| | | China: Perception vs. Reality
| | 国际贸易理论论文
[摘要] morgan stanley organized a china tour last week for a group of international investors. the tour included two days in beijing to visit economic policy makers and resource-sector companies and one day in shanghai to visit consumer-sector companies. the investor group reached a more positive view on china’s economic outlook than the previous investor group that were on a similar tour 18 months ago.
morgan stanley organized a china tour last week for a group of international investors. the tour included two days in beijing to visit economic policy makers and resource-sector companies and one day in shanghai to visit consumer-sector companies. the investor group reached a more positive view on china’s economic outlook than the previous investor group that were on a similar tour 18 months ago. the group, mostly first-time visitors to china, were overwhelmed by the physical development unfolding before their eyes in china and were persuaded by many companies that the current trend could continue on the needs-based argument, i.e., many chinese people still didn’t have and therefore need property.
unfortunately, the needs-based argument, though seductive, is misleading, in my view. sustainable development requires income and investment growing at similar paces. when the latter grows faster than the former for an extended period, as what has occurred in china over the past five years, a correction is inevitable. foreigners’ positive sentiment could extend china’s investment cycle by sustaining capital inflow to pump up china’s credit growth. but, as china’s investment cycle becomes too extended, it becomes more dependent on volatile short-term capital inflow and, hence, is quite vulnerable to a confidence shock.
the combination of excessive optimism towards china and rising us interest rates makes a hard landing in china more likely, in my view. foreign capital inflow helps local governments and businesses to resist tightening measures by the central government, causing both the investment bubble (and the eventual adjustment) to become bigger.
policy consensus
on the first day, the delegation visited several of china’s key policy makers in economic affairs. the messages from the policy makers showed a consensus at the top that china’s economy was overheating and more tightening measures were possible if the data on investment in april and may were to remain as strong as in the first quarter.
china’s fixed asset investment (43% of gdo last year) rose by 43% in the first quarter. it amounted to 17.2 percentage points of increase in china’s nominal gdp. nominal value of consumption, based on retail sales data, probably increased by 10% in the first quarter, equivalent to about 5.6 percentage points of increase in nominal gdp. the current account, based on the trade data, probably had a negative contribution to nominal gdp growth by 5-6 percentage points. therefore, china’s nominal gdp probably increased by 17-18% in the first quarter from one year ago.
rising prices of grain and commodities drove china’s inflation. most of the commodity-induced inflation reflects deterioration of china’s terms-of-trade and doesn’t affect the gdp deflator. rather, food price rises should be in the gdp deflator. combining agriculture and commodity inflation ex-imported portion, china’s gdp deflator was probably between 3-4%, even though inflation could be twice as high. therefore, china’s real gdp could have grown by 13-15% in the first quarter, which would be consistent with 16.4% growth in electricity consumption. the historical elasticity of electricity demand to gdp is less than one.
i went through the above exercise to gauge economic growth because china’s gdp and price data are not accurate and apparently inconsistent with sector data. i usually trust industry data more than gdp or price data that require aggregation.
china’s gdp is probably growing twice as fast as the historical trend. fast growth, however, is not a necessary condition for tightening macroeconomic policy; china is a poor country and should grow as fast as it can if the rapid growth is sustainable. china’s economic growth now depends mostly on investment. the motivation for the investment boom is based on price appreciation on the existing capital stock, especially in the property sector, rather than profits from future sales.
the returns on capital are low in china even during such a massive economic boom. the investment boom would only increase future competition that would drive down profits. but, a declining profit outlook and asset appreciation are not consistent. what is occurring is an unsustainable investment bubble, in my view. therefore, china should tighten macro conditions to cool its economy.
if the fixed asset investment doesn’t slow significantly in april and may, i believe that the chinese government will likely and should take new measures to reduce liquidity in the banking system and to decrease demand for credit by tightening conditions for using land as collateral for loans or even raising interest rates before the fed.
resource bulls
the resource sector companies presented to investors a picture of supply shortages that will last. the critical call is that china’s current trend is not cyclical but sustainable. even though the resource sector is investing aggressively to expand capacity, china’s demand would grow equally fast or faster and, hence, the current exalted prices for minerals would last.
