Tuesday 26 April 2016 by Opinion

Chinese economic miracle - too beautiful to resist, too ugly to ignore

China will eventually become the world’s largest economy on the sheer weight of numbers, but the ride will be bumpy to say the least.  Australian investors will be caught up in the draught regardless of what we do. This note explores industries likely to benefit and those that may suffer


China remains a mystery. Back when Europeans first tried to do business 800 years ago, China was the world’s second largest economy (behind India) before disappearing into relative obscurity from the 1800s.

Now China has taken back its second place in the world economy and is expected to claim the number one consumer position in the next 30 years or so, shortly after it becomes the world’s largest economy. 

At the same time, China’s growth is increasingly dependent upon debt-fuelled investment in inefficient industries such as steelmaking. Since the GFC, the Chinese government has used cheap debt as a mechanism for maintaining economic growth.  China is responsible for 40% of all new debt created worldwide since 2007.

The beauty of the Chinese consumer growth story and the ugliness of the debt growth story make it impossible for investors to ignore.  For Australians, even if you prefer not to invest in China itself, almost every investment is impacted by the health of the Chinese economy, even term deposits.

So for anyone reliant upon their investments for their current or future lifestyles, an understanding of the health of the Chinese economy is a must, even if only for the purposes of reducing anxiety when seeing the inevitable headlines about the latest news out of China.  When stockmarkets are running strong, as is the case in recent weeks, the news from China tends to be positive or at best silent.  When markets are more bearish like we saw in January this year or August last year, all we hear is the bad news.

China truly is a mix of beauty and outright ugliness.  Between our Smart Income report, Wire articles and our seminars, we have covered several contrary issues, but in this rapidly shifting story, it is worth the risk of repeating ourselves if it helps our readers improve their understanding of the risks that all Australian investors face when it comes to the magnificent yet murky economic miracle of our time.

The beautiful China – The second coming of the Chinese consumer 

In 2007, the highest watched NBA (US basketball) game of all time was around 105 million viewers.  That is until the Milwaukee Bucks played the Houston Rockets in November 2007, when a new record of 280m viewers was set.  Yao Ming was playing for the Rockets and Yi Jianlian for the Bucks, both Chinese superstars, drawing in 17 Chinese TV networks and 200m Chinese viewers.

In that same year, Tasmanian farmer Robert Ravens bought a remote farm as a retirement asset.  He used his surplus lavender to make “Bobbie Bear”, a bright purple teddy bear that could be heated to help the bear cuddler sleep.  In 2013, a young Chinese celebrity named Zhang Xinyu posted a picture of herself on her (social media) Weibo account hugging her Bobbie Bear.  The picture went viral, and young Chinese followers of Zhang flooded Ravens’ business with orders.  Ravens had to turn off internet orders, and then phone, email and pre-orders.  Someone even hacked his site to place an internet order, so he restricted purchasers to on-farm only, and one per customer only.  Then came an onslaught of visitors - 60,000 in the next year.  Copy-bears were then sold online and resold throughout China, so Ravens used an authentication number to enable Chinese consumers to show they had the real thing.  

In 2008, an all too familiar story broke in China: food contamination.  This time was different though; this time it was baby formula that was intentionally mixed with melamine, a flame retardant plastic fraudulently sold as a protein alternative that causes renal failure in humans.  A huge 290,000 infants were sick or hospitalised and six died.  The other reason that this time was different to China’s previous many food scandals was now China’s middle class had the money to seek out alternatives.

The Australian and New Zealand producers were the beneficiaries.  The result was a rush by Chinese students in those countries to the local Woolies or Coles to buy as many cans as they could.  Buying the product for $20-25 a can in Australia, shipping them to China where they could be sold for $90-100 a can.  Supermarkets in Australia were forced to limit purchases to two cans per person, regardless of their nationality.  That limit exists in many urban supermarkets today.  If you don’t buy baby formula, you might have missed this, but as a parent of four kids, this did not go unnoticed in our house!

These scandals, combined with the Chinese consumer newly found incomes have resulted in an increasing number of investment success stories like the NBA, Bobbie the Bear and baby formula. 

Swisse and Blackmores have experienced extraordinary growth in vitamin sales; Belamy’s and Fonterra in NZ have seen baby formula sales directly into China soar by more than 100% in the past 12 months; Fauldings, a 170 year old Adelaide based pharmaceutical company is selling baby formula, “superfoods” and probiotics directly into China and now rejecting Coles and Woolies as distributors.

So extreme is the concern about food safety that KFC and McDonalds are considered healthy options in China, according to McKinseys’ survey of middle class families.  This is not because the Chinese believe the food to be low in fat or salt, but because they are considered to be low in toxic chemicals. 

It’s not just food and health products producers that are the winners from this re-emergence of the Chinese middle class.  Cinema patronage in China jumped 50% last year, passing the US as the world’s largest cinema market in terms of volume, and it will likely pass the US in terms of value within the next 2-3 years.  Chinese films are now being produced in Australia – China’s biggest star, Louis Koo, is currently in Australia for the production of an anti-corruption film backed by Alibaba, Ten-cent and the Shanghai government. 

And of course there is property, tourism and education.  Nearly 140 million tourists are expected to leave China in 2016, and these are not cheap spenders.  Global Business Travel Association estimates see the Chinese consumer passing the US in terms of business class travel by 2019.  A whopping 550,000 mainland Chinese will be educated offshore, often followed by parents’ investment in property in the same country.  Outbound property investment will almost certainly be the explosive growth market of 2016, following the Chinese government’s 13th “five year plan” calling for Chinese companies and investors to “go west, go out [offshore] and go green”. 

