By HENRY H. MCVEY Feb 24, 2015

Over the past 10 years, China has been the fastest growing major economy in the world.  It has also had among the worst stock market returns as capital was misallocated badly to drive growth and employment in areas of the economy that either lacked competitive advantage and/or did not create productive returns on capital. Today, we envision a different outlook for China. We see a slower growth economy with the potential for a better stock market in the near-term.  Key to our thinking is that China now has a fast growing services economy that is larger than its combined construction and export sectors. We also see an e-commerce initiative that is driving both convenience and efficiency, and lower inflation that 1) makes real estate less interesting; and 2) gives the PBOC more flexibility to ease. The bad news is that China remains a country undergoing a massive transition across many parts of its economy, fixed investment and export activity in particular. Our bottom line: The upside for being in the right as well as the downside for being in the wrong sectors has never been higher in China, particularly given our view that the current rebalancing effort is likely to accelerate even more in the quarters ahead.

In an effort “to learn more about China,” I recently made another extensive trek back to the mainland. My goal was to gain further insights into the key macro trends now shaping the country’s growth trajectory during what we view as one of the most complex and consequential times in recent Chinese history.

Interestingly though, while the intent of this latest visit – like almost every one that I have made since my original trip in 1995 – was for me “to learn more about China,” it was clear this time that many of the Chinese with whom I spoke now increasingly want “to learn more about the world,” eager to better understand how the global economy might affect their businesses and the country’s future. However, the desire by both local business leaders and public officials to “learn more” certainly should not come as a huge surprise these days, particularly as China works to further open up its economy and stand even taller on the global stage.

Overall, I left China with much greater appreciation that there are some noteworthy structural shifts unfolding across the economic, political, and social spheres of the country that warrant investor attention. Specifically, our trip confirmed our views that 1) new trade/export initiatives are now almost entirely focused on gaining share in higher-valued added segments of the markets (versus defending existing low value-added enterprises); 2) the fast-growing e-commerce sector in China is uniquely positioned to disintermediate key parts of the “old economy,” and 3) many global services-based businesses in China are now growing faster than local traditional fixed investment enterprises.

No doubt, China Inc. is undergoing a sea change – change that we believe has important investment implications for almost any global investor. To this end, we thought it might make sense to highlight some key macro-related investment conclusions from our recent trip as well as our latest proprietary research on the Chinese economy and its markets. They are as follows:

1. After years of being more reserved than the consensus, we are finally making the call that investment as a percentage of GDP has peaked (Exhibit 1). Importantly, we are making this call not because overall investment has become an outsized proportion of GDP. Rather, our trip underscored that environmental concerns – by becoming more important than job creation – are now driving public and private corporate behavior. Consistent with this more conservative projection, we think that decisions over key spending initiatives and growth targets are now increasingly being made by Beijing, not local provinces.
2. Against this backdrop, the government is prodding the private sector to allocate more resources toward services that can boost overall growth in China without as many environmental issues. In addition, a larger services sector will help to chip away – in aggregate – at the country’s overly leveraged corporate sector.
3. Despite lower oil prices, energy efficiency remains a major focus. See Exhibit 29 for full details, but our research shows that oil demand grew about 0.69% for every 1.0% of GDP growth in 2014, which is significantly lower oil intensity than the 0.94% ratio that prevailed ten years ago. See below for details, but – looking ahead – we see it falling even further, underscoring that China appears to be making progress in the area of energy efficiency at a time when many of its emerging market (EM) peers are not. That said, even with improving efficiency, we still forecast that China will account for a full 36% of total incremental global oil demand through 2018.
4. Contrary to conventional wisdom, we do not view the recent rate cut by the People’s Bank of China (PBOC) as highly stimulative in nature for the Chinese economy. In fact, we left Beijing with the view that the recent rate cut was primarily designed to slow non-performing loan formation in the existing corporate sector, particularly a weakened industrial sector. By comparison, we think the PBOC can use the reserve ratio requirement to more effectively facilitate liquidity needs of both banks and small- to medium-size businesses. As such, we could see many more RRR cuts ahead, particularly as we think China may now have a deflation/disinflation issue.
5. Reforms, including anti-corruption initiatives and greater transparency in the financial services arena, continue to gain momentum, despite their near-term chilling effect on GDP growth. The good news is that comparisons are now getting more favorable in many hard hit areas, including high-end hotels, luxury retailers, and restaurants. Probably more important in our view, we see signs that the government is finally raising the bar on pricing credit risk properly at the local level. In our view, if China is ever to mend its excessive lending habits, reining in credit at the local level is required.
6. China’s Internet economy is having a profound effect on traditional commerce. Indeed, China’s online sales effort is already larger than the United States’s. A key reason for the country’s rapid success, we believe, is that China’s large Internet companies face much less competition from traditional vendors, retail in particular, than in other countries. This advantage is significant because it likely means that companies like Alibaba, Baidu, and Tencent could garner outsized market share if they can deliver compelling logistics, customer service, and offerings. It also means, in our view, that developers likely have built too many traditional malls and stores, a trend we think investors are now just starting to appreciate. Details below.
7. Though it may pause, we do not believe that the current rally in the China A-share market is over. Equity issuance is a critical variable in the deleveraging process, so – all else being equal – higher, not lower prices are more desirable for the Chinese leadership. Moreover, from an asset allocation standpoint, a low inflation environment favors stocks over real estate, which has traditionally been viewed as an effective hedge against the “norm” of high inflation and low deposit rates. Finally, albeit slowly, the financial services system, which accounts for 36% of the China A-share Index, is implementing enough changes to potentially lift valuations off their extremely low base.

