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Monday, July 24, 2006

What Investors Should Know About China

Sticking with the China theme on this blog, I'm posting a very interesting note from Stephen Roach. No gloom or boom scenarios, just an observation on the differences in application of economic policies between east and west. A very good to disclaimer to investing in China. Enjoy!


The more time I spend in China, the more I am struck by its inherent contradictions. I have made three visits to China in the past 12 weeks alone — breaking my own personal record. Over this period, I have spent considerable time in discussions with the Chinese leadership and its top policy officials. I have visited companies — small and large, alike. I have had a glimpse of the future, spending a weekend in Tianjin — the heart of the Binhai New Area, which could well be China’s next mega development zone. I have also traveled to the remote reaches of Hainan Island. I gave two lectures at leading Chinese universities, with ample opportunity to engage and debate a broad cross-section of students — by far, the nation’s greatest asset. I even dabbled in a now thriving contemporary Chinese art market. As I sit back and try to pull it altogether, I realize I am asking the impossible. Rich in contrasts and replete with contradictions, China defies generalization.

China's contradictions: micro vs. macro

Yet we in the West are biased toward looking at China through a very macro lens — focusing on its daunting scale and what that means for us. Ironically, that misses the basic tension that defines Chinese reform and development — a tug-of-war between the micro and the macro. Beijing is the center, the personification of the control mechanism that drives China’s macro story. Western impressions of China are formed by pilgrimages of the masses to the power centers of Beijing. These days, I often run into more of my friends in the restaurants and government agencies of Beijing than I do in New York. It is the Mecca of the China story — but it is not China. The real China exists at the provincial and local level — far removed from the Beijing-centric power network. Even after 27 years of extraordinary reforms, the real China remains very much a micro story — oftentimes at odds with the macro story that drives Western perceptions. This is one of those times.

China’s image suffers from the “1.3 billion syndrome” — the daunting math of economic development for 20% of the world’s population. As the scale of a rapidly growing Chinese economy — now the world’s fourth largest — hits a critical mass, suddenly the arithmetic takes on new meaning. The implications are all too familiar. If China stays its present course, by 2015, the size of its economy should surpass that of Japan. By the year 2030, it will pass Europe. But the real story is China’s “delta.” If the Chinese economy maintains a 12% dollar-based growth trajectory over the next 30 years, while the rich countries of the industrial world hold to 5-6% paths, then by 2035 China’s annual dollar-based growth delta will be larger than that of the US and Europe, combined (see my 13 January 2006 essay, “The Global Delta”). There’s not a multinational corporation in the world that hasn’t run numbers like this. Nor is there a politician in the developed world who hasn’t had to face the concerns of workers and voters that stem from the implications of these calculations.

China's contradictions: economic control vs. marketisation

The problem with this perspective is that it portrays China as a monolithic force, driven by the presumption of a relatively seamless transition from a centrally-planned economy to a market-based system. In my view, that is the most important contradiction of the new China. While economic control was close to absolute under the old model of the state-owned economy, that is not the case today under the increasingly marketized system. Power has been diffused away from the center, making macro control from Beijing exceedingly difficult. There’s nothing new, of course, about provincial, city, and village power bases in China. There are over 5000 years of history behind the fragmentation of governance in the Middle Kingdom. But what is new is the juxtaposition between China’s persistent fragmentation and its increasingly market-based system — a dissonance that adds considerable complexity to our understanding of recent and prospective trends in the Chinese economy.

The most visible manifestation of this fragmentation shows up in China’s runaway investment boom and the inability of the government to do much about it. The macro numbers speak for themselves. Fixed asset investment hit 45% of Chinese GDP in 2005 and should exceed the 50% threshold in 2006. There can be no denying the pro-investment requirements of Chinese economic development — namely, urbanization, industrialization, and infrastructure. But China has broken the mold in tilting its growth model toward the supply side of the macro equation. Even in their heydays, investment ratios in Japan and Korea never got much about 40%. For the second time in two years, Beijing has imposed a series of tightening measures on China’s overheated investment sector. Like the “cooling off” of 2004, three sets of actions have been taken — a modest 27 bp increase in lending rates, a 50 bp point increase in the bank reserve ratio, and a series of administrative controls targeted at China’s hottest industries. However, if these measures didn’t work a couple of years ago, I doubt they will today when dollar-based nominal GDP is 35% larger and fixed asset investment flows are over 60% greater than they were in 2004 (see my 19 June dispatch, “Scale and the Chinese Policy Challenge”).

