Volume 63, Number 1
Our strongest impression after our latest trip to the Middle Kingdom is that China and the US (indeed, the entire Western developed world) are moving in opposite directions. Communist centrally planned China is moving away from the state being in control of the economy, while in the West government interference and guidance is on the rise. In China, taxes and fees are being reduced and government controlled banks are being instructed to lend more aggressively to small and medium sized businesses. In the West, taxes and fees are being raised (especially at the local level) and banks are reticent to lend to all but the already well healed. In China, the middle class is growing rapidly, while in the West it is being hollowed out. China’s focus is increasingly domestic as growth in world export markets falters, while the West is looking for export led growth – often associated with a weaker currency – to provide an engine of growth. Indeed, China is aiming to eliminate its current account surplus both by building up stockpiles of imported commodities and by opening its capital markets so that locals can invest internationally. The era of China as a source of cheap labor and exports is ending, and the era of China as a leading investor and financer of world growth is just beginning.
We had mentioned in an earlier newsletter that China was floating hints that it might allow some investors to send money out of China – a development which we think is game changing for the world financial markets. Typically, the process for developing this idea would entail rumors in Hong Kong, then some discussion in the Mainland, a pilot project, and finally adoption. This process took about three years for the idea of a property tax replacing land sales as a major source of provincial government revenues. The process is still underway for provincial debt issuance. However, while we were in China, Premier Wen Jiabao announced a pilot project to allow for private individuals in Wenzhou – the traditional center of aggressive property investment in China –to undertake direct foreign investment. The rapid development of this still controversial idea along with Premier Wen’s call for the big four banks monopoly on lending to be broken up indicates that the new leadership is committed to speedier integration of China into global financial markets. The timing of these moves and the very public handling of Bo Xilai’s banishment make it clear that the Party is moving forward toward capitalism with Chinese characters, not looking backward.
This trip took us to Xian and Baoji in Shaanxi province, both ancient capitals located at the foot of the mountains and headwaters of both the Yellow and Yangtze rivers. The historical importance of this region is based on the stable food supply due to availability of water. For centuries, he who controlled the water controlled China. For 4,500 years of China’s 5,000 years of history, the capital was always well inland in the center of the Middle Empire. Indeed, the Great Wall is centered on Xian, the capital it was meant to protect! It is only after the Mongols conquered the nation in the 14th century that the capital moved east to Nanjing and Beijing. Note that most of what Westerners think of as Chinese history (Kublai Khan, the Great Wall, and the Forbidden City) all happened after Marco Polo (or more correctly his uncles) “discovered” China. Since the unification of China under the Qin dynasty in 220 BC (Qin pronounced Chin, hence China) the country has always been predominantly a Han ethnic super majority of 80% or more, but a Han Emperor last ruled China in 1644. Until the founding of the Republic in1912, the country was ruled by Manchu Emperors and until after World War II by the Japanese. There is great pride in the rebirth of China over the past twenty years, and significant confidence in the leadership to maintain growth. Despite the clear slowing in the economy, none of the people we spoke with was concerned – they were simply trying to get their share of the still robust 7%-8% growth. We did get a lot of questions about the sustainability of US growth and the possible depth of the European recession. There is concern as China is still a major exporter, even if it is now a major importer as well.
Xian reminded us that China, like any continental nation, exhibits wide variety. Xian is primarily known as the aerospace capital of China. It has nearly 100 universities and boasts one million students in a population of 8.5 million. High tech companies with strong defense ties dominate the economy. Indeed, we learned that many of the “locals” were transplanted from the industrial Northeast when the defense industries were first started under Mao. Many international firms are located here to take advantage not of cheap unskilled labor, but cheap skilled labor as there is a large population of engineers. High tech products are exported, but increasingly the aircraft parts (Boeing and Airbus are both here) and computer chips are being sold into the Chinese domestic market – now both the largest aircraft market and mobile phone market in the world. Many of the companies we visited were highly mechanized. When we asked one German entrepreneur why he would develop a high tech, capital intensive product in China, he pointed to the pro-business attitude with land subsidies, tax breaks, low regulatory hurdles etc. all of which made starting new technologies far easier than in the West. Samsung had just announced a $7.5 billion assembly and testing facility in Xian. Apparently the project had been planned for Chongqing, but with Bo Xilai’s downfall clouding that city’s political hierarchy it was quickly moved to Xian. Since the land assemblage for such a project was impossible on such short notice, village elders were paid handsomely to encourage relocations so that the project could start on time. All things are possible in a centrally planned economy – and foreign businesses love it.