The story of the Chinese consumer will change the landscape for many Australian companies forever.  The Chinese middle class is growing so fast that more than 50% of the newly middle class families in the world are in China.  And they are spending their money on the healthy and happy futures of their families: addressing food safety concerns by buying clean and green food; buying offshore property to secure their families future in a safer, cleaner country; and increasing spending on leisure activities such as travel and cinemas.  In addition to the direct spending by the Chinese consumer, Australia is the 2nd largest recipient of Chinese overseas direct investment after the US, an extraordinary position considering we are the 13th largest economy in the world. 

Australia isn’t guaranteed a place in this future, but we are in the driver’s seat.  We have a reputation for producing “clean and green” food; we have the world’s first free trade agreement; and we are trusted by the Chinese relative to the other major economies particularly the US and Japan.  If Australian companies can leverage this advantage, the upside is several times the size of our small economy today. 

So the only question for Australian investors is how to profit from this.  The issues are not complicated: firstly you need to find products that the Chinese will likely buy; spread your bets as the Chinese consumer is fickle; and have the patience to ride out the inevitable volatility that comes with anything to do with China.  But buying into these companies before their share prices go ballistic and potentially become a bubble themselves is the toughest issue.  For those with the resources, buying prior to listing is an option.  But for those that can’t buy unlisted companies, volatility and hype will be the biggest risks.

The Ugly China – addiction to debt that could lead to GFC Mark II 

George Soros, the hedge fund king who has amassed billions with smart betting on market outcomes told Bloomberg last month that China: 

“Eerily resembles what happened during the financial crisis in the US in 2007-08, which was similarly fuelled by credit growth. Most of the money that banks are supplying is needed to keep bad debts and loss-making enterprises alive.”

Following the release of The International Monetary Fund’s last Global Stability Report, their chief economist Maurice Obstfeld said the trade-off for the short term recovery in China’s economic growth is even more trouble down the road because of the use of more debt to stimulate the economy. 

The report’s section on China reads like a horror story for anyone with a basic understanding of credit fundamentals.  The ratio of debt to EBITDA has risen from 2x to 4x since 2010.  The percentage of corporate debt with an interest to earnings ratio of more than 100%, ie “at risk debt” has risen from 4% to 14% in the same time, putting the total amount at-risk at US$1.3 trillion.  In the steel industry, this number is now 39%; 35% in each of mining and retail (despite the consumer spending boom as above); and 18% in manufacturing.  The average payment to suppliers has been stretched to 72 days, far higher than any other major economy. Reported non-performing loans are 6pc of GDP but not much is reported. The IMF has warned that bad loan losses could amount to US$756bn, more than the total losses experienced by US banks during the GFC years. 

Debt is the alarming excess, but production capacity is also deeply concerning and also related in the sense that excess capacity means lower prices which means lower ability to repay debt.  China’s surplus steelmaking capacity is greater than the total production capacity of Japan, the US and Germany combined.  And it’s not just steelmaking. The Asian Development Bank listed ferrous metals, raw chemical materials and chemical products, non-metallic mineral products, general equipment, electrical machinery and equipment, and automobiles as the most problematic sectors. 

Property excesses are not the real issue; industrial excesses are.  In fact, since 2000, according to the global economics research group Conference Board, investment in mining equipment and metal processing equipment has been 11x and 5x higher than investment in residential property.

Excess capacity is leading to lower prices; prices have fallen 50 months in a row now.  This in turn is leading to lower profits.  Last year, Chinese industrial firms posted their first annual decline in aggregate profits since 2000.  And the issue is much greater with the state-owned enterprises; the return on assets of state owned enterprises is 70% lower than privately owned companies (half of which are foreign owned). 

China will eventually become the world’s largest economy on the sheer weight of numbers, but the ride will be bumpy to say the least.  Australian investors will be caught up in the draught regardless of what they do.  Our economy is permanently linked to China.  Equities, the AUD, interest rates and therefore term deposits, property, small business, inflation, aged care, food prices…the list goes on, we are exposed.  Australians reliant on their assets for the current or future lifestyles, which is 99% of the population, have to make a choice: are they traders or investorsDo you want to try to time the market’s ups and downs as the China story plays out over the next decade or more; or do you want to protect your position for long term growth and income?

Investor strategy

The answer for the majority of investors should probably be to be the investor not the trader.  Trading against financial markets is like trying to make money against horseracing bookmakers every day – possible, but dangerous, stressful and improbable.  For the investor, long term growth from China comes from the consumer, not the industrial sector.  Spend your time looking for long term consumer plays likely to benefit from the inevitable rise of the Chinese middle class, but make sure you don’t jump on board too late,  after the hype has already increased share prices too much.  Private (unlisted) companies should be included to maximise returns.

Long term risk comes from the implications of China’s debt bubble bursting.  Such a burst will crash iron ore prices, the AUD and more than likely global equity markets, particularly those overpriced as much as the US’s.  The magnitude of the corrections would likely mirror the impact of the GFC in 2008 and 2009, but this time without the Chinese economy available to save the world from recession.  The US economy is strong but the US and China are now co-dependents so a correction in China will impact even the US economy. 

Investors, unlike traders, should protect themselves from this by reducing equities exposures gradually, but preferably during 2016 and 2017 as the debt bubble cannot go on inflating indefinitely.  And they should hedge against the severe impact such an event would have on the Australian economy by “shorting” the AUD, ie investing a meaningful percentage of their assets in foreign currencies, preferably quality currencies such as the US Dollar and the Great British Pound.