By HENRY H. MCVEY Feb 20, 2014

The Chinese economy is still undergoing a significant transition, including its diminishing role as the low cost “manufacturer to the world.” As such, the government has been aggressively repositioning the economy towards higher value-added manufacturing and service-based initiatives. Over time China’s robust reform initiatives may allow it to ultimately reposition itself for more sustainable growth and wealth creation for investors. However, China will not be an overnight turnaround story, as many of the macro headwinds we identify in this paper appear more structural in nature. Given this view, investors should expect a slower economic trajectory as nominal lending growth is brought back below nominal GDP.

I recently traveled back to mainland China to learn more about the significant “political work” that is occurring under the country’s new leadership team of President Xi Jinping and Premier Li Keqiang. I have made several additional trips to China of late to learn more because it feels like “political work” has again become the “lifeblood of all economic work.” Without question, substantial political and economic reforms are now occurring at a time when growth expectations for China are still high. In fact, despite some sluggish data out of China recently, consensus forecasts are still for the Chinese economy to account for nearly one third of total global growth in 2014 (Exhibit 16).

The good news for our macro effort is that KKR now has a formidable footprint in China—one that has helped me to better understand some of the key corporate drivers and important economic trends now occurring throughout the country. All told, KKR investments employ nearly 52,000 people through 30 companies and partnerships in China across a variety of industries.

So what did I learn during my travels? See below for more details, but my summary thoughts are as follows:

  • Similar to what we laid out in early 2013 (see our note China in Transition, April 2013), the Chinese economy is still undergoing a significant transition, including its diminishing role as the low cost “manufacturer to the world.” As we discuss below, China’s economic transition away from low-end manufacturing towards more value-added exports and services, has important implications for global growth, commodity usage and capital flows, in our view.
  • There was a clear message on which reforms really matter most from an economic perspective. Interestingly, there was almost no one in Beijing who mentioned the changes to the one-child policy as a centerpiece of the recent Third Plenum of China’s Communist Party, where the leaders recently introduced their economic and political blueprint. Rather, the primary focus among locals is on reforming state-owned enterprises (SOEs). This includes a lower-cost structure, more competition, and a broader set of shareholders, including foreigners in some instances. In the eyes of many local Chinese, the government may have already notably exceeded expectations in terms of its announced agenda in this area. The key will now be execution.
  • However, to achieve successful long-term SOE reform, our strong view is that the financial sector should first be in a position to handle the fallout from SOE reform. That is not the case today. The good news though, for long-term investors is that there are significant initiatives underway to create a more market-based financial services system, which is important for correctly pricing risk assets. The bad news is that the movement to a market-based interest rate platform could be quite bumpy. In particular, investors should probably brace for increased price discovery and funding mismatches throughout the financial services system, as the government seeks to again reduce nominal lending growth below nominal GDP. Key areas on which to focus include bank leverage, shadow lending, and local government funding vehicles (LGFVs).
  • In the near term, economic rebalancing towards consumption largely remains an aspiration. To be sure, our view is not that consumption is lagging. In fact, as we discuss below, consumption growth in China is booming (e.g., as Exhibit 27 shows, average real private consumption growth between 2000 and 2012 was 8.7%). Rather, real estate and other fixed asset investments are growing even faster, unfortunately crowding out some notable improvements made in consumer spending via higher wages and ongoing urbanization. Not surprisingly, leverage levels have soared (see Exhibits 45 and 46 for details), including a 55% increase in corporate leverage since 2007 (and this figure does not include popular off balance sheet arrangements). All told, our work now shows that the amount of credit growth required to generate one unit of GDP has increased to nearly 10x from just 3x in 2007, a more than threefold increase (Exhibit 5).
  • We are lowering our target range for 2014 GDP for China to 7.2%-7.5% in 2014 from 7.4%-7.7%; more importantly though, our research leads us to believe that slower structural GDP growth in China is inevitable in the coming years. As we discuss below, we worry near term about ongoing credit and deleveraging issues, which could affect investor sentiment, financial services lending, and ongoing fixed asset investment. Longer term, we see several structural headwinds, including slowing urbanization, weakening demographics, and the law of large numbers, all of which will continue to put downward pressure on the country’s potential long-term growth rate. Importantly, these headwinds are coming at a time when excess capacity and excessive debt levels are likely to lead to lower returns on investment.
  • Our trip gives us additional confidence that our existing macro framework for investing in China may be on target. On the one hand, our research suggests that investors should continue to avoid capital goods, commodity producers, and export stories related to China as the low cost “manufacturer to the world.” On the other hand, investors will likely find that services-based industries, including healthcare and wellness, likely still have sufficient running room, we believe. Importantly, though, even within services industries, we think the new government’s anti-corruption focus is likely to gain, not lose momentum, and as such, investors should consider these initiatives when allocating capital.

Overall, we left China with two bigger picture conclusions. First, while we acknowledge that — in isolation — each reform may not amount to an earth-shattering change, we do think China’s current reform initiatives may allow it to ultimately position itself for slower but more sustainable growth and wealth creation for investors. That said, many of the macro headwinds now facing the country appear somewhat structural in nature, so implicit in our view is that the China reform story will take years, not months or quarters, to reach fruition.