the call on china’s demand, however, is not credible to me. china’s investment demand is growing three times as fast as the trend. if the current trend lasts for two more years, china’s fixed investment would rise above 50% of gdp. such a high level of investment in a major economy is unprecedented globally. in my view, the super strong chinese demand for minerals is likely to end in the coming months.
i am bullish about resources over the long run. i believe that 2-3% real price appreciation in resources over the next two decades is likely due to china’s demand. but, the dramatic increase in the prices of mineral resources by 50 or 100% reflects china’s investment bubble rather than the normal appreciation with china’s industrialization.
consumer bears
the consumer companies that the group met were much more cautious, even though they have seen improving profits. they are keenly aware of competition. because china is a major market for global companies, serious players all want to target market shares. thus, price wars in some hot sectors (e.g., automobiles) are quite likely. profit margins in these sectors would likely drop to international levels or even low.
the good thing about the consumer sector is that we do not see bubbles. hence, consumer demand is more reliable when china’s economic cycle turns down in the coming months. the cautious attitude of the businesses in this sector makes me more comfortable about their resilience.
further, i am bullish about the consumer sector in general. china must bring its fixed investment down to 35% in the next ten years. the government has to implement policies to encourage consumption and decrease savings rates to offset the drag on the economy from slowing investment.
shanghai magic
our delegation was quite concerned about the economic outlook after hearing evidence of ‘overheating’ and the poor condition of the financial sector from some government officials. the company visits in beijing didn’t change the mood much either. beijing’s traffic jams and polluted air negatively affected the group’s psychology.
shanghai, however, changed everything. shanghai’s clear skies made the group’s mood more buoyant. even though the group stayed in shanghai for one day, several investors already formed firm convictions about the place. a number of investors began to doubt their overheating conviction and began to accept the popular argument that the chinese needed to accumulate more stuff and, hence, that the current investment boom was not a bubble. at the end of the day, one investor simply said to me, ‘i like shanghai’.
the visual impact of shanghai on first-time visitors is quite powerful. it appears similar to tokyo or new york, not what one would expect in a country with a per capita income of us$1,000. because the physical appearance of a city is usually correlated with the wealth within, visitors to shanghai would subconsciously draw such a link. thus, it is natural that such visitors would compare shanghai’s property prices with london and tokyo’s, and not consider the prices as too high. and, it is easy for visitors to accept the explanation for the disconnect between price and income that shanghai’s population possess invisible income.
actually, the ‘invisible’ income is not a bad explanation. shanghai’s development is based on capital inflow, mostly from its vast diasporas in hong kong, taiwan and the united states. most of its wealthy residents left in 1949 and many accumulated a vast amount of wealth wherever they settled down. a large number of its residents have also left to work in other countries in the past two decades. they have been sending money to their relatives in the city for buying properties or buying themselves.
the political uncertainty in taiwan has triggered a second source of capital inflow in the past four years. to hedge against declining property prices in taipei, many taiwan residents have bought properties in shanghai. this new source of money accelerated shanghai’s development in recent years.
because china’s vast labor pool keeps construction costs low, shanghai has managed to use the inflow of funds to build a very expensive-looking city. that is why shanghai can leave such a strong impression on its visitors.
comparing shanghai with new york or tokyo is a dangerous proposition, in my view. most great cities develop because they host many competitive businesses that pull wealth in. fifth avenue, for example, was rebuilt many times as financiers and trading houses in new york accumulated more money. the rising competitiveness of japan’s electronics and automobile industries around tokyo generated the wealth to support a large and physically impressive city.
shanghai, however, has not produced a competitive industry that has generated a lot of wealth in the city. instead, property is shanghai’s core business. it sells properties to outsiders and uses the land sales proceeds to build its infrastructure. no other great city has developed with such a model. i am not saying that this model is not sustainable. it, however, limits how high property prices can rise.
property prices in other cities are normally determined by income generated in competitive industries. shanghai has to attract sufficient capital inflow by selling properties to build the city. hence, it always needs to supply a lot to outside buyers and, therefore, cannot control quantity, which would curtail revenue, or keep prices too high, which, though creating bubble demand in the short-term, would decrease demand eventually.
