By HENRY H. MCVEY Jul 16, 2012

China staged a mighty rise at the dawn of the 21st century to become the world’s preeminent manufacturer. The economic growth and prosperity it has reaped in the process will go down as a remarkable chapter in the annals of one of the most ancient civilizations. Now begins a new chapter—one of transition—as China adapts to rapid changes within and around it. With the European continent in turmoil and tepid growth among its trading partners, we do not believe China’s export economy can further sustain the meteoric trajectory it has enjoyed since 2001. The other major issue is that real estate can no longer be relied on to stimulate growth and consumption, in our view. So what are China’s prospects? We do not agree with the hard landing thesis, but we do think the economy has downshifted to a slower rate than the consensus is forecasting. Strong consumption trends may help, but exports are likely to remain challenged. This is a significant change in the Chinese growth model. As a result, we believe the government will likely have to use non-traditional fixed investment as a “plug” to achieve its targeted growth rate in the near-term. This balancing act is likely to create more uncertainty than in the past. But amid that uncertainty, we see opportunity, particularly in consumer-related areas that are quickly shaping the tone and direction of this country’s transitioning economy.

We remain focused on China as a “swing factor” in global GDP growth. Given the enormity of China’s contribution to the global economy, we spend a great deal of our time evaluating the country’s trends. To this end, we recently spent another week in Beijing discussing the economy, markets, policy, and investment opportunities with a variety of local businessmen, policy makers, and political leaders. And as we suggested in our previous paper last fall, China is likely to account for 30–35% of total incremental global growth—even by modest accounts—over the next 3–5 years1.

Our trip confirmed our view that the consensus on China’s GDP growth is still too high. For 2012, we maintain our forecast of 7.5–8.0% annual GDP growth versus a consensus of 8.2%2, which we still think needs to come down closer to our range. In fact, after discussing current trends with business leaders and policy makers, we fear that China might even fall short of our forecast for the year. Key to our thinking is that not only is China’s export economy now facing some structural headwinds but its consumption economy, while strong, is not enough to offset slowing fixed investment.

Tighter liquidity has been hampering growth for some time, but we believe it has been the European sovereign crisis that has hurt global demand more than the Chinese authorities were forecasting. As a result, we weren’t surprised to see the central bank starting to ease its monetary policy again, particularly given that we forecast inflation trends to decelerate meaningfully in the next few months.

Even after the recent rate cuts, we understand there is still a vigorous debate among government officials about how much fiscal stimulus should be dispensed. Chinese leaders more familiar with the capital markets are concerned that too much additional stimulus could ultimately undermine the central bank’s ongoing battle with inflation. By comparison, other officials measure success more closely with the level of job growth. Given our benign view on near-term inflation, we now expect two additional cuts in the reserve requirement ratio (also known as the cash reserve ratio, which is the minimum reserve required of commercial banks to hold) and think that short-term interest rates could fall by an additional 50 basis points in the next 12 months.

In our view, China offers growth investors a lot of opportunity, but the public markets are still likely to disappoint. Every visit to China excites us anew about the potential investments we see in core growth areas like consumption, infrastructure, logistics, healthcare and wellness, and services in general. Yet, unfortunately for mainstream investors, the public equity markets provide very little exposure to these areas. State-run enterprises account for 71% of the total market capitalization of the China H-Share index3. By comparison, consumer-related areas account for just 3% of the same index.4 We therefore view concentrated public equities, private equity and developed-market investments with Asian linkages as more appealing alternatives.

We remain cautious on China’s banking sector, though we believe recent reform is a step in the right direction. Recent reform, aimed at widening the band on loans and deposits, is encouraging. But China’s banking system still has some major flaws that must be addressed as the country’s economy becomes more open and globally integrated. We think its current non-performing loan (NPL) ratio5 of 1% is likely too low by 300–400 basis points. Embedded in our assumptions is a high-conviction view that capital was poorly allocated during the government’s 2009 campaign to stimulate growth through increased fixed investment.

Looking ahead, we believe Chinese consumption will remain strong, but other drivers will be needed to sustain growth at the government’s targeted rate of 7.5%. As we detail later in this report, consumption-led economies typically grow at a slower pace than economies driven by fixed investment. China’s fixed investment is expected to ebb in the future, as will its role as the manufacturer to the world. Yet, as the country transitions towards a more consumption-led economy, in our view, it will likely have to use fixed investment—particularly in infrastructure—to fill in the “gap” at certain points in the cycle when its ‘new’ mix falls below targeted growth levels. Without question, now appears to be one of those times.

