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- The Chinese government's deliberate decision to move China's economic focus from a low-cost manufacturer to a higher-value producer of goods and services has implications for the country as an investment destination and for the wider world.
- The focus for short-term concern has been China's property bubble but, with a war chest of $3.5 trillion in foreign-currency reserves, the country can absorb any problems with relative ease. Life is easier when you start with a pile of savings rather than a pile of debt like the UK and US.
- In the longer term we have concerns about the country's ability to manage social change, as the government brings down growth to a more sustainable level may inadvertently highlight wealth discrepancies and exacerbate civil unrest. While there are signs that the country is maturing, it should never be forgotten that it remains an undemocratic and authoritarian single-party state.
- Whilst there are plenty of investment opportunities, the majority of these are unattractive. Given the country's influence on the rest of the world, there are other ways to tap the nation's growth potential.

Investing in China, and ascertaining its prospects is not straightforward – it is a nation full of contradictions: a country with a vast amount of rural poverty but the world's second-largest economy; ostensibly a communist dictatorship, but at the same time a capitalist powerhouse. It is now in the middle of an unprecedented transition, changing from the world's main low-cost manufacturer to a model more akin to a developed nation, where growth comes neither from exporting nor building but rather through domestic consumption.

China's economic health matters to all of us, in particular because the country was instrumental in keeping the global economy afloat after developed economies inflicted the financial crisis on the world. Its importance is increasing; imports of goods and services in China climbed to 27% of GDP in 2011 from 14% in 1991.

In the short-term we are confident the country can easily overcome any economic hurdles related to its massive building programme of recent years. This resilience should help underpin the US-led recovery and create opportunities elsewhere in the world, but we are wary of allocating much to China directly. The deliberate decision to move up the value chain and let its currency appreciate means that it no longer makes sense to categorise it as similar to countries like India or Thailand – there are better places to benefit from an increased demand for low-cost manufacturing as the global economy recovers. At the same time, a combination of factors means any worthwhile investments tend to be oversubscribed, and therefore overvalued.

A Deliberate Change

China is changing for the simple reason that its present course is unsustainable. If you have expanded at about 10% every year for the past two decades, have overtaken Japan as the world's second-largest economy and seen living standards increase immeasurably over that period (World Bank Data shows that GDP per capita increased from $363 in 1992 to $6,188 in 2012) you cannot remain forever the world's go-to low-cost manufacturer with a never-ending supply of low-paid unskilled workers. In this situation you can either manage the transition to becoming a more developed economy or you can let circumstances play out. The Chinese government is quite obviously choosing the former.

For evidence one need only look at the country's regular five-year plans, which list its goals over the next half decade. The last one in 2011 showed it was committed to its urbanisation project, with plans for millions of subsidised housing units. It set targets for domestic consumption (the government said earlier this year it would increase the minimum wage to 40% of average urban salaries by 2015) and focused on actively moving up the value chain in manufacturing by allocating more money to research and development. In the short term its commitment to this transition can be seen in how it has allowed the renminbi to appreciate against the dollar this year, even as most emerging market currencies slid amid concern over economic imbalances in India and Indonesia.

With the Chinese government determined to rein in its unsustainable rate of expansion, the World Bank recently reduced China's 2013 growth forecast to 7.5% from its April estimate of 8.3%, a figure that has only slid below 9% once in the past 10 years. From a long-term global perspective this is beneficial, as a more viable rate of growth, and an economy less based on a building boom and more dependent on middle-class consumption is a more realistic long-term economic model. So what sometimes may appear to be a hard landing is in fact a managed transition from a high-octane emerging-market economic model to a more sustainable developed market structure.

A Bubble the Chinese Can Afford

On-going concerns that China still could suffer the aforementioned hard landing are focused on its burgeoning property market and any associated bad loans. The raw statistics give substance to fears that the country is in the midst of a property bubble – new home prices in China's four main cities showed their highest rise in August since January 2011, climbing an astonishing 19% in Guangzhou.

One factor driving property investing has been the lack of any worthwhile alternatives for locals, who face limits on what they can invest outside of the country resulting from capital controls. This has artificially pushed up the price of local stocks, the only equities readily available to them. At the same time bank deposits, in line with the rest of the world, are paying scant interest.

