Investment - bull in a China shop

Many investors are bullish about China’s growth prospects, but over-investment in unproductive asset classes by the Chinese authorities should be ringing alarm bells, writes Robert Keavney.

Despite the failure of socialism in Eastern Europe, which culminated in the dismantling of the Berlin Wall, a large proportion of Australian investment professionals currently believe that centrally controlled, command economies provide the greatest long-term growth potential – at least so far as China is concerned.

I first visited China 18 years ago and was stunned by the speed and scale of what was unfolding. This was probably well ahead of most in focusing on the China phenomenon, so I have not been a chronic China sceptic.

However, China’s economy has become artificial, and is therefore unsustainable.

A road to nowhere?

We are constantly regaled with reports of how many new roads, railways, cities and power stations are being built every year. This, China advocates want us to believe, is a sign of a healthy economy and a dazzlingly attractive investment opportunity.

But let me pose a question: if China built twice as many roads and cities next year as it currently plans to, would that make it twice as strong an economy and twice as attractive an investment opportunity as it currently is?

Those who believe that the scale of China’s construction is sufficient proof of its economic strength would have to conclude that redoubling the scale of its construction would be evidence of redoubled strength.

But this makes no sense.

If the Tahitian government covered half the surface of the island in new roads over the next 12 months, would that make it a more sustainable economy and a more attractive investment opportunity?

Or would it be an island that spent too much money on roads? Analysis of the economic benefit of this new Tahitian infrastructure would be required before forming a view on whether the spending was appropriate and justified.

Surely this same analysis should be undertaken about China’s new infrastructure. Knowing that they are building massively is not enough information to determine the underlying health of the economy.

It is widely understood that there is a massive migration to the cities taking place, involving hundreds of millions of people. Undeniably, a great scale of development must be required to house these people and provide them with essential services. 

However, the question is whether the infrastructure spend taking place today is appropriate for this purpose. Is it still too little, or could it be too much? One must have a view on this to understand whether China’s growth is sustainable.

Making the case

There is growing evidence that China is over-investing on a massive scale. 

There are reports of the construction of cities with almost nobody living in them.

Anyone interested in doing some satellite research on this can use Google Maps to view Ordos, Kangbashi, Dantu, Zhengzhou New District, Erenhot etc. and then view Beijing; zooming in reveals a stark difference. Beijing’s streets are chock-a-block with cars. The newer cities’ roads are almost empty. Why would they build empty cities? We’ll return to this.

Actually we do not need to do any investigation to confirm that there is excessive construction, as China’s official statistics make it overtly clear.

America’s gross domestic product (GDP) primarily consists of private consumption, which traditionally contributes more than two thirds of the total.

It is normal in most countries that consumption is the main component of GDP. However, approximately half of China’s GDP is investment and the proportion has been steadily growing.

Conversely, personal consumption has been a steadily shrinking proportion of GDP for many years and is currently around the mid 30 per cent range.

Note that, in this context, ‘investment’ does not have its usual meaning. For our purposes we can loosely consider it to mean the construction or purchase of non-financial assets (‘investment’ includes all construction, the purchase of housing but not the purchase of shares, bonds, etc).

According to the Absolute Return Letter (February 2011), published by Absolute Return Partners:

“China has in recent years invested to an extent never before experienced anywhere in the world. To have fixed assets representing nearly 50 per cent of GDP is unprecedented ... It goes without saying that when you have too much capacity, the return on invested capital will ultimately prove disappointing. But China is not a capitalist economy where one needs to think about petty things like that (or so they seem to think).”

In a market economy, over-investment is punished by falling prices. If too many industrial properties, power stations or any other assets were built, the over-supply would cause prices to fall. Responding to this, construction would slow down or cease until the surplus supply was cleared and prices began to strengthen.

However, Chinese authorities are not bound by market forces. The primary motivation of the ruling party in China is to stay in power. They believe the best way to ensure this is to facilitate an increase in the living standards of the population. Thus they are motivated by the creation of jobs. And massive construction projects require many people employed – even if the construction is surplus to needs.

Thus, applying normal economic criteria, capital is being massively misallocated in China. Economic growth that is based on the disregard of return on capital cannot be sustained indefinitely.

Asianomics’ report India’s State of Confusion describes the inadequate return on capital in relation to China’s listed equity market, noting that most of the largest companies on the Shanghai index are state-owned. Asianomics reports that the return on equity of Chinese shares from 2002 to 2009 was half that of India, and suggests that many Chinese companies are failing to preserve the real value of capital. It warns that investors will not continue to supply capital to value-destroying companies.