There are no changes to our global asset allocation targets. We remain underweight cash, European public equities, and developed-market sovereign debt. Our outlook on Asian private equity—especially in China—is positive. In our view, private equity remains one of the most efficient strategies to gain exposure to rising consumption in emerging markets, which we perceive as a critical theme and important source of potential returns in the future. We’re also comfortable maintaining our outsized position in what we call “spicy credit,” which includes emerging-market, mezzanine, high-yield and investment-grade debt. Finally, given that our target allocation is significantly tilted to the corporate sector, we think that an overweight allocation to real assets makes sense because it provides exposure to an asset class that does well when high input costs adversely affect corporate margins.

Details of Trip

China’s economy has slowed more than expected. I generally plan visits to China when I want to feel better about global economic growth trends. That did not happen this visit. Rather, from what we could tell, China is witnessing a broad-based slowdown across fixed investment, consumption, and especially exports—a slowdown whose magnitude appears even more severe than that of 2008 (Exhibits 1 and 2). This is not to be taken lightly, since China is expected to account for more than one third of global growth the next few years, and Asia as a whole is expected to drive 60% or more of total incremental global growth (Exhibit 3).

For the record, our prediction that China’s economy would stabilize in the second quarter of 2012 did not materialize—whether because of a sluggish real estate market, economic woes in Europe or other reasons. Yet, we maintain our 2012 GDP growth forecast for China, which has stood at 7.5–8.0% since the beginning of the year. The current consensus calls for 8.2%, revised downward from 8.5%, and it’s clear to us that it should come down even further (Exhibit 4).

What felt different this visit. During our visit to China last fall, Beijing was intent on taming its housing market excesses through a more aggressive interest-rate policy. Its central bank was duly clamping down on fixed investment growth by tightening credit availability to developers across cities of all tiers. All told, in 2010 and 2011 the central bank raised the 1-year lending rate 5 times—a total of 125 basis points—while lifting its reserve ratio requirement for major banks 12 times by a total of 600 basis points over the same period.6

The outcome of these initiatives was substantial and is now on display throughout the country. Specifically, overall home prices in China have declined 1.8% in nominal terms and 4.8% in real terms, though in certain cities the damage has been much worse, with prices having fallen by 15% or more.7 By comparison, between December 2008 and December 2011, home prices rose at a compounded growth rate of 12.4%—an impressive rate in absolute terms, albeit one that was driven by nominal GDP growth of 15.3% and supported by an exceptionally vigorous economy (Exhibit 7).

If there is good news on the real estate front, it’s not that we expect another bout of home-value appreciation. Such a pattern, in our view, would create too much social unrest and would be inconsistent with what the central bank has been trying to achieve over the past 12 months. It could also be de-stabilizing, given where price-to-income ratios (Exhibit 8) and square footage per dwelling (Exhibit 9) have increased in many instances.

Our bottom line: We believe real estate can no longer be the engine of growth in China. As Exhibit 10 shows, its contribution to GDP is already outsized relative to its peers. Moreover, there are still large pockets of excess that remain to be worked off, including some in several Tier III and Tier IV cities.8 Our overall impression is that national home prices will struggle to appreciate much from current levels in the near-term.

However, in the near-term we do not expect a bust like the one witnessed in Spain recently or in the United States after 2006. Our guarded optimism stems from the rate of home ownership in China’s urban areas, which is still less than one unit per household (or 0.78, to be exact), according to a research paper published by Eric Zhang, a property analyst at the China International Capital Corporation (CICC) investment bank.9 Using Japan as a proxy, Zhang’s findings suggest that a ratio of 1.1 units per household is when property prices typically succumb to significant price erosion.

Household-formation and disposable-income trends—two important growth drivers for the housing market—also currently remain solid (Exhibits 13 and 14). Separately, estimates for current urbanization levels are in the 45–51% range, which we believe is far from saturation levels. Finally, the Chinese government—unlike that of Spain, the United States or Ireland—controls market supply and dominates lending, which we believe affords a tailwind that would cushion any downturn in housing prices should demand weaken significantly more than expected from this point on.

Apart from changing role of real estate in the Chinese economy, we’ve observed another macro development during our recent visit concerning the money supply. The dynamics of this supply, which we think incorporate both cyclical and secular components, have changed. On the cyclical side, there is a clear relationship between money supply and the tightening of credit conditions resulting from the sequence of rate hikes in 2010 and 2011 (Exhibit 2). But the secular component—the slowdown in foreign-exchange accumulation as a result of the Chinese currency’s appreciation toward fair value—is less understood, but we believe it matters for two reasons. First, China will no longer see rapid liquidity expansion from the buildup of foreign-exchange reserves, which now total a staggering $3.3 trillion10. Second, credit growth will now likely be more reliant on internal measures like reductions in the reserve requirement ratio (RRR); and within the interest rate arena, monetary policy will likely converge toward that of established markets, with loan growth becoming more closely linked to interest rates versus just loan quotas.

