Hong Kong based hedge fund analysts Winston Chu, Pep So, and Perry Tan sat down with SumZero for a roundtable on the macroeconomics of China. This is part two of the SumZero China Macro series which began with Vladimir Yuzhakov’s exclusive SumZero memo The 5 Biggest Misconceptions About China's Economy. This week Messrs. Chu, So, and Tan--all long-time SumZero members and top finishers in SumZero investment contests--independently answered a battery of questions regarding China’s economic past, present, and future.
What do investors need to know about China from a macro perspective?
Pep So, HSZ Group There are many things to cover but two main things come to my mind: 1) capital control and market efficiency, and 2) economic reform and transition.
Capital control and market efficiency: Despite being the second largest economy and stock market in the world, China still has many characteristics of an emerging market. In particular, it is a closed economy which capital cannot flow in and out freely. As a result, the domestic stocks are predominantly (over 95%) owned by domestic investors. And of these domestic investors, retail investors are the main participants, representing the majority of the trading volume (>70%). These retail investors are often less educated compared with institutional investors, so the stock market in China tends to be more irrational compared with global markets dominated by institutional investors. The Chinese retail investors also are often news or theme-driven traders with a very short investment horizon, which also is a major reason that the Chinese stock market is not very efficient. Generally speaking, small caps tied to hot themes are trading at a much higher valuation compared with large caps that are “boring” in nature, regardless of their business fundamental or profitability.
Economic reform and transition: We have seen progress in China’s economic reform. In particular, the importance of state-owned enterprises (SOEs), in terms of their contribution to China’s total investments, urban employment, corporate earnings, etc., has declined substantially in recent years. This is structurally positive as SOEs are generally less efficient compared with private companies as they usually prioritize social goals over shareholders. I have also noticed progress in economic transition in the country. China is slowly shifting its focus from manufacturing and fixed asset investments to consumption and provision of services. It is also becoming more self-fed with declining reliance on imported goods.
Winston Chu, Frontier Asia Capital Stop looking at headline sensationalist numbers/articles; GDP and other economic indicators don’t mean much if they can’t be practically applied back to individual sectors and companies. China’s also pretty bad at guiding the market/expectations, and forecasting isn’t very useful.
Perry Tan, Black Crane Capital China is one of the most dynamic and fastest growing countries in the world. Also, China is a Communist regime by name, but in fact is becoming more and more business friendly. The boom and emergence of the tech giants is a testament of the Chinese entrepreneurial spirit.
That said, there is a lot of dead weight in the economy. The previous splurge in fixed asset investment has now resulted in overcapacity in numerous industries. Many companies are highly in debt and the Government appears to be more inclined to bail out these companies than let market forces do its job. Therefore, you won't see normalisation of ROICs in these industries in the foreseeable future. The typical corporation in China is asset rich, cash poor and probably highly levered.
Do you see recent slowdowns in China as an effect of missteps in centralized planning?
Pep So, HSZ Group I think such slowdown is very normal given its huge size. Investors should not expect the second largest economy in the world to grow at a fast pace forever. More importantly, the quality of growth is improving. As I mentioned before, China is slowly shifting its focus from manufacturing and fixed asset investments to consumption and provision of services. This means lowered reliance on credit growth which is healthy for the country in the long term. However, during this process, we could see a lot of problems surfacing such as lingering inventory issues or higher unemployment on the back of overcapacity. These are deflationary in nature, therefore a slowdown is inevitable.
Regarding centralized planning, China has the longest history of centralized planning among all countries in the world and I don’t think centralized planning is a major reason for China’s recent slowdown; on the contrary, I would be very worried if China decides to decentralize things quickly today. The decentralization process has to be gradual, and I believe the country leaders are fully aware of this.
Winston Chu, Frontier Asia Capital The slowdown is a natural product of the shift to service and consumption in a country that culturally saves 50% of household income. Be it 7% or 6%, who cares..it’s still ripe with decent opportunities.
Perry Tan, Black Crane Capital Yes. Previous growth is hugely driven by infrastructure spending. Unfortunately, the headline GDP growth was a ticking time bomb, with fueling debt levels, capital misplaced to dying/commodity-like industries, banks' preference to lend to value destructive SOEs which led to the emergence of shadow banks that were funded by the banks that in turn lent to small and medium-sized enterprises etc. The A/H stock connect (pump up the market so levered companies can raise equity...), refinancing muni-bonds, companies repurchasing offshore bonds and relisting onshore are all attempts increase capital flow into the economy. But it isn't farfetched to say that the wealthy Chinese are moving money offshore, not onshore, especially the owners of commodity like businesses with no moat that see overseas opportunities, or want a foreign passport.
