By John Mulcahy
May 2009:- China is the interesting economy, as everyone knows, but few
understand.
With US$2 trillion in reserve, half of which is in US Treasuries, China has options no one else has. The conundrum for President Obama and the West in general, is that aggressive protectionism may induce far greater pressure on China. It may force liquidation of Treasury positions, with cataclysmic consequences for the dollar. Chinese Premier Wen Jiabao, during the National Peoples Congress (NPC) and China National Peoples Political Consultative Committee (CNPPCC) meetings, cheekily asked the US to ensure China’s investment in the US was safe! A reasonable entreaty, after Madoff et al!
The underlying point, though, is important. Prior to the Chinese comments,
US Treasury Secretary Tim Geithner challenged the Chinese government to revalue the renminbi. By the time the G20 met in London in April, Geithner was urging G20 counterparts not to put pressure on China in relation to its currency, What do you suppose happened in the interim, other than China making the point that it is propping up the US Treasury?
Inventory liquidation and rush to buy bargains
China is always chaotic, and my recent visit demonstrated that nothing
has changed. Many factories have closed, but others are busy. My
principal contact in Southern China owns a company which has clients
such as Apple, DELL, Microsoft, Flextronics, etc. He has seen a major
shift in focus, in that Apple, for example, had insisted on maintaining
inventories of 4-6 weeks in the US for most products, but is now
manufacturing to order. There is massive inventory liquidation and a
much tighter focus on de-risking the supply chain (i.e. shortening the
supply chain, reducing inventories, shipping direct to customers).
I strolled through a huge shopping mall with Burberry, Chanel, Armani,
etc. and saw very few customers, except in the centre of the mall an
area cordoned off and containing racks of garments, mainly for women. At
11.00am on a Friday morning there was a scrum, and hard currency
exchanging hands almost in a frenzy. These were branded fashion goods
selling at deep discounts, an example of the inventory liquidation
process. There is cash around, and unlike the Japanese consumer, Chinese
consumers will buy at the right price.
Tourists from China are by far the biggest group in all markets in east
Asia, i.e. Southeast Asia, and they are increasingly evident in tourism
numbers in Europe and North America. Anecdotally, I am told by an old
friend who has been in retail in Hong Kong for 50 years, that the
mainland Chinese are not like the Japanese of the 1980s. They are
reluctant to pay for good hotel rooms, but will spend the bulk of their
money on branded goods.
Risk of revolt if unelected Government doesn’t deliver prosperity
On a more macro level Wen Jiabao disappointed some observers by failing
to increase the stimulus package 4 trillion renminbi ($500bn). However,
his message was clear. The target GDP growth rate for 2009 is 8%, and
while it will be difficult to achieve the Chinese government will not be
found wanting. Statistics on the balance of payments show what is needed, on the one hand, and possibly the solution. Exports were in freefall earlier in
the year, but capital investment is up sharply. Domestic demand is
slower, but still running at 15% growth year-on-year.
While some western analysts remain sceptical, Chinese economists who
had been suggesting growth would slow to 6% or slower are now suggesting
the targeted 8% is achievable. We need to bear in mind one crucial truth –noone elected China’s Government. I ts only legitimacy is the delivery of continuous prosperity for the people. If it fails in that bargain there will be another revolution. Mao’s Little Red Book is available to tourists in street markets in every city – it is never quoted or even seen in public
as a relevant guide to policy. As such, ideology carries little weight
in China in 2009, and the social contract is all. The 5 million members
of the Chinese Communist Party can continue to govern provided they
continue to deliver economic prosperity.
How China intends using its huge financial resources
With US$2 trillion in reserves, what do you suppose the Government in
Beijing intends doing? It must shore up domestic confidence, and by investing in a range of sectors, such as infrastructure, healthcare, education, etc, it will mop up some of the unemployment resulting from the collapse of the export
markets. On the other hand, it will take advantage of the devastation in
global markets by underpinning its sources of supply. The purchase of a
stake in giant mining company Rio Tinto is one example. Be sure there
will be many others as China using its financial muscle to acquire
commodity assets at cheap prices; BEIJING knows that there will be a different stage to the cycle at some point, and the game will be on again. In the short term, there is little reason for China to bid up prices in the
spot markets, and activity is more likely to be at a corporate level,
but don’t under-estimate domestic demand.
