Collectively trading at about eight times forward earnings and around book value, Chinese stocks are pretty cheap.
In fact, China’s stock market is actually down 9.6% from where it was exactly five years ago.
There’s no question that the Chinese market is a momentum market — it could surge any day. But for some time, I have been skeptical of the assumption that the China bull story can continue without significant political and market reforms.
That China has been an incredible growth story, pulling many millions from poverty, is indisputable. In 1990, China’s GDP was roughly equal to that of Taiwan; now, it is ten times bigger.
But China’s investment-led industrial growth, already into its 16th year, is getting pretty long in the tooth. Real fixed investment has increased at a faster rate than GDP in nine of the past ten years.
The longest previous period of investment-led economic growth was a mere nine years, experienced by both Thailand and Singapore, according to research from Pivot Capital Management.
And I have some unwelcome news: China has substantial overcapacity in manufacturing, real estate, and infrastructure, as well as deteriorating credit quality and weakening export markets. Its brittle political system will make the chances of adjusting to consumer-led economic growth remote at best.
This conviction led me to write a 55-page confidential report entitled “The China Skeptic: Eight Troubling Trends.” Here are some snapshots from it…
The China Skeptic
Investment in China is at 62% of GDP, and the return on every marginal dollar invested in the nation is decreasing.
In 2000, it took $1.50 of credit to generate a dollar of GDP. By 2008, a dollar increase in GDP required $7 of new credit.
And the global macro picture will only accelerate the China challenge because it will shine a spotlight on China’s shrinking export markets and industrial overcapacity.
One example of this overcapacity is China’s steel capacity, which is equal to that of America, Japan, Russia, and the 27 countries of the European Union combined. It also has an aluminum capacity eight times larger than that of America on a per-capita basis.
China’s role as a low-cost base for global manufacturing is also less compelling given all the logistical issues that go along with supply lines spanning the Pacific. Apix Partners studied five manufacturing segments over a five-year period and found that China’s pricing advantage for goods arriving in California relative to domestic prices has declined to zero.
To make matters worse, Mexico’s manufacturing wages are now below China’s — one reason net exports have contributed nothing to China’s growth over the last four years.
This leads to the issue of credit quality and the possibility of China’s own homegrown debt bubble. Research shows that rather than China maintaining a manageable public debt-to-GDP ratio of 35%, the inclusion of off balance sheet items like guarantees of local government bonds brings this number closer to an uncomfortable 62%.
Beijing Banks
China’s five biggest state-owned banks wrote off $11 billion in bad loans last year, and this is just the tip of the iceberg.
In addition, China’s non-performing loan data is clearly being managed and does not even include the $200 billion in bad loans from China’s top four state-owned banks that were moved “off balance sheet” to state-run asset management companies.
China’s bank lending explosion after the financial crisis led credit-to-GDP to rise to 140%, levels equal to America in 2008 and Japan in 1991 — just before their respective market meltdowns.
This expansion in state-owned bank lending power should also push aside cherished hopes that China will, over time, turn more control and ownership to private capital and management. One must look no further than China’s ten largest companies, which are all state-owned or controlled, as are 34 of the top 35 companies listed on the Shanghai exchange.
In The Next Asia, Stephen Roach puts it this way: “There are worrisome signs that China just doesn’t get it, that it is clinging to antiquated policy and economic growth strategies that presuppose a classic snapback in global demand.”
Since China’s leadership bases its legitimacy largely on producing high levels of economic growth and employment, internal pressures and sharp divisions as to how to deal with the slowdown within the party will emerge. Unemployment is thought by many analysts to already be over 10%, and it will worsen to uncomfortable levels.
When it finally sinks in that China is not a provider of global growth but rather in the same slow-growth, high-debt boat as America and Western Europe but without their durable political institutions, all bets will be off.
China could be the growth story of the century — or maybe not.
Until next time,
Carl Delfeld for Wealth Daily
