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When I look at China it scares me - it brings back dark memories of July 1997.
I was working as an analyst in an office above the Hard Rock Café in Kuala Lumpur. For months, investors had been fleeing the country in the wake of a devastating currency crisis. I had a front row seat during the total collapse of a major economy. It proved an invaluable lesson in the pitfalls of investing in Asia.
I remember a stern statement sent to a leading tycoon to top up many millions of dollars as collateral or face immediate legal action; I remember the pulsating trading rooms emptying; I remember companies slamming the doors to investors as managements became preoccupied with a fight for survival.
It was very unpleasant. OK, the traffic in the business district was definitely lighter for a few weeks – it was a lot easier to get home at night. But the troubling thing was just how quickly an economy can go into deep-freeze. And when you think about China today, that’s the episode that you need to bear in mind.
China is fading fast
Last week, China reported weak economic numbers, prompting the government to cut the reserve required ratio for banks resulting in looser monetary policy.
A lot of people are urging investors to invest in China. I think that would be a terrible mistake. China is in the midst of a very painful episode in its history. The economy has recently slowed to its slowest pace in two and a half years. And that is likely to continue.
China suffers from serious bottlenecks, including lofty property prices, rising wages and higher logistics costs due to manufacturing's move to the hinterland (the 'Go West Policy'). The results are higher inflation (3.4% at the latest count) and slowdown in foreign direct investments (which in fact peaked in August 2011).
China typically generates top-line nominal growth of 14% on average, but the split between growth and inflation has fallen to the lowest in over a decade in the last two years. Meanwhile earnings are tumbling.
The profitability for Chinese non-financial state-owned enterprises (SOEs) is at the lowest level since 2001 (excluding 2008). And the latest reporting season for Chinese stocks was the worst since 2008.
While MSCI China trades on a prospective price/earnings (PE) ratio of 9.7 times and an estimated 11.6% earnings per share (EPS) growth, analysts have been busy downgrading their numbers since September 2011.
I see the fundamental problem being that profitability appears to be on a secular decline. This is evident by proposed reforms such as reducing the cartel power of state-owned enterprises (the majority of listed stocks), market pricing of key inputs such as capital and energy and higher taxation (to pay for social reforms).
Last time reforms took place was in the late 1990s, focused on SOEs and banking reforms, which helped unlock huge productivity gains and fuel China’s high octane growth rate for a decade. The snag was it took the stock market more than five years before it moved sharply higher. The same could happen again, further aggravated by a West that is de-leveraging.
Investors are backing away from the stock market
Not that investing in Chinese stock market is a good idea anyway.
The Shanghai market, the leading local exchange, is a very peculiar beast. Following WTO-membership it started with total inaction for almost five years. Then, in a short period, spanning from March 2006 to October 2007, the marked surged 2.5 times. The gain was short-lived and it hit a trough in November 2008.
The market yielded 52% over 11 years – equivalent to a 4% compound annual growth rate – compared to an average real GDP growth of 10%. That translates into a real return of 1.5% pa, meaning in plain language that 85% of the GDP growth was not captured by the stock market.
Investors sense something is not right. They recognise a corporate culture that has become renowned for accounting scandals. Short-sellers, aided by independent research houses, have been investigating Chinese companies listed in the US and Hong Kong for years. Last week, rumours in Hong Kong suggested a well-known research house has a list of 36 names under negative review.
Local investors are also less enthusiastic as the number of newly opened accounts in Shanghai has dropped to the lowest level since 2001. Instead investors have aggressively bought wealth management products, which are investment products that can avoid regulatory caps on deposit rates. Companies and people have moved their deposits to areas that can give higher returns.
This has three major implications:
• it puts strain on banks’ balance sheets and ability to lend, which may help to explain the disappointing loan growth;
• it forces entrepreneurs to pay high interest rates for loans: the percentage of loans charged above benchmark lending rates has increased from 30-40% to a record high of over 60%.;
• perhaps most worrisome, it makes it more difficult for the government to control the economy; the shadow banking system is estimated to account for one quarter of the total outstanding credit in China, up from 18% in 2009.
A survey shows that 60% of Chinese millionaires are thinking about emigrating to the U.S., Canada or another country, the Wall Street Journal reported. The main reasons cited in the survey were their children's education, fear of sudden changes in China's political situation and concern about worsening business conditions.
China’s slow-motion crash
My personal experience from investing in China over many years is that is a policy-driven market: good news fuels spurts of robust stock market performance. And given the political handover within the Communist Party in November – where seven out of the nine politburo members are to be replaced – I think that looks less likely.
China operates a closed capital account and non-convertible currency meaning that liquidity cannot be pulled by investors on a short notice, as was the case in the Asian financial crisis. Instead of a short and sharp crisis like in 1997, I envisage a prolonged downtrend – like Japan – as the financial system slowly digests poor loans and misallocation of capital.
China as the best long-term way to invest in Asia is probably wrong. At least that is the experience from Europe, according to a recent study by Credit Suisse. While the biggest economies - Germany and France - offered a paltry 2.9% annual return over the last 112 years, the smaller peers yielded far higher: Sweden (6.1%), Finland (4.8%), Netherlands (4.8%) and Switzerland (4.1%).
I see no reason why Asia should be much different. That’s why, as you know, I’ve been talking about an Asia that is no longer dominated by China. As China gets sucked into a slow-motion crash, the likes of Malaysia, Indonesia and Singapore will do everything they can to boost bilateral trade. And that is going to produce some formidable opportunities.
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Lars Henriksson
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