By HENRY H. MCVEY Apr 09, 2013

From almost any vantage point, it appears that China is at somewhat of an inflection point in its rich cultural and economic history. The government, under its new leaders President Xi Jinping and Premier Li Keqiang, should deal with some important structural issues: slowing urbanization, increased export competition, heavy real estate lending and wide income inequality. We do not want to underestimate these significant challenges, but our recent time spent on the ground in China gives us confidence that there are important early signals that this administration will tackle these issues, though its approach to structural change is likely to be evolutionary, not revolutionary, in nature.

As the founder of Taoism, Lao Tzu was one of the great Asian philosophers, with a distinguished history of inspiring millions, including even Confucius. By comparison, as a somewhat mediocre student of American history at the University of Virginia, it was not until my most recent trip to China that I had the privilege to be inspired by some of his work. Of his many writings that I reviewed during my travels, his advice to “anticipate the difficult by managing the easy” felt especially relevant — as if he could be speaking directly to China’s new leadership, President Xi Jinping and Premier Li Keqiang.

Without much effort, the new Chinese leadership should be able to “manage the easy” by providing clearer direction and better guidelines to several important parts of the economy that are certainly in need of some reform, including energy, financial services and real estate. If there is good news, it’s that the two new leaders are moving quickly, accelerating initiatives to liberalize policies around interest rates and refining margins.

In terms of “anticipating the difficult,” however, the story is clearly more complex, and it will require that the new administration think creatively over a longer period of time about how to lead China in an increasingly interconnected global economy. As an example, the country’s exports are currently being hit hard by a dramatic slowdown in European consumption, which is beyond China’s control, while the price of corn, a critical input in any rising per capita GDP country, is being adversely affected by record drought conditions in non-Asian economies like the U.S1. At the same time, the Internet is creating unprecedented tensions around human rights, political activism and economic inequalities.

So as we think today about how China might look tomorrow, we thought it might make sense to outline how we believe this new leadership team will both “anticipate the difficult” and “manage the easy” in the months and years ahead. Our thoughts are as follows:

  • We are more confident than the consensus about steady and deliberate reform in the coming years. We appreciate that almost every politician promises reform when he or she first takes office, but this time in China does feel different to us. In particular, we put a heavy emphasis on two recent statements coming out of Beijing that are consistent with what we learned on the ground during our last visit. One was by the exiting President and General Secretary of the Communist Party of China, Hu Jintao, who recently stated that GDP per capita should double by 2020 versus 20102. This was the first time that GDP per capita was included in the economic growth targets for 2020, and we think it sends a major signal about creating more equitable, efficient and sustainable growth. The second was by Hu Jintao’s successor Xi Jinping, who recently said that the new administration would be “crossing the river by feeling the stones” (i.e., taking a measured approach to reform). As we detail below, we expect Xi Jinping and Li Keqiang to embrace change in a methodical way that does not tear further at the already weakened social fabric of the nation, which has 1.4 billion citizens. If the new leadership delivers on its promises, we think certain targeted industries like high-end manufacturing, healthcare and energy efficiency should benefit disproportionately.
  • Contrary to popular opinion, we do not expect a massive fall-off in fixed investment. We disagree with the consensus that China can easily rebalance from a fixed investment towards a consumption-driven economy; we do not think it can afford to do so. Rather, we believe such a transition will take years and be linked to the build-out of a more formal services industry in China. Also, the country — which is on the cusp of negative population growth — should continue to build infrastructure to not only create jobs but also to keep current productivity high so that it can remain efficient in an increasingly competitive global economy. Whereas India and Brazil are already seeing higher inflation and lower productivity on the heels of a significant fall-off in fixed investment in recent quarters, China is not (Exhibit 11). No doubt, having nearly 50% of GDP dedicated to fixed investment is now unsustainable, but recent heavy investment in roads, bridges and tunnels is allowing the country to maintain stronger and less volatile growth than either Brazil or India, a profile that we think the new government is committed to maintaining.
  • We no longer see the central bank using interest rates and liquidity to stoke growth. Rather, we see market-based reform as a new tool for improving growth and lowering the country’s cost of capital. If there was a clear message from Beijing, it was that the lowering of interest rates in the past to stimulate growth has led to many unintended — and in some instances undesirable — consequences. Moreover, given that essentially every large developed economy is pursuing quantitative easing, China is increasingly concerned that external capital may continue to flood its markets, creating outsized asset prices. So as we discuss below, in our view, the focus will be on lowering the country’s overall cost of capital and encouraging growth through the liberalization of financial services, including greater reliance on the interbank market. While we believe this initiative towards liberalization is clearly the right one, it will not be easy as the government should still do more to control housing prices and outsized credit-related lending patterns.
  • China remains a potent exporter, but the new administration is likely to pursue a more targeted approach to the export sector than in the past. Coupled with a dramatic fall-off in European exports, we think that the country continues to rapidly shift its priorities towards high-value-added products, automation, and intra-Asia consumption. In our view, this shift in strategy has significant implications for both economic and rebalancing priorities, including a heavy emphasis on the services economy. Demographic headwinds may also soon make automation a priority as the Chinese population of younger workers aged 15-29 will actually shrink at an average pace of five million a year between now and 2030, largely due to the one-child policy implemented in 19793.
  • Urbanization: A tale of two cities? Between 1990 and 2010, urbanization was clearly a major driver of growth. The 1990-2000 time period was characterized by a ramp up in rural-to-urban migration, while the 2000-2010 time period was characterized by rapid urban real wage appreciation and home prices. But urbanization also created a massive divergence within the population. Since 1985, the average wage in Shanghai and Beijing has increased 56 times (5500%) versus “only” 25 times (2400%) in rural areas like Gansu and Qinghai4. The other big macro factor relating to urbanization that should be rethought is that the pace is now finally slowing, and is likely to decelerate to less than 10 million annual rural-to-urban migrants by 2030 versus an average of 15.8 million over the past twenty years (Exhibit 39). As this transition occurs, it has implications for, among other things, GDP growth and infrastructure investment.