Baoji, about two hours west of Xian, reminded us of both the intensity and the long time horizons involved in centrally planned projects. Baoji had several new development zones, all of which appear to be results of the massive stimulus in early 2009. These projects are only halfway along or less in their construction phase and still years away from full development. We saw layouts for the city which will entail another decade of heavy construction investment. Indeed, everywhere we went in Shaanxi looked like Shanghai in 2005, when the joke was the crane was the national bird of China.
Despite all of the construction –and especially residential construction – housing remains one of the biggest problems in China. Unlike Beijing and Shanghai, one cannot attribute the empty apartment buildings to wealthy entrepreneurs holding them as appreciating assets. Rather the problem is one of simple mathematics. Home prices in China have remained virtually unchanged over the past year. This comes after a fifteen percent increase in the two previous years. Interestingly, the prior three years were quite similar, with no growth on home prices in 2008 – even before Lehman – after a 15% spurt in the prior two years. Bottom line, housing prices have risen at a modest 5% annual rate over the past six years, or 37%, while urban income growth has been double digit resulting in a cumulative 85% gain. Thus, housing is 25% cheaper relative to income today compared to 2006. But that doesn’t help much when you have to put 50% down. The down payment you need today is 37% bigger than in 2006 – and housing cost are at least five times income, often much higher. Even saving 50% of your income for six years might not get you to the Promised Land as it has been hard to invest the savings at a return as high as home price appreciation. This is part of the reason why high yield wealth management products (often promising 2% a month) – some of which are just Ponzi schemes where your “return” is coming out of your original investment – are so popular. A woman from Zhejiang is currently on trial for her life because she accrued over $50 million in such deposits to support her now defunct (although apparently legitimate) business. Interestingly, there is widespread sympathy for her situation as many in China are in such get rich quick schemes. This potential source of instability is another reason the government is maintaining downward pressure on home prices and trying to clean up banks off balance sheet lending.
In the wacky world of Chinese economic data, first quarter real GDP was announced as 8.1% higher than a year ago. This resulted in just 7.4% growth in the first quarter compared to the fourth quarter at an annual rate. Both these numbers seem believable when one notes that electricity use and rail traffic (two of the three Li Keqiang indicators) are growing at rates similar to 2002 when GDP last grew at 8%. However, nominal GDP was announced up 12.1% from a year ago, resulting in just 4% total (not only consumer) inflation — which suggests a massive deflation in the first quarter. We suspect the nominal was “managed” downward to show progress on inflation. Fixed investment is still growing over 20% faster than a year ago and retail sales grew over 15% from a year ago. A sharp contraction in government investment did occur in the first quarter as credit growth was curtailed, but credit growth is returning to normal, so this should not repeat in the remaining three quarters of the year. Two very positive trends for the economy are a 9.8% real growth in urban incomes and 12.7% for rural incomes due to stronger crop prices. With 3.5% CPI inflation, both are growing faster than nominal GDP (but not as fast as retail sales) showing the growing power of the consumer. Meanwhile, government tax revenues (most from corporations) are still rising faster than GDP, up 14.7% over the past year, allowing room for more tax cuts. The tax cuts are being directed at small and medium businesses and low income households, so there is a clear redistributive effect as China fosters its growing middle class.
As students of history, we note three periods of exceptional development for the middle class in England and America. The first was the 1500s in England, when wool merchants and skilled tradesman began to mingle and intermarry with the nobles and knights of the old aristocracy (who were made even richer by Henry VIII’s expropriation of church lands). The second is the late 1800s and early 1900s in England when landed aristocracy saw their wealth surpassed by the nouveau riche of the industrial entrepreneurs – who in turn rewarded their workers much better than tenant farmers had been treated. Finally, post WWII in the US saw the rise of Ozzie and Harriett and Leave it to Beaver as global labor scarcity enhanced unions and skilled professionals opportunities to boost their incomes. Marc Faber in his latest letter notes that in Asia just such an intermingling of the upper middle class with the wealthy is underway – in large part because labor is becoming scarcer. Meanwhile, in the developed world, class lines are increasingly clear with increasing polarity in political groups a result. Today, France will narrow down their election to Hollande, a socialist calling for the return of the 60 retirement age and new taxes on the rich, and Sarkozy, the sitting President who lowered taxes and raised the minimum retirement age. We are not sure how things will turn out in the West, but in Asia (and Brazil and Turkey and elsewhere) a developing middle class is certain to attract increased investment from developed world companies looking to repeat their earlier successes.