Overall, for the first time in several trips, I left Beijing more encouraged, not less, about the economic transition that is occurring. Indeed, whereas last year our China deep-dive was titled China: Repositioning Now Required, this latest visit gives me greater confidence in China’s Rebalancing Act. Of upmost importance to us is that the Chinese economy has finally reached a tipping point towards services, which is now the largest and fastest growing part of the economy (Exhibit 2).

However, strong growth in services is no longer an economic luxury for China; rather, we believe it is a necessity. Simply stated, a growing services industry has emerged as an important force of stability in an economy that is under massive pressure in other sectors – pressure that is now so immense that it could derail our overall outlook for the country if 1) services do not continue to grow faster than the overall economy; and 2) downsizing of excessive fixed investment – and the corresponding leverage – are not handled properly. Our concern about the latter risk rests squarely on our strong view that there was a debt-fueled growth bubble in China that started in 2009 as nominal lending soared way above nominal GDP (Exhibit 8).

Importantly, our concern about excessive fixed investment does not rely just on economic theory, or historical precedent. Rather, our frequent visits to mainland China in recent years continue to uncover an increasing number of examples of economic carnage linked to poor allocation decisions in both China’s fixed investment arena as well as its low-end export market. We also see the adverse impact of excess capacity in recent inflation trends, which hit just 0.8% year-over-year in January.

From what we can tell, both sectors of the economy (i.e., fixed investment and low-value exports) are now under significant siege, and unlike past trips, neither the private sector nor the public sector seems committed to trying to stave off their demise. In fact, given the focus on improving the environment for the country’s middle class, many Chinese now want these former growth relics to disappear as quickly as possible.

From an investment standpoint, we still believe investors should generally avoid hard commodities linked to the prior China Commodity Super Cycle unless they are a low-cost producer and/or provide some value-add in the global food chain. Simply stated, we believe that the fallout we are seeing in areas like steel, iron ore, etc., is secular, not cyclical. Separately, general consumer retail growth is slowing more than expected as there is too much square footage growth at a time when e-commerce is gaining massive market share at the expense of ill-prepared traditional merchandisers.

By comparison, in our view, healthcare services, environmental remediation, and the Internet are all likely to see not only strong growth, but also multiple re-ratings upward. Importantly, we still see China as a rising GDP per capita story, as wage growth remains among the highest in the world on a real basis (Exhibits 5 and 6). From a style perspective, given our view that China will need to use additional liquidity measures to stave off strong disinflationary pressures, we think that Chinese stocks with compelling dividend yields and reasonable earnings growth are likely to be strong outperformers in 2015. Ironically, after years of strong GDP growth but poor stock market performance, we think the opposite might occur in 2015.

On the debt/restructuring side, there is likely a massive opportunity to help companies not only in China but also in countries like Australia, Brazil and Canada, many of which we believe bet too big on the sustainability of the China Growth Miracle. For our nickel, the fallout from China’s investment slowdown could be one of the largest opportunities across the global capital markets over the next five years. As such, we continue to believe that investors marshal significant resources behind this idea on a global basis. We certainly have moved our asset allocation in this direction as we recently made Distressed/Special Situations our largest overweight position in our 2015 target allocation (see Getting Closer to Home published in January 2015). All told, we allocate a sizeable 15% of our entire portfolio to this opportunity, compared to a benchmark weight of just zero.

The Big Transition: Services Up, Investment Down

Life is pleasant. Death is peaceful. It is the transition that’s troublesome. Isaac Asimov

While we have spent the vast majority of our time at KKR analyzing the fallout from a structural slowdown in the China fixed investment story, this trip was the first one where we repeatedly learned about the services sector in China reaching somewhat of an economic inflection point. Importantly, we are not making a “gut” instinct call. Rather, as one can see in Exhibits 2 and 7, recent macro data support our view. Specifically, China’s services sector is now not only growing faster but it is also a bigger part of the economy. While services is a broad-based term, we left most impressed with the strong macro tailwinds we saw in key growth sectors like healthcare, entertainment/media, and environmental services.

Without question, the aforementioned economic transition is a big deal as services are often less capital intensive, grow more quickly, and require less leverage. Services industries also often cater more to domestic consumption versus exports; in addition, wage growth in services often has more flexibility to track upward growth in GDP per capita than exports.