Overall, we now feel comfortable maintaining our 2013 China GDP forecast of 7.6-8.1% for 2013 versus a Bloomberg consensus forecast of around 8.1-8.2%. Our slightly more cautious growth outlook centers on our view that structural reform, while typically a long-term positive, can sometimes slow growth in the near term. A good example is the recently announced capital gains tax on real estate, which is expected to be implemented this summer and likely to impact growth in 2H13, we believe. Another example is that the new government’s more austere approach to ‘gifting’ is curtailing excessive spending at the high end of the Chinese consumption market, a trend we expect to continue given the current focus on reforms. Separately, we continue to see inflation in the 3% to 4% range this year, in line with government forecasts (Exhibit 1), while we continue to see corporate profit growth at below-trend levels (Exhibit 4).

Exhibit 1

Inflation Appears to Be in a Bottoming Process And Could Be Headed Higher

Data as at January 31, 2013. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 2

In Aggregate, Residential Property Values and Disposable Income Have Moved in Tandem…

Data as at December 31, 2011. Source: China National Bureau of Statistics, Economy Research Institute of Chinese Urban and Rural Construction, Haver Analytics.

Exhibit 3

…However, the Gap in Home Price-to-Income Ratios Now Varies Widely From One Area to the Next

Data as at December 31, 2011. Source: China National Bureau of Statistics, Economy Research Institute of Chinese Urban and Rural Construction, Haver Analytics.

Exhibit 4

Despite Solid Economic Growth, Corporate Profitability Has Been More Challenging

LTM = Last Twelve Months. Data as at December 31, 2012. Source: China National Bureau of Statistics, Haver Analytics.

In terms of our overall asset allocation outlook for 2013, we continue to try to take advantage of several high-conviction, key macro investment themes. First, we believe that the illiquidity premium being afforded to investors across the direct lending, special situations and mezzanine businesses is significant. Indeed, with real rates negative in Europe and the U.S, we think the ability to earn unlevered returns 3-5% in excess of what is currently provided by traditional liquid credit is compelling. Second, we favor real assets investments with yield, growth and inflation hedging capabilities. Third, we think now is the time to shun deflation assets in favor of reflation investments like bank loans, public equities and private equity. Finally, we believe that a more thoughtful approach to the emerging markets, including emerging debt, concentrated public equity portfolios and private equity (particularly with a consumer focus) may make sense versus owning passive indexes that are in many instances linked to inefficient state-run enterprises.


In the section below we provide more color on the latest trends we see unfolding in China after the recent government transition.

Rebalancing and Reform: Back to the Future

“Economic planning is not tantamount to socialism, because economic planning is also practiced in capitalist countries; the market economy is not tantamount to capitalism because a socialist country can also have a market economy. Both economic planning and the market economy are economic means. The essence of socialism is to emancipate and develop the productive forces, destroy exploitation, eliminate polarization and attain common prosperity in the end.” Deng Xiaoping, 1987

In our humble opinion, investors are underestimating the level of reform that the new government will both need and want to embrace over the next few years. Following in the footsteps of Deng Xiaoping circa 1987, we look for Xi Jinping and Li Keqiang to do more to “develop the productive forces, destroy exploitation, eliminate polarization and attain common prosperity in the end.” Without question, many Chinese citizens with whom we speak feel that income equality is now a major issue. They should: the China National Bureau of Statistics’ most recent Gini coefficient analysis showed that China’s ranking increased to 47.4 in 2012 from 42.5 in 2005, identifying China as among the worst of the major countries tracked by the income equality index. One can see this in Exhibits 5 and 6.

Exhibit 5

Income Equality in China Has Become a Significant Issue…

Data as at January 31, 2013. Source: China National Bureau of Statistics, World Bank. Per World Bank/IMF data, of the 15 countries that have 2012 GDP of more than US$1 trillion, China’s Gini coefficient ranks third worst after Brazil and Mexico.