We can conclude this section on the artificiality of China’s growth story by an extreme example. If some country’s GDP was 100 per cent investment, with nil private consumption (and with other components of GDP contributing nil), it would be a desperately poor nation – no matter how mammoth the scale of the investment. Why then is China’s growth, which is 50 per cent investment, seen as implying a sustainably strong economy and a beguiling investment opportunity? 

Questioning the numbers

There are great difficulties in assembling accurate data for such a massive emerging nation as China. This was highlighted by the divergent estimates by various authorities of the quantum of loans from banks to local governments at the end of 2010.

The National Audit Office estimated CN¥8.5 trillion, the China Banking Regulatory Commission suggested it was CN¥9 trillion, while the People’s Bank of China stated it was CN¥14 trillion.

The highest estimate is 60 per cent greater than the lowest, so it is reasonable to conclude that no one in China knows exactly how many loans exist from banks to local governments.

And surely this is not the only vague economic statistic in China. This suggests that accurate quantification of the risks in the banks’ loan portfolios is impossible.

One fact which is known is that China’s growth has been strong and relatively stable for many years. How do we know? The Chinese authorities have published their growth rates. But are they a reliable source? Is one allowed to wonder if they might have fibbed?

The Absolute Return Letter reports a leaked document, published by Wikileaks. This quotes Li Keqiang, who is being tipped as China’s next Prime Minister. Keqiang describes China’s GDP figures as “man made” and “for reference only”.

He goes on to suggest that a more realistic picture of China’s growth rates could be found in electricity consumption, rail freight volumes or bank lending. Annual electricity consumption since 1995 suggests a much more volatile economy than official statistics. Published annual GPD over that period has been in the 8 per cent and 14 per cent range. 

Annual growth in electrical consumptions has ranged from 1 per cent to 22 per cent per annum. Note that there has been strong average growth in electricity consumption over this period. The point to understand is that there is inaccuracy, and an element of PR, in China’s published data.

Blowing bubbles

One of the causes of the GFC was the housing collapse in the USA, triggering defaults on sub-prime mortgages. At its over-priced peak, American house prices were 6.5 times average disposable income. Tokyo’s housing bubble at the end of the 1980s was even more over-priced, at eight times disposable income. However, the Absolute Return Letter claims that residential properties in Beijing and Shanghai are now trading above 20 times disposable income.

No doubt someone will build a case that this time is different, but the only rational response to this statistic is extreme caution. And as the GFC has just demonstrated, collapsing property prices undermine bank balance sheets.

Supporting these concerns, Fitch estimates that private debt is now almost 150 per cent of GDP, nearly four times the level of the average emerging economy.

It would appear there are clear and present threats to China’s banking system.

An Asian Ponzi scheme?

China’s economy has elements of a Ponzi scheme. As long as they continue construction on an always increasing scale – surplus to requirements, ignoring market price as the arbiter of value and being indifferent to whether an adequate return is achieved on capital – the economy will maintain its strong growth. 

However, at some time, economic reality will reassert itself. The consequences of this are not likely to be pleasant. I am making no short-term forecast. Who can know when a Ponzi scheme will founder? Perhaps it will be an outbreak of inflation that forces a policy change.

Even without excessive investment, China’s growth rate would exceed most developed nations.

It needs to be stressed that, over the very long term (multi decades), it is possible that China’s re-emergence as a global power may continue, though they face the same demographic challenge which has contributed so much to Japan’s malaise.

In any case, in the meantime, they must face the consequences of having artificially over-stimulated their economy. 

During the inevitable period of readjustment, Australia may pay a price for our over-dependence on the resource sector.

With China having become one of the largest economies in the world it is easy to forget that it remains an emerging nation, with all the attendant risks that implies.

This includes significant volatility of markets. Any participants in the investment industry during the bursting of the dot com bubble will remember the implosion of the tech-heavy Nasdaq index.

In the year to October 2008, the Shanghai index fell more rapidly than the Nasdaq had done.

Several studies have found there was no historical relationship between economic growth and equity returns in emerging nations.

This undermines the simplistic investment manta often heard in recent years: the BRIC nations (Brazil, Russia, India and China) have high growth, so invest in them.

In the case of China I believe there is an identifiable risk to satisfactory returns, while ever China’s growth is pumped up by over-investment.

This leaves us with a question: the next time someone presents evidence of the staggering amount of construction in China, should that encourage investment in China or scare it off? I am in the scared camp.

But perhaps some believe that authoritarian, command economies have a good track record.

Robert Keavney is an industry commentator.