As we show in Exhibit 10, healthcare services, technology, financial services, and railroad/logistics are all growing nicely, with strong macro and political tailwinds. We also heard a lot about services-based businesses that help with tourism and travel inside and outside of China. According to the National Tourism Administration, the number of Chinese leaving the mainland for outbound tourist trips recently exceeded 100 million for the calendar year ending November 2014 versus just 8.4 million in calendar year 1998. Growth in years ahead, however, looks even more compelling in absolute terms as President Xi Jinping recently suggested that the 100 million could reach 500 million within just five years1.

Importantly, these services-based industries are necessary to improve productivity, which is crucial to help drive down aggregate debt levels across China’s over-leveraged corporate sector as well as to further improve GDP per capita. Also, because high-value-added services often require more human capital than traditional capital expenditures, they often require less lending. As such, this initiative should help to bring lending growth back down towards nominal GDP growth over time, a key focus of this new government (Exhibit 8). It will also rebalance bank financing away from State Owned Enterprises (SOEs) and towards households, which will help to bolster the government’s rebalancing effort.

On the other hand, our research as well as our on-the-ground discussions lead us to believe that many traditional parts of China’s fixed investment are now “officially” in secular decline. Indeed, as Exhibits 9 and 10 show, the overall level of fixed asset investment, which we view as a broader measure of total investment in China because it includes land sales associated with local real estate activity, is decreasing. In addition, many other key sectors – including mining and manufacturing – are all growing slower than the declining average. Probably more importantly, in our view, was that this was the first trip where there was a consensus across both the private and public sectors that the China Growth Miracle that defined the 2000-2010 period had come to an end.

Importantly, we believe that fixed investment is not being de-emphasized just because it had reached an unsustainable 48% of GDP. Rather, over-investment has become a major social issue as it has created pollution and environmental concerns that the middle class of China find offensive. Indeed, as Exhibit 13 suggests, China’s pollution metrics are well above their emerging market brethren, and they dwarf developed market countries like the United States and Japan. Not surprisingly, many locals with whom we spoke referred us to the air quality index at www.aqicn.org, which as of February 5th, 2015, had an “unhealthy” reading for six of the seven major cities it tracks. Beyond daily pollution, Exhibit 14 also shows a full 27% of all global carbon dioxide emissions come from China.

So whereas we used to believe that job growth was essential to maintain social stability, we no longer hold this view, particularly now that China’s is passing the peak of its working age population growth. Rather, it now appears that environmental safety may have trumped employment as the government’s most pressing near-term priority. We believe this shift in sentiment is a big deal because social pressure by China’s 1.4 billion people has emerged as a far more potent catalyst in affecting government behavior than the Chinese capital markets, particularly given that the Chinese government has $4 trillion in reserves and essentially runs a closed capital account.

As we look ahead, our base case is that growth in fixed asset investment (FAI) continues to decelerate from 15.7% in 2014 towards the high single digit range over the next five to ten years. Here is our logic in rough terms: in the past, China grew its economy at real GDP of around 12%, with inflation ranging from 4-8%. In this environment, it was not uncommon for nominal GDP growth to reach 16-20%, with FAI growth hitting 25-30%. However, as we look ahead, we see much more modest growth and much lower inflation. Specifically, we are now forecasting around 6-7% real GDP growth and just 2-3% inflation. As such, nominal growth in GDP is now likely to be around 8-10%, or just half of what it was in the past.

So, if China’s central government is serious about rebalancing its economy, it will need to rein in provincial spending if it intends to truly narrow the overall gap between FAI growth and nominal GDP growth. To accomplish this feat, we posit total FAI will need to grow in just the single digit range. This scenario is the base case we outline in Exhibit 17. Meanwhile, as Exhibit 17 also shows, our bull case for FAI growth is that the country ignores economic theory and continues to grow fixed investment at the expense of long-term stability, while the bear case for FAI growth assumes that China experiences a mini-credit crisis that dampens access to credit across the FAI arena.

If our math is right, then our FAI slowdown thesis has important implications not just for China but also for commodity-linked countries like Brazil, Australia, and Indonesia. Simply stated, it means that the global industrial and commodity food chains that defined the boom period during the past decade will likely continue to undergo a significant hollowing out. We think this headwind will be particularly severe for countries that did not allocate capital properly, under-invested in infrastructure, and/or suffered from excessive government interference.

Exports: Transition Under Way Too

China will encourage its companies to explore the international market…. Li Keqiang, Davos 2015

While the key message from our most recent trip to China was clearly the juxtaposition of a decrease in fixed investment spending versus upward growth in the services sector, another important development is the notable shift that is now occurring from low-value-added to high-value production across the export sector in China. This news is not necessarily “new” news; however, whereas during past trips there was some debate about whether China could maintain its competitive position as a low-end exporter, that debate now appears to be over. Recent government statistics certainly seem to acknowledge this point. Indeed, as one can see in Exhibits 20 and 22, Chinese production of low-end goods such as textiles, leather, electronics and garments are all now being aggressively ceded to South East Asia, Mexico, and Africa. Moreover, if the Trans-Pacific Partnership (TPP), a giant trade deal between the U.S., Canada, and 10 other countries in the Asia Pacific region, does come to fruition, many traditional parts of China’s export economy could face even more significant near-term headwinds.