Exhibit 6

….As China’s Gini Coefficient Ranks Third Worst After Brazil and Mexico

Japan as of 1993; Australia as of 1994; France as of 1995; U.K. as of 1999; Germany, Canada, Spain, Italy, and U.S. as of 2000; India and China as of 2005; Mexico as of 2008, and Brazil as of 2009. Source: World Bank, Haver Analytics.

If there is good news (and we think there is), we believe the new leadership in China is sending a message that it understands the gravity of the situation. We thought it was particularly telling that Xi Jinping commented on New Year’s Eve that — using another historic quote from Deng Xiaoping — the new administration would be “crossing the river by feeling the stones.” Put another way, we think the new leadership is saying that — unequivocally — reform is coming (i.e., it will “cross the river”) but it will move deliberately, not abruptly (i.e., “feeling the stones”) as it consolidates power and drives change.

So what are the key areas on which we think China will “cross the river” in the coming years? We see at least four:

  • Improvements in GDP per Capita. Exiting President Hu Jintao’s recent speech about doubling GDP per capita by 2020 versus 2010 is a big deal, in our view. And further expanding upon these ideas, the State Council recently issued “Opinions on Deepening Income Distribution Reforms,” which called for 35 measures aimed at reducing poverty and addressing income disparity. Within this mandate, a key measure is that state-owned enterprises will now need to pay out an additional 500 basis points of cash flow in the form of dividends (increasing to 5-15% from 0-10%) by 2015. A large portion of this new dividend income will be earmarked for social spending, we believe. In our view, it is these types of visible programs that will not only create a higher standard of living in China but also build confidence for its citizens to help generate more internal demand.
  • Bigger Social Safety Net. The aforementioned “Opinions” report also suggests increasing the share of total public spending on social insurance by 20% to 12% from the current 10% level. This initiative is, we think, a direct attack on the weak Gini coefficient report, which we highlighted earlier. To be sure, it is not enough, but we think it is a major step in the right direction. As China’s safety nets grow, its massive savings rate, which is currently 32.8% (Exhibit 9), should rebalance towards more normal levels, which should be good for overall growth trends.
  • More Reliance on Services. At present China’s economy is only 45% services-based versus 56% for India and 68% for Brazil; however, we think that it can reach at least 48% by 2015, which is a touch higher than the government outlined in its 12th five-year plan5. This prediction is significant for China because, as countries trend towards more services, capital intensity, energy demand and pollution costs as a percentage of GDP all tend to fall. Meanwhile, high-value-added services industries like technology and healthcare typically start to grow more quickly at this point in a country’s development cycle, which would increase productivity and wages as well as lower the country’s dependence on manufacturing and fixed investment.
  • Land & Environmental Reform. In our view, China cannot have real reform without addressing the current land ownership conundrum in its rural areas. To review, rapid urbanization in the 1990’s as well as the regional governments’ need to drive revenues have left rural farmers disenfranchised, without land rights in many instances. In fact, the Chinese Academy of Social Sciences estimated that disputes over land accounted for 65% of total social disturbances in China’s countryside in 20106. However, it appears that the new government is committed to dealing with this issue as the State Council recently backed a surprisingly strong amendment to overhaul the current land management program. This fight will not be easy though, as local governments generated over US$450 billion in revenues from land sales last year7. In addition, we think that the government understands that there is growing concern around air, food and water quality, and as a result, we expect steady reform in these areas.

While we are confident that change is forthcoming in China, we also appreciate that there are several reasons why this process will be an evolution, not a revolution. First, given that the government is cracking down hard on gifting/grafting, consumption trends are likely to run substantially below average in the near-to-medium term. Second, regardless of how quickly incomes are redistributed, there will likely be an important offset. Specifically, as consumption grows, so too do the country’s imports of consumable goods, which reduces net exports and thereby acts as a partial offset to overall growth. This interrelationship is often missed by market pundits, and as such, we think it is worth reinforcing. Third, a lot of Chinese are now just entering the consumption phase of their life cycle. According to the consulting firm McKinsey, the middle-income population in China will grow to 51% of the entire population by 2020 from 6% in 2010. As incomes grow, so do spending habits and a larger portion of wallet share are expected to go towards experiences and services rather than manufactured goods. However, this transformation will not happen overnight.

Exhibit 7

China Consumption Set to Grow In Line With Incomes

Data as at March 31, 2012. In real 2010 dollars. Source: McKinsey article entitled Meet the Chinese Consumer of 2020.

Exhibit 8

As Income Grows, Consumption Patterns Shift Towards More Service-Based Products

Figures may not sum to 100% because of rounding. Data as at March 31, 2012. In real 2010 dollars. Source: McKinsey article entitled Meet the Chinese Consumer of 2020.