Exhibit 1

SOEs Now Make Up 72% of the China HSCEI Index

The Hang Seng China Enterprises Index (HSCEI) consists of Chinese companies whose shares are issued in China but are traded in Hong Kong. SOE = Sovereign owned entities. Data as at December 31, 2013. Source: Bloomberg.

Exhibit 2

Since the Crisis, Non-SOE’s Have Notably Outperformed SOEs

The Hang Seng China Enterprises Index (HSCEI) consists of Chinese companies whose shares are issued in China but are traded in Hong Kong; SOE = sovereign owned entities; performance of equal weighted basket of HSCEI constituents split into those that are sovereign owned and those that are not, using constituents as of May 31, 2012 which are available on Bloomberg. Data as at January 31, 2014. Source: Bloomberg.

Second, from a purely investment perspective, our primary view remains that capital allocators to emerging markets, China in particular, may still be rewarded for increasing their weightings towards private market investments versus public market investments in the near term. Private investment in China allows a more targeted approach towards long-tail themes like wellness, beauty, logistics, and healthcare. By comparison, the large Chinese public equity market has 72% of its weightings in poorly performing large cap, state-affiliated companies that need to be overhauled during the upcoming reform process (Exhibit 1). That said, if SOE reform does gain further momentum, then this area of the public markets could quickly become of interest, particularly given current valuations relative to its non-SOE brethren.

Exhibit 3

Real GDP Growth Has Not Led to Improving Shareholder Returns

LTM = last twelve months. Data as at 4Q2013. Source: China National Bureau of Statistics, Factset Aggregates, Haver Analytics.

Exhibit 4

Rapid Loan Growth Will Eventually be Accompanied by Rising, Not Falling, NPL Ratios

Data as at December 31, 2013. Source: China Banking Regulatory Commission, Haver Analytics.

Exhibit 5

RMB Credit Growth Per Unit of GDP Has Increased Meaningfully Since the Great Recession

Data as at December 31, 2013. Source: People’s Bank of China, China National Bureau of Statistics, Haver Analytics.

Exhibit 6

Credit Growth Is Now Running Almost 2x Ahead of Nominal GDP Growth

Data as at December 31, 2013. Credit = Total Social Financing. Source: People’s Bank of China, China National Bureau of Statistics, Haver Analytics.

No doubt the China transformation about which we have been writing for quite some time may not take place overnight and will likely remain bumpy – potentially more so than the consensus now thinks. In particular, we see three potential areas of deleveraging in the Chinese economy that could provide a downside surprise to growth expectations over time. First, the Chinese “authorities” should address the 67% increase in local government funding that has taken place since 2010 (Exhibit 32). Second, sizeable non-traditional lending, including the rapid growth in the trust sector, definitely needs to be reined in (Exhibit 28). Finally, Exhibits 45 and 46 show that total corporate leverage, including bank leverage, has ballooned 55% since 2007. If there is good news, it is that the country’s efficient infrastructure, its low total-government-debt-to-GDP ratio, and its strong reserve position should help to act as potential economic shock absorbers along the way.

Ultimately, we believe the Chinese government will need to return nominal lending growth back below nominal GDP without creating a major shock to growth or employment along the way, we believe. From almost any vantage point, this task will likely be difficult, but given that China currently accounts for nearly one-third of total global growth these days, we can’t think of a more important set of macro variables on which investors should focus in 2014 (Exhibit 16).


Update: China in Transition

“It may be hard for an egg to turn into a bird: it would be a jolly sight harder for it to learn to fly while remaining an egg. We are like eggs at present. And you cannot go on indefinitely being just an ordinary, decent egg. We must be hatched or go bad.” C.S. Lewis

While I am almost 100% sure that C.S. Lewis did not intend for his readers to have this reaction, the aforementioned quote immediately makes me think of China and its current economic transition dilemma. Simply stated, China must now appreciate that it “cannot go on indefinitely” as the world’s low-cost manufacturer of low value-added goods for two reasons. First, as the government has promoted higher wages in recent years as part of its desire to drive greater consumption, China has begun to price itself out of an increasing number of traditional low-end manufacturing and export mandates. Indeed, as Exhibit 7 shows, wage growth has exploded in China in recent years, and as Exhibit 9 shows, this surge in employee labor costs is coming at a time when we also see improved competitiveness from places like Indonesia, Vietnam, Cambodia, and Laos.

Exhibit 7

Wages in China Have Become Less Competitive in Recent Years

Minimum Wages Per Month in USD

Y/Y Change in Minimum Wage




































































































































China – Vietnam













China – Cambodia













Data as at December 31, 2012. Source: CIMB report dated May 1, 2013.

Exhibit 8

A Slowdown in Low Value-Added Exports Has Hurt Overall Export Volumes

Data as at December 31, 2013. Source: China Customs, Haver Analytics.

Exhibit 9

China’s Manufacturing Wages Are Now Soaring Above Other Emerging ASEAN Countries

Data as at December 31, 2012. Source: BofA Merrill Lynch Global Research estimates per report dated 17 January 2014, CEIC.