I believe China is the key swing factor in the global recovery, but they
will not “bail out” the West. They will concentrate on protecting their
domestic franchise and spend aggressively on infrastructure. This is
essential – transport in China is abysmal; there is no national
distribution network. There will be spin-off benefits, and I do believe
some underpinning of demand for base metals.
Source:- Barton’s Asian Charts
Powerful internal economies of China and India
Equity markets are beginning to show some green shoots, and while there
may be a bear trap (I don’t think we know all there is to know about the
banks yet) some accumulation has been appropriate. China is producing some interesting companies with stocks offering excellent value, despite the
recent rally.
Korea, Taiwan and China are all heavily geared to the developed world’s
consumption, and there will continue to be data that shows the
decimation of the global manufacturing trade. But the argument in favour
of China, especially, and to some extent India, is not based on denying
this global decline in trade. Rather, it is based on the relative
ability of these economies to focus on their inward markets and drive
domestic consumption. China has the resources to stimulate its domestic
economy – it can liquidate some holdings in US Treasuries – and it has a
profound incentive to do so. The Chinese Communist Party rules China on
the basis of its demonstrable success in delivering prosperity. The
communist (Maoist or Marxist) ideology is either non-existent or
discussed only within the unreal environment of the National Peoples
Congress. In the real world – “The Chinese Street” – the only role the
Chinese Communist Party plays is to drive the huge economy on its
long-term goal of building the biggest economy in the world, in overall
and, more pertinently, per capita terms. If there is a real or perceived
failure by the Party leadership in maintaining this exponential growth,
the risk of social unrest and ultimately of a de-stabilisation of
government is manifest.
Government must create work for 20 million newcomers each year
Informally, as I have myself experienced, Chinese officials will
acknowledge the existence of this social contract, and it definitely
drives policy. How this plays out in the current and projected global
environment is already taking shape, and will continue to do so. China
has a massive infrastructure deficit, especially in relation to
transport, water and (renewable) energy. It has a need to protect growth
at or around 8% in real terms. While conventional wisdom holds that a
typical developing country must grow at 6% a year to avoid employment
loss, and indeed to create employment for the new entrants to the labour
force, China’s internal “floor” for growth is 8%, which is deemed to be
the minimum required to sustain reasonable employment. It should be
borne in mind that every year almost 20 million workers enter the
work-force in China, and this is not balanced by retirees (China’s
pension structure still places the overwhelming onus on the State and
quasi-State sectors to provide cradle-to-grave support). Creating work
for 20 million people a year is equivalent to creating an Australian
economy every year, and should thus not be under-estimated.
In short, China has in its post-centralist history not been afforded the
luxury of succumbing to global economic forces. It has no option but to
“subsidise” the global aspect of its economy by stepping up the
investment in infrastructure, on the one hand, and on the other hand
dramatically upgrading production capacity in the agricultural sector,
which will assuage the political pressure from the 800 million rural
citizens.
Inward looking Government will aggressively stimulate demand
While the collapse in Taiwan and South Korea’s exports is
devastating, we should not assume that China, for one, has no ammunition
left. China remains more inward- than outward-looking, and while it has
continuing global ambitions, its leadership will use everything in their
power to maintain a satisfactory level of economic activity by
aggressively stimulating domestic demand. I don’t believe this is a
Pollyana view, as there will always be HIGH risk investing in China, but
we should put the economic backdrop into perspective.
India’s case is slightly different, but some of the factors favouring
China are also applicable. India has never had a global financial
system, so its banks and indeed its savings overall have not had the
same exposure to international financial markets as their counterparts
elsewhere. The ability for India to continue its growth momentum based
on domestic demand is less obvious than that of China, which is sitting
on far greater reserves, but it would be inaccurate to extrapolate
problems with “post-emerging” economies such as Taiwan and Korea into
identical issues with the large population countries. There will be
very exciting investment opportunities in China and India in the next
few years, but this requires intense due diligence and plenty of time
and knowledge to find the right assets.
John Mulcahy, former UBS Head of Greater China Equities, is a business consultant and regular visitor to China and Asia