April 2004

China


In our work on Japan we learn more about China, a country whose influence is increasing by the day. For instance, last year the only significant positive contribution to GDP growth in Japan was exports and 80% of the increase was entirely due to China. Although China may be further away from our own shores its effect either directly or indirectly for the UK can only increase. As a result we thought it would be helpful to catalogue some of the important facets of what is happening in China and its influence on the world.

One way of characterising China today is to compare its development with that of Britain in the industrial revolution. 30 years ago China was an agrarian population whose fortunes ebbed and flowed with the latest harvest. Localised famines were regular occurrences. China's development since then is on the scale of the industrial revolution in Britain in the 18th century. The main characteristic of each period was a massive redistribution of population from the land to the cities in search for work. China's working population today is 750m people. The urban population has increased 3 times in the last 30 years, yet today 10m people are arriving in the cities every year in search for work. The migration is not yet half complete and will probably take another 30 years.

An important source of tension in China is its political system, which we believe is bound to change in time. Today's political structure is inherited from the totalitarian model of Mao's China and is founded on strong loyalty to the Communist party. Its flaw in a modernising economy is the unhealthy link between political power and wealth accumulation. Political power confers the authority to regulate, which, through corruption, ultimately dictates who gets rich. Unlike market based economies, most wealth accumulation in China results from political privilege breeding resentment and sowing the seeds of political unrest. The sale of land is the most important source of funds for urban development because the government owns most of it. However, land sales are opaque. Prices differ materially for similar parcels of land. The potential for corruption in the land market is enormous. Local authorities have been building urban infrastructure by borrowing money from local branches of banks, in turn, themselves owned by the state and therefore subject to the whim of politicians, using the value of land as collateral. The authorities trust that land values will appreciate sufficiently to pay down the debts while the improved infrastructure tempts new industries and migrant workers to pay the taxes of the future. The central government turns a blind eye to this activity, as its main agenda is to create the 10m jobs a year needed to deter any political dissent in the underprivileged rural population. As is often the case the infrastructure projects are revealed to lack commercial viability. The banks have to shoulder the losses (ultimately a cost to the taxpayer) with the politicians avoiding any moral hazard. This is why, today, in the later stages of an economic boom, banks are still saddled with the bad debts of a previous generation of poor investments. Ultimately there will be a backlash, especially if too much money is concentrated in too few hands and also if the taxpayer is able to link his economic hardship to poor decisions on the part of corrupt politicians or government officials. Traditionally China's political dissent began in the rural population. Following China's recent development it is just as likely that trouble will begin in the cities as it did 100 years ago in Britain.

It is no coincidence that in the developed economies, inflation and inflation expectations have fallen on the realisation that 750m Chinese workers were joining the global workforce. Admittedly, the direct competition between us and the 750m is far removed today, but for a Japanese assembly worker the reality has been hitting home with vengeance. An equivalent Chinese worker doing the same job with the same degree of efficiency earns less than a tenth of his salary. This is why China has become the primary destination for foreign direct investment from Japan over the last 3 years, as it has for many other developed countries. Investment in the rest of Asia has dropped off sharply. Furthermore, despite this massive foreign investment there seems no constraint on the supply of new workers, so despite a 7-10% GDP growth rate the pressure on wages, outside the government sector is more likely to be down not up. Only when China's supply of fresh workers is exhausted should we be worried about inflation reappearing again. In China wages have never been linked to inflation and as China dominates the global supply of labour this is proving and will prove to been the norm in other countries that trade with China as well. Henceforth, the primary effect of whatever inflation there is in the world will be to redistribute income from away from households down the value chain. In practice householders will strive to redistribute their income to alternative products before surrendering to a price rise. In doing so there is an ongoing self correcting mechanism that is working today to prevent inflation ever appearing to the extent that some observers expect.

Low growth in wages has provided a lucky break for the world's central bankers for the last 20 years. With the inflation in wages under control, largely thanks to the Chinese, the bankers have been successfully in tackling most other causes of inflation to engineer a steady but benign disinflation for the world economy. However just as the last problem is solved deflationary risks have arisen, as Japans central bank will testify. The continued wide gap between Chinese and developed counties wages threatens to export deflation to the developed world. The Japanese and the other western governments have prevented any such deflationary threat so far by reducing interest rates to boost their money supplies and encourage loan growth. In the 1970's printing too much money contributed to a wage price spiral and widespread inflation, but bought little change to their debt to GDP ratios. Today printing too much money contributes to rising asset prices but little change in GDP resulting in a soaring debt to GDP ratio. Rising asset prices have encouraged consumers or businesses to advance their consumption or investment, buying tomorrow's goods today with cheap money secured on expensive assets or shaky incomes. At some point the loans have to be returned. This is what is happening in Japan today. Bank loans have fallen 26% since 1998. Were it not for a massive expansion of government debt, now 160% of GDP, partly held by the banks, money supply would have contracted reflecting the fall in loans, raising the spectre of a debilitating debt deflation.

