China Field Trip

China’s economic growth and transformation has been remarkable, but the system is under huge stress. The real problem relates to credit. Kerr Neilson explains the enormous challenges China’s economy is facing and identifies the sectors where we see the best prospects for growth.

Please do not read into this assessment that we have lost interest in China’s re-emergence.  What has been achieved has to be seen to be believed, but the system is under huge stress. 

Cities Visited - Shenzhen, Nanjing, Yichang, Chengdu and Shenyang

There is no lack of enterprise or hunger for advancement in China.  Labour costs have risen a lot and in the coastal province, may typically be ¥6,000 pm (US$1,000).  This has reduced the labour arbitrage against other low cost countries but companies are countering this by moving inland or up the value-added chain.  Aiding this process has been the infusion of improved technological know-how often secured through joint ventures with foreign firms (mandated by government policy in industries nominated as strategic).  There is also the benefit these ventures enjoy from government policy to promote local ventures over foreign competitors.

The real problem relates to credit.  Private enterprise, referred here largely as SMEs have miserable access to credit funding.  The State Owned Enterprises (SOEs), which account for only 30% of the economy, are hogging the credit market.  Worse still, they are bad payers and stretch out their trade terms well past 90 days thereby imposing significant funding stress upon their private suppliers.  They have other short comings such as being slow to innovate and have accounted for about 20% of new jobs in a country which feels the need to create nine million new places a year.  They tend to be in the capital-heavy industries with pitiful returns on capital (CLSA estimate 3 to 4% Return on Capital Employed (RoCE) across the group) and seem hardwired to grow in size regardless of their ability to justify the expansion in terms of profitable prosperity.  There is a haunting resemblance to the Japanese model here.

None of this would matter except for the People’s Bank of China’s (PBoC) excited response to the GFC in 2008.  Within one year, they had infused about Rmb14 trillion into the economy (representing 35% thereof) for fear that the melt-down which was occurring in the rest of the world would infect the home economy.  This was mother’s milk for the Chinese property developers and the speculative game resumed.

It is not hyperbole to claim that property is and has been at the heart of the Chinese transformation.  Rather like the US in the early 1800s, as the land grab moved west, property sales fuelled and levered the funding of “economic progress”.  Here it has been the wherewithal for the development of the Provinces with many a sad tale of the dispossession of poor farmers whom not long ago were regarded as pivotal to the class revolution.

Without the monetisation of State land ownership, Local and Provincial governments would not have been able to fund the re-building of China into a global power.  So central and certain has been property price appreciation that all credit and business transactions are set against it.  Cash flow is not a subject discussed in pleasant company.  Levitation of property values is what matters.

At one meeting with the world’s second largest yeast company, 150/-t pa, we were told about the company’s return on equity (ROE) but we could not discover its leverage levels.  We were assured that in China the focus is on the debt to assets ratio, not debt to equity!

All is well so long as there is a compliant supplier of extra credit.  We observe that credit continues to grow by 16% or more a year, yet strangely the economy is slowing and may already be expanding at less than 10% pa nominal.

This credit, incidentally, falls largely to the SOEs, not private enterprise.  Apart from the funding difficulties, private firms face strong wage increases, an appreciating currency which adversely affects their exports, and under-utilisation. This year blue collar workers are getting about 10% more than in 2012 while the minimum wage is being hiked in some provinces by 15%.

The yeast company suggested their local wage costs were running at Rmb6000 pm versus their experience in Egypt at Rmb700 pm (US$114).

Who cares?  The government has plenty of levers to pull.  The tax take is low, concessions and rebates abound.  It has huge flexibility to inject liquidity, to sell off parts of SOEs and to raise taxes.  Why worry?  Well the interbank market is worried.  Rates on Thursday, 20 June spiked in the interbank market to over 10% overnight – someone needed cash in quantity and quickly to meet their obligations.  That can be fixed by the PBoC by granting funds at the discount window and presto, all is well, perhaps!