Second, by allowing its currency to appreciate significantly in recent years, China has made it even more difficult for its manufacturing sector to remain competitive on the global stage. As Exhibit 10 shows, its currency has appreciated at a time when China’s peers in the emerging markets, including several of its major trading competitors, have seen their currencies depreciate by 10-20% over the past 12-18 months. Without question, this currency differential is significant, as it is exacerbating many of the competitive headwinds on the export front that China already faces from higher labor costs. Not surprisingly, as Exhibit 11 shows, China’s attractiveness as a destination for business operations has dropped while other ASEAN countries and Mexico have actually gained momentum.

Exhibit 10

The CNY Has Appreciated Relative to Other EM Currencies…

Data as at January 29, 2014. Source: Bloomberg.

Exhibit 11

…At the Same Time, China’s Competitors Are Becoming More Formidable

Source: Results of FY2013 Survey Report on Overseas Business Operations by Japanese Manufacturing Companies dated November 2013.

But make no mistake: The Chinese government understands that – to steal a line from C.S. Lewis – it “must hatch or go bad.” As such, the government has been aggressively repositioning the economy towards higher value-added manufacturing and service-based initiatives, often at the expense of its traditional low-end export heritage. The good news is that recent initiatives appear to be headed in the right direction. In fact, as Exhibit 12 shows, higher value-added exports reached 49.2% of total exports in December 2013, up a full 820 basis points since February 2006. But even with these substantial gains, the contribution from higher value-added exports is now just large enough to offset the decline in lower-value-added exports. As such, overall export growth is still trending below what we believe the government would prefer (Exhibit 13).

Exhibit 12

The Trend Towards Higher Value-Added Exports at the Expense of Re-exports Is Underway…

Data as at December 31, 2013. Source: China Customs, Haver Analytics.

Exhibit 13

…In the Near-Term, This Baton Hand-Off Will Affect Overall Export Growth

Data as at December 31, 2013. Source: China Customs, Haver Analytics.

So where does China’s “economy in transition” story go from here? From our vantage point, we expect the following to occur. First, we expect the government to move even more aggressively to encourage additional growth in higher value-added businesses. This shift in focus means that services, including scientific research and technical services, are likely to become an even bigger part of the economy. Already, the service sector has increased to 46% from 22% in 1980 and 39% in 2000, and by 2015 we think this percentage could reach at least 48%1.

Growth in private healthcare and all its related services will also be an important part of this transition. Even before the Third Plenum directives, the government had implemented a stretch 2015 goal of making 20% of hospital beds linked to private providers, compared to just 12% in 20112. And within the Plenum outline, there appears to be concrete reforms that will further open up the healthcare market, including loosening restrictions on existing private scale players in the hospital arena as well as encouraging new private players in the healthcare support/services arena.

Exhibit 14

By Repositioning Its Economy, China Is Trying to Protect Its Share of Exports…

Data as at August 31, 2013. Source: IMF, Haver Analytics.

Exhibit 15

…By Altering Its Mix of Exports Towards Higher Value Added Sectors

Data as at December 31, 2012. Source: World Trade Organization.

Second, China will have to continue to reposition its export model. Consider the following: Since China became a member of the World Trade Organization in December 2001, its share of world exports has grown steadily to 11.9% from 4.4% in 2001 (Exhibit 14). Consistent with this outsized growth, China now controls 41%, 38% and 33%, respectively, of the total global market share in data processing, clothing and textiles (Exhibit 15). These concentrations are now quite formidable, underscoring our basic premise that China will need to find new alternative sources of growth in the export market.

Based on our research including multiple visits to mainland China, we believe that the country will likely devote an increasing share of resources to high value added sectors of the economy such as autos/parts, chemicals and pharmaceutical products. We are not alone in our thinking. Premier Li Keqiang recently emphasized that “China has entered a new stage in which the country must rely more on sci-tech innovation to guide and support its economic development and social progress.” Importantly, our strong view is that, as part of this transition effort, China will need to move from being a fast follower to a true innovation pioneer.

Third, China must continue to strengthen trading ties with its peers in Asia and the rest of the developing world. As Exhibit 16 shows, growth in global GDP is likely to come from emerging economies, not the U.S. or Europe. Though it can still do more, China has already made a lot of progress in this area: China’s exports to emerging economies have already increased thirty-fold since 1995 versus just an eleven-fold increase to the developed world over the same period3. As a result, Chinese exports to developing countries are now 32% of its total exports versus just 15% in 1995 (Exhibit 17). Maybe more important though, is that exports to emerging Asia are now 11.4% of total exports, which is now higher than exports to Japan (7.4% of total exports) and fast approaching the United States (17% of total)4.

Exhibit 16

China Is Still Expected to Account for Almost a Third of Global Growth in 2014

Data as at October 8, 2013. Source: IMF, Haver Analytics.

Exhibit 17

More of China’s Exports Are Now Headed Towards Emerging Economies

Data as at December 31, 2012. Source: IMF, Haver Analytics.

Reform Initiatives: What Really Matters

No doubt, one does not have to travel all the way to Beijing to appreciate that China’s government has embarked on an aggressive set of reforms. In terms of the Third Plenum agenda set in 4Q13, many of the press reports covering the event hailed it as the most important one since the 1978 Deng Xiaoping economic inflection point.