The Chinese' gambling mentality also is not helping. Chasing property, stocks, bonds, money market products, only increases the volatility in the market and leads to greater booms and busts.
Classical Keynesian economists talk about how fiscal spending can boost GDP, and Monetary Policy talks about how lowering savings results to spending and inflation; neither of these schools of thought touches on innovation, which is the driving force for the US economy.
How much longer will the Chinese national stimulus program last, both in policy and economic effects?
Pep So, HSZ Group Monetary policy wise, I expect this to last much longer. I think the country will go through a deleveraging process in the coming years so accommodative monetary policy is much needed. Any missteps in its monetary policy during its deleveraging cycle could lead to a deflationary scenario similar to Japan’s in the 1990s. However, I do not expect any major economic stimulus like the “RMB4 trillion economic stimulus package” in 2008/09 as that has resulted in a great deal of misallocation of capital.
Perry Tan, Black Crane Capital Don't know. The debt to GDP is already 240%...
Where do you see China 5 and 10 years from now in terms of industry focus, standard of living, and personal freedoms?
Pep So, HSZ Group Industry focus: I see structural shift from low/mid-end manufacturing to high-end manufacturing. China has well-established infrastructure and adequate capital to support this transition. China will also benefit from young working force (80s and 90s) with better education. Infrastructure and property sectors will be much less of a focus compared to now. Consumption and services sectors will be the new focus.
Standard of living: As consumption becomes a major GDP contributor, the demand for better and more sophisticated products will be on the rise. These include a wide range of products, including food, apparel, sportswear, medication, education, etc. Under this backdrop, I expect continuous product upgrades driven by innovations. I are very positive on the rise in standard of living in the coming 5-10 years.
Personal freedoms: We are seeing improvement as Chinese people are having more alternatives to share their opinion compared with the past. But it will be a long way to go if we take western countries as the standard.
Winston Chu, Frontier Asia Capital No major views here…industry will obviously shift more to tertiary and standard of living will improve. I wouldn’t bet on a meaningful improvement in personal freedoms, especially with the current administration being more nationalistic and egalitarian than the previous ones.
Perry Tan, Black Crane Capital Consumption will play a larger role in the economy in the future. The move from secondary industries to consumption such as computers, sportswear, travelling etc. Assuming that 2015's 6.9% GDP growth is accurate, services now account for 50.5% of the economy. On paper, this is a plus, but one also has to factor in the declines in the industrial sector.
Are western universities poaching the best of Chinese academic talent?
Pep So, HSZ Group That’s mostly correct. Many outstanding Chinese students choose to study overseas, in places like the US, the UK and also Hong Kong. But many of them also decide to move back to work in China right after graduation or after gaining a short period of working experience overseas. So that does not necessarily lead to talent losses.
How has entrepreneurial culture and private wealth changed in the past 5-10 years? Where are they headed in the next 5-10?
Pep So, HSZ Group In the past 5-10 years, property owners and landlords are the major beneficiaries over the sharp growth period in China. However, entrepreneurial culture has yet to benefit most as the big companies in China were mostly dominated by SOEs during the period.
In the coming 5-10 years, things will change dramatically. SOEs’ position will be lowered significantly, while innovative private companies and high quality services provider are going to be winners. In other words, entrepreneurial culture will be crucial in terms of wealth creation in the next 5-10 years.
Winston Chu, Frontier Asia Capital Absolutely, it’s grown explosively from ~3m private companies and 24m proprietorships in 2004 to 12m and 42m respectively in 2013. Profits jumped nearly 20-fold. The SME sector is still mostly untapped, “growth” is a certainty though the question should be more on returns…whether the growth is value destructive.
Perry Tan, Black Crane Capital The Chinese always had an entrepreneurial culture. From Haier becoming one of the global white goods appliance makers, to BAT, Xiaomi, LeTV, many have created companies against all odds and in many instances had to work around the legal system because the Chinese government has not come up with the regulation for the new industries yet! Alibaba going into the banking and creating money products is a good example of this. Expect to see private companies playing a larger role and exerting more influence in China in the future.
That said, because of huge growth opportunities and a very dynamic landscape, being the market leader does not guarantee future success because unlike a Pepsi/Coca Cola, the smaller companies in China have more pockets of opportunities to grow into. This means that the moats of businesses in Chinese companies though present, are probably not as wide as foreign companies in more established "boring" industries. We see this in BAT's investments in O2O and video, everyone is forced to land grab and burn through their cash. Furthermore, no one really knows the true market demand for many goods and services in China, thus the risk of overcapacity.