What though if the SOEs and local government have been borrowing incrementally to meet interest payments and to roll existing debt obligations?  We cannot know because of the opacity of these entities’ finances.  Land sales are claimed by local government to be a small part of their revenues but when asked for enumeration, answers tend to be obscure.  Fitch has estimated this as 6% of GDP and this seems to represent about 20% of these entities gross revenues.

There is also the phenomenon of the underground banking system (which one entrepreneur shrewdly observed was so profitable that he chose to sell his interest in a kerb lender) and the rise of wealth management products (WMP).  These arose from the constraints placed on bank’s borrowing and lending rates but unlike the securitisation that segregated lenders from originators in the US in 2004-2007, these products gave the banks a new stream of revenues and are currently estimated to amount to Rmb8 trillion in this Rmb52 trillion economy.  Some are pretty clean, being the securitisation of bank loans and passed through to wealthier individuals as a yield sweetner.  Some, a full 40%, are issued by trust companies which put them in a different category and allow them to introduce more exciting elements of the credit spectrum such as the debt attached to local government infrastructure projects and receivables from property developers and the like.

This is a delightfully seductive business for the promoters.  The borrower gets funding well-above the bank lending rate but at least has access to credit, while the individual white collar worker who is approached to put in a minimum of Rmb20/- to 100/- gets 3-4% more than he/she would get from a bank deposit while the promoter, a party affiliated trust company (68 of them) catches another 3 to 4% pa spread.  What could be better – well perhaps lending against cash flows?  This is not on the agenda as we can rely on the sublime notion of urbanisation, power laws of ever-expanding mega cities and rising asset values. 

What we do know is that all the SMEs we spoke with were experiencing payment problems from their customers – there is a daisy chain of extending credit.  The large four state banks outwardly look fine.  Loan-to-deposit ratios of around 60%, they are relatively well-managed after the personnel clear-outs associated with the 2002 credit crises but they are still servants of the state-planning mechanism with a senior party official on every board.  Ultimately they will probably be on the hook for the indiscretions of the WMP’s that they distributed or endorsed and bear the brunt of losses of the local county banks which have over-extended themselves to their local governments and their grandiose schemes of a social nature.  The large banks are priced close to book value – 1.1x book and seemingly cheap with price to earnings ratios (P/Es) of 10x or 11x but in a country which at a relatively early stage of financial intermediation has debt to GDP in excess of 200%.

More challenging than this is to identify what will drive growth in China over the next year or so.  Companies visited by another group this week found that industrial companies were operating well-below capacity – not because of inadequate funding but because of soft demand.  After the initial shock of a credit crunch, which is likely to be contained by the PBoC, what will fuel the growth engine?

A rise in inter-provincial trade, the consumer, and special government projects such as environmental protection are strong contenders but are they enough to partially compensate for an economy used to a heavy diet of capital expenditure of over 40% of GDP? …probably yes.

The senior executive from Cushman and Wakefield reported that the property developers managed to off-load their stocks in 2011-12, at the cost of only a 6% dip in residential prices and having troughed in May 2012, prices have been rising and are up by say 10% from their lows.  They have since embarked on nation-wide projects that represent 4.5 years of yearly off-take.  He frightened us though with his observation that developers have shifted their emphasis to commercial development and are actively adding to their stock of shopping malls and office blocks notwithstanding rising vacancy levels and sub-economic returns.  The guiding theme seems to be build-them-and-they-will-come.

C&W calculates Grade ‘A’ office inventory in 2012 in the top 20 cities at 32 million m² with supply over the subsequent three years at 40 million m².  Retail inventory in the same cities is put at 55 million m² with future supply of 30 million m².  As with residential, the pressure points are in the regional (second and third tier) cities that are most prone to over- exuberance while the core coastal cities have been relatively sedate.  CLSA’s research shows residential inventory in tier 1 and 2 cities at 15 month sales while for tier three cities it is more like 30 months’ supply.  Affordability is calculated at about six years’ family income in these latter cities but 12 to 15 years of family income in Beijing, Shanghai and Hangzhou.  Estimates for end users versus investment buyers are vague with investors in the t2 and t3 cities probably accounting for 30% of sales.