But through a series of meetings in Mandarin with all local Chinese over several days, one does get a better understanding of which reforms appear to really matter. So what did we hear? We heard several things. For starters, we left Beijing with the strong impression that corruption will remain openly under attack. As Xi Jinping recently commented, “Every CPC official should keep in mind that all dirty hands will be caught…officials should hold party disciplines in awe and stop taking chances.5” From what we could tell, his message certainly seems to be catching on. In Beijing, for example, high-end restaurants that used to cater to government officials were literally vacant when we arrived as grafting/gifting is now frowned upon. Several high-end hotels are also suffering a similar fate. This intense focus on anti-corruption now appears broad-based as it is denting wide swaths of the Chinese economy, including everything from dining to autos to alcohol.

Meanwhile, while there were many press and sell-side research reports around measures to loosen the one-child policy (which obviously has important longer-term fiscal and human rights implications and is a policy deeply championed by the 25-45 year old age group), we did not find too many locals immediately focused on this part of the agenda. Rather, we got the clear impression that reforming the state-owned enterprises was a top priority. In our humble opinion, this SOE initiative – if executed on properly – could actually be significantly long-term bullish for the poorly performing Chinese stock market.

To review, this market has been one of our least favorite markets for years, given its heavy weighting in state-run enterprises (72% of total) and its declining return profile (Exhibit 18). But with the current trailing P/E ratio of 10.6x versus 31.8x in October 2007 (Exhibit 51), any positive news on the direction and/or return profile of these underperforming companies that span across the financial services, energy, telecom and industrial sectors could be quite powerful over time, and as such, we need to closely watch the pace of follow-through by the government in this area.

Exhibit 18

The Chinese Government Is Committed to Improving SOE Returns

Data as at December 31, 2012. Source: Ministry of Finance of China, China National Bureau of Statistics, Haver Analytics.

Exhibit 19

China Corporates Have Levered Up to Soften the Blow on Return on Equity

Asset turnover = Sales/Assets. Data as at January 27, 2014. Source: Factset Aggregates.

The second big reform on which to focus is financial services liberalization. In the near term, investors should expect both deposit insurance and deposit rate liberalization. In the past banks could only set deposit rates at no more than 10% above benchmark. So, any near-term move to increase the band on deposit rates could dent net interest margin (NIM) in the banking sector, but we think the longer-term effect is actually likely to be positive because it represents a further shift away from top down, government-based control on money supply towards a more market-based price and risk-based control system. Also, higher deposit rates likely mean more competition for some of the more risky products like wealth management and trust products. Indeed, as the PBOC just stated in its February 8th, 2014 release, “The market needs to tolerate reasonable rate changes so that rates can be effective in allocating resources and modifying the behavior of market players.”

We should also look for the government to begin to break the cycle of non-bank companies borrowing cheap and lending long to riskier clients. This will likely be achieved through higher interest rates on both the short and long end. On the short end, we think the central bank must continue to allow SHIBOR to increase, which directly pressures financial services companies and products that have aggressive funding structures. And by liberalizing the long end of the curve, those SOEs and LGFVs that have been issuing low coupon bonds and subsequently lending the capital out for a handsome profit are now seeing this arbitrage called into question. No doubt, there is still a long way to go to contain the shadow banking system in China, but the aforementioned techniques are both clear examples of using slow-moving reform in a more market-based system to increasingly discourage bad behavior.

Over time, we think that the aforementioned milestones will help the government achieve one of its major long-term macro goals: Bringing total credit growth in line with or below nominal GDP growth. As we showed earlier in Exhibit 6, this relationship has gotten substantially out of whack since the government promoted credit growth to help counter the Great Recession’s impact on the domestic economy in early 2009.

Exhibit 20

SHIBOR Spikes Have Become More Frequent

Data as at January 30, 2014. Source: Bloomberg.

Exhibit 21

Higher Bond Yields May Affect Demand for Credit

Data as at January 31, 2014. Source: Haver Analytics.

The third important reform, which is likely to come slower, surrounds fiscal reform. This reform is likely to include better alignment between central and local government on tax revenue and expenditures. Opinions vary, but our basic conclusion is that this initiative also represents further consolidation of power by the new central government. In the end, we think that local governments will get a nationwide property tax framework implemented to generate a more stable revenue source, but that many of the most important issues, including healthcare, education, and social security will increasingly be controlled by the central government.

In terms of outright disappointment on the reform front, many folks tend to agree that property reform was underwhelming. In particular, there was little mention of reform around escalating home prices and excessive growth in LGFVs. We agree, but a radical overhaul of these two macro thorns in the near term is highly unlikely as it would be too destabilizing for both growth and the existing financial services system. It would also be in direct conflict with this government’s stated approach of “crossing the river by feeling the stones,” meaning that while reform is coming, the new leadership will move deliberately, not abruptly, as it consolidates power and drives change.

So as we look at the big picture after assessing a variety of announced reform doctrines across a variety of sectors, our primary conclusion is that the 2013 Third Plenum will likely be remembered as an important inflection – almost as bold as that of Deng Xiaoping in 1978. It also helped to solidify Xi and Li as leaders who are willing to embrace a dramatically different approach than their predecessors. Indeed, today their commitment to reform is no longer in question as the government has laid out a decisive roadmap for increased market forces, less corruption, and potentially more balanced growth over time. A year ago by comparison, many investors with whom we spoke openly questioned both the intensity and commitment of this new government to implement reforms.