What are the biggest misconceptions westerners have about China?
Pep So, HSZ Group I want to highlight two misconceptions here: 1) China is nothing more than a low-cost supplier, and 2) China has too much debt and it is on the verge of collapse.
China is nothing more than a low-cost supplier: China is often viewed as a low-cost global supplier, which is lack of innovation and R&D prowess. Sometimes people label China as a copycat. I think that’s a big misconception. China in fact leads all emerging markets in innovation, ranking number 29 in the world according to the Global Innovation Index 2015. China’s R&D expenditure ranks globally number 2, and R&D as a percentage of GDP has jumped four-fold in 20 years to 2.1% (vs the US at 2.8%). China’s steadily rising export market share globally has led to growing strengths and innovation in the product chain. China is continuing to enhance its global competitiveness via higher investments in R&D, in other words, “Made in China” is evolving into “Innovated in China”.
China has too much debt and it is on the verge of collapse: China indeed is under a massive debt burden, with a debt-to-GDP ratio of 200-300%, depending on one’s data source. As such, many investors think China, like many emerging markets in the past, is going to be in trouble when US$ strengthens. In this regard, I think a country’s vulnerability depends largely on its external debt level in US$ and its foreign reserves.
Let’s do some quick math here. Let’s assume China’s total debt to GDP is 300%, i.e. China’s total debt is roughly US$30 trillion. According to State Administration of Foreign Exchange, China’s external debt totaled US$1.7 trillion by end of June 2015, of which 49% was denominated in RMB. Let’s assume the remaining 51% is denominated in US$, so that’s US$870 billion. Compare this figure to China’s current foreign reserves of more than US$3 trillion. So, if the problem is having too much internal debt under its own currency, things become relatively straightforward, since in the most adverse scenario, the central bank can act as the lender of last resort and ultimately print money, i.e. the case in the US and in Europe.
Winston Chu, Frontier Asia Capital That everything is fake. Surprisingly I hear this a lot; developed market investors will question the smallest details that are known for fact in China…say for example Baidu’s market share.
Perry Tan, Black Crane Capital China products are fake, they are copycats, and all companies are frauds.
Is China at significant risk holding so much US debt?
Pep So, HSZ Group Not really in our view. After all, there are not many better alternatives given China’s huge amount of foreign reserves of US$3.3 trillion, especially under the prevailing global deflationary trend.
Some investors may think gold is an alternative and I partially agree as I think gold is an ultimate hedge against loss in faith in global currencies and also global central banks’ credibility. This is a legitimate concern given all the money printing happening around the world for years, but we have yet to see meaningful recovery in growth. However, gold is not a good alternative for China mathematically. In the world there are total 5.7 billion ounces of gold; that’s around US$6.8 trillion if we take the recent price of about US$1,200 per ounce. If China shifts all its US debt holdings into gold, China will be holding about 50% of global gold reserves, which will put the country in a very risky position.
Will US internet companies ever effectively compete in China against Baidu, Alibaba etc.? Will Chinese tech companies ever compete effectively in the west with Google and Amazon etc.?
Pep So, HSZ Group I can’t rule out the possibility of US internet companies becoming competitive in China against Chinese internet giants but I think it’s not easy. I think Chinese internet companies are competitive beyond government protection. Baidu’s CEO Robin Li put it precisely that many foreign companies including Google are not “connected to the ground” such that they are not “local” enough to compete in this independent market. I also think Chinese internet giants have well-established ecosystems which are difficult to challenge. In investment terms, these companies have durable and widening economic moats, or sustainable competitive advantages. In addition, the internet industry is often a “winners take all” game. Players with small market share are likely to continue to lose market share to dominant players. Search engines are a typical example.
I feel the same on the other way around, i.e. Chinese internet companies may not be competitive against Western companies in the West. But that’s alright, the two markets are big enough individually.
Winston Chu, Frontier Asia Capital US internet companies have effectively no chance in China vs the established companies (at least competing in core businesses). The large China players have already established significant moats via customer captivity and network effect. Moreover, the products are superior. This is actually difficult to fathom for US investors but Chinese internet companies that have copied an idea have tended to also improve the user experience and add features at an incredibly fast pace. For example, on Tencent’s WeChat you can almost manage your entire life out of an app. Furthermore, the Chinese government skews the advantage via policies that limit foreign ownership, restrict/filter content and others. There’s almost no such thing as anti-trust over here. Conversely, Chinese companies really have no interest in competing in the west…the domestic market is big enough.