Fourth, it will also take time to not only re-establish a social safety net but to also change perceptions and consumption patterns linked to the benefits of having a social safety net. Remember that in 1990, in an effort to improve profitability of state-owned enterprises (SOEs), China relieved SOEs of their obligation to provide social services (such as medical insurance and pensions) to their workers. As a result, household savings rose from roughly 10% pre-1990 to almost 33% today! Given that it took more than 20 years for households to raise their saving rate by 2300 basis points, we think it may take many years, not months or quarters, before it trends back closer to 10%. Finally, the government should actually convince high income earners – not just middle income earners (as the consensus believes) – to spend more as studies suggest that this market segment currently saves 63% of what they earn each year. One can see this in Exhibit 10.

Exhibit 9

Without a Social Safety Net, Household Savings Surged

Data as at 3Q2012. Source: China Household Survey, China National Bureau of Statistics, Haver Analytics.

Exhibit 10

Interestingly, Though, The Chinese Savings Rate Is Actually Skewed by the High Savings Rate of High Income Earners

Source: Credit Suisse report dated 6 August 2010 by Vincent Chan. Credit Suisse sponsored Professor Wang Xiaolu of the China Reform Foundation in his second study of China’s grey income and income distribution.

So our bottom line is that we think it’s best to think about China slowly but deliberately rebalancing its economy over the coming years. Without question, we believe the key to rebalancing lies in greater wealth distribution and more broad-based savings patterns. However, as we show in Exhibit 10, the lion’s share of the savings is now deeply concentrated with the citizens who are making the most money. This must change, in our view. In addition, the country’s economic reforms should drive the percentage of services in the economy higher, allowing GDP per capita to increase and the economy’s capital intensity to decrease. We think the government clearly understands the trade-off between consumption and retirement security, but we also believe that the new leadership will be “crossing the river by feeling stones” so as not to create significant economic uncertainty or social dislocation along the way.

Fixed Investment: A Double-edged Sword

British playwright William Somerset Maugham once wrote that, “We know our friends by their defects rather than by their merits.” To some degree, he seems to describing the current public court of opinion on China these days. No doubt, China has some major issues with which it must deal. In particular, the country’s fixed investment as a percentage of GDP is unsustainable, in our view. This much we know.

What might be less clear to folks who do not spend a lot on time on the ground in China is that the country’s prior investment in infrastructure, which many investors have criticized as being excessive, is now serving as a major point of positive differentiation in some instances among the emerging market countries we visit, including Brazil and India. Simply stated, China is not seeing the same level of productivity fall-off that we are now seeing in other emerging countries like Brazil and India.

To quantify this belief, we looked at the two primary drivers of GDP: labor force growth and productivity growth. As one can see in Exhibit 11, all the large emerging market countries (and even the U.S.) generally have positive labor force growth trends, which is obviously important to overall GDP growth.

Exhibit 11

Productivity Has Been Key To China’s Growth

Data as at December 31, 2011. Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Instituto Brasileiro de Geografia e Estatística (GBE), China National Bureau of Statistics, India Central Statistical Organization, International Labour Organization (ILO), World Bank, IMF, KKR Global Macro and Asset Allocation analysis.

As we also show in Exhibit 11, the major differentiator in overall GDP growth, however, has been productivity growth. At 9% annualized from 2000 to 2011, China has dwarfed almost every major country in the global economy. We attribute a lot of the country’s productivity success to its appropriately skilled labor force and vast and functioning infrastructure, including roads, rails, highways, and subways. By comparison, countries like Brazil have chronically under-invested in education and infrastructure, and it is now affecting overall growth as urbanization reaches peak levels. In fact, productivity was actually negative in Brazil in 2012, a period during which the country had contracting negative fixed-investment growth for three of the year’s four quarters8.

Exhibit 12

Fixed Investment Has Now Reached 48% of GDP

Data as at December 31, 2011. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 13

Investment in China Towers Above Other Countries

Data as at October 8, 2012. Source: China National Bureau of Statistics, Biro Pusat Statistik, General Statistics Office of Vietnam, Bank of Korea, Central Statistical Organization, India, Instituto Nacional de Estadística Geografía e Informática, Turkish Statistical Institute, Singapore Department of Statistics, Instituto Nacional de Estadística, Cabinet Office of Japan, Instituto Brasileiro de Geografia e Estatística, Statistisches Bundesamt, Office for National Statistics, Bureau of Economic Analysis , Central Statistics Office Ireland.

Equally as important, China’s economy has not suffered the same GDP drawdown since the Great Recession. As Exhibit 14 shows, China’s peak-to-trough GDP move has been much more modest than what we saw in other major BRIC economies, Brazil and India in particular. We link this performance to the country’s ability to drive productivity above wages, which has been important for sustaining growth in both good and bad markets. In fact, between 2004 and 2011, there was only one year when productivity fell below real-wage growth, and that was during the global financial crisis of 2009. By comparison, in Brazil real wages have grown above productivity for six of the past eight years.

Exhibit 14

China’s Peak-To-Trough Move Has Been Much More Modest Than That of Brazil and India

Data as at 3Q2012. NSA = Not Seasonally Adjusted. Source: China National Bureau of Statistics, India Mayin Organization, Instituto Brasileiro de Geografia e Estatística, Haver Analytics.

