“One thing I have learned about China is that there is always something to worry about”by Anthony Bolton / February 20, 2014 / Leave a comment
The night skyline in China’s largest city, Shanghai ©XU XIAOLIN/CORBIS
As we move through 2014, views on China, particularly in the world of investment, are unusually polarised. Some argue that China can continue to grow at close to the rapid rate it has achieved for the last couple of decades—a rate that has not just transformed its fortunes and standing in the world but changed profoundly the way that many look at development. Others predict that the economy will collapse in a western-style banking crisis some time soon. Both are unlikely, in my view. My cautious optimism stems from the deep changes in the economy now underway, and on my belief that the new leadership in China realises the need for reform and has the desire and the power to see this through. One thing I have learned about China is that there is always something to worry about. Four years ago, I moved to Hong Kong to run an investment trust that specialises in Chinese companies listed on stock exchanges. Under the country’s licensing regime, because the company I work for is entirely owned by non-Chinese I would not be allowed to do my job in China—so I am based in Hong Kong. During that time, I have met a very broad section of senior Chinese businessmen. I have undertaken over 1,250 company meetings and travelled to China about once a month as well as meeting many China experts. That is the reason that I am neither as alarmed as those predicting collapse nor as sanguine as those expecting that the record of the past few years will simply continue.
The sources of potential worry in the last two or three years have been legion. Some are widely known, such as pollution and corruption. Others include inflation (the official rate of inflation often under reports the true rate); excessive government borrowing (the huge local government infrastructure spend after the global financial crisis was generally financed by a big increase in debt); consumer savings products (called “wealth management” or “trust products,