Perry Tan, Black Crane Capital Very difficult. The other players will have to burn through just as much cash as BAT [Baidu, Alibaba, Tencent] to stand a chance. That is before considering regulation and competition between existing players.
What key metrics should investors be paying attention to with respect to China?
Pep So, HSZ Group Other than the usual figures that we all look at (e.g. GDP, PMI), investors should also pay attention to China’s foreign reserves, bond yield and SHIBOR.
Monthly foreign reserves data: Investors should keep track of the changes in foreign reserves as this is a key measure of a country’s financial strength. Currently China still has the largest foreign reserves in the world with over US$3 trillion. The amount has contracted in recent months though amid capital outflows, which I believe were mainly because Chinese companies have been paying off their offshore debt as a result of rising expectation of RMB depreciation.
10-year sovereign bond yield: Like many other countries, China’s 10-year bond yield is a proxy for mortgage rates or borrowing costs in the country. It also reflects the inflation trend of a country. China’s 10-year bond yield has recently dropped to a 7-year low at less than 3%, plunging from over 4.5% 3 years ago. This is primarily because of China’s central bank’s effort in loosening monetary policies amid weakening inflation outlook. On the other hand, the decline in bond yield has made equities’ dividend yield more attractive.
SHIBOR: The Shanghai Interbank Offered Rate (SHIBOR) is an important indication of overall liquidity in China’s financial system. SHIBOR tends to surge when liquidity tightens, which is usually negative for equities. I find it interesting to see SHIBOR has remained stable in recent months amid all the concerns about China’s currency depreciation and accelerated capital outflows. This shows overall liquidity remains healthy in China’s financial system and therefore I think investors have been overly concerned about China’s.
Winston Chu, Frontier Asia Capital I specialize only in looking at individual companies but if there were a key metric, I would look at return on equity vs debt and map out concentrations across sectors.
Perry Tan, Black Crane Capital For general macro: GDP, debt/GDP, loan growth, percentage growth of private sector
For investors: ROICs, moats
Risk for value investors: buying at below asset value is meaningless unless you believe in increased earnings or disposal of assets i.e corporate events
Risk for GARP investors: analyse the moat of the business before making projections, there is a tendency for funds to pile onto the loved names at any multiple, so the good companies are in general not cheap. The Chinese market is very competitive in this sense, perhaps the most capitalistic economy. Any company with high ROICs will attract new entrants and because the end user is very price sensitive, price competition will result in declines in returns of capital. Ultimately, the end user benefits, not the company
What are the biggest risks associated with China in your view?
Pep So, HSZ GroupShadow banking: In January 2016, the size of shadow banking (total social financing volume less bank lending) was RMB880 billion, accounting for about 25% of the total social financing volume. The shadow banking credit is often given to risky borrowers who cannot obtain loans from banks, therefore more likely to result in bad loans. The government is aware of such risks and has implemented multiple regulations to restrict the growth of shadow banking in China. I see this as a big risk if the size of shadow banking continues to expand.
Property market: I think property is the sector with highest potential to trigger systemic risks. It is also the biggest GDP contributor of about 30% if you also include its indirect impact. On the back of interest rates cut since 2014 and also industry-specific policies such as lowering mortgage down payments, property prices have been quite strong in high-tier (first and second-tier) cities, the inventory level has also become healthy in these cities; but that’s not the case in low-tier (third-tier and below) cities, in which prices have yet to recover and the inventory level is worrying.
Currency risk: Many investors are worried about a major currency devaluation in China. As discussed above, as I don’t think China is going to default on its external non-RMB denominated debt, a major currency devaluation is unlikely. I also don’t see the possibility of China of joining the currency devaluation competition to boost exports. I don’t think it helps much anyway because the slowdown in exports is more about the weakness of global demand rather than exchange rate.
Winston Chu, Frontier Asia Capital A controlled blowup. The developed world will never see China actually blow up ie “hard landing”; without a truly free market I believe the government can always stabilize most of the issues and repackage it. Currently, the main issue is the entire system is overlevered. The government is attempting to deleverage by recapitalizing banks with debt for equity swaps which are then recycled into the economy. I have no idea what the end picture looks like.
Perry Tan, Black Crane Capital China has a huge debt level, an aging population and the desire for capital to flow out of the country because of possible mistrust of the government and/or fear of being purged. If the Government liberalises the market completely, the yuan may be sold off. If the Central Government bails out the inefficient companies, then China risks becoming Japan. If China allows market forces to determine the outcome of these companies, then you risk social unrest...