How China will navigate economic transformation

By Hugh Young
Published in the South China Morning Post, 31 August 2008

My Olympic memories often return to the British relay team, and how often they dropped the baton. But the spectacular opening ceremony in Beijing may prove just as enduring as some of the extraordinary feats seen on the track and in the pool.

It set me wondering if China’s coming economic transition from export machine to consumer society will be as smooth and coordinated as its synchronized dancers; or, like the experience of my (not so) athletic compatriots, painful and embarrassing.

The premise behind this transition is that the mainland will gravitate from making low value-added goods for export to making higher value added products more for themselves. For that has been the usual trajectory of economies that have modernized: Japan in the 60s; Korea in the 80s (though both are still highly export dependent).

But China starts from a skewed position. Consumption today is a paltry 38% of GDP, meaning that the savings rate is an extreme 62%. And if we look at the makeup of China’s economy today, we find it is rife with other imbalances.

There seems to be a widely held view that China’s growth in the medium-term will be stable. Stripping out the contribution from net exports, which can be fairly volatile, one is left with consistent growth of eight per cent or thereabouts. Since this residual, the argument goes, represents domestic demand, which has been stable in the past, it should continue at this rate.

But this is rather naïve.

Much of this domestic expenditure relates to the export sector. It is difficult to quantify but perhaps it may amount to as much as 20% of gross fixed capital formation, itself 43% of total expenditure. If external demand continues to fall, as seems likely, such capital expenditure will be threatened. Indeed a recent survey by CLSA of 105 small- and medium-sized companies, many export-related, found that 34% of them will cut capital expenditure this year.

It will be very hard for total investment to continue to grow at 20 per cent if investment in the export sector is being cut back.

Second, much of China’s consumption has been driven by those employed in the export sector. Many export-related businesses, such as textiles, are labour intensive, so their importance for domestic consumption is further magnified. News is leaking out of hundreds of clothing companies in coastal regions being closed down. Job losses will quickly feed through to retail sales.

In addition to falling external demand, China’s exporters are being further squeezed by higher commodity prices, a rising currency, stricter labour law resulting in higher wage costs and tighter access to bank credit. As one company in CLSA’s survey put it, “[2008] is a year for survival, not expansion.”.

But I think that China’s difficulties in the medium-term may be more profound than being exposed to a typical, if deep, cyclical slowdown, in which feedback effects gradually loop through the economy. China’s economy has become so imbalanced over such a prolonged period that it will not be able to adjust in a normal, relatively painless way.

Vitaliy Katsenelson has compared China’s economy to the runaway bus in the film Speed, in which the bus, wired with explosives, will blow up if its speed falls below 50 miles per hour. Here, China’s 1.3 billion people are the innocent passengers on board the economic juggernaut, unable to play a role either in driving the bus or saving it.

The problem is that Hu Jintao is no Keanu Reeves. Although China’s is still a command economy, its people will increase spending only if they have confidence about the future, confidence that comes with safety nets and stability.

That means there is a reliance on public spending and perhaps an overestimation of its ability to compensate should weakness emerge elsewhere in the economy. In practice, there is a limit to the extent to which spending can be increased effectively. Long lead times for inputs such as cranes and engineers can cause serious bottlenecks. And if confidence is in short supply, government spending can be a little like pushing on a string, as higher incomes get saved rather than spent.

Perhaps government efforts at this point in China’s transformation would be better directed at supply side reforms. Nowhere would benefit more than the banking system, itself another area of imbalance. Consumer loans account for just 12 per cent of all lending in China, compared with 19 per cent in the US. Loan deposit ratios languish around 60 per cent, a function both of lending quotas and poor recycling of external surpluses. The plastic revolution is coming and its effects will be far-reaching -- which is why there is an ‘official’ charge card for the Olympics.

Right now we are getting very mixed signals about what is going on in the economy. One month export growth falls sharply, the next it rebounds. Food-led consumer inflation is falling but producer inflation is rising. Views on the outlook for China’s economy seem to change from one day to the next.

All this uncertainty makes it very difficult to have a view on the market. When will it be time to buy?

In truth, I’ve always found it impossible to time a market, so I avoid trying. Our focus instead has been on identifying sound businesses with trustworthy management teams that care about minority shareholders. If they’re any good, and the homework has been done, the price at entry hardly matters in the long run.

Our regional performance last year and the year before was affected by our large underweight to the China market but now this stance has started to pay off. I suspect that we may be in for a nasty year or two for the economy. But I’m bullish about the opportunities, especially once I start to feel comfortable with the big banks and their management.

Who, watching those earlier Olympiads, would have believed that one day we’d be talking cheque books, not red books?