There is no end to the property supply to soak up this demand. The larger building projects remain highly ambitious (or ludicrously optimistic, depending on your point of view), containing resplendent skyscrapers, luxury apartments, majestic offices and glitzy shopping malls. A good example is the plan for Tianjin by Goldin Group (pictured below), owned by Hong Kong Property magnate Pan Sutong. It even boasts its very own twin towers and already houses a polo club (a sport bankrolled by the nation's wealthy elite).

Investing In China

A photo from a recent trip showing Tianjin's polo ground surrounded by half-built skyscrapers

Is this excess a problem? Only if the country could not afford it. Unlike Ireland for example, where a considerably smaller real-estate bubble was funded by loans from overseas, China holds $3.5 trillion of foreign reserves after running a massive trade surplus in recent years. There is no doubt that China chose to let this bubble inflate in order to keep money whirring around its economy while the financial-crisis-induced downturn depressed demand in the wider world. There's clear evidence now that the boom, having served its purpose of keeping the global economy afloat, is being gradually wound down by the government (as can be seen in declining commodity prices).

So we should not be overly concerned about this bubble, nor the effect a crash would have in unleashing a wave of bad loans on the country's banking sector. China has shown in the past a willingness to nationalise bad debt when necessary. Quite simply, the difference between China and the Western nations who faced a spate of property-bubble-induced bad loans that led eventually to the financial crisis is the difference between having billions of dollars of savings and owing billions of dollars, the former giving you the ability to throw money at whatever you choose.

Changes Across Society

The jury is still out on whether China will successfully manage the social transition from its status as an emerging market to a developed nation, and whether a society that becomes wealthier, more educated and has access to more information will be as acquiescent in accepting the diktats of an authoritarian regime (an informative lesson in the nature of a government that can do what it wants occurred when we were about to take a flight on a recent trip and the authorities decided to shut the country's airspace down, leaving many thousands of travellers waiting for hours with no explanation, and absolutely no apology).
We are concerned that the government's plan to slow its exceptional growth rate may unleash some unintended consequences. Most notable, we fear that the majority of the population, who have been positively distracted by increases in their own wealth, will now take greater notice of the vast inequalities that have built up in the past 20 years (a decade ago China had no dollar billionaires – it now has 315 of them, more than any other country apart from the US). This huge wealth coexists with extreme poverty, with about 27% of its more than 1 billion citizens living on less than $2 a day, according to the World Bank. China's Gini coefficient, which measures the disparity of incomes on a scale of 0 to 1 (with 1 being more unequal), stands at 0.47, compared with 0.34 for the UK.
To distract the masses from this gap, the Chinese leadership has been utilising the 'last refuge of a scoundrel' by stirring up nationalist sentiment. Unfortunately it has not done much to quell that nationalist sentiment turning into anti-Japanese agitation. This reached its natural conclusion in 2012 in the dispute with Japan over the Senkaku/Diaoyu islands, which led to attacks on businesses selling Japanese goods and the vandalism of Japanese-made cars. If left unchecked, this nationalism could inadvertently lead to a deeper conflict.
That said, there is an increasing maturity on the part of the Chinese people in dealing with the side effects of its rapid growth. The new regime of Xi Jinping is taking great pains to show that it will not tolerate corruption, even at the highest levels of the party (as can be seen in the conviction of Bo Xilai). New technology means that a groundswell of change can come from the bottom up, with an increased revulsion at corruption-funded excess. Yang Dacai, a corrupt official who gained the nickname 'Brother Wristwatch' because of his penchant for expansive timepieces, was prosecuted and jailed after photographs showed him wearing watches he could not possibly afford on his salary. (The incident in some ways sums up China's efforts to reconcile openness and totalitarianism – in a nod to the popular power of the Internet, the campaign against Yang took place on Sina Weibo, the Chinese equivalent of Twitter. The reason China has its own version of Twitter? Because the US site, along with anything else that might promote unfettered free speech, is blocked in China.)
Another consequence of the country's rapid development has been increased environmental damage and pollution. While its major cities such as Beijing are barely distinguishable from their Western counterparts, with a KFC or McDonalds at every corner, they will soon resemble their European and US counterparts in more unpleasant ways. City infrastructure is already creaking under the weight of the amount of traffic, with eight-lane motorways clogged up at rush-hour and an unpleasant haze of smog hanging in the air – living in this environment gives the unpleasant impression of being stuck in a Tupperware container.
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A smoggy haze envelops building sites on the outskirts of Beijing