However, China is certainly not sitting idle. With competitors like Japan, Vietnam and Indonesia weakening their currencies (Exhibit 21), China’s private sector — with the backing of the government – has focused on areas, including telecom infrastructure, generics, pharmaceutical equipment, and rail equipment, where it has been able to quickly move up the food chain. In the past, China pursued more of a fast-follower role in many sectors, but today its capabilities in areas such as technology, industrial equipment, and healthcare now rival global leaders. In rail equipment, for example, China exported over $4 billion of goods in 2014, up 23% from the prior year, to over 30 countries, including Australia and the United States2. Moreover, China’s project contractors are now involved in nearly 350 international railway projects, up 48% year-over-year3. One can see the overall magnitude of the country’s successful and broad-based export repositioning in both Exhibits 20 and 22.

The downside of this trend for foreign investors is that China is fast becoming a sophisticated competitor to global multinationals, particularly those from Japan and Korea to the United States and Europe. Consistent with this view, our research and on the ground conversations lead us to believe that foreign companies are increasingly having a tough time conducting business in China. In particular, there has been growing concern around cybersecurity and restrictive global Internet and Information and Communications Technology (ICT) products and services requirements that inhibit competition and have the potential to impede growth4. Exhibit 24, which details the World Bank’s Ease of Doing Business Index, certainly confirms this trend at a more macro level. Meanwhile, Exhibit 25 highlights that on a more micro level, state owned enterprises (SOEs) are becoming increasingly more competitive. Using the rail export example again, we note that state-owned companies CNR and CSR Corporations account for about 70% of total rail equipment export value, according to the General Administration of Customs5.

So our bottom line is that China has successfully made the transition towards more higher value-added exports, which makes sense for an economy that is promoting higher wages and increased consumption and services, as it prepares to face its demographic challenge of slower population growth ahead. We believe maintaining momentum in the quarters ahead will not be easy as the U.S. uses trade agreements to “pivot” East at the same time that many rival countries to China use their local currencies to further improve their competitive positioning in the global marketplace. As such, while we do not expect a major currency devaluation in China (Exhibits 26 and 27), we do think that the recent pace of appreciation may now stall, or potentially even reverse somewhat in the near term. Without question, we believe the associated volatility is headed higher.

For investors, there is somewhat of a double-edged sword. On the one hand, by providing important growth platforms to local Chinese companies in global sectors such as healthcare, technology, and industrial goods, we believe China is finally building a diverse set of industry “champions” that are much better suited to compete on the world stage. On the other hand, these new competitors are likely to dent margins through increased global competition both inside and outside China. As such, finding companies with sustainable pricing power will likely become even more important in the years ahead.

Unlike Many Other Parts of EM, China Is Actually Becoming More Energy Efficient

Given the recent carnage in oil prices, we have been spending additional time discussing consumption-related trends in emerging markets. Interestingly, our work shows that, outside of China, there is actually no evidence of improved EM oil efficiency. In fact, our work shows that the oil intensity per unit of economic growth in these countries has actually increased. Indeed, one can see in Exhibit 28 that between the pre-crisis (1994-2007) and post-crisis (2008-2013) periods, there was actually a parallel upshift in EM ex-China’s oil demand function at almost any given level of GDP growth. What also surprised us is that the increased energy intensity has been consistent across almost all EM regions, including Brazil, Russia, the Middle East, and Africa.

In China however, we believe we are seeing a very different story playing out. Specifically, our research shows that oil intensity has been declining in a slow but steady fashion. Exhibit 29 shows that as of 2014, oil demand was growing about 0.69% for every 1.0% of GDP growth, notably below the 0.94% oil intensity ratio that prevailed just ten years ago.

How has China become more efficient while its EM brethren have not? We see at least two key factors at work. First, China is a net oil consumer, giving it an intrinsic incentive to whittle down its national oil bill. At current prices, we estimate China’s net oil import bill amounts to 1.3% of GDP, which is actually higher than both the U.S. (1.0%) or EU (1.1%). By comparison, EM ex-China is actually a net oil producer.

Second, China has been starting from a point of notably intense energy demand, which in our view, lowers the degree of difficulty for future improvements. As Exhibit 30 underscores, China’s BTUs of energy consumption per unit of GDP are among the highest in the world. Maybe even more importantly, Exhibit 30 also shows that China is currently near the peak of its energy intensity life cycle such that efficiency is likely to improve substantially in the future as GDP per capita grows.