Here lies the wrap-up of this tale.  What has worked before is the presumption for the future.  Circumstances have however changed.  The SMEs face a weaker demand environment, and the SOEs, in most cases, seem to have more capacity than they need (there are endless words and statistics on the surpluses of steel, cement, aluminium and some chemical products).  This is showing in their returns on assets which on average are in low single figures at best and this will curtail their prospects as interest rates more truly reflect the credit risks.

Contributing to this uncertainty is the “Four Winds” message delivered by the President on Wednesday, 19 June regarding the need for party officials to adapt or face extinction.  This may have had some bearing on the PBoC’s behaviour last week and the desire to ‘teach the smaller banks a lesson’ but of course, ran the risk of greater dislocation than was anticipated.

Please do not read into this assessment that we have lost interest in China’s re-emergence.  What has been achieved has to be seen to be believed.  The massive and effective build out of infrastructure, the concurrent greening and beautification of the roadsides and parks – which came years later in early movers like Japan and Korea, the leaps in technology and now the gradual provision of improved health, education and social security are magnificent achievements but the system is under huge stress.

Over the last five years government spending on healthcare is up 262% and on education up by 197%.

The Hukou system of resident registration – also seen in Japan, Korea and in fact parts of Europe - either rural or urban, defines amongst other things, the level of healthcare, schooling and pension benefits granted to migrants who settle or work in the industrialising cities.  There is a very large disparity in benefits and the huge cost of providing equivalent social services to migrants is hampering implementation of reform and may contribute to a sense of injustice.

The migrant panel we spoke with were feeling the pinch - clearly from the high cost of education (Rmb10,000 pa quoted for a primary school place) and healthcare and saw little prospect of finding enough money to buy a home which in some cases might improve their chances of getting into the queue for an urban hukou.  Huge sacrifices were made for the child (and incidentally the one-child policy is likely to be abolished soon) and schooling, above all, is the priority.  There are an estimated 220 million urban residents without an urban Hukou out of a total of 690 million urban residents.

The oversupply in several key industries, and by extension, their capital expenditure supply chain, suggest that this transition to a consumer-led economy is going to be extremely bumpy.  The official growth real rate of 7.5% seems unduly optimistic given our reading of the stress that will come from the inevitable failure of firms and ongoing consolidation.  The daisy chain will find its weakest link as SOEs/local governments can no longer roll debt obligations and many of the ambitious projects will be seen to have insufficient cash flow to meet their interest and principal payments.  Yes, consumer spending will likely take-up some of the slack and has been contributing nearly half of the growth in the economy for the last decade so long as confidence is not dented by say wealth management product failures or the loss of some jobs.  The emergence of the typical urban consumer has barely started, yet e-commerce is as vibrant in China and anywhere we know.  Accompanying this phenomenon will be a significant need to upgrade the logistics system to meet personalised deliveries, from trucking fleets, to automated high volume warehouses.  This is one area where China really lags behind modern practice.

At present logistic costs to GDP are put at 18% in China versus 8 to 9% in the industrialised world.  Compare this with over 300 million on-line shoppers for general merchandise valued at Rmb1.3 trillion, equivalent to 6% of total retail trade:  this figure was under Rmb500 billion in 2010.

So while we have reservations about general business conditions in China, please remember that in every economy there is creative destruction.  In the case of China there are several sectors that will grow regardless.

At Platinum we have placed our faith in the inevitable growth of e-commerce and the internet with these companies accounting for nearly 4% of our 6% exposure to China (Platinum International Fund as at 30 June 2013).  Similarly, slower growth prospects have kept us short the Australian dollar.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.