Over the last 25 years Chinese GDP has increased 8.5 times and exports 45 times. Now China is the USA's largest trading partner. Last year the USA ran a $125bn trade deficit with China alone. For China this outsized trade surplus with the USA is balanced by deficits with Japan, Taiwan, the EU and commodity producing nations, so that China's own balance of trade today is in small deficit. The $125m deficit with the rest of the world reflects Chinas thirst for investment and producer's goods to satisfy its fixed investment boom. Some three quarters of China's nominal GDP growth last year was due to growth in fixed investment. This is investment in new steel mills, assembly plants, and aluminium smelting facilities but also infrastructure projects and property. This pace of growth meant that last year China consumed 7% of the world's total consumption of crude oil, 31% of global coal, 30% of iron ore, 27% of steel products, 25% of aluminium and 40% of cement. This pace of demand in such a short space of time had a predicable effect on prices in China. The price of an array of steel products was up between 20% and 37%, ferrous metals by 19% and non-ferrous by 16%. Electricity rationing has become widespread. At the same time as contributing to higher input prices this pace of investment generated excess capacity. Due to overcapacity, car prices in China are now falling by 10-15% per annum. The input price inflation and output price deflation, in transferring value added upstream, should result in a serious squeeze in corporate profitability. The government has been railing against this unsustainable rate of fixed investment for 6 months, has tightened banks reserve requirements twice and has used its influence in approving projects to dampen the pace of investment. Even though the government would like investment to decelerate gradually, these periods of excess never end smoothly especially when the pace of growth needs to be brought down from above 50% (in the 1st quarter of 2004) to a sustainable rate of 12% or so. There are likely to be big falls for the price of commodities and products that have done so well from China's investment boom and the threat of bankruptcies and accumulating bad debt for those who financed it.

One reason why fixed investment is so strong in China is because foreign exchange reserves have more than doubled between 2001 and 2003 allowing domestic credit to expand by 55% during these 2 years, as China sterilises little of the capital inflow. Another more sustainable reason is due to the household savings rate, which probably amounts to as high as 20% of GDP (including stock purchases and deposits into pension and housing funds). This is partly due to demographics. Those born in the 1950's need to save for their retirement now and will continue to do so for the next 10 to 15 years. But it is also due to an understandable insecurity when competition in the labour market is so fierce and the price of education and healthcare is rising (both are provided by the state but, unlike in this country, paid for at the point of consumption and are subject to no competition). Expecting a consumption boom in China is misplaced for the immediate future even though modest and prudent consumption by an expanding middle class will likely drive provide growth opportunities for some global conglomerates.

The USA demands that China appreciate its currency versus the US$ to narrow product price differentials and reduce its trade deficit. It is not clear what difference this would make without a massive change in the rate of exchange given the difference in wage levels. What difference would a revision in the exchange rate make anyway while the surplus of labour is so large? China is experiencing a massive capital inflow in anticipation of a currency revaluation, but if the investment boom ended, triggering losses for some, history tells us that this capital would be fickle and would reverse quickly. Oddly enough China would be in the opposite situation then with market participants arguing for depreciation in the currency to help inflate away future bad debts.

Are there any conclusions we can draw from all of this? Certainly it reinforces our view on inflation and our positive view on bonds. Our long held view has been that there will be no inflation in the foreseeable future and that we should regard the inflationary era from 1970-2000 as an anomalous time in world financial history. As a result we think it possible that long bond yields in major developed countries will remain stable, with scope for declines, perhaps towards 3%, the average real interest rate over long periods of time inflationary and otherwise, and a commonly experienced yield in the years before 1970.

We concur with what Morgan Stanley implied in its recent China advertisement in the Financial Times that as an investor, the way to make money from China is to invest in what it cannot produce. Although certain commodities may be an obvious example, the prices of these commodities have to be affordable and commensurate with China's purchasing power as measured by its wages. As labour is in structural oversupply such a rapid rise in commodity prices as we have seen is not sustainable. We prefer to wait for Chinese consumers to become attracted by branded goods and anticipate that many will be offered by non-Chinese companies although it may be some time before the Chinese have the ability to afford the products in the volumes necessary to materially affect these businesses. Obvious candidates include LVMH, Diageo, Unilever and Nestle and maybe Heineken.

Michael Lindsell
Apr 2004