Looking ahead, we expect even more improvements in China’s oil efficiency. Specifically, Exhibit 29 details our view that the rate of efficiency improvement continues on a trend such that by 2018, 1.0% of GDP growth will require just 0.4% of oil demand growth, down from 0.69% currently. Factors driving this improvement, in our view, will include a combination of a) increasing energy efficiency within each segment of the economy, and b) a “mix shift” towards less energy-intensive economic activities. On the former, we believe that absolute energy efficiency will be driven by things such as the government’s mandate that the fuel efficiency of new passenger cars increases by 38% between 2015 and 20206. Meanwhile, on the latter, we anticipate that the positive “mix shift” will be driven by the government’s increasing emphasis on consumption-led growth and more services.

We too see scope for basic Chinese industry to become less oil-consumptive. For example, Exhibit 31 illustrates that industry accounts for about 40% of all Chinese petroleum consumption versus a global average of 19% according to the International Energy Agency. As such, from an industrial standpoint, we see the oil consumption in industry mean reverting towards global averages over time as the Chinese economy shifts away from fixed investment. However, part of this decrease in industry usage will likely be offset by growth in consumer consumption, we believe. Today, transportation fuel accounts for just 35% of Chinese petroleum consumption, versus roughly two-thirds for total global consumption. As we look ahead, we see the potential for a significant ramp in transportation fuel usage by Chinese consumers, driven largely by auto ownership. All told, as shown in Exhibit 32, we believe that the number of motor vehicles in China will increase at a CAGR of 11.9% per year from 2014 thru 2020, with the number of vehicles rising from 144.4 million in 2014 to 283.4 million over the same period. And while 283.4 million vehicles on the road may seem surprising, we note that the numbers of autos per Chinese driver will be just 0.72, compared to 1.2 today in the United States7.

In terms of converting the macro into the micro, we use Exhibit 35 to translate our macro efficiency outlook for China into an absolute oil consumption forecast. Under the base case we outline above, we believe Chinese oil demand grows by 2.7% annually through 2018, which is down significantly from an average of 4.9% over the past ten years, but still well above our aggregate global demand growth forecast of just 0.9% on average over the same period. We also include bull-case (4.3%) and bear-case (1.6%) scenarios for Chinese oil-demand growth. The key driver of the bull case, in our view, would be China’s leadership reversing course on its strategy of less investment driven growth. Conversely, we see the bear case for demand emerging if Chinese credit quality evolves adversely versus our current expectations, creating a bout of deleveraging and particularly poor GDP growth (Exhibit 34).

Before ending our thoughts on China’s energy outlook, we think it’s critical to emphasize that, even though its demand growth is slowing, China will remain — by far — the key “swing factor” in global energy consumption, in our view. Exhibit 36 illustrates how China now accounts for fully 22% of absolute global demand, higher than the U.S. (18%) or the entire EU (13%). Meanwhile, China’s incremental energy demand story is even more striking. For example, despite the efficiency improvements outlined above, we forecast that China will account for fully 36% of incremental global oil demand through 2018 (Exhibit 37). Given such outsized figures, one can see why China will remain the key market driving commodity developments over the long term.

Rate Cut Intended to Slow Non-Performing Loan (NPL) Formation, Not Necessarily Just Stoke Growth

Without question, one of the “hot” macro debates in China centers around whether Governor Zhou, who heads the People’s Bank of China, should have lowered rates in November 2014. Recall that in November last year, the PBOC made a 40 basis point reduction in the lending rate (5.6% from 6.0%), the first rate cut in over two years. The PBOC also lowered the one-year deposit rate to 2.75% from 3.0%.

The optimistic rationale for the recent rate cut was that China was trying to bolster lending for small-to medium-size businesses (SME). We certainly acknowledge that there are merits to this view. However, our research and our on the ground conversations lead us to conclude that rate cuts in isolation are probably not substantial enough to unclog lending and/or stimulate additional demand in the traditional SME channels. Also, because high loan to value consumer mortgages are not that prevelant in China, there is not the same refinancing benefit that one might see in a country like the United States.

What a rate cut does accomplish, in our view, is that it lowers the overall interest expense for existing corporate borrowers, many of which are now both over-levered and underperforming. As my colleague Frances Lim recently pointed out to me, total industrial profit growth declined a full 8.0% year-over-year in December 2014, China’s largest decline since 20118. Moreover, December’s contraction follows on the heels of a 4.2% drop in November9. But as Exhibit 39 shows, poor performance has not been isolated to just the industrial sector. Rather, it has been broad-based and likely worse than the consensus now thinks. As we show in Exhibits 40 and 41, overall return on equity in China’s corporate sector has actually been falling in recent years, driven by decreasing asset turnover, despite increasingly higher leverage.