Exhibit 15

Historically, China’s Double-Digit Real Wage Growth Was Justified by Its Double-digit Productivity Gains

Data as at December 31, 2011. Shaded areas denote periods when productivity growth was above real wage growth. Source: China National Bureau of Statistics, Haver Analytics.

Given this backdrop, we do not think that China is going to suddenly abandon a high fixed-investment ratio in favor of consumption. Rather, we think that the country will begin to shift its fixed investment away from real estate and low-end manufacturing toward more value-added production, biotechnology, energy efficiency and services, including healthcare, education and wellness. Within its fixed investment allocation, we look for the government to invest more heavily in roads, rails, subways and logistics (Exhibit 16).

Exhibit 16

The Nature of Fixed Asset Investment (FAI) Projects is Shifting

Year-over-year Change in Monthly Fixed Asset Investment as a % of Total FAI






















Real Estate











Water & Utilities

































Agri & Mining






















Total FAI Y/Y











Data as at January 17, 2013. Source: China National Bureau of Statistics, Haver Analytics

Exhibit 17

Manufacturing and Real Estate Will Eventually Become Less of a Focus

Data as at January 17, 2013. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 18

Real Estate: China Appears to Be Maxing Out

Annual data as of 2012. US real estate investment includes “Dwellings and Other Buildings and Structures” per the Bureau of Economic Analysis (BEA); Germany real estate investment includes “Residential and Nonresidential” construction; Japan real estate investment includes “Residential and Other Buildings & Structures;” China real estate investment represents value of real estate investment completed annually. Source: BEA, Statistisches Bundesamt, Cabinet Office of Japan, China National Bureau of Statistics, Haver Analytics.

We also think China will try to improve productivity by driving greater infrastructure investment and growth in its less developed, western regions. The intent, we think, is to improve the country’s rural economies, narrow the income gap, and hopefully alleviate some of the environmental issues like overcrowding and pollution that are now so rampant in tier-one cities.

Exhibit 19

Looking Ahead, China Is Expected to Try and Capitalize on Its Excess Capacity to Increase Productivity

Data as at July 6, 2012. Source: IMF Country Report No. 12/195 dated July 2012.

Exhibit 20

High GDP Per Capita is Concentrated Along the Coast. We Think Expansion of Smaller Cities Will Account
for a Larger Share of Urban GDP Growth Through 2030

Data as at February 6, 2013. Source: China National Bureau of Statistics.

So contrary to popular opinion, we actually feel strongly about what China has achieved through its fixed-investment-led productivity. That said, we fully acknowledge that no economy can sustain itself on high fixed investment forever. Already, the fixed investment proportion of the Chinese economy has been greater than 40% for ten consecutive years (Exhibit 12) and has started to drive capacity utilization down. While excess capacity can help to reduce inflation trends in an emerging market, we believe it is also often associated with a declining return on invested capital, which eventually leads to unproductive assets and higher loan losses in the banking system.

Hence, as we look ahead, we believe China should begin to be more judicious in fixed-investment outlays, focusing more intently on allocating capital towards industries and regions that will allow the country to maintain its significant productivity advantage. If it can make this transition successfully, then we believe some of the current negative sentiment surrounding the country’s high fixed-investment ratio may ultimately prove to be misguided.

Financial Services: Relying Less on Traditional Banking to Stimulate Growth

Another important insight we gained from our most recent visit to China is that is that the country has become a microcosm of two megatrends that we see occurring throughout almost all the emerging markets that we visit. First, similar to India, Turkey and Brazil, China is still dealing with a “hangover” from the excessive government stimulus that was used to fight off economic slowdown during the Great Recession. Whereas our research shows that India and Brazil overdid it on consumption stimulus, China appears to have gone too far in the area of real estate lending. As Exhibit 21 describes, loan growth surged to 34% year-over-year in June 2009, well above the historical average. To date, non-performing loans have actually continued to trend down, which we think is clearly unsustainable on the heels of such aggressive lending practices. All told, we believe that the Chinese banking system could need $50-$100 billion just to cover the excesses from this recent lending binge.

Exhibit 21

Surge in Loan Growth in 2009 Likely to Lead to Higher Non-Performing Loans

Data as at January 31, 2013. Source: China Banking Regulatory Commission, The People’s Bank of China, Haver Analytics.

Exhibit 22

As We Look Ahead, We No Longer Look For Such Aggressive Easing Cycles As We Saw in 2009

Data as at January 31, 2013. Source: China Statistical Information Center, People’s Bank of China, Haver Analytics.

Second, as central banks in the developed markets use heavy quantitative easing (QE) to try to reflate their economies, we think they are increasingly putting themselves at odds with emerging market leaders like China, Brazil, Turkey and India, which are constantly battling cyclical inflation — and as a result, worry that QE tied to employment in the West could drive unintended inflation in their home markets.

Given these views, we think the likelihood of the new Chinese administration using rates to re-stimulate growth over the next few years is quite small. Already, as one can see in Exhibit 23, the degree to which loan growth has fueled GDP growth is significant.