Like all rebalancing cycles, the Chinese one will take time to play out, but we think the era of loose liquidity and manipulated loan growth in an undervalued exchange-rate environment will usher a new era of more stable credit growth (Exhibit 15), as exchange rates and the policies that surround them move closer to equilibrium (Exhibit 16).

Chinese policymakers made it clear that the government does not want to repeat its recent mistakes. To fully appreciate why the Chinese government is so concerned about over-stimulating the economy via fixed investment this time around, consider some historical perspective. Following the dot-com bubble burst and the 2001 global recession, our research shows that many emerging-market countries (including China, Brazil, Turkey, and India) displayed significant economic growth and market outperformance as they emerged from the global economic trough of 2003. Capital markets in emerging economies expanded mightily as a result, generating new found interest among retail and institutional investors. Inflation was generally low while growth was consistently above average. At the same time, the developed-market consumer was still consuming more than historical averages (and borrowing against home equity to do it), which helped emerging countries boost their exports and also fueled their own domestic consumption.

At the dawn of the Great Recession in 2008, all the large emerging economies pursued aggressive macro-economic policies to avoid a major, sustained economic downturn. China expanded its fixed investment in real estate and infrastructure to boost its national economy (Exhibit 18), whereas many of its peers, including India, Brazil, and Turkey, favored stimulus measures to encourage consumption. All these policies worked—yet they were disproportionately high relative to the actual economic downturn these countries experienced. As a result, they have led to unintended macro consequences—including excess consumption in Brazil, Turkey, and India, and outsized fixed investment in China—with significant fallout11.

India now faces near-record inflationary pressures; China is dealing with the hangover of too much fixed investment; Brazil faces an insufficient infrastructure to satisfy its burgeoning middle class; and Turkey is now saddled with a massive current account deficit of 9–10% of GDP12.

So, as we look forward, China—like many of its emerging market peers—faces a difficult dilemma as it considers whether to counteract today’s ebbing growth at the expense of not fully ridding itself of the excesses of its previous round of stimulus, in our view. Exacerbating this issue is that politicians whose careers depend on growth and jobs are always confident that more stimulus is better than less.

Upon observing the mood of senior Chinese officials, our impression is that the severity of Europe’s crisis will impel China to pursue an easier monetary policy in the foreseeable future. Even before China’s rate cut of 25 basis points on June 8, we had learned from several business leaders and policymakers that help is already on the way, so to speak, in order to counteract the negative economic impact of Europe’s woes—an impact that appears to have already spilled into June. To date, China has approved the funding of several significant infrastructure projects, which were followed by an uptick in real-estate transaction volume 13. Our work leads us to expect another reduction in the banks’ reserve requirement ratio (RRR) in the near future.

With inflation at 2.2% in June and likely headed lower (Exhibit 19), China has a lot of wiggle room to maneuver its monetary policy. The drop in the producer price index (PPI)—and the consequent widening of the spread between it and the consumer price index (CPI), which has now turned positive—is a significant development,14 since positive PPI/CPI spreads are usually beneficial for profit margins. This backdrop should allow the government significant room to navigate monetary policy, and we would expect another two reserve ratio cuts and think that short-term interest rates could fall by another 50 basis points over the next 12 months (Exhibit 20).

We also think it’s important to consider China’s starting point now, as it moves forward, relative to other countries. In a world of low interest rates—even near-zero rates, in the U.S. case—China still has its reserve ratio requirement of 20.5%. Moreover, its banking system has a loan-to-deposit ratio below 75% and $3.3 trillion in reserves15. In macro terms, we believe these are big, powerful tools that can be leveraged further by Chinese officials particularly if Europe weakens further.

In the very near term, we would still anticipate a more incremental approach to easing and fiscal initiatives by the Chinese. However, if growth does not meet or exceed the government’s 7.5% target by late-summer—or if Greece or Spain defaults—we would anticipate China to abide by its clear objective it has stated all along: that its government is focused on economic growth, and that it will do what it takes—even at the risk of higher inflation—to achieve its growth target and help create 10–15 million new jobs each year.