Beyond the financial benefits of lowering rates to the corporate sector, we left Beijing thinking that there was somewhat of a human element to the rate cut. Specifically, we believe, the PBOC felt it necessary to send an “emotional” signal to the market that it appreciated that growth in the real economy had undershot expectations. In addition, excess capacity has pushed down inflation towards almost unattractive levels, and we sense there is growing concern about stabilization of inflation expectations. This concern certainly makes sense to us as excess capacity in the corporate sector has driven the Producer Price Index (PPI) negative for 34 months and to its lowest level since October 2009, while headline inflation is now running under one percent. Without question, we believe the exceptionally low inflation is symptomatic of weak domestic demand and overcapacity in many industries. 

Looking ahead, we think will see more rate cuts coming after the Lunar New Year. With fixed investment slowing strongly, overall growth remains quite low at a time of below trend inflation. As such, as we show in Exhibits 44 and 45, real rates now appear quite high in China, particularly relative to other economies. However, if we are right that the rate cut primarily just helps existing businesses that already have loans outstanding, then more must be done on the liquidity front to both calm nerves at existing corporates but also to encourage capital formation for new business ventures. Given this view, our strong belief is that China must meaningfully lower its reserve ratio requirement, or — at a minimum — further boost the loan-to-deposit ratio for the banking sector.

The good news is that the government appears to be coming around to our thinking. In January, for example, the central bank announced that it was going to increase loan-to-deposit ratio flexibility. Specifically, the PBOC began to allow interbank deposits and loans to non-bank financial institutions to be included in the “official” loan-to-deposit ratio calculation. Then, on February 4th, 2015, the central bank announced it would reduce the RRR by 50 basis points, its first across the board reduction since May 2012. In absolute dollar terms, the total RRR reduction frees up about $145 billion across the entire banking sector, though we believe that the signaling mechanism attached to the cut (i.e., the PBOC is now looking to protect against downside risks by doing an across the board cut for the first time in two years) is likely the more substantial news for long-term investors.

Overall, we are quite concerned about the negative impact of low, falling inflation and high, increasing real rates on the Chinese economy. Without question, it provides China with a relatively restrictive monetary backdrop at a time when anti-corruption initiatives are still affecting business confidence. Hence, we believe we could see many more RRR cuts ahead. Key to our thinking is that we believe that additional RRR cuts can potentially serve as a more effective catalyst for getting money into the economy for new growth initiatives versus just traditional interest rate cuts.

To be sure, adding additional liquidity to the system does come with risk, particularly at a time when it is unclear what the multiplier effect is on the economy (which was not the case in 2009). However, at this point we see more downside to the Chinese economy if the central bank does not act more aggressively. For the corporate sector, we also believe that, as we mentioned before, there is an “emotional” component to having the PBOC institute multiple easing measures to guard against liquidity squeezes and weak profits. Finally, with inflation running near zero and the Producer Price Index now negative, China must now solve for the disinflation risks – a rarity among EM countries these days. Importantly, though, we see China primarily using monetary policy tools, not the dramatic currency initiatives that many EM and G10 countries have recently embraced, to improve its macro backdrop and growth profile.

Financial Services Transparency: A Methodical Improvement

While I had many memorable experiences during my 16 years of employment at Morgan Stanley earlier in my career, spending time with some of the big Chinese banks prior to their initial public offerings certainly ranks high up there. As one might expect, meeting with these pre-IPO companies gave me a real window into how credit is initially extended and then accounted for as it seasons in China. Not surprisingly, this aforementioned experience also gave me a healthy dose of skepticism about Chinese lending practices in recent years, ultimately leading me to conclude that China — or any country for that matter — cannot consistently grow lending well above its nominal GDP for a sustained period without significant long-term implications.

However, given that the Chinese financial services system is now clearly a target of President Xi Jinping’s reform initiatives, my skepticism has been slowly morphing towards cautious optimism. In particular, these days we see two notable positives worth considering – something we have not been able to say in quite a long time. First, more and more capital formation is being transacted in the capital markets and away from the “old school” Chinese banking system. As Exhibit 47 shows, growth in the Chinese bond market has been explosive in recent years, reaching 18% of GDP in December 2014. While this ratio is well below that of the U.S.’s 25%, it compares favorably with that of EMU’s 12%10. We also think it is well above the level of many emerging market countries, the lion’s share of which still rely on traditional – and often opaque – bank funding standards.

Second, outside of the corporate sector, we believe the new ability of provinces to finally issue debt is important if China is going to reduce the moral hazard that has previously haunted its overall lending practices. According to China’s Ministry of Finance, 10 provinces/cities, which accounted for about 45% of total China GDP in 2013, received permission to issue municipal bonds starting in May 2014. The bonds, which vary in maturity from 5-10 years, trade on the interbank market and securities exchanges11. In doing so, Chinese provinces now seem to have an incentive to pay back as well as extend the duration of their obligations and behave in a way that promotes a positive credit rating (i.e., they are finally accountable to investors). We view this announcement as somewhat historic as it should 1) make the provinces less reliant on the local government financing vehicles (LGFVs); and 2) increase transparency between issuer and investor.

