China's Cinderella Story
Everyone knows that when the clock strikes midnight for Cinderella, the carriage turns back into a pumpkin, the horse into mice and the jeweled gown into rags. The spell is broken and reality returns. I keep thinking of China in this context.
One of the big questions of the year is whether China blows up or not. Hard landing or soft? When will the clock strike midnight on the Chinese? Things are slowing down, and it feels like it’s getting late.
But first, why does this matter? China matters because China is big. If this were 1980 — when China’s economy was about one-seventh the size of the US’s economy, no one would care. Today, the appetite China has for raw materials is no secret, and is one of the main reasons why miners and oilmen are flush with cash. So if you invest in miners and oil companies, then the answer to the hard landing question decides the fate of your portfolio.
For some ideas on this front, I turned to my friend Ben Simpfendorfer, founder of the Hong Kong-based Silk Road Associates (and author of an excellent book, The New Silk Road). He also writes a very good letter focused on China called China Insider. Ben speaks both Mandarin and Arabic and has traveled extensively in Asia and the Middle East. As such, he has an inside look on two cultures that few Westerners will ever see.
I admire his work for these reasons, and also because he is critical and thoughtful about China’s prospects, whereas many others are either unfailingly sunny or permanently apocalyptic.
In his latest letter, which just hit my inbox this morning, Ben addresses the very question I open with: hard landing or not?
“I expect no hard landing in 2012,” Ben writes. As for 2013-15, Ben is much more bearish. As with any prediction, though, the reasoning is more important (and more interesting) than the conclusion. The key is to understand that China still has a lot of spending power. Let’s take a look…
“China could afford to go on another debt binge in the event that the economy appears to slow abruptly,” Ben writes. “Sure, it has implications for medium-term growth (and I’ll get to that in a moment), but the ability to continue borrowing, or further relax fiscal and monetary policy, does rule out the risks of a hard landing in 2012.”
In the past, China was able to skirt the financial crisis because it simply commanded its state-owned banks and state-owned firms to embark on big projects. It has the firepower to continue to do so in 2012. One place it will certainly focus on is housing. Housing prices are falling nationally. But housing markets are intensely local. You should be suspicious of attempts to aggregate them. Ben appreciates this.
“A look at major city clusters around the country shows that property sales have collapsed in areas centered on Beijing, Shanghai and Hangzhou,” he writes, “even as they remain steady in places such as Chongqing, Hefei and Shenyang.”
“My own experience — traveling through nearly a dozen second-tier cities over the past six months — echoes the data, with some cities clearly about to suffer a horrible property crash even as others look more balanced owing to less supply, but also a stronger local domestic economy (typically the coastal provinces) that is less reliant on fiscal stimulus.”
As to that stimulus, China’s government plans to build 7 million public housing units annually over the next five years. This is a big increase from the 3 million units China’s state-owned units built in the years 2008-10. And it’s also a lot bigger than the 5 million units the private sector created over that time.
But think what this means. It’s an artificial stimulus. Its goal is mainly to keep people working. However, the market itself clearly does not support such an increase. Ben peels back some of the numbers on the profits earned by builders.
The five large state-owned firms earn profit margins of only 8%, according to data compiled by SouFun (a leading real estate data provider). This compares with 15-25% profit margins for private companies in recent years. I’m taking these at face value, though my suspicion is that the data overstate the profitability of the public firms.
You know, though, how economics works. As profit margins shrink, this is the market’s signal that the capital is perhaps best used elsewhere. Governments can ignore this signal, at least in the short term. But private firms cannot. They must serve the wishes of consumers or they will go out of business eventually. They also have owners who will see that the profits no longer compensate for the risks. They will pull back. And this is what’s happened.
This next chart is telling. It shows you the number of units built each year by private and public firms. You can see the big jump in public construction, which was part of China’s stimulus plan. But look at that blue line. It’s leveled out and declined last year:
“In effect,” Ben sums up, “the shift toward construction of more public housing implies that state-owned firms, operating at smaller margins, will capture an ever-larger share of economic activity…at the expense of the more-dynamic private sector.”
So more and more of China’s economy becomes dependent on government spending. We know that such government spending leads to bridges to nowhere. Or, in China’s case, empty office buildings, empty condo towers, empty malls and, indeed, empty cities. That’s a big problem — but it’s probably not a 2012 story.
Ben concludes: “Whether because of chances that a property crash is limited to certain parts of the country, or because of China’s ability to pump more credit into the economy, the odds are that 2012 turns out to be surprisingly dull, with the economy slowing, but still growing at above an 8% rate…”
It’s also an election year in China. Senior leadership will change in China in late 2012. All the more reason to expect massive spending from government coffers to keep the spell unbroken, if only for another year.
The time frame just beyond 2012 is the problem. Maybe the government spends so much that it produces reasonable-looking economic numbers and keeps people employed, but the resulting economic growth would have been a fantasy. Economies exist only to satisfy human wants and needs. They do not exist to produce numbers that look good in economic reports. China’s economy will have failed, just as other state-directed economies have failed, in its essential task of serving consumers. It becomes, then, an expensive fiction. China’s coffers, as rich as they appear, are also not inexhaustible. All of this means there is an inevitable quality to the collapse here, though the timing is hard to call.
At least for 2012, it seems investors can count on China coming to the table with its usual gusto to spend money. But the clock is ticking and midnight approaches.