A Banking Conundrum Remains. While our outlook on long-term domestic consumption in China is positive, we remain cautious on the country’s banking sector, taking a few factors into consideration. China’s banking system benefits from the government’s suppression of the deposit rate (though recent announcements about flexibility on the lending and deposit rates is an important first step towards addressing our concerns), which we believe allows the banks to earn an outsized margin and State Owned Enterprises (SOEs) to receive below theoretical market loans16. Yet this policy makes capital allocation inefficient and also comes at the expense of Chinese households, in our view, which are being asked to earn negative real rates of return on their investments.

Additionally, China’s hangover from the excess lending of 2008–2009 has not fully cleared in terms of non-performing loans (NPLs). We have been studying financial services long enough to know that China’s year-over-year growth rate of 34.4% in 2009—or mortgage growth rate of 52.7% in 2010—should not translate into an NPL ratio of 1%, regardless of underwriting standards (Exhibits 23 and 24). We think the real loss rate will rise toward 4%, 300 basis points higher than its current level.

To state the obvious, low NPL ratios are inconsistent with spikes in loan growth, so we were not surprised to read the following statement by the China Banking Regulatory Commission on June 5, as published in China Daily:

“We are already aware of an obvious increase in overdue loans and ‘special-mention’ loans. Further statistics and analysis are necessary for us to discover the cause of the inconsistency and how much hidden risk there is.”

However, while we remain cautious on the banking sector as a public-equity investment opportunity, we do not expect a total collapse in financial equity valuations, since Chinese banks command monopoly positions in key markets, earn significant pre-provision profits, and have decent reserve levels. Rather, what we expect is more of the “extend and pretend” that we’ve witnessed thus far, which, over time, may exacerbate some of the return on capital issues that China faces as a country. In our discussions with leading policy makers and business leaders, we were told that some of the highly controversial local government funding vehicles have already been allowed to roll over their maturities.

We Believe Demographics are Getting Ready to Turn the Corner. While demographics aren’t usually among the most riveting macro topic to discuss, they are important because they are highly instructive to understanding the macro backdrop and forecasting the future. As Exhibit 27 shows, China will start to face a major demographic headwind by 2016 as its working-age population peaks at 996 million—or 73% of total population—by 2016. It is then expected to decline by 21% (or 206 million people) between 2016 and 2050. To realize the magnitude of this decline, consider that the entire U.S. population was just 313 million in 201117. Further, the labor force’s participation rate18 is expected to fall as China’s population ages. Based on current rates, we estimate that China’s participation rate will fall by at least 200 basis points over the next 40 years as the percentage of people aged 65 and older rises from just 8% to 25.6% in 2050 (Exhibit 28).

Why does this matter? Firstly, we expect savings rates will likely fall as the elderly began to draw down on retirement savings to fund their lifestyles. From what we can tell, to date, we have actually not seen any marginal shift away from savings towards consumption in China as rapid income growth has driven savings rates higher. In fact, urban household savings rates increased from 11.9% in 1989 to 30.5% in 201119. Meanwhile consumption as a percent of GDP fell to 35% from 51% during the same period20. So, as the maturation of the Chinese society occurs, the decline in the Chinese labor force’s participation rate may also present investment opportunities as the government enacts policies to provide a social safety net in the form of healthcare, welfare and various entitlements for workers and retirees.

Finally, as China’s labor force matures, we think the economy’s emphasis will shift from labor toward capital, and that there will be a big push toward value-added industries like automation to maximize worker efficiency and help offset the headwinds to growth that demographic forces are likely to generate in the coming years.

China’s Equity Market Does Not Reflect China’s Economy. As we’ve stated earlier, the investment opportunity set in China’s private-equity sector is far more attractive, in our view, than in public equities. Recent data supports our view: The Hang Seng China Enterprises Index (HSCEI), which consists of Chinese companies whose shares are issued in China but traded in Hong Kong, has fallen 34%, as at June 5, from its peak in November of 2010. This doesn’t surprise us. After all, state-owned enterprises (or SOEs, most of which are financial-services and energy outfits) account for 71% of the index’s market capitalization (Exhibit 29). In other words, China’s public equity market is not representative of the growing consumption trend in China. In fact, the consumer-discretionary and consumer-staples sectors make up only 3.5% of the index. If faced with a choice among public Chinese equities, we continue to favor the pair trade of non-SOEs over SOEs, as the latter have underperformed the former by 44% since 2008 (Exhibit 30).