President Xi Jinping’s government then turbo-charged these initiatives by announcing in mid-December that it would no longer accept new applications for repo agreements that are based on collateral pledged on LGFV and corporate bonds that do not sport a AAA credit rating, or if the issuer is rated lower than AA. Estimates vary, but our research shows that somewhere between 70-80% of the value of bonds traded on exchanges could be subject to these rulings. We acknowledge that bonds traded on an exchange (versus off market) are not yet a majority, but we think these initiatives send a strong message about the government’s desire to clean up the system. Moreover, as the exchange-traded bonds gain market share, the “new” system will set the standard for the expectations between buyers and sellers.

Despite these important improvements in underwriting and transparency, we do not want to understate the bigger issue: There is still a lot of bad debt in China, and it risks undermining the country’s transition towards a markets-based financial services system. As one can see in Exhibit 48, overall lending has surged in China in recent years, and we believe defaults will likely become much more commonplace in 2015 and beyond. Without question, we think a default cycle – like the move towards ratings, exchange-traded bonds, and the interbank market – are part of the government’s long-term reform plan to bolster China’s financial services system.

However, despite our view that rising defaults will challenge the longstanding implicit guarantee that now exists between many lenders and borrowers in China, our strong belief is that China will actually not face a major near-term banking crisis for several reasons. First, we think the government has little incentive to create a “big bang” write-off type event that likely unsettles both local and foreign investors in its financial services. Rather, we think the government intends to use methodical policies both to highlight and defuse problem areas of excessive leverage and risk taking. An interesting example of late is the dollar-based default by Shenzhen-based real estate developer Kaisa Group Holdings Ltd. In this instance, the company defaulted as it appears the government prevented it from selling some of its properties to raise cash. While it certainly caught investors off guard in terms of both disclosures and leverage levels, the default has not created a widespread panic the way some market pundits had predicted.12

Second, the recent improvement in the stock market is a big deal as it now provides an attractive backdrop for financial intermediaries and corporates to issue secondary equity in order to delever their bloated balance sheets. Without question, the recent introduction of the Hong Kong-Shanghai “Through Train” is already acting as a major magnet for equity capital flows into the country. To review, this “stock connect” is a pilot program adopted in the fall of 2014 to allow mainland China and Hong Kong investors to place orders to trade eligible shares listed on the stock exchange of the other side. Separately, we also see the possibility that China A-shares get included in the MSCI Emerging Market Index by 2016. Most estimates suggest that China A shares – were they to be included in the index — would be nearly a 12% weight. Such an inclusion could drive around $45 billion of inflows into the market if portfolio managers elected to reduce the inherent underweight that would occur from inclusion of China A-shares in the MSCI EM Index, according to a recent Merrill Lynch study.

Third, with $4 trillion in reserves and a low government debt-to-GDP ratio of 52%, the Chinese government has the flexibility to onboard debt in problem areas, including the banking sector, local provinces and trust companies. Already, we believe that several provinces have repaid outstanding bank debt by transferring their liabilities to the central government. Importantly, because the yuan trades largely in line with the dollar, Chinese entities that borrow in the international markets likely will not face some of the dollar denominated headwinds that countries like Brazil, Indonesia and Malaysia do.

Looking at the big picture, as China moves forward in 2015, there is little question in our minds that the way credit is extended and managed has become one of China’s biggest macro priorities. Indeed, with total credit to GDP now over 200% (Exhibit 48), China has lost some of the flexibility that it had to maneuver in recent years. As such, the aforementioned initiatives to transfer more risk to the capital markets for accurate pricing as well as the government’s decision to allow for some defaults are important steps towards fixing what we believe now is China’s biggest Achilles heel. No doubt, there is more work to be done, but – after years of using credit as a blunt stimulus tool with little repercussions – we believe China appears to be finally starting to address some of the financial services’ excesses that have built up in recent years.

E-Commerce: Creating Economic Shock Waves All Across China

Driven by the three pillars of chat, search, and content, we think that the Internet’s presence in China could ultimately be more impactful on traditional commerce than it has been in the United States. Key to our thinking is that, whereas U.S. Internet firms like Google and Amazon had to deal with incumbent firms like Costco, Walmart, and Target, big box retailers are not established in China nor do they have a formidable online presence. As such, companies like Baidu, Tencent, and Alibaba are literally leapfrogging traditional retail merchandisers in an unprecedented way in China. Moreover, because China never really had as big of a personal computer (PC) or land line culture as the United States, the move towards mobile, search in particular, is creating growth in a way that is unique to China and its consumer population.

Against this favorable backdrop, we were not surprised to learn that China has already surpassed the United States in online sales, a trend we expect to continue over the next five years. Importantly, by shifting more commerce online, the Internet in China is forcing traditional industries in areas like medicine and retail to become more efficient and productive, which is exactly what we believe the government wants to help clean up its over-leveraged corporate sector. The service sector is not immune either. Just consider that customer assets in Alipay’s Yu’E Bao, its Mobile Money Market Fund, have jumped to $96 billion from zero in just over 18 months13. Given its size, the fund now ranks as a top three global money market fund after Fidelity and Vanguard14.

