Reflections on China

I first went to China in 1987. The soot in Beijing was so thick that a white car, if one existed, would be black with soot within an hour of entering the city. The fact is that hardly any cars existed. Everyone rode bicycles. The few that did were typically black, and owned by the government. The soot came from the giant smoke stacks of obsolete coal burning manufacturing plants within the city limits.

The residents of Beijing wore three colors of clothing; grey, blue and green; and practically everyone wore a “Mao” suit. The first night that I turned on a shower in my hotel room, the plumbing fixtures literally broke off in my hand. Practically every adult I talked with wanted to leave the country and come to the U.S. My guide begged me to bring him to the U.S. when we left.

Needless to say things have changed. The economic miracle that has been taking place in China is now widely known throughout the world. In fact, skeptics now call for the pace of growth to collapse and for there to be a “hard landing” for the Chinese economy. My observation, after three weeks in country, would be-don’t count on it. The Chinese economic miracle has a long way to go.

Let me use this point to insert my normal “caveat” or equivocation. No one can accurately forecast the current growth rate of the Chinese economy. Even the Chinese government struggles with that. Official numbers seem to indicate that their GDP has grown 9.5 percent over the trailing 12 months. However, Larry Kudlow recently reported a number as high as 15 percent.

Even the professional investment community that specializes in China finds it hard to agree. The China Fund, a closed end equity fund that specializes in China recently stated the following in a report to shareholders dated August 31, 2005:

“We detect clear signs that the Chinese economy is now - finally - decelerating. Truck sales, machinery imports, FDI inflow, loan growth and property transactions have all slowed. Macro-economic numbers such as industrial production growth remain high in absolute terms (+16.1% in July, down from +16.8% in June).”

In late August UBS would have agreed with The China Fund’s assessment. However by the time UBS issued their report called A Radical Rethink of the China View on September 23, 2005 they had dramatically revised their point of view. Indeed China’s economy appears to be reaccelerating. Here is an excerpt from that report: “

Just a few weeks ago, following the seemingly strong August import numbers for China, we put out a report entitled Beware the “China Bounce” (Asian Focus, August 19), cautioning investors against getting too excited about a Chinese reacceleration….

Suddenly, things look very different. We just compiled the July index for property construction activity (unfortunately, the data come out with a nearly two-month lag) From a moderate 10% to 15% growth pattern in the second quarter, July construction growth jumped up sharply, to nearly 30% y/y”

In short, it looks like we're in the middle of another construction boom—just the opposite of what we’ve been saying over the summer. And the apparent upward trend is suddenly very strong. We'll see what the August and September data tell us, but unless they drop sharply on a month-on-month basis, we’re very likely to see a continuation of 30% y/y growth rates. And this already puts us back at the pace of the 2002-03 “boom” days.

Will it last? How long can it last? We can’t say for sure ... but it could well be more sustainable than we earlier thought possible.

Personally, I believe that the minimum time that it will last and that would be through spring or summer of 2008, when the Olympics come to Beijing, China. The Chinese are throwing everything they’ve got into rebuilding Beijing and every other major city in the country. And, they seem to have the capital to do it. After all they are the largest holder of foreign exchange reserves after Japan. And, they have partnered with innumerable private business partners to provide capital needed for this gigantic infrastructure build out.

These pictures represent just a few of the thousands of major construction projects that are going on throughout China. These yellow construction cranes were every where. All the smokestack industry has been moved out of the city of Beijing and high rises are going up everywhere.

So what is the biggest threat to China’s economic growth rate? The answer is America’s economic growth rate. A whole lot of the “economic miracle” in China is being financed by selling cheap goods to us—and lending us the money to buy them. If the U.S. goes into recession in 2006 or 2007, China’s growth rate will surely slow down.

They are keenly aware of that condition are doing everything they can to position their economy in the future so that they can thrive even when we do not. Which brings me to a set of observations, and/or predictions that I would like to make for you. Some of these will be controversial, and you may not agree with all of them—but they represent my current best thinking on the topic of China’s economic miracle. I also think they represent the thinking of some of the Chinese people we visited while there.

• China’s economy will become less dependent on their link to the U.S. as their domestic consumption grows, and as personal consumption in other Asian countries grows.

• There are over 3 billion people living in Asia. That is almost one half the population of the entire planet. They are all working on developing “free trade” zones, similar to our NAFTA, and other techniques to speed economic growth and reduce dependence on Western trading partners.

• As more of those 3 billion people reach a point at which they have sufficient income to be substantive consumers, China and other Asian countries will have successfully made the transition to economic independence from the West. That is something they strongly desire

• However, even if they achieve that goal they will not break economic ties with the West. They value the trading relationships. Yet they seek the independence. They are very clear about that.

• Even if China reaches a point at which its national gross domestic product exceeds that of the U.S. their per capita GDP and personal income will still remain way below that of U.S. standards. At their current growth rate it may take them only another 20 to 30 years to have a larger national economy than that of the U.S.

• There will be no war over Taiwan. I predict that within 20 years Taiwan and China will reunite peacefully because the differences between their systems of economics and government will have disappeared. They already consider Taiwan to be part of China, and simply a “rogue” province.

