FLASH REPORT: China Update
June 2010

he popular and financial press is rife with opinion, most of it negative, regarding the Chinese economy. The concerns are varied, but generally include the imbalances in the economy, the impact of loose monetary policy on the real estate market, and therefore the stability of the country’s banking system. While based in fact, we believe that these fears are overdone, especially in an environment where mentioning flaws and saying the word “bubble” draws signifi cant media attention.

The Chinese economy and society are developing, a process that is neither easy nor steady. Development does not occur at a constant pace or uniformly across all aspects of a country’s economic, legal and political systems. China’s size, in terms of both geography and population, exacerbate this asynchronous development. Longer term, we are bullish on the Chinese economy and have not seen any persuasive evidence that the progress of development is about to stop.

Short term, can things go wrong in China? Yes, at times horribly so. The current economy is being compared to historical bubbles, from tulip bulbs to the South Sea bubble. Yet the talk of bubbles misses the point. Yes, these bubbles occur, yes they burst, and one certainly would like to avoid them. What matters in the short term is when to invest in China and when to avoid it. Our current view is that this is still a good time to own Chinese shares.

Part of our short term decision-making is impacted by a recent selloff in fi nancial and property stocks. These stocks have reacted quite sharply to speculation of a real estate bubble, and to recent actions by the government to limit credit. Chart 1 shows the performance of the MSCI Chinese Property Index. Property shares are off 30% from recent highs in December 2009 and over 55% from the all time highs in the fall of 2007. Investors who sense a bubble because these stocks have rebounded off their lows have missed a large part of the story. We think that the volatility in the sector strongly warrants an active approach to investment management.

If we were to think about China as one large company, the crux of the issue is: “What is the expected return on the money spent for infrastructure development?” Some projects were built to meet local employment or other measures, and others will end up having little or no lasting economic value. For example, a story originally broadcast by Al-Jazeera highlights the town of Ordos as evidence of overbuilding with little chance of full utilization. It is a fair criticism and no doubt not the only example of wasteful projects. However, Ordos is a city with a population of 1.3 million, relative to the country total of 1.3 billion. There is a danger of over-generalization.

China has overbuilt infrastructure given its current level of consumption. But it is premature to suggest that infrastructure is overbuilt for its ultimate level of consumption. China is still a relatively poor, rural and agrarian country. Table 1 shows China’s economic development relative to other large developing and emerging market countries across some relevant metrics. We believe these, and similar statistics, show a country rapidly industrializing and urbanizing, but in a growth pattern consistent with other major emerging markets.

Those most negative on China have cited the government’s promotion of real estate and the potential for a property bubble due to low interest rates and relaxed lending standards. These concerns are valid enough. However, the property “market” in China is generally less than 15 years old, newer in some cities. It is hard to know what equilibrium looks like in those markets, as supply and demand characteristics are changing. Incomes in China are rising commensurate with property values, unlike in the US where incomes remained stagnant during the housing boom.

In addition, China has altered its monetary policy several times over the past decade. The most recent period of monetary easing began in the second half of 2008 in direct response to the global recession and resulting credit crisis. Aspects of monetary policy in China are already being tightened. The government can be accused of being too fast, too slow, too aggressive or too passive with respect to policy. But that puts the Chinese central bank on the same footing as the Fed, or any other central bank, struggling to assess and respond.

As so often occurs, China’s greatest strength also contains its greatest weakness − the rate of domestic savings. High savings rates should allow the economy and banking system to heal during any subsequent bad debt problem. Overall, the economy has less leverage in the system due to high levels of household savings, high mortgage down payments and over $2 trillion in foreign currency reserves. But neither savings nor government driven spending alone can make the economy grow and develop.

China does need to increase domestic consumption. However, there are vast data from independent sources suggesting that the middle class is growing. GM is selling more cars, KFC is selling more chicken, Samsung is selling more phones, imports of consumer goods of all sorts are rising, and so on. There is real economic activity taking place, not simply the stockpiling of commodities or building unnecessary housing. Is this enough? The answer is unknown, but to say definitively that it is not enough, is premature. The government is aware of the need to promote the middle class and to raise workforce productivity. The difference between China and the Asian Tigers of the 80s and 90s is that China has a large enough domestic market to warrant investment in the production of goods for its own market.

Given the uncertainty, should one assume consumption will grow or stagnate? To us, the growth path, however inconsistent and meandering, makes more sense, because that is human nature. It is the very basic premise of economics − resources are constrained, but individual and societal wants and desires are not. People want a better life. They want nicer housing, better food, more material goods. Once they start getting them, they seek less tangible goods, such as a cleaner environment and political rights. This has been the path of other countries, including the US. We think this is the path that China is on, although not step for step.

The shorter term issue for China is payment of debt until economic activity increases and the various infrastructure and real estate projects become cash flow positive. There is risk in the banking system. However, China has substantial private savings, as well as over $2 trillion in foreign currency reserves that can be marshalled to cover any losses. Such an infusion into the banking system is not the desired result, and may make certain investments unattractive in the near term. We do not believe this represents a threat to the economy as a whole.

Unlike the debt issues facing Europe, problems in the Chinese economy are cyclical, not secular. We do not share the view that bad debt problems will be devastating to the Chinese economy and society, and are surprised at the level of hyperbole used when discussing the country. When the economy slowed in 2008, there were predictions of mass riots and social disorder as unemployment rose with declining exports. We hear similar dire predictions now about bad debt and a real estate bubble. China survived the invasion by Japan, the Communist Revolution, the Great Leap Forward and the Cultural Revolution. It will survive a period of too loose monetary policy