The China Miracle Continues

By Byron Wien of BlackStone

This was my third trip to China this year and I was impressed to see the country succeeded in bringing its growth rate below 10% for the third quarter, coming in at 9.6% down from 10.3% in the second. This was important because the policy makers there fear growth in excess of 10% could result in serious inflation pressures. The level of inflation in the quarter was 3.5%, which is believed to be a reasonable and containable rate. The government has slowed the rate of monetary expansion from the stimulative levels of last year. At that time the authorities were worried that the economic recessions in Europe and the United States would have a profound impact on Chinese exports and growth would decline to levels limiting the increase in employment.
Last year’s stimulative policies were effective and growth continued to be strong, primarily as a result of internal domestic demand. The much-feared real estate bubble, which looms as a threat to China’s stability in the minds of many Western observers, is considered to be a manageable problem by most analysts within China. They acknowledge that there are a number of high-end condominiums that are unsold, but the majority of China’s housing stock is more modestly priced and the demand for it by the increasingly urbanized population is robust. Since many Chinese investors are not comfortable owning stocks and prefer something more tangible, real estate is a popular storehouse for wealth. As a result, ownership of multiple apartments is common. This results in a high cost of owning an apartment, but a more reasonable cost of renting. A friend of mine rents a 1600 square foot apartment with a $2 million market value for $2000 a month. One percent rates of return are common. A few months ago there was a story floating around that there were 64 million vacant apartments in China. Support for this statement comes from the fact that there was no electricity being consumed in the units. Local analysts, including Stephen Green, Standard Chartered Bank’s local expert on real estate, wonder where the assertions came from since few Chinese apartments have separate meters and most renters pay for electricity on an allocated basis.
At the end of October the government issued its twelfth five-year plan and there were few surprises. Previous plans have emphasized investment in infrastructure and the development of export-oriented industries. The latest plan has few quantitative objectives but clearly focuses on an expansion of the consumer’s role in continuing Chinese growth. This is viewed as a kind of “economic rebalancing.” Other phases of importance in the plan are “regional growth,” “industrial upgrading,” which I read as productivity enhancement, and “energy efficiency.” The plan also includes objectives such as “new strategic industries,” “income distribution,” “social housing,” and “land market and property tax reform” (there are no real estate taxes in China now) According to Tao Wang, the remarkably insightful economist at UBS, the structural changes in the new five-year plan will benefit technology and consumer products and services rather than traditional manufacturing. The emphasis on industrial upgrading should increase the demand for capital equipment from companies throughout the world. While the previous five-year plan (2006 – 2010) resulted in annual growth of 11.4%, even though the developed world was in recession for part of that period, government investment played a dominant role. However, the objective of reducing energy consumption per unit of gross domestic product growth made little progress.
Whether the new plan will reach its objectives is uncertain at this point, but it is clear that China continues to move forward at an impressive pace. It is now the second most important economy in the world at 9% of the world’s gross domestic product and if it maintains its present growth rate, its economy could be larger than that of the United States in twenty years. China’s per capita income is only about $4,000 versus $40,000 in America, but the country is more comparable on a purchasing power parity basis.
The problems are significant; air pollution is serious in the major cities, as anyone who has been there has experienced, and nobody knows what the long-term health implications of this will be. The filtering of information by the state limits intellectual freedom. Examples are China’s conflict with Google and its strong control of the distribution of Western films, only ten of which are allowed into the country each year. The Chinese authorities acknowledge that the human rights and intellectual freedom issues are controversial, but officials there are focused on growth and creating jobs for the hundreds of millions of citizens with current low living standards. They view dissent as a diversion which slows their forward progress. While social policies are important, there is no talk of taxes and fiscal deficits in China, a sharp contrast with the United States. The one-child policy obviously has long-term implications, as does the lack of a healthcare and retirement safety net. The prevalence of petty corruption is an embarrassment. Nevertheless the economy moves ahead relentlessly and the optimism of the people is palpable.
I attended the Shanghai Expo, which is a kind of World’s Fair. It began in May and ran until the end of October. Seventy million visitors have attended and more than a million have been on the grounds in a single day. Without a special pass you can wait up to eight hours to get into a pavilion where you will spend less than an hour. I saw the presentations of three different countries and they were revealing. The videos have to be mostly without language because the visitors speak so many different ones. In the United States pavilion video both Hillary Clinton and Barack Obama spoke in English (with Chinese subtitles) about the need for world cooperation. The key presentation, however, was a symbolic film where a young girl has a dream for a vacant neighborhood lot that is filled with discarded debris. She plants a flower, and though others in the community are indifferent another flower is planted, but before the project can gain momentum a storm occurs and the flowers are washed away. When the sun comes out, a diverse group of people in the community come together to create a kind of park at the site complete with an old bathtub which has been carved out and converted into a bench. The message seems to be that America is a place of many ethnic groups who can work in harmony to achieve an objective. A cynic might say that that the message is that America has created a mess of things (fiscal deficits, deteriorating educational standards and a dysfunctional government) and it is going to take a lot of hard work to get the country back on the right course.