Without question, the stakes have become even higher as e-commerce transitions from the computer to handheld devices. All told, China now has at least 500 million mobile Internet users, which represents 80% of total China Internet users. One can see this in Exhibit 53, while Exhibit 54 underscores how powerful Alibaba, Baidu, and Tencent have become on the global e-commerce stage as this transition towards mobile unfolds.

The downside of the e-commerce boom in China is that traditional merchandisers and retailers appear to be adding capacity at what could be the wrong time. Already, retailers are complaining of not only less foot traffic but also lower conversion rates of those folks who do come into a store to shop. And the situation may get worse. Indeed, according to the investment bank Goldman Sachs, there will be 16%, on average, year-over-year growth of new retail gross floor area (GFA) supply during the 2014-2016 period, compared to 12% year-over-year growth during the 2010-2013 period and just 2% in 2005-200915. Moreover, these additions are coming at a time when online retail sales as a percentage of total sales is expected to grow to 12.4% in 2017 from just 7.9% in 2013, according to iResearch16.

We also think more government regulation is inevitable. The recent confrontation Alibaba endured with the Chinese government surrounding selling counterfeit goods clearly speaks to this issue, and we look for more government intervention ahead. That said, we were encouraged to learn more about how the government is supportive of growth in the e-commerce sector, which means the overall regulatory backdrop should generally remain favorable for online sales, mapping, reservations, etc., across a growing number of industries. However, as we have already seen with the aforementioned Alibaba spat, the government is committed to making sure that Chinese e-commerce champions the formal, not the informal, economy.

Looking at the big picture, we left Beijing with the distinct impression that the government and the private sector believe that the destiny of its local Internet leaders like Alibaba and Baidu is to transition from being national champions towards becoming dominant global titans capable of playing a leading role in shaping the future direction of e-commerce. These companies’s successes also validate China as a cutting edge innovator that can challenge the United States.

Beyond the intellectual and monetary satisfaction that local Chinese enjoy from the sizeable value creation that has occurred in the sector, locals too know that e-commerce is also a prerequisite for success if China is going to transition from a fixed investment economy to a knowledge-based one that is heavily reliant on services to further improve GDP per capita. As such, we view the recent development and growth in China’s e-commerce industry – as well as the related “knock on” industries the Internet is fostering – as essential to the rebalancing story we are now championing.

Conclusion: A Better 2015 Amid Slower Growth

Over the past 10 years, China has been the fastest growing major economy in the world. It has also had among the worst stock market returns as capital was misallocated badly, which drove both growth and employment in areas of the economy that either lacked competitive advantage and/or did not create productive returns on capital17.

Today, we see a different story. We see a slower growth economy with the potential for a better stock market in the near-term. Key to our thinking is that we now see a services economy that has grown larger than construction and manufacturing. We also see an e-commerce initiative that is driving both convenience and efficiency, and lower inflation that 1) makes real estate less interesting; and 2) gives the PBOC more flexibility to ease modestly. Finally, we see an economy less ravaged by new corruption surprises in 2015. That’s the good news.

The bad news is that China is a country undergoing a massive – and potentially destabilizing – transition across many parts of its economy. Low-end value exports are being badly disintermediated by cheaper global competitors, while fixed investment is now under siege by both the government and the private sector. A stricter government also continues to redefine the rules of engagement on how business and politics are conducted. All told, 63 senior officials, including four former State leaders have been investigated for graft since November 2012, according to the CPC Central Committee for Disciplinary Inspection. No doubt, these forces at work represent massive economic headwinds, and they are likely to continue to adversely affect many parts of the Chinese economy, particularly those that are already over-leveraged and/or overbuilt.

Our bottom line: The upside for being in the right as well as the downside for being in the wrong sectors has never been higher in China, particularly given our view that the current rebalancing effort is likely to accelerate even more in the quarters ahead. We also left Beijing with the distinct impression that, while there is no direct initiative to delever uncompetitive SOEs, there is a clear understanding that services-based companies, which require less debt and less leverage, will receive priority treatment under the new Xi and Li regime. The hope, we believe, is that if these companies can be emphasized and nurtured, productivity can be increased. As a result, aggregate corporate debt to GDP should begin to move back towards more sustainable levels.

What does this mean for investments? We believe equity should be allocated towards the areas that represent growth in this new macro regime, including environmental remediation, healthcare services, robotics, logistics, etc. High yielding companies with even modest growth should also do well in an environment of low inflation and more liquidity.

On the other hand, investors with a focus on recapitalizations and restructurings should focus on industries that will feel the downdraft associated with China spending less marginal dollars on low end exports and domestic fixed investment. Importantly, we think that this is a multi-year, multi-sector, and multi-country opportunity that requires sound underwriting and full appreciation of this long-tail shift we are seeing in China’s macro economy.