10/25/13 – Inside Information from China

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 25, 2013 10:06:58 AM

and tagged Economics Lessons

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This morning, I had the chance to talk with the lead fixed income (bond) portfolio manager from one of the largest Chinese mutual fund companies. Arranging the call was a bit difficult, what with the difference in time zones and our travel schedules (which is probably a metaphor for something or other), but the conversation turned out to be well worth the effort. As an aside, we really do live in a miraculous age, where you can talk to someone on the other side of the planet.

The manager’s point of view was an interesting one; he told me at the start of our chat that, being from Hong Kong, he considered himself an outsider. He had lived in Beijing for years, though, and his wife was from the mainland, so he had a broader perspective than a typical Hong Konger.

This was interesting for a variety of reasons, not least in that it illustrates how, while an American like me might perceive Hong Kong as part of China, a native doesn’t see it that way. This is a good example of how the U.S. perspective on China, or at least mine, doesn’t always register all the shades in the picture.

One of the primary themes of the manager’s remarks was that, since the financial crisis of 2008, China has made enormous progress. Many of my observations over the past couple of years seem to have been largely on track, but things have changed, especially at the governmental level, since then, and many of the country’s problems are at least much smaller.

The primary concern I’ve always had was whether China could make the transition from an export-driven economy to a consumer-driven economy. The manager hit this directly from a couple of different angles. The first was average worker wages, which have more than doubled over the past couple of years. I’ve mentioned this before, in the context of the U.S. manufacturing renaissance, but he pointed out that it’s this increase in wages that has led to the construction of shopping malls everywhere and a surge in auto sales, which were up even with slower growth earlier this year. Wage growth amounted to a large wealth transfer from companies and the state to the working classes, which was driving the consumption transformation that had worried me.

He also noted that the government was largely behind the rise in average worker income as a deliberate policy objective; it had, in fact, driven it by raising wages for workers on post-financial-crisis infrastructure projects to above then-market levels for manufacturing. Pensions are also said to have doubled over the past several years.

Rising wage income has reportedly led to consumption accounting for about half of all growth now, as compared to a third in 2009. That’s significant progress, if still not all the way there, and driven by deliberate government policy.

We also talked about the problems with China’s financial infrastructure—the intertwined areas of wealth management products and local government finances being the biggest two. He made several good points about how this has been largely an accounting problem, with local governments tasked with spending money that the central government did not provide but will ultimately stand behind. Similarly, with the wealth management products, the government has a majority ownership stake in the major banks and will stand behind whatever does go bad—which really shouldn’t be that much, as many of these products have rolled over and been taken back on the banks’ books.

What was particularly evident in our conversation was the manager’s continual focus on what the government had done or was going to do. His points about the financial resources available to the central government—which can certainly cover a multitude of sins—and the deep connections between the central government and the problem areas were things I did not fully appreciate.

His other very apposite point was the generally low levels of leverage across the system. Leverage, as we have found in the West, is what kicks off crises—and there just isn’t that much there.

The last thing worth mentioning is the manager’s repeated and specific examples of policy changes and actions that have been made, or are planned, that will address many of the concerns that I and others have. The total impression is that China’s leaders understand what has to be done and are doing it.

Overall, I feel much better about China than I did before the conversation. We covered a lot of ground—certainly more than I expected to in about 45 minutes—and the manager made a powerful case that my concerns about China are overblown. I get it.

And yet, going back to a point I made earlier, the repeated assurances of what the government has done, what the government plans to do, how the government actually owns the companies or banks and can therefore direct them—it all underlines just how much of the China story depends on the continued political stability, and current direction, of the Chinese government. I’m prepared to believe that my economic concerns are at least moving in the right direction, but my concern about the potential political risks remains. With all that has been done and all the progress that has been made, the ability of the central government to do as much harm as it has done good persists. Economically, China may well be in better condition than I thought, but investors should remain aware that progress depends on the goodwill of the government.

By the way, I have left out the firm and name of my interlocutor to prevent attribution of the opinions here to anyone but myself. I am very impressed with his insights and grateful for his time.

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