China bears are misunderstood13 September, 2012, 14:12. Posted by Zarathustra
Michael Pettis published his latest excellent newsletter, in which there is a point that we want to touch on.
We are bearish about China for the next few years (let’s say 2-3 years, roughly). However, is that it? Is that a collapse that will destroy the country or anything? Is this going to forever destroy China’s chance of becoming the next superpower, so to speak? Well, we are actually agnostic about that.
We ourselves cannot have put it better, so here we quote a paragraph from Michael Pettis (who would rather be described as a sceptic, not a bear):
Unfortunately any skepticism is regularly interpreted as a prediction of disaster. As part of the feverish China hype it seemed that anyone unwilling to agree with some of the more hyperventilated nonsense about China was accused of predicting a collapse, and a collapse within months at that. But to say that a development model has reached the point at which it no longer generates healthy growth, along with which debt is building up at an unsustainable pace, and which will require a very difficult adjustment, is not the same as to say that the country will collapse, and especially not the same as saying that it will collapse with in six months or a year. It just means that an adjustment is needed, debt levels must one way or another be addressed, and the longer it takes to begin the adjustment, the more painful it will ultimately be.
For bears like ourselves, the problem with China bulls, as Michael Pettis has very accurately pointed out, is that bulls really think the China bears are predicting an imminent catastrophe every other month (so to speak). Of course, there are people like that, but most are not. Surely we have mentioned a lot of rather scary stories about debts and many other messy stuff. However, we are not suggesting that China will be drowned by all these difficulties and will sink to irrelevance forever. Actually, far from that.
As we said in the final piece in the series about China’s hard landing, a hard landing is not going to be a catastrophe that will forever make China irrelevant, and we still think that there will be chance that China will still become the biggest economy in the world within a century. A hard landing is only going to delay the timing of it, and the country will still be there, only growing much more slowly in the years to come.
Among the challenges China is facing, we have clarified our point about over-investment in China, that it is not about the absolute level of capital stock, and it is not even about the level of capital stock per capita, but it is really about the level of capital stock relative to the income level or economic output. China is just a fraction as rich as the United States or the United Kingdom, so China should have lower capital stock per capita.
By saying that China is currently over-investing, we are not saying that China has to stop investing in infrastructure, real estate, and manufacturing capacity forever.
|By Thomas Richter/user:THOMAS (Own work) [GFDL or CC-BY-SA-3.0], via Wikimedia Commons|
If China grows to be the richest country in the world, we will surely see a much higher capital stock. The point that we are making is that over-investment is now hurting returns on investments, and the debts associated with all these investments are becoming unsustainable. The pace of fixed asset investments will have to be slowed down. That is a necessity, and in a totally free market (which does not exist, of course), investments would have slowed down drastically long ago when it became clear that many of them would have been unprofitable. But after a period of adjustment when bad debts are tackled, and consumption picks up, productivity increases, etc, there will be demand for more fixed asset investments.
And exactly why does China need to growth at 7-8% forever? Is 3% growth really going to be that bad for Chinese people and investors? We have doubt. We understand the argument that unemployment will go up, and wealth will be destroyed in the short-run, but for one thing, Michael Pettis has pointed out numerous times that rebalancing away from investment will means higher growth rate of household income vis-à-vis investment growth and overall growth, and hence higher growth rate in consumption. Is slower growth going to be hugely destabilising for the society when average Chinese households can actually consume more? Probably not.
But setting the social instability and political risk aside (which will probably be catastrophic, and we surely cannot rule out such risks, but let us say that the probability of those materialising is very low), as an investors, are we going to feel very miserable about a 3%-growing China? Not necessarily. As we said in our series about Chinese hard landing:
How is it that an economy grows at 7.6% yoy is squeezing corporate profitability so hard? How is it that an economy growing at 7.6% yoy feel like there is not enough demand for all the goods and services being produced? Even if we are all cynics and think that China’s GDP growth has been overstated by 2 percentage point, 5.6% yoy remains pretty decent (not for China of course), and yet corporate profits are collapsing.
And how is it that the US economy grows at 1.7% in Q2 (annualised) yet US corporate profits are at record high levels?
People active in the Hong Kong/China stock markets should have learned in a hard way that stock returns probably really have very little to do with GDP growth. One of the big reasons that Chinese companies have been doing so badly is that, in our view, they have been investing too much in productive capacity which in turn produces too much, and now find that there is simply not enough demand for their products, even though the economic growth remains at above 7%.
If you have an unbalanced growth which suppresses consumption demand and reduces returns on investments, is that desirable at all to have 7% growth as far as investors are concerned? Our answer is NO. If, after rebalancing and that everything goes on well, that consumption growth exceeds investment and overall growth, so that gradually returns on investments improve over time, are we going to be worried about China growing at 3-5% or even less? Our answer is NO.
So, yes, we are bearish over the prospect in the next few years, and it is likely that we remain so in the near future. However, with the adjustments imminent as the economy slows, we are actually getting closer to the point where we might consider turning optimistic. When that point will happen? For now, we have no idea.