Storm in a (China) Teacup


One the most debated points in markets today is whether or not China is heading for a hard landing. Our strategic partners at MitonOptimal were fortunate to recently have met Arthur Kroeber, managing director of GK Dragonomics (an Asian research house, based in China). He gave them his expert opinion on what is really going on in China today. His insights were very interesting, the most important of which was the biases that investors have when it comes to analyzing China.

Many investors, base their China hard landing view on comparisons with the US and Japan. In the US case they cite the housing market, arguing that China is going to have a similar housing collapse and that this will lead to a massive slowdown in growth. Arthur countered this by contending that China is, in fact, very different in this regard. They still have a huge shortage of housing, especially at the lower end.

While it is true that there is a bubble at the top end of the market as well as in certain regions, this is not true for the country as a whole. China needs to build ten million new homes a year, just to meet demand and that, until very recently, it was only building seven million a year. As a result, the deficit between supply and demand remains wide. This is a very different dynamic to that of the US which still suffers from an oversupply of houses.

Demand in China has been fueled by the migration of rural workers to the urban areas, with Arthur pointing out that there are currently sixty five million people living in temporary shelter, under bridges and in construction sites. This is greater than the entire population of the United Kingdom! The financing of the housing market is also very different in China, where 60% of housing is bought with cash.

The other comparison that Arthur argues, people often (incorrectly) make is to compare China to Japan. The argument goes that productivity growth cannot continue forever – at some point it will all end in tears. Arthur argues that China is in fact at a very different point in its lifecycle. One should not be comparing China to the Japan of the 1990s, but rather to the Japan of the 1960s. This effectively means China has still many years of productive growth ahead of it. The movement of rural workers to urban areas will ensure this. Currently only 50% of China is urbanized. The western world has urbanization rates of 80% and GK Dragonomics are projecting that even by 2030 China will only be at 70%.

Gordon Orr, a director in McKinsey’s Shanghai office agrees with this. He believes real estate will stagnate. In an effort to further cool prices, the authorities will maintain purchase and credit restrictions that contributed to the deterioration of property markets in the second half of 2011. According to the China Index Academy, local-government revenues fell as a result of declining land sales – by 13 percent in Shanghai, 14 percent in Beijing, and 29 percent in Nanjing from January to November 2011, compared with the same period in 2010. Fear of local-government defaults and a general property rout may induce the central authorities to ease restrictions. Nonetheless, Beijing will continue to prioritize the construction of affordable housing for the poor in an attempt to prevent a hard landing in the construction sector.

Kroeber does concede, however, that China will indeed slowdown from the heady heights of 10/11% real growth rates to date. Consumer prices jumped 4.5 percent last month in China, the world’s second-largest bullion consumer, the government said recently.

“China’s inflation remains elevated and this will keep demand for gold strong,” Cheng Xiaoyong, an analyst at Baocheng Futures Co., said from Zhejiang in China. Some investors buy gold as a hedge against inflation. Holdings in exchange-traded products backed by gold were at 2,385.85 metric tons yesterday, within 0.3 percent of a Dec. 13 record, according to Bloomberg data.

However, broader inflation in consumer prices appears to have peaked, but those of food rose at twice the rate of the consumer price index in the closing months of 2011. Inflation is highest for meats – the price of pork and beef rose by 27 and 14 percent, respectively, over the 12 months ending in November 2011, compared with the same period in 2010. The trend reflects changing consumption patterns among urban consumers and the growing middle class, who eat more meat, thereby increasing demand for cereals to feed animals. The availability of food imports is limited, and the rate of productivity improvement in domestic agriculture remains low. Moreover, price volatility is high, since even minor disruptions can affect supply dramatically.

Given all of this, China will cut back on its investment spending as it is starting to rebalance the economy towards domestic demand. Kroeber is expecting growth rates of 7.5%. This might come as a bit of shock to investors, but what needs to be appreciated is that even at these rates of growth, China will still be contributing massively to world growth given the very high base that China is growing from. To put this into perspective, China added USD5.9 trillion to global GDP in 2003-2011 and for the next 10 years GK Dragonomics are predicting that China adds USD26.5 trillion to global GDP, five times the previous growth numbers, despite real GDP growth rates falling by a third. The base effect really matters here!

So, in summary, we remain sanguine about a hard landing in China, with growth more likely to slow than come to a hard stop. Even with a slowdown expected, China will still contribute massively to world growth.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]