What is still open for debate, though, is the pacing and the reaction from vested interests. To be sure, the agenda is bold, but reform means change, and change is often anathema of those who held positions of power in the past. The good news is that these reforms are coming at a time when the traditional pillars of the Chinese economy are under pressure, which we think is precisely the right time to push through a new economic agenda. In particular, given the profitability and market capitalization declines in the SOE sector as well as pressures on traditional Chinese exports, we believe there is likely a greater propensity for more broad-based reforms to be embraced. But even with this macro tailwind, we still see considerable risk that local government officials may look to delay many of the aforementioned reforms, particularly those that ultimately further consolidate power at the central level.

Near-term Economic Rebalancing Remains Aspirational

While the government’s reform agenda appears inspirational, its ability to rebalance the economy remains aspirational in the near term, in our view. For many years folks inside and outside of China have talked to me about China’s ongoing shift towards consumption and away from fixed investment. In theory, this transition makes a lot of sense. The problem is, as Exhibit 22 shows, it is not happening. Indeed, fixed investment as a percentage of GDP has actually increased for 23 of the past 32 years, and it now stands at a new record.

Exhibit 22

Fixed Asset Investment (FAI) Has Been Running Above 40% For the Last Ten Years

Data as at October 12, 2013. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 23

Investment in China Has Run Well Ahead of Other Developing Countries

Data as at January 12, 2013. Source: World Bank, Haver Analytics.

So what has been driving this long-term “underperformance” of consumption relative to fixed investment in the economy? From our vantage point, we would argue that consumption has not actually underperformed. In fact, nominal consumption in China has been growing at 13.8% over the past ten years, more than three times as fast as U.S. consumption growth, which has averaged just 4.1% over the same period (Exhibit 26). China’s consumption growth has also been formidable relative to its Asian brethren. Specifically, as Exhibit 27 shows, China’s real consumption growth during the 2000-2012 period averaged 8.7% versus 6.4% for India, 4.4% for Indonesia and 7.3% for Malaysia, respectively, over the same period.

Exhibit 24

China’s Economy Is Now Much More Skewed Towards Fixed Investment

Data as at December 31, 2012. Source: China National Bureau of Statistics, India Central Statistical Organization, Instituto Brasileiro de Geografia e Estatística, Haver Analytics.

Exhibit 25

Fixed Investment Has Grown Faster Than Consumption in Recent Years

Data as at December 31, 2012. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 26

Despite Heavy Fixed Investment, Consumption Growth in China Has Remained Robust…

Data as at December 31, 2013. Source: People’s Bank of China, China National Bureau of Statistics, Haver Analytics.

Exhibit 27

…Even When Compared to Its EM Brethren

Data as at December 31, 2012. Source: China National Bureau of Statistics, Bureau of Economic Analysis, Cabinet Office of Japan, Central Statistical Organization India, Badan Pusat Statistik, Bank of Korea, Department of Statistics, Department of Statistics, Malaysia, National Economic and Social Development Board, National Statistical Coordination Board, Directorate-General of Budget Accounting & Stats, Instituto Brasileiro de Geografia e Estatística/Haver, Instituto Nacional de Estadística Geografía e Informática, Departamento Administrativo Nacional de Estadísticas, Turkish Statistical Institute, South African Reserve Bank, Haver Analytics.

Rather, we think the issue centers on outsized growth in fixed investment. All told, fixed investment has grown at an outsized annualized clip of 24.0% over the past ten years, fueled by credit growth that has increased at an average pace of 18.5%6. By comparison, nominal GDP has “only” grown at an average rate of 16.0% over the same period. As a result, fixed asset investment as a percent of GDP has risen to 70% in 2012 from 33% in 2000 (Exhibit 22), while gross capital formation/fixed investment as a percentage of GDP has grown to 48% from 35% over the same period (Exhibit 25).

Our research leads us to believe that aggressive practices in areas such as non-bank lending and local government projects has been the primary catalyst for the strong growth in fixed asset investment in recent years. In terms of non-bank lending, there is no exact proxy, but one can get a feel for its growth by tracking what is sometimes called Other Social Financing. As Exhibit 28 shows, there has been significant growth in non-traditional bank lending, which is captured in the government’s definition of the Other Social Financing category. To be sure, not all Other Social Financing is suspect, as the category actually includes everything from entrusted loans, trust loans, bankers’ acceptance, corporate bonds and certain equity financings. That said, trust loans, which we think are now one of the most controversial parts of the non-traditional lending market, have grown sharply in recent years (Exhibit 31). All told, they now account for 4% of total loans outstanding (Exhibit 30). Equally as important, leverage in these products has crept up notably in recent quarters, and at a time we think that the credit quality has headed in the other direction.

Exhibit 28

Non-Bank Lending Has Surged in Recent Years

Total Social Financing as at November 31, 2013. Source: People’s Bank of China, World Bank, KKR Global Macro & Asset Allocation calculation.

