As regular readers know, I’ve been a long-term China bear. This attitude has become mainstream recently, but I still believe there’s value in thinking about China. First of all, I could still be wrong, and second, looking at China as an investment gives us another chance to ask some of the questions I posed the other day.
First, of course, is do we understand what’s going on? Earlier in the Chinese story, the answer was yes. China was using very low wage rates to attract manufacturing, the products of which were then sold to Western markets—a simple, well-proven business model. Recently, though, that model has developed cracks. Chinese wage rates are no longer as attractive, while demand from the West has dropped off.
As this happened, Chinese banks stepped into the gap with cheap financing, and the government acted to support demand by increasing infrastructure spending and attempting to boost consumer spending. This is where I start to doubt whether I understand what’s going on. With infrastructure spending at unsustainable levels, with financial imbalances building up, and with demand from the developed markets unlikely to support growth at previous levels, this clearly isn’t the original model. Consumer spending is restrained by multiple domestic laws, which don’t appear to be changing any time soon. I think we have to answer this question no for the moment.
Second question: does it make sense? As should be clear from the above, what I see is a financing-driven economy that depends on cheap loans—the funding for which is, ultimately, finite. China has fully exploited its existing export markets, which are unlikely to grow at historic rates, and is trying to make up the difference with internal consumption and infrastructure spending. Neither of those succeeded in driving growth in the past, so what has changed to make them work now? Again, I think the answer has to be no, but perhaps a qualified no in this case. If the Chinese government makes changes to support more consumer spending, this could conceivably become a yes.
The third question, about the valuation levels of the asset, is a little tricky. In the case of China, let’s call this current economic growth rates, which are down considerably from previous years for the reasons above. The question is whether they’ll go down even further. Right now, the consensus seems to be that current growth rates are sustainable. I have my doubts, but let’s give this one a yes.
Question four is the big one: does success depend on things being different this time? I think the answer is clearly yes. The model that China has used so successfully over the past 30 years is over; while China will remain a major exporter, it is no longer the low-cost option and, in any event, has saturated many of its markets. Future growth thus depends on China successfully making a transition from one economic model to another. As we are seeing, this isn’t an easy task, especially in the aftermath of a global economic crisis, with all countries looking to increase exports and protect their own economies.
And now for the final question: how does this blow up? If I had to bet today, it would be financial imbalances. The wealth management products, which have had no much press recently, appear to present a systemically dangerous asset-liability mismatch. Or, to put it in U.S. terms, we have the system equivalent of a house financed with a mortgage that has to roll over every three months or face foreclosure. As long as lenders are willing to lend, this isn’t a problem, but . . . Other potential land mines include increasing bankruptcies in the private sector, leading to higher unemployment, growing social unrest, and a simple consumer pullback.
Overall, while I wouldn’t rule out the ability of the Chinese government to maintain stability, the level of growth appears likely to continue to decline. The weaknesses increasingly outnumber the strengths, and the situation is getting worse.
As an investment, China clearly doesn’t pass the five-question test at the moment. The real question is whether it can restructure its economy to maintain growth at current levels. In my opinion, the answer is no.