China’s Rebalancing is Underway... But It Will Take Some Time And Requires a New Framework

When you jam-pack several days’ worth of research, it’s easy to focus on incremental data points and inadvertently miss the larger story. Yet the flurry of meetings we conducted with business people and public officials during our recent visit to China helped crystallize to us the big picture: It’s that China’s rebalancing away from fixed investment and exports and towards consumption has started. That’s the good news. The bad news is that it will not be easy and this transition is likely to adversely affect folks that continue to cling to the “old model” of low-value-added exports and heavy real estate fixed investment.

So what’s changing? Well, we think it’s important to appreciate that China’s current account surplus has shrunk meaningfully in recent years (Exhibit 31)—a trend we attribute to its appreciating currency, as well as to rising wages, which make absolute consumption more feasible (Exhibit 32). The government also recognizes that, with European demand slowing and the U.S. increasing its manufacturing competitiveness, China cannot continue relying on its exports to drive as much of the incremental growth that it has in the past (Exhibits 33 and 34). In our view, this slowdown is a secular, not a cyclical shift, and it has significant implications for investors that have allocated capital to this part of the global economic ‘food chain.’

...And Rebalancing Means Slower Growth

As we mentioned above, the challenge is that overall consumption is not yet a big enough percentage of the economy to allow the country to maintain its past growth rates—and historical precedent supports our view on China’s slower growth trajectory moving forward. As consumption rises above 40% of GDP and fixed investment falls below 40% of GDP, GDP growth rates tend to slow (Exhibits 35 and 36). In our humble view, not enough policy leaders and investors have focused on this relationship, which is important because it signals what may happen when an economy transitions towards consumption and away from fixed investments: It may slow significantly.

If our prediction proves right, then fixed investment may again become the catalyst for an annual GDP growth of 7–8%. However, if it is more in infrastructure related projects than real estate, then the positive multiplier effect on the economy will certainly be more limited. It is also clear that the Chinese government wants to do more to encourage consumption by expanding healthcare and retirement benefits; however, the world’s volatile macro backdrop has not afforded China a normal environment in which to impose its revised macroeconomic policy. And given what’s going on in Europe, our view is that China will be unable to rely on a spike in consumption in order to drive economic growth. Instead, we believe the Chinese economy will likely evolve more gradually toward consumption but use shorter-term fixed investments, including in railroad infrastructure, to sustain growth levels above 7% over the next 5 years. Without question, we hold the view that China and its peers in the global economy must be prepared for a bumpier ride than in the past.

Summary

My travels to China date back to 1995, and it’s clear that this is a country again in transition. By this I not only refer to the upcoming government leadership transition this fall. My team and I suggest that China’s export economy is not likely to be a major driver of economic growth over the next few years, which is one of the reasons we’ve come across such dispirited perspectives from U.S. companies that cater to industrial China. After all, China did rise to fame and enjoy prosperity by becoming the manufacturer to the world after its introduction to the World Trade Organization in 2001—but now its economy is charting shifted territory.

It is also clear that lending to finance fixed investment, in isolation, is no longer a viable strategy for boosting growth during short-term economic pullbacks, in our view. Local municipalities are overleveraged; residential real estate is fully valued in many instances; and banks probably have artificially low loss rates. So China is decidedly a country in transition: It cannot rely on many of its traditional levers to rekindle growth as easily as it has in the past. In the near-term, however, it has no choice but to try. In other words, until consumption can by itself “carry the day,” government-mandated and financed fixed-investment projects may still have to be embraced during times of stress, even at the risk of sluggish returns on capital. We do not state this lightly, since it could involve a bumpy economic ride with the potential for higher inflation and/or slower growth than what China’s central bank desires.

We also believe that China will continue to grapple with demographic headwinds and with tensions over how to accept the proliferation of social media—both important factors to consider when surveying the country’s investment landscape.

But as part of this economic and social transition, there is also a lot of opportunity being created. Investment plays on consumption trends, as well as the logistics-related, health and wellness, and services industries are appealing to us. We view them as big, long-tail ideas with potential nominal growth rates exceeding 20% annually for quite some time.

Our premise is that China still has further room to grow. The urbanization rate, which we view as one of the key drivers of China’s future growth, still stands at only 44.9%, compared to 80% in some emerging other countries (Exhibit 11). Also, as factories and infrastructure are now being built in—and moved to—western China, this expansion should add more stability to the country’s growth profile.

Finally, in a world of bank failures and sovereign debt crises, we believe China’s huge reserve base and high reserve ratio requirements will likely serve as a near-term cushion, and its government’s decisions to stimulate growth or adapt to change need to be made quickly and decisively.