Exhibit 29

Non-Bank Loan Funding Typically Has a Higher Cost and Is Shorter Duration in Nature

Funding Source

Funding Cost

Bank Loans

Around 6%

Bonds Issued

Around 6%


8 – 12%

Trust Loans

13 – 16%

Private Sector

Around 15%

Source: Morgan Stanley funding cost estimates as at December 31, 2013.

Exhibit 30

Trust Loans are Just 4% of Total Credit…

Data as at December 31, 2013. Source: People’s Bank of China, Haver Analytics.

Exhibit 31

…But Have Been Growing Rapidly

Data as at 3Q2013. Source: China Trust Association, Haver Analytics.

Meanwhile, LGFVs, which cater to – among other things – infrastructure and real estate projects, have also boosted fixed investment in recent years. As Exhibit 32 shows, local debt has ballooned to 17.9T RMB versus 10.7T RMB, a 67% increase, versus just a 23% increase over the same period for central government debt. Importantly, many of the cash flows now associated with these fixed investment projects now appear suspect. In fact, according to the investment bank CIMB, less than a third of LGFVs are actually generating enough cash flow to service their debt7.

Exhibit 32

Absolute Levels of Debt Have Grown, Particularly in the Local Government Debt Markets…

Data as at June 30, 2013. Source: China National Audit Office.

Exhibit 33

…But Appear More Muted Once Normalized Against GDP

Data as at June 30, 2013 using RMB 57 trillion nominal GDP as 2013 denominator. Source: China National Audit Office.

So as we look ahead, the recent surge in both LGFVs and Other Social Financing lending could create some additional volatility for at least three reasons. First, in lieu of deposits or public equities, local Chinese investors have increasingly bought income-oriented wealth management and trust products, some of whose cash flows are directly linked to poorly performing LGFVs and Other Social Financings projects. Importantly, we now expect the government to allow for more “managed” defaults and bigger haircuts as credit issues become more common place in the quarters ahead. Second, because some of these retail products are highly levered, both the equity and the corresponding debt supporting these structures are also at risk. Finally, while local governments have never been self-funding (Exhibit 34), the ability and the desire for the central government to provide costless bailouts could get more difficult as nominal GDP growth in China continues to slow (Exhibit 35).

Exhibit 34

Local Governments Have Never Been Self-Financing…

Data as at December 31, 2012. Source: Ministry of Finance of China, Haver Analytics.

Exhibit 35

…But Central Government Support Is Getting Harder as Nominal GDP Growth Decelerates

Data as at December 31, 2012. Source: China National Bureau of Statistics, Haver Analytics.

Importantly, our meetings in Beijing confirmed our belief that both the shadow banking market and the LGFVs lending markets are seen as significantly imbalanced by the new administration. The international press now appears to have caught up with local sentiment, as there has been a lot written lately on the growing risk of default in the fast growing trust market, including the recent bailout of the $3 billion yuan (US$500M) Credit Equals Gold No. 1 trust by unnamed parties.

However, we do not look for a massive purge of the aforementioned excesses. Rather, we think this government still intends to “cross the river by feeling the stones.” That said, investors should expect a growing number of defaults on Chinese investment products/trusts in the months and quarters ahead, not all of which will be bailed out by the government and/or the private sector. This viewpoint is significant because it likely means more volatility and a drag on economic growth if we are right. Regardless, we remain confident that the government may continue to use higher SHIBOR rates as a catalyst to not only slow growth in these specific lending areas but also to reduce the annual growth of fixed investment.

Without question, this process is likely to be a bumpy one, but we believe it is necessary in order to bring nominal lending back below nominal GDP. Probably more important, it represents a potential catalyst for rebalancing an economy that is overly committed to fixed investment at the moment. But this will not be easy and it will likely mean structurally slower growth in the years ahead. Indeed, as Exhibit 37 shows, China’s GDP growth has traditionally been much slower when fixed investment has been running at more “normal” levels in the mid-30 percentage points of GDP.

Exhibit 36

If China Does Become A More Consumer-Oriented Society, Its GDP Growth Rate Is Likely to Fall

Annual data from 1971 to 2012. Source: China National Bureau of Statistics, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Exhibit 37

Less Robust Fixed Investment as a Percentage of GDP Also Likely Means Slower Growth for the Chinese Economy

Annual data from 1971 to 2012. Source: China National Bureau of Statistics, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Lowering 2014 GDP Forecast; Longer-term Structural Headwinds Likely to Weigh on Growth

It doesn’t matter whether a cat is white or black, as long as it catches mice. Deng Xiaoping

It may just be me, but when I talk to investors there always seem to be two camps on the China growth outlook. On the one hand, some folks tell me not to worry, as the Chinese government will do whatever it takes to hit its near-term growth targets. On the other, China bears with whom I speak are convinced that the macro burdens are now so heavy that a significant slowdown in growth is inevitable, regardless of the government’s intention and macro levels.

Our view, by comparison, is less extreme than what we consider to be these two “book end” viewpoints. Specifically, we do think that the government is committed to reforms, including reining in excessive lending. However, we do not think that the Chinese government will push reforms so fast that it results in sharply higher unemployment, and consequently, social unrest. As such, our best estimate for economic growth in 2014 is now around 7.2-7.5% versus our prior estimate of 7.4-7.7%. Driving our more conservative thinking for 2014 is that we now expect more flare-ups in the financial services sector during 2014 as credit is further reined in by the government. In particular, we think that the recent last minute $500 million bailout of the Credit Equals Gold Trust No.1 will not become the standard for how China deals with this segment of the market as the government tries to change investors perception that these products are risk-free. If we are right, then there will ultimately be some trust and capital markets-related failures this year that may negatively affect sentiment, credit growth, and ultimately GDP trends.