China's contradictions: local vs. central control

This is where Chinese macro policy makers could quickly find themselves in a serious bind. Investment activity is driven very much at the local level, funded by a still highly-fragmented Chinese banking system. Fixated on social stability and job creation, local communist party officials through their influence on local bank branches often have more to say about investment project approval than company management teams or credit officers in head offices in Beijing. The impact of local banks also dwarfs the role of regulators and central bankers. The implications of this “fragmentation effect” are not lost on China’s senior policy officials. It undermines policy traction at the macro level and raises the risk of a boom-bust response of the investment sector if Chinese officials were to go too far in their tightening efforts. The relatively modest moves in the current tightening cycle reflect just such a concern, in my view. Yet the risk is that the current tightening campaign may have to go considerably further.

What I find particularly interesting is that Chinese municipalities are now taking it on themselves to issue regulations to cool off their overheated property markets; Shenzhen has taken the lead in that regard, with a 22 June announcement of ten tightening actions coming some three weeks after Beijing’s so-called administrative edicts. According to press accounts, while there was little response to the national edict, the Shenzhen residential property market has come to a virtual standstill in response to the local actions. This is an important real-time example of the tension between relatively impotent national tightening measures and the traction achieved through local actions.

In my recent meetings with a broad cross section of Chinese banks and companies, the tension between local and central control was a recurring theme. This was true not only in matters of project finance but also in the increasingly important issue of environmental policies. Motives are very different in both cases. For local officials, concerns over job creation, income support, and social stability are paramount. In conversations with local businessmen and bankers, I got the distinct impression that they viewed their mandates and objectives independently of what was going on elsewhere in China.

That was especially the case in Tianjin, whose Mayor, Dai Xiang Long, the former governor of China’s central bank, certainly knows a great deal about macro policy concerns. Now charged with running this hyper-growth area about 175 km east of Beijing, Mayor Dai suddenly sees local growth imperatives in a very different light. He characterized the Beijing view — especially the last shift toward tightening — as being very much at odds with pro-growth local objectives. But at this point in time, the bankers and businessmen I met with largely viewed the recent actions of the central government as more of an irritant rather than a major constraint. Mayor Dai, of course, wore two hats. Over dinner, he conceded that while sustainable growth for the overall Chinese economy was probably a number much closer to 7% than the current 10% pace, for Tianjin, he felt the pace was probably closer to 20%.

China's contradictions: need for resolution

The resolution of this contradiction is critical for the sustainability of Chinese economic development and reform. Fragmentation and concomitant disparities within the economy and its social structure remain salient features of the growth experience. China, as a whole, may average out to a 10% growth rate in any given year, but the dispersion across the nation is extraordinarily wide — with clusters of hyper-growth at close to 20% surrounded by rural areas where growth remains relatively stagnant.

Along with this dispersion in real economic activity comes an equally fragmented banking system, dominated by largely autonomous local branches. This seriously compromises the transmission of shifts in monetary policy to the real economy. If the central bank attempts to restrict bank lending by raising interest rates and reserve requirements — as is the case at present — under the best of circumstances, a fragmented banking system can be expected to respond very unevenly. In fact, it may well take more monetary tightening to accomplish a given policy objective in a fragmented banking system than would be the case if the system was tied more closely together. Banking reform is critical to resolving this dilemma. The public listing of state-owned banks should force a shift from locally-driven “policy loans” to commercially viable credit lines. Only then, can monetary policy levers be expected to have a meaningful impact on tempering the excesses of the investment cycle.

China still appears to be a long way away from a fully functioning macro system. As I crisscrossed this extraordinary country over the past 12 weeks, I was struck more than ever by the tension between the micro and the macro — the contrast between autonomous pockets of hyper-growth and the macro policy strategies of Beijing. This strong sense of fragmentation seriously complicates well-intended efforts of macro control. Until China can resolve this contradiction, effective policy management of its rapidly growing economy remains elusive and the risk of a boom-bust endgame cannot be ruled out.


At 10:57 AM, Anonymous Anonymous said...

This means that what the market is discounting now is only one side of the curtain and not the whole. I would therefore conclude that whatever data that China has presented and will present to investors will always be understated. Nice article.


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