China's Reforms Continue

From China’s shadow banking system to the latest signs of weakness in the property market, from the rapid growth of e-commerce to the surge in tourism, Joseph Lai, co-manager of the Platinum Asia Fund, discusses the challenges and opportunities in China’s economic transformation.

Since commencing economic liberalisation some 30 years ago, the Chinese economy has undergone an incredible transformation beyond the imagination of even the most optimistic pundits.

Movement of cheap labour to urban centres and private sector entrepreneurship turned China into the factory of the world.  Metropolises sprang up across the country driven by rapid urbanisation and income growth.  Urbanisation rose to 50% of the population and the gap widened further between urban and rural incomes.

Gross domestic product grew at an average of 10% over the last 30 years.  Exporting US$2.2 trillion of goods, China accounts for 12% of the world’s total export market.  At the same time, property market sales volume has grown at a breakneck pace of 18% pa for the last 15 years!  The associated steel and cement capacities also climbed relentlessly in response to this insatiable demand.

Recent data coming out of China has been lacklustre.  Much of the concern centres around China’s shadow banking system which grew in excess of 30% in the last five years post the global financial crisis.  Trust Products, worth around US$2 trillion was one of the major components and the recipient of disbursements were property developers and local government (related) entities.  Given the boom in credit creation, the credit quality was likely suboptimal.  More borrowers will default but we believe the eventuality of a debilitating systemic crisis is highly unlikely.

One has to bear in mind that the Chinese shadow banking system is implicitly or explicitly backed by the Central Government.  Its balance sheet is robust with total government debt-to-GDP ratio sitting at a reasonable 50%.  The country is still growing at a decent pace, lessening the debt burden over time.  Further, most debt is denominated in the Renminbi, money printing is a potential policy lever.

What is important is to halt the continual accumulation of low quality lending.  From this perspective, the banking regulator has strengthened the risk management process for financial institutions and encouraged the development of the more transparent corporate bond market.

The latest sign of weakness emanates from the property market.  Lending controls have reduced buyer appetite.  The volume of property transactions year-to-date is down 9% from a year ago.  Prices in many cities are edging down, with the smaller second and third tier cities reporting more significant declines than the bustling cities of Beijing, Shanghai and Guangzhou.  Instead of rushing in to buy properties, many prospective buyers are now waiting.

Despite mild easing of monetary conditions, a devaluation of the Chinese currency and incremental relaxation of the restrictive property purchase rules, property investment will become less fashionable, particularly with a large stock of near complete residential blocks.

We have often commented on the unsustainable nature of China’s investment-led growth and the structural economic slowdown that can be expected out of China as the country shifts away from this growth model.  We, however, urge readers to avoid premature judgement.  This is now a vast, complex economy with many choices lying open to policy makers.

China is taking various steps to encourage the market to participate more in resource allocation, reducing the influence of State-owned Enterprises (SOEs) while favouring private enterprise.  As the economy changes from export and investment, to consumption, the energetic market-oriented operators, responsible for the bulk of jobs created, are taking full advantage.

Importantly, at the same time, tightness in the labour market and rising productivity has pushed wages higher.  Financing for consumer goods, a fuel to consumption, is merely a fraction of that of developed economies!

The locals are seeing their wages rising, job opportunities are abundant and consumer credit (car loans predominantly) are growing in significance.  These newly minted aspirational consumers like to travel the world, connect to the Internet, and buy the latest brands.  It is not a surprise that Chinese car sales are growing nicely at a 15% clip!.

“Reading ten thousand books is not as useful as travelling ten thousand miles” is a renowned Chinese proverb.  With increasing wealth, China has well and truly picked up the travel bug.  Last year, 98 million outbound trips and 3.2 billion domestic trips were made by Chinese nationals.  Modern lodging facilities, ranging from the budget to the luxurious, are springing up across the country to satisfy the voracious demand.  Our Chinese hotel (China Lodging) and on-line travel websites (Ctrip and Qunar) are seeing an amazing upsurge in bookings.

The rise of China’s Internet population is staggering especially considering as recently as 15 years ago, most did not even have access to fixed line telephony.  Today close to half of the population, more than 500 million, have access to the Internet and this is growing even faster now thanks to the mobile internet!

Shopping over the Internet (e-commerce), which offers superior price and range is leaving the under-developed off-line retail and logistic sector in its dust.  E-commerce sales value in China is around US$295 billion a year, growing at a 40% rate, equivalent to 7.9% of total retail sales.  This figure is low compared with the more mature markets (South Korea at 16% and still growing), suggesting vast potential in China.  Our exposure to the key Internet properties (search, social networks and on-line video) will undoubtedly benefit.

E-commerce in China is competitive and many e-commerce players in China are building their own logistic platforms to be best-in-class in delivery.  JD.com, the ‘Amazon’ of China, has more than 86 warehousing centres across the country, close to 1620 distribution stations and more than 214 pickup stops in 495 cities.  Its competitor, Alibaba Group, is teaming up with the major express delivery companies and aims to build a super logistics network over the next 8-10 years that will eventually ensure delivery within 24 hours across the country, supporting trillions of US dollar on-line sales a year.

Logistics is important, not only in the on-line world.  Consumer goods need to be transported across this vast country.  The Chinese logistics sector is backward and inefficient.  Logistic related costs in China represents 18% of GDP compared to below 10% for more developed peers!  It is little surprise that this industry is catching up fast.

The modern logistics industry is opening up the country for consumer goods and along with it palletised transport.  Over the last six years, pallet usage, still at its infancy, has grown a remarkable sixfold.  Forklift sales have also taken off over the same period.  Weichai Power, with its dominant truck engine business and owner of 25% of Linde (forklift), is exposed favourably to this trend.

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.