More importantly, frequent visits to China in recent quarters convince us that long-term, downward pressure on the country’s growth rate is ultimately inevitable, even for a country with 3.8 trillion dollars in reserves, a population of 1.4 billion, and a leading position in the global economy. Key to our thinking is that we see several structural shifts that are likely to put downward pressure on growth over the next five to seven years. They are as follows.

First is the inevitable slowing from urbanization, which affects productivity growth – and ultimately GDP growth. One can see in Exhibit 38 that the rural-to-urban migration recently peaked and is now headed lower. Meanwhile, agriculture, which is traditionally one of the lowest productivity areas in the economy, now accounts for less than 13% of GDP versus 21% in the 1990s and 33% in the 1970s (Exhibit 39). As such, there is just less structural productivity improvements to now occur.

Exhibit 38

Migration From Rural to Urban Decelerating...

Data as at December 31, 2012. Source: Source: China National Bureau of Statistics, UN, Haver Analytics.

Exhibit 39

…And Has Begun to Face Difficult Headwinds

Agri % GDP

10-Year CAGR (%)

Urban Pop

Real GDP






















Data as at December 31, 2009. Source: China National Bureau of Statistics, Haver Analytics.

Slowing urbanization also has a direct impact on productivity, which beyond labor force growth is the most important GDP input. As Exhibit 40 shows, increased productivity from local Chinese moving from the country to the city has begun to face more difficult headwinds. To be sure, this decline will not occur overnight, and there is the potential for the Chinese worker to improve productivity. However, given that we are much further along in the urbanization cycle (Exhibits 40 and 41), we expect continued downward pressure in the months and years ahead.

Exhibit 40

China Is Losing the Tailwind of Urbanization

Data as at December 31, 2012. Source: Source: China National Bureau of Statistics, United Nations: World Urbanization Prospects: The 2011 Revision (POP/DB/WUP/Rev.2011/1/F2), KKR Global Macro & Asset Allocation Estimates.

Exhibit 41

Not Surprisingly, Productivity and Real GDP Are Decelerating in Tandem

Data as at October 8, 2013. Source: China National Bureau of Statistics, World Bank, United Nations World Population Prospects, OECD Economic Outlook long-term database estimates for 2020-2050.

Second, as Exhibit 42 shows, there is also an important demographic issue to consider. While China’s total population will not peak until 2030, its working age population actually peaks in 2015. Moreover, its young population (i.e., those aged 15-29) actually peaked in 1991, and are now having an impact on the country’s dependency ratio. This means that its labor force growth will soon turn negative as there are fewer young people entering the work force. The government certainly understands this issue and it is trying to improve it, as evidenced by the recent relaxation of the one-child policy as well as increased social safety net benefits. However, there is no quick fix to the country’s sizeable demographic challenges. So, as we look towards the next five years in China, we believe that the government will have to do a lot more to just maintain, much less improve, its current labor force growth to prevent a further demographic-led growth slowdown (in addition to maintaining social stability).

Exhibit 42

Fewer Young People Entering the Labor Force…

Data as at July 12, 2013. Source: United Nations, Haver Analytics.

Exhibit 43

…and China’s Dependency Ratio is Rising Quickly

The dependency ratio is the ratio of population aged 0-14 and 65+ per hundred of population aged 15-64. Data as at January 3, 2014. Source: United Nations, Haver Analytics.

Third, the law of large numbers has come into play, as China is now simply so much bigger. As a result, it just becomes much harder to maintain such high growth rates off such a large base. All told, the economy grew to US$ 9,264 trillion in 2013 from US$ 1,198 trillion in 2000 (Exhibit 44). Meanwhile, as Exhibit 44 also shows, China’s GDP-per-capita has skyrocketed in recent years. In fact, GDP per capita in China reached US$ 6,569 in 2013 from US$ 941 in 2000, which represents an annualized growth rate of 16.1%.

Exhibit 44

China’s High Growth Rates Will Be Difficult to Maintain


Nominal GDP US$

GDP Per Capita US$

Urban Pop (mil)

% Urban Pop’n

15-24 Yr Old Y/y%

Yuan /US$















% Chg















Nominal GDP US$

GDP Per Capita US$

Urban Pop (mil)

% Urban Pop’n

15-24 Yr Old Y/y%













% Chg












Data as at January 19, 2014. Source: China National Bureau of Statistics, Federal Reserve Board, BEA, World Bank, IMF, UN.

Fourth, the economy needs to restructure, particularly its large corporations and financial institutions. All told, as Exhibits 45 & 46 show, China’s corporate leverage—as defined by its assets-to-equity-ratio—has increased 55% to 2.27x from 1.53x, and these figures do not include any off-balance sheet, financial services liabilities linked to implicit trust product guarantees. As a result, it now should embark on an important deleveraging cycle, particularly within its sizeable banking sector. This transition will not be growth friendly, as moving back towards an environment where nominal lending growth again runs below nominal GDP will present both growth headwinds and volatility along the way.