Exhibit 23

Bank Loan Growth Has Been a Driver of GDP Growth in China

Data as at December 31, 2012. Source: China National Bureau of Statistics, People’s Bank of China, Statistical Office of the European Communities, European Central Bank, Bureau of Economic Analysis, Federal Reserve Board, Haver Analytics.

Exhibit 24

Credit as a Percent of GDP Has Risen to Roughly 180% from Just 120% in 2008 and Under 90% in 1990

Data as at December 31, 2012. Source: People’s Bank of China, World Bank, KKR Global Macro & Asset Allocation calculation.

By comparison, we did hear a lot of discussion about trying to “liberalize” the lending market to be more efficient and less reliant on traditional procedures for credit creation. In particular, we believe that the development/growth of a non-bank lending market and the development of a strong interbank market are the two major areas on which to focus.

So, how is this deregulation initiative going? Well, we would note the following:

  1. In terms of social financing, non-bank lending is now the country’s main source of new financing. In fact, in January 2013, the net increase in RMB loans were just 42% of total credit (known as total social financing in China) versus 70% in 2008, and 92% in 2002 (Exhibit 26).
  2. The other big initiative is the development of the interbank market. Whether it is SHIBOR (Shanghai Interbank Offer Rate) or CHIBOR (Chinese Interbank Offer Rate), the government and its central bank want to create a short-term lending and repo market that can form the foundation of what it hopes will develop into what now exists in the United States and Europe. Estimates vary, but our research shows that there is growing consensus that 15-25% of assets in the banking system are now priced off the interbank market.

While these liberalization efforts mean that the Chinese government will ultimately be ceding some control over the lending market, economic gains in efficiencies should more than offset loss of control, we believe. Key to our thinking is that as the state-run companies migrate towards issuing more debt versus bank loans, we believe it could lead to lower overall financing costs for the SOEs, making them more profitable and faster growing. In addition, it may lead to greater differentiation among companies as spreads may start to more accurately reflect the health of a company’s financial condition. Another potential positive is that as the SOEs get more credit from the capital markets and less directly from the banks, it would allow China’s large banks to lend more to the small- and medium-sized businesses, many of which currently rely on more expensive regional banks or even the “shadow” market for financing. And by pulling more business away from “shadow lending,” it increases the regulated market by shrinking the unregulated market, which is important as the country tries to develop more broad-based financial services standards.

Exhibit 25

Capital Availability Grew Meaningfully in January, But a Lot of It Is Now Outside of the Banking System

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

Exhibit 26

Today RMB Loans Make Up Just 40% of Total Credit, Down From 92% in 2002

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

Exhibit 27

The Corporate Bond Market in China Has Begun to Develop Very Quickly

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

Importantly, even as the government encourages private sector efficiencies, there are multiple other ways that the government can retain control over key “hotspots” in the lending market. For example, the government’s recent announcement to implement capital gains taxes and increase down payment requirements in the residential market represent important positive steps, we believe. Separately, if the new government follows through on its intention to overhaul how regional governments acquire and resell land, then, in our view, it will be in a much better position to dictate the pace and trajectory of the country’s developmental lending.

So as we look ahead, we applaud the government’s multiple efforts to make its economy less reliant on traditional bank lending. To be sure, this initiative may reduce the government’s ultimate control of large banks, but it should create better growth and long-term return profiles for both the financial services system and its corporate clients. In our view, the trade-off is well worth the cost, particularly as we watch the country deal with the “hangover” from excessive government-mandated lending during the Great Recession.

China Is No Longer a Low-cost Producer

It was 1995, and it was the summer before my first year at the Wharton Business School that I backpacked through Southeast Asia, including China and Vietnam. Even after just a few weeks on the ground, what was clear to me was that Asia’s low-cost wages and entrepreneurial spirit had the potential to significantly damage the U.S. manufacturing sector. Fast forward to 2001 – China enters the WTO, and in the subsequent ten years, the U.S. loses nearly six million manufacturing jobs as China truly emerges as the manufacturer to the world.

Today though, when I visit China, it feels the movie is playing out again, but this time with China’s manufacturing sector being the vulnerable party to lower-cost producers like – ironically – Vietnam, one of the other countries I visited during my trip in 1995. As Exhibit 28 shows, China’s wages have risen well above many of its Asian peers, and not surprisingly, as Exhibit 29 shows, exports in countries like Vietnam have surged in recent years. Importantly, we think rising wages, particularly at the low end, are a structural phenomenon as the population of younger workers aged 15-29 will shrink at an average pace of five million a year between now and 2030, largely due to the one-child policy implemented in 19799. By comparison, this age bracket had actually been growing by two to three million per year annually until recently10.

Exhibit 28

China Wage Growth is an Outlier

*Published growth rates but likely to change (based on coverage of less than 40%). Data as at December 31, 2012. Source: Global Wage Report 2012-2013 ISBN 978-92-2-126237-4.

Exhibit 29

China’s Exports Have not Recovered as Strongly as Vietnam’s

Data as at January 31, 2013. Source: China Customs, General Statistics Office of Vietnam, Haver Analytics.

