's where the soft-law, improvisationist system may realize its advantages (see crazy driving in China). When the problem becomes undeniable, various arrangements could be made among banks, borrowers, local governments and the central government such that the can is either kicked down the road or hidden in the bush, or at worst, everyone shares some loss without spoiling the whole game. The parties could negotiate private settlements to avoid public liquidation with rigid time limits, move things off balance sheets or to another entity, etc. This is how they dealt with the massive (in relative terms) bad-debt problem in the late 90's. And same as then, as long as the economy stays relatively healthy, kicking the can down the road may not be quite as bad an idea as some think.

Though they are no competition to the western world, Chinese banks play their own game in China and they are masters at that. And don't go by the western book and think printing is the only option. There's a vast pool of ready funding in the form of unseen savings. In Wenzhou, a small, rich city not far from Shanghai, active underground private funding is estimated to be tens of billions of yuan. Multiply that by whatever you think is reasonable and suffice to say it's not a small number.

Soft global demand? Very likely, and very likely to last decades. China has little control here. But it's not entirely powerless either. In recent years China has been trying doggedly to lessen its reliance on exports. The effort is two-pronged. One is to boost domestic demand. Second is to diversify external demand through strategic investments all over the developing world. Success of the effort has been slow, but steady.

Hard landing? It's always a risk. But China has had a pretty impressive track record in avoiding it over the past 20 years. My personal experiences tell me that there's still some fuel left in the China growth engine. People are generally content and happy (I know, how could they, damn commies). There's still a huge pool of willing and able labor resources, huge needs for infrastructural investments, and huge reservoirs of real estate supply and demand to serve as a financial pivot in either direction. As always, this time could be different. But I think the odds for an "ok landing" are good.

Over the next few years, China may not be able to sustain the 8%+ growth rate the world has gotten used to over the past 20 years. Especially if the developed world remains in a slump, limping from crisis to crisis, as I expect. But it's likely to remain a star in relative terms, possibly the only star at times. The recent panic sell-off due to predictions of China growth slowing to 5% in five years was comical. I mean, where else can you find 5% growth after the U.S. exhausts the printing option, the Euro disappears, and the third European war begins to brew? The relatively primitive, closed, and improvisationist nature of the Chinese financial system turned out to be a life saver for China during the Asian financial crisis and the '08 crisis. That was no accident. And it will continue being the real source of limited decoupling and safeguard for China for the next few years. And that's no accident, either. OK, I'll go dissolve into the flurry of peach flowers now.

Beyond 2020, however, my China outlook becomes very grim.

The first pillar of my long-term pessimism in China is the same as my current pessimism in the west, namely baby-boomer retirement. China's baby-boom started in the early 60's and the ensuing retirement wave starts around 2020. And the cut-off in age distribution is extremely abrupt due to the birth-control policy first enforced in the 70's. Some cultural and societal differences may help lessen the pain. But I'm of the conviction that nothing short of a technological revolution can fight demographics. The only hope is that, by 2020, the developed world may be bottoming out from the lost decades of baby-boomer retirement; Japan very likely, the U.S. maybe, Europe is more uncertain.

The second pillar is a new observation as far as I know: The reason for the apparent lack of innovative force in China is systemic and is deeply embedded in the socio-economic structure. It has little to do with the political system (at least not directly), even less with ideology, and nothing racial. I will elaborate below.

A healthy, sustainable economy needs a proper mix of specialists and generalists. Specialists directly drive innovation and implementation, while generalists do all the other things. Specialists tend to be individual contributors and, as such, need to be compensated in money and/or motivated with respect and pride. For all the cynicism about the U.S. not making anything except prostitutes and beer, there's still reasonable space for many types of specialists in the U.S. They take pride in their work. And they're generally well respected and paid for for what they do.

China has a long tradition of respecting specialists, though not all the same types nor in the same ways as in Europe. But that tradition has been washed away by the tide of rapid socio-economic transformation of late. The current benchmark for social success in China is such that if you are not a manager or boss of some sort by the age of 40, you're a loser. As a result, most capable people start to focus on climbing the corporate/government ladder after turning 30, willingly or not, with fitting talent or otherwise. During this trip I met many dozens of old friends, from high school to graduate school. With the exception of a few entrepreneurs, nobody, none are doing specialist work. I was appalled. I still am. And it gets more pathetic for the younger generation; the dream job for recent college graduates is civil service.

In a modern economy, white-collar labor before age 30 is statistically a negative productivity group. Society pays more for their on the job training than it gets from their actual work. The peak productivity years are from age 40 to 50.

So, what's been happening in China over the past 20 years (and especially the last 5-10 years) is that the society has systematically cleansed itself of innovative forces and molded them into either generalists or waste. This is a tragedy and China will pay for it dearly. So far it's not been much of a problem, only because the Chinese economy is mostly at the lower end of the value chain. Infrastructure, adequately skilled blue-collar labor, generalists who facilitate the flow of people/finance/material/info -- these things have more immediate impact than innovation. But China cannot go on forever staying at the lower end of the value chain. The lower end of the global value chain simply isn't big enough to feed China forever. At some point, China needs to migrate up the chain, similar to Japan and Korea, only on a much bigger scale and with more diversity/complexity. But I don't see how this is possible.

China has been strangling itself 10 years down the road.

There are many other potential problems, of course, among them increasing economic disparity and decreasing economic mobility. But I consider them either secondary or more solvable compared to the two factors I mentioned above.

If you're short China now, e.g., via FXI, good luck and be ready to jump. But I'll be with you in 10 years.

As a note of caution, I did find a flock of black swans in JiuZhaiGou, a beautiful national park and nature's wonder in the high mountains of Sichuan. Consider yourself warned, including things of infinite improbability.

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