Exhibit 45

Pre-crisis, Return on Equity in Emerging Markets Was Higher with Lower Leverage



LTM Net Margin


Asset Turnover


























LTM = Last twelve months. Data as at June 30, 2007. Source: MSCI, Factset Aggregates.

Exhibit 46

Post-crisis, Return on Equity in Emerging Markets Is Lower on Much Higher Leverage



LTM Net Margin


Asset Turnover


























LTM = Last twelve months. Data as at December 31, 2013. Source: MSCI, Factset Aggregates.

In the end, slower structural growth in China represents an important change in an economy that has suffered few setbacks in recent years. To be sure, downshifting in economic growth will create more uncertainty and volatility in the near-to-medium term, but we actually think it could be a long-term positive if a few important conditions are met. First, we believe strong employment growth should be maintained. The good news is that our work shows that there are still more jobs than there are applicants throughout China. Indeed, according to the latest government statistics, the country’s labor market demand-supply ratio rose to 1.10 in 4Q13 from 1.07 in 3Q13, despite growth slowing to 7.7% from 7.8% over the same period (Exhibit 48). This ratio is important because it suggests that unemployment would not surge in a slower growth environment (Exhibit 47). Second, if slower growth brings fewer environmental headwinds, we think it would serve as an important offset to the growing number of Chinese citizens focused on smog, living conditions and excessive waste. This issue is not to be under-estimated as current poor environmental conditions are already creating social discord, particularly in large urban areas. Finally, if slower growth results because of less corruption and excessive lending, we think it could cool some of the social tension that now appears to be bubbling up among low- to middle-income Chinese citizens.

Exhibit 47

Despite Weaker Growth, Demand for Labor Is Still Robust

Data as at 4Q2013. Source: Ministry of Human Resources and Social Security of China, Haver Analytics.

Exhibit 48

Urban Job Growth Has Remained Strong, Despite Slower GDP Growth

Data as at December 31, 2013. Source: China National Bureau of Statistic, Haver Analytics.


2014 should again, we believe, be a year of substantial repositioning in China, particularly as it relates to the country’s economic drivers. Consistent with this view, Chinese Premier Li Keqiang recently noted that, “As the economy enters a phase of transformation, the slowdown of its prospective growth and moderation of the Chinese economy from a high speed to a medium to high speed are only natural.8

Against this macro backdrop, we think that there are several important considerations worthy of investor attention. First, if we are right on the changing macro backdrop for China, it means that investors should continue to avoid capital goods, commodity producers and export stories related to China as the low cost “manufacturer to the world.” As we detailed in this report, both higher wages and a more robust currency are major structural headwinds. However, services-based industries, including healthcare and wellness, by comparison, still have lots of running room, we believe. Second, we think the new government’s anti-corruption focus is likely to gain, not lose momentum, and as such, investors should make sure not to allocate capital towards businesses that are exposed to anti-corruption initiatives.

Exhibit 49

Strong Economic Growth in China Has Not Rewarded Many Investors

Data above is an index of returns for China Real GDP and China A Shares from 2000 to 2013, with 2000 equaling 100. Data as at December 31, 2013. Source: China National Bureau of Statistics, Shanghai Stock Exchange, Haver Analytics.

Exhibit 50

By Comparison, In the U.S. the Story Has Been Quite the Opposite

Data above is an index of returns for U.S, Real GDP and U.S. S&P 500 from 2000 to 2013, with 2000 equaling 100. Data as at December 31, 2013. Source: Bureau of Economic Analysis, Standard & Poor’s, Haver Analytics.

Exhibit 51

If China Can Improve Its SOEs, the Upside Is Now Much More Significant

Data as at February 4, 2014. Source: Factset Aggregates, MSCI.

Exhibit 52

On the Other Hand, Many Non-SOE Companies Now Look More Fully Valued On a Relative Basis

Data at February 11, 2014. Source: Bloomberg.

Third, while we have lowered our forecast for GDP this year, our research and our on the ground due diligence give us confidence that growth is slowing, not falling off a cliff. However, the longer-term growth trajectory is clearly down – and potentially more quickly than some folks now think. This viewpoint is significant as China is expected to account for 32% of total global growth and 54% if you include its Asian brethren, many of which draft off China (Exhibit 16). Fourth, we should take comfort that the increased movement towards market-based initiatives will ultimately be constructive for Chinese capital markets. As we mentioned above though, this transition is likely to be bumpy along the way. Fifth, if the government executes on its plan, then SOEs, including both its banks and non-financial corporations, could – over time – become more attractive investments, particularly given their current low valuations. Given that China has been one of the fastest growing but worst performing stock markets for quite some time, this would represent a significant shift in the macro landscape.

1 Data as at December 31, 2013. Source: China Customs, Haver Analytics.

2 China Twelve Five Year Plan and China Health Statistics Yearbook 2012.

3 Data as at December 31, 2012. Source: IMF, Haver Analytics.

4 Ibid.3.


6 Data as at December 31, 2012. Source: The People’s Bank of China, Haver Analytics.

7 Data as at September 30, 2013. Source: CIMB Malaysia.