Last winter's toxic smog in Beijing galvanised the authorities to ban the construction of new coal-fired power plants in areas around Beijing and Shanghai and instead develop the use of natural gas and nuclear power.
The government is also taking steps to loosen some of the more authoritarian and restrictive aspects of living in the country. Its planned reform of the hokou system, which required Chinese citizens to register if they moved from region to region so as to access social services and effectively became a barrier to movement around the country, should help encourage economic growth as well as making movement easier and more pleasant for its citizens (like allowing working fathers to move their families to the cities with them). Some senior advisors are also lobbying for an end to the one-child policy, while the recent meeting of top Communist Party officials pledged to liberalise land ownership laws.
But China's leaders are also keenly aware that there is a downside to giving your citizens more freedom, particularly freedom to those who would cause social unrest. Simmering inter-racial tension in the Xinjiang region between Muslim Uighurs and Han Chinese is a major concern to the authorities. The alleged terror attack by Uighurs on tourists in central Beijing in October will strengthen the argument of those in the Communist Party who maintain that the only way to keep a multi-ethnic country of 1.3 billion citizens from fracturing is through a strong-armed state.
The link between all these issues is the fine line that the Chinese government has to tread between developing its nation economically and satisfying demands for a more equitable and sustainable model; making its citizens richer while clamping down on nuisances such as corruption and pollution; and loosening the restrictions on its people while avoiding social unrest and maintaining the hegemony of the Communist Party. Worryingly, recent history would seem to show any authoritarian Communist regime that embarks on a process of political liberalisation won't likely survive the transformation.

The Investment Case

Leaving aside longer-term concerns about China's transition, it is worth considering how China stacks up as an investment destination at present. Given that China is moving away from being a low-cost manufacturer, then it does not make any sense to invest in the country on that basis any more (as we noted in our July Financial Market Overview, where we said we are moving money to countries such as Mexico).
Now that the country is slowly but surely becoming more like other developed nations, where the main part of economic growth derives from internal consumption, it is probable that the majority of new investment opportunities in the country would centre on tapping this trend (annual consumption increased from $2.2 trillion in 2008 to $3.6 trillion in 2011, an increase of 64% in just three years – it climbed just 7% in the US over the same period).
Noteworthy among potential investments at present has been the impending initial public offering of Alibaba, China's answer to Amazon, where analysts are speculating that it could raise as much as $15 billion. Those kinds of headline figures should arouse suspicions of bubble territory in any investor. Indeed we are wary of most investments in the country for three key reasons.
First, China's transition is happening right now and therefore any projections are being made in a rapidly changing environment. Conventional investment theory tells us that stock prices are the total of all future (estimated) earnings, and if those estimates turn out to be wrong then the price paid will be wrong. Correctly valuing a stock in a country where the annual growth rate hasn't dipped below 7.6% since 1990 is fraught with dangers of over extrapolating growth trends into the future. In an economy growing this fast, should any analyst forecasts be out by just a fraction of a percentage point, that's the difference between a significant investment profit or loss.
Second, Chinese governance does not always meet the standards we expect in the West. Many of its most successful and largest businesses are state-owned enterprises: foreign shareholders sit very low in the pecking order when it comes to reaping the rewards of business. Another impediment is the repeated issuance of new shares to raise capital (an easy task in recent years given the amount of foreign money chasing the Chinese miracle), which has seen many early shareholders almost diluted out of existence.
Third, for those companies that are independent, have not diluted their shareholders' interests and have a decent business, demand for them is so huge that it has pumped up share prices to astronomical levels. Restrictions on investing overseas mean that a considerable amount of Chinese money is chasing a relatively small number of quality shares. Throw in money from overseas investors, many of whom have an asset allocation that must be invested in the country, and you get a recipe for seriously overinflated prices.
In short, for the relatively small number of good quality businesses untainted by the issues we have highlighted, demand is already very high, and we are not prepared to pay what we consider overinflated prices.
This does not however mean that one cannot take advantage of China's growth in our investment portfolio. As we highlighted in the October Financial Market Overview, we continue to use European high-end manufacturers as a way to access Chinese growth. This principle can be extended elsewhere, and we have no doubt that as Chinese domestic consumption increases, so too will the exporting prospects of less mature emerging nations. Essentially, there are countries queuing up to take China's place as low-cost manufacturing hubs, while China itself will become more like the US in terms of its effect on the wider world; creating investment opportunities around the globe because of the sheer power of its internal consumption.



This content was generated prior to Turcan Connell Asset Management Limited operating as Tcam.

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