there are two ways for shanghai’s property prices to converge quickly with those in other great international cities. first, it could shift from the capital inflow model to the export of high value-added services or goods. we should be able to observe such a transition when we see indigenous companies similar to toyota or samsung in shanghai. but the local government tightly controls shanghai’s economy and the state-owned enterprises dominate it. the odds are low that highly entrepreneurial and creative businesses would originate in shanghai.
second, the wealthy businessmen that buy shanghai properties today may decide to settle in and operate out of shanghai, i.e., shanghai can’t create its own wealthy class but may be able to import one. this scenario is quite popular but isn’t likely either, in my view. in the past, only wars and ethnic purges have tended to cause a large number of wealthy people to relocate to one place over a short time period. besides, shanghai doesn’t have the tax structure to attract rich people to settle down there.
i suspect that shanghai’s property prices would only converge with those of rich cities slowly. three decades would be the minimum, in my view. shanghai’s price for high-end property is about one fourth of manhattan’s. if you attach a 4.7% risk premium to investment in shanghai relative to that in manhattan, the convergence trade would give you zero returns over a three-decade horizon, as the appreciation potential is exactly offset by the risk premium.
what is occurring in shanghai appears to be driven by the psychological impact of the convergence trade rather than its reality. as more people jump on the bandwagon, it could become self-fulfilling in the short term, as is the case at present. however, without the support of local wealth accumulation, the price appreciation today would reverse tomorrow, in my view.
the nature of shanghai’s development model makes the city highly sensitive to fed interest rate levels. shanghai’s diasporas are a dollar-denominated group. when us interest rates rise, they will be less tempted by the appreciation potential of shanghai property.
separating cyclical and secular trends
because china is not transparent and the economic data are not reliable, investors often have to rely on personal visits to cities and companies to understand what is occurring. it usually takes years of experience to draw useful information from such visits. for newcomers, the most difficult part is to distinguish between secular and cyclical trends.
the scale of china’s physical development in infrastructure and urban landscape offer such a powerful image that often overwhelms the first-time visitors to china. as one member of our tour group commented, ‘you can see gdp growing before your eyes’. the data support this impression. china’s fixed investment has accounted for more than one third of its gdp in the past two decades, even higher than japan’s during its rapid growth phase. chinese people are essentially postponing their consumption to spend a disproportionate share of their income on investment. this is the secret of china’s success.
however, apart from this powerful secular trend, china also experiences big economic cycles that are driven by us interest rates and global demand for china’s exports. the two determine the resources available for china’s investment via capital inflow and export income. china’s cycles are quite significant. china’s fixed asset investment rose by over 30% last year (reaching 43% of gdp) and by 43% in the first quarter of this year (it could reach 47% of gdp in 2004). the secular trend for fixed investment is between 10-15%. china’s current investment growth is thus about three times as strong as its secular trend.
when the investment cycle is at its peak, visitors to china often see a very rosy picture. not only is demand strong, prices are often high enough to generate good returns for many businesses. in the first quarter, the government reported rmb 234.8 billion of profits for industrial companies at national-level, up 44.2% from one year ago; iron ore mining saw profits up 777%, petrochemicals 213%, ferrous metals production 137%. the improvement in profit is occurring mostly in upstream industries with supply bottlenecks.
however, rapid credit growth, fueled by capital inflow, is the reason for the extraordinarily rosy picture. the credit surge has supercharged the investment cycle, causing bottlenecks in upstream industries. the bottlenecks redistribute national income to such industries from workers via inflation, i.e., the sharp rise in china’s gdp deflator reflects such income redistribution. but, profits from such redistribution are not sustainable. as the investment boom removes such bottlenecks, the income distribution would revert to normal.
as the investment to gdp ratio has risen very rapidly between 2002-04, some sort of reversal looks inevitable and such a process would be a drag on the economic growth. the trigger for the reversal would be a slowdown in capital inflow. this could happen either due to a confidence shock or a significant rise in the fed funds rate. the former is hard to predict. the fed funds rate appears poised to rise by 60 bps before the year end as priced in the market. china’s investment slowdown appears not too far away. if china’s fixed investment continues to grow at a 40% annual rate in the coming months, i believe the slowdown could become a hard landing.
（摩根斯坦利全球论坛, andy xie (from tokyo)）
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