The French presentation was very direct: We may not be growing as fast or have as powerful military but we know how to enjoy life. A visitor takes a long escalator ride up to the fourth level and then walks down a sloping ramp looking at films and other visuals along the way. The first one, not surprisingly, is on food, but instead of extolling the great French chefs of the past, they installed cameras in the kitchen of the high-end restaurant in the pavilion to show you the skill and creativity going on there. You then pass on to views of the incomparable buildings and parks of Paris, then scenes of the Riviera and finally there are some major paintings from the Louvre. The message is clear: If you want to be a happy person, surrounded by beauty, come to France. I didn’t go to the German pavilion but those who did told me the message was: We make products that are the best in the world. They may cost a little more, but they’re worth it.
Finally, in the China pavilion the focus was, as expected, on hope for a better tomorrow. Unlike the American message of harmony and teamwork, their message was one of creating opportunities for succeeding generations. To me the most creative part of the exhibit was a huge photo mural done in the style of a Chinese scroll painting, depicting village life hundreds of years ago. The difference is that the figures in the mural moved, conducting the tasks that make up their daily activities. The message seemed to be: we have come a long way from the past and we have a lot further to go, but we’re getting there.
While I was in China I had the opportunity to talk with some executives who were operating manufacturing facilities there, and to see a high-tech factory outside of Shanghai. China is beginning to experience some of the problems encountered as an economy matures. Young people are ambitious and impatient. They are anxious to build their resumes and are always on the lookout for better opportunities. The key to success is to have global product standards, but plants need to be run by locals who can build relationships with the workers. Part of the vitality of China’s industry comes from the entrepreneurial nature of the people. There is a greater focus now on developing products for the domestic market rather than for export. One problem is that Chinese managers do not put as high a premium on safety as their American counterparts.
There is a lot of competition for skilled Chinese workers and these people are in a position to make demands. Wage pressure is likely to increase in the future and the currency is likely to be revalued upward. Both of these changes will make China less competitive, but they have such a significant advantage currently that the impact is not likely to be seen for a while. There are also some cultural problems. While workers are hard-working, I heard complaints about the short-term orientation of Chinese managers and their willingness to take shortcuts which are not usually in the best interest of the company.
There are some secular problems brewing. While enormous progress has been made developing China’s infrastructure, there is still much more to do with a population of 1.3 billion. The country still has only 20% of the railway tracks of the United States although it has trains that travel at 250 miles per hour. Agriculture is the principal occupation of 35% of the population, so urbanization has a long way to go. A significant proportion of their population now goes to college, up from 3% twenty years ago, and there is concern that the college graduates are having trouble finding work, but the number of people in the 15 to 24 age group is declining and that is where the entry level workers come from. Perhaps this is a problem that will solve itself in time.
An American business school professor who has a cautious view of China pointed out that the country has benefited from some unsustainable conditions. The savings rate is 40% and unlikely to stay there in a more consumer-oriented economy. Foreign direct investment has been huge, a trillion dollars a year in a $5 trillion economy. Productivity has been improving at a 20% rate, and that has to come down. The trade surplus plus foreign direct investment has led to an enormous build-up in reserves and in the longer term that is likely to lead to political pressures with other countries, as we are seeing in the currency battles China is having with the U.S. Imagine what would happen if China were to start to bid for American companies again as they attempted to do in 2005.
The professor also said income inequality is likely to be an issue going forward. Environmental problems may be developing faster than the government can fix them. As the standard of living rises and the population ages the inadequacy of the healthcare system could become severe. The country has more business schools than the rest of the world combined, but the quality of most of them is not high. Most graduates are very transaction-oriented and not focused on the longer-term issues related to building a great company. As the middle class expands, the lack of democracy will become a bigger issue. Finally, the Chinese government seems less willing to engage in major structural reforms than it was 15 years ago.
Putting it all together my near-term optimism about China remains undaunted. I recognize the enormity of the longer-term issues and I will be watching closely to see how they are addressed. China accounts for a third of the world’s growth today and I expect that to continue for at least the next five years. The stock market will remain volatile but it is imperative that every investor has an understanding of the considerable opportunities that are continuing to develop there.