• It would be more accurate to characterize China as a “nationalistic” country rather than “communistic”. They are full of pride in their developing country. They are quick to point out that China’s economy was the largest in the world for 17 of the last 20 centuries. They are ready to take back the leadership.

• Economic choices take priority over political choices. They know that their future is best secured by developing a strong economy. Their politics have become “practical” rather than dogmatic.

• Taiwan and Hong Kong, in particular, give them “models” to observe and work with relative to a more democratic political society and more open economic models. They will not compromise their opportunity to keep experimenting and learning from Taiwan and Hong Kong.

Personal and religious freedoms have been expanded tremendously since 1989. But they still have a long way to go. For example, if you want to move from one province in China to another, you must apply for a permit to do so. On the other hand, there was no religious freedom in China 15 years ago. Today there is.

These people are Buddhists celebrating the Moon Festival in the Llama temple in Beijing. This temple was closed when I was in China 18 years ago. On this day it was jammed with people openly celebrating.

China continues is progress toward becoming an economic superpower

Last week, China’s capital markets witnessed an event not seen for decades: two foreign entities, the International Finance Corporation (IFC) and the Asian Development Bank, were granted permission to issue renminbi-denominated bonds in the domestic market. The two entities reportedly had negotiated for the right to do so for four years. The exact size and timing of the two bond issues have not been finalized, though the IFC has indicated interest in raising about 1 billion renminbi (about $123 million). The new bonds have been dubbed “pandas” by market observers.

Capital market regulators in China are keen to develop the breadth and depth of its domestic bond markets. Historically, China’s banks have been the primary conduit of external finance within the economy, but recent regulatory reforms have allowed Chinese corporations to tap debt and equity markets more readily. Other recent capital market reforms include changes to the country’s currency exchange rate regime, announced in July; and the first international IPO of a domestic bank, accomplished during the prior month. (From the Matthews Funds weekly report).

This is an important step for China in its drive to become a major economic superpower. It is also the next step for the renminbi to take its place among the world’s major currencies.

Other stunning progress

• Twenty years ago Shanghai had one “skyscraper”. Today it has over 300.

• There are 47 cities in China with populations that exceed 1 million. There are nine in the United States.

• The current forecast is that by 2040-2050 the Chinese economy will be the largest in the world as measured by Gross Domestic Product (GDP). The United States is forecasted to be number two; and India will be number three.

• The Chinese economy has doubled in size every 8 years for the past 30 years. The U.S. economy has doubled in size once during that time.

• 60 percent of Chinese still live down on the farm; one out of every eight people in the world is a Chinese peasant. And each year, some 20 million of them leave the countryside for the city to get jobs.

• At current rates then by the year 2020, China's cities should add some 300 million newcomers, more than the entire population of the US to house them; China has to build a couple of extra Shanghais every single year.

• Last year, Shanghai surpassed Rotterdam to become the world's second busiest port.

• Chinese consumers now scoop up 12 percent of the world's luxury goods --mostly when they travel abroad -- compared to 17 percent by US consumers.

Not everyone is Benefiting from the “Economic Miracle”

China’s population has been very clearly divided into the “haves” and “have nots”. By most estimates the “farmer peasants” are poorer today than they were when the “economic miracle” began. In fact, some of them call it the “economic mirage”.

There are still hundreds of millions of Chinese who live on less than $2.00 per day. Worse, significant dislocation has impacted tens of millions of peasant farmers whose land has been confiscated, through procedures similar to eminent domain in this country.

Farm land is rapidly being converted to urban uses, and in most cases the farmers have received below market compensation for their land. If losing their land is not enough, many have also lost their life savings. Much of China’s current economic “miracle” has been financed by the high savings rate of the Chinese people. They put their money in banks, much the same way that savers in America do. The big difference is that the banking system in China is totally controlled by the central government, and least until recently.

It is well known that there has been little to no discipline in lending policies at Chinese banks, and many of them are technically insolvent today. It is no wonder then that their have been tens of thousands of protests against government policies and actins over the past several years. It is also no coincidence that the Communist Party of China has announced, within the past few days, a new economic plan for the development of the country over the next five years. The policy emphasizes a slower, but potentially more sustainable growth rate for the national economy. It also attempts to acknowledge and address some of the problems related to the extreme economic disparity that separates the poor peasant farmers from their wealthier urban brethren.

One consequence of this new policy will be increased investment in the rural areas. Another will be emphasis on creating a more domestic consumption of the goods and services produced in China. Accomplishing these goals will take capital expenditure, and that some of that capital is the money that previously has gone into buying copious amounts of U.S. Treasury bonds. As more is spent domestically, it is likely that less will find its way into purchasing our debt. The natural consequence may be that we have to find ways to finance more of our own debt. That may mean that American’s will have to learn to save, or that we will have to raise interest rates to attract capital from elsewhere.

Either way, the next five years may be dramatically different for both the Chinese economy and the U.S. economy.

Respectfully Submitted,

Paul Krsek
For K&A Asset Management, LLC

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Updated: November 28, 2005

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