Exhibit 30

Overall Minimum Wage is Still Way Below Average In Many Cities in China

Data as at December 31, 2011. Source: China National Bureau of Statistics, Haver Analytics.

Exhibit 31

China Is No Longer the Low-cost Producer in Asia

Data as at December 31, 2011. Source: Bureau of Labor Statistics, Haver Analytics, KKR Global Macro & Asset Allocation estimates.

Somewhat to our surprise, many of the folks we met with in China did not dispute our thesis. Rather, they emphasized that China needed to continue to move up the value chain on the export side, which makes sense given recent trends. As Exhibit 32 shows, the crossover towards value-added, or ordinary trade, from re-exports, or lower-value add, finally occurred in 2011. And by year-end 2013e, we think that this proportion could potentially be north of 50%.

Exhibit 32

China is Moving Up the Food Chain and Rebalancing Its Exports Towards Higher Value Added Products

Data as at February 28, 2013. MMA = months moving average. Source: China Customs, Haver Analytics.

Exhibit 33

After China Joined the World Trade Organization (WTO), Its Share of Global Exports Grew Rapidly

Data as at September 30, 2012. Source: International Monetary Fund, Haver Analytics.

Given this sizeable increase in the value-added area, China has not actually lost share in the overall export economy. In fact, as one can see in Exhibit 33, its share has steadied around 11.2%, an all-time high. A key part of this upward migration has been growth in the biotechnology, life science and optical electronics areas. All told, these three industries grew at 14.1%, 17.5%, and 23.4%, respectively in 2012 versus just 3.3% on average for the entire low-value-added segment11.

So as we look ahead, we think the China export economy will continue to grow. However, we think the changing underlying composition of what China is able to export is hugely important for investors in the country. Specifically, we believe that low-cost production will continue to move into western China, which has direct implications for infrastructure, real estate and logistics companies that do business in China. Second, we expect China to commit significant resources to the build-out of higher-value-added areas. This initiative is key, we believe, because it could lead to higher wages for employees, less energy intensity throughout the country and potentially more stable economic growth. It could also help to make China a much more global competitor in industries such as healthcare, technology and energy efficiency. Third, we look for China to continue to focus closely on its trading relationships throughout Asia. As one can see from Exhibit 34, this area now represents the lion’s share of the country’s export-related growth.

Exhibit 34

Asia Made Up the Lion’s Share of Chinese Export
Growth in 2012

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

Exhibit 35

49% of Total Exports from China Go to Asia

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

Urbanization Update

What do Jinan, Changchun, Zhengzhou and Shijiazhuang have in common? There are all relatively “obscure” Chinese cities that have populations of at least five million. To put that in perspective, within the United States only New York City has over eight million inhabitants, while the U.S.’s second largest city, Los Angeles, had a population of just four million (i.e., less than many of China’s “obscure” cities)12. All told, 2011 data by the China National Bureau of Statistics shows 127 cities with populations of one million or more people. Without question, the trend towards more and greater urbanization is, as we show in Exhibit 37, one of – if not the most important – drivers of economic growth in China. Interestingly, despite such strong growth over the past decade, China is still only 50% urbanized versus a full 85% urbanized for a country like Brazil.

Exhibit 36

China’s Urbanization Rate is Still Relatively Low…

Data as at January 2, 2013. Source: World Bank, Haver Analytics.

Exhibit 37

…and With Urbanization Comes Growth

Data as at January 2, 2013. Source: World Bank, IMF, Haver Analytics.

What is even more interesting about the country’s current urbanization statistics is that they actually include the nation’s approximately 265 million migrant workers (or approximately 19% of the total population). To put this in context, China’s population of migrant workers, which shifts seasonally between rural homes during the harvest and urban cities, is the equivalent of 1.7 times the entire U.S. labor force of 155 million. So adjusting for all the migrant workers who travel to the cities for work for part of the year and then return to the country for farming, China’s urbanization rate is probably somewhere between 35-45%. We believe that is good news as it means more growth ahead13.

The potential bad news is that our work suggests that recent urbanization momentum is now slowing. Consider the following. As we show in Exhibit 38, between 1990 and 2010, the total population in China increased by 17% or at an average annual pace of 10 million a year. Over the same period, China’s urban population increased a full 120% to 670 million from 302 million. Assuming that the natural rate of increase in the urban population is roughly equal to that of China’s total population, we estimate that migration from rural to urban areas averaged at a rate of 15.8 million per year.

However, as we show in Exhibits 38 and 39, we estimate that the pace of urbanization has now peaked. A key input in our slowdown analysis is that the country’s younger working-age population (ages 15-29), is now shrinking at an average annual pace of five million a year versus a net contribution of two to three million each year from 2006 to 2009. Unfortunately, the pace of decline (i.e., five million a year) is expected to continue until 2030, which will clearly dampen recent trends14.

Exhibit 38

Urbanization is Set to Slow

Data as at December 31, 2012. Source: World Bank, United Nations Department of Economic and Social Affairs, Population Division (2012). United Nations: World Urbanization Prospects: The 2011 Revision, CD-ROM Edition.

Exhibit 39

The Pace of China’s Annual Rural to Urban Migration Has Peaked

Rural to urban migration based on United Nations projections for urban population % of total and population growth through 2050 and assuming natural urban population grows at the same rate as the total population. Data as at December 31, 2012. Source: China National Bureau of Statistics, United Nations: World Urbanization Prospects: The 2011 Revision (POP/DB/WUP/Rev.2011/1/F2), KKR Global Macro and Asset Allocation Estimates.

Importantly though, we think that there are offsets that the government can embrace to dampen the blow.  Specifically, if China can actually narrow the current sizeable wage-gap differentials that exist (a major priority of the new government, as we mentioned above), it will make a notable contribution to sustaining economic growth.  As such, we were encouraged that the government recently implemented minimum wage hikes in rural areas. But it still has a long way to go: Urban incomes have increased 5500% versus “just” 2400% in rural areas (i.e., more than double) since 1985, so any improvements in this area will take time to have a major impact15.

Exhibit 40

The Urban vs. Rural Wage Divide

Data as at December 31, 2011. Source: China National Bureau of Statistics.

In addition, the government is pushing greater urbanization in western China, which does not have the same wage (Exhibit 40) and real estate differential as the east coast. As such, incremental growth in these less developed areas of China may also help to offset the impact of an overall decline in the absolute amount of Chinese citizens migrating towards urban areas.

So as we look ahead, our conclusion is that the China urbanization story, which has been one of the structural underpinnings to the country’s impressive growth rates, is now beginning to decelerate. In our opinion, this transition will mean finding alternative ways to sustain GDP as it becomes less reliant on the traditional migration pattern towards the eastern, more export-oriented part of China. For the government, this transition may mean it needs to have a greater focus on services, including healthcare, education and retirement products. In the end, our work shows that this transition, if done properly, keeps the downshift in GDP expectations in China towards 7.5-8.0%, above bearish predictions of 5-6% but down from 10%+ in the past. Importantly though, we think the sustainability and quality of 7.5-8.0% will be significantly higher than what the country was recording during its breakneck periods of double-digit GDP growth.


From almost any vantage point, it appears that China is at somewhat of an inflection point in its rich cultural and economic history. As a result, the government — under its new leaders President Xi Jinping and Premier Li Keqiang — must now deal with some important structural issues: slowing urbanization, increased export competition and heavy real estate lending patterns. We do not want to underestimate these significant challenges, but our recent visits to China give us confidence that there are important early signals that this administration will tackle these issues, though its approach to “cross the river by feeling the stones” means that structural change is likely to be evolutionary, not revolutionary in nature.

Given this view, we think that fresh capital going into China should consider concentrating more heavily on the country’s burgeoning services sectors. Key areas on which to focus include healthcare, logistics and transportation. In addition, we expect to see increased opportunities in environmental sectors, air and water quality in particular. By comparison, we think investors should take a more cautious approach to traditional growth sectors like non-residential real estate, European exports, and traditional manufacturing infrastructure.

We also look for China’s new government to deal more directly with what we think is a difficult situation in its banking system. Through liberalization of interest rates and a restructuring of its lending practices, we think that it can overcome some of the missteps the country made during the 2009 lending bonanza. In addition, we look for the government to be more focused on how it deals with real estate lending and regional government lending practices. In our view, both are in need of significant long-term reform.

So while China will likely experience some bumps in the road as it works to reform several key industries, we still feel confident that China can attain our 7.6-8.1% target in 2013. Probably more important though, is that we think that the new government is doing more than enough in key “pivot” areas like financial services, exports and real estate to ensure that China can indeed hit our long-term target of driving at least one third of total global GDP growth over the next three to five years.


  • 1
  • 2Way forward for new leadership,” China Daily Asia Pacific, December 3, 2012.
  • 3 Data as at June 19, 2012. Source: United Nations World Population Prospects.
  • 4 Data as at February 17, 2012. Source: China National Bureau of Statistics.
  • 5 Data as at December 31, 2012. Source: Instituto Brasileiro de Geografia e Estatística (GBE), China National Bureau of Statistics, India Central Statistical Organization,Haver Analytics.
  • 6 Wall Street Journal, “Unrest Grows as Economy Booms,” September 26, 2011.
  • 7 Data as at December 31, 2012. Source: Ministry of Finance of China, Haver Analytics.
  • 8 Data as at December 31, 2012. Source: Instituto Brasileiro de Geografia e Estatística (GBE).
  • 9 Ibid.3.
  • 10 Ibid.3.
  • 11 Data as at December 31, 2012. Source: China Customs, Haver Analytics.
  • 12 Data as at December 31, 2011. Source China National Bureau of Statistics and the United States Census Bureau.
  • 13 See footnote for Exhibit 39 for more details and sourcing. United States labor force stats from the United States Census Bureau.
  • 14 Ibid.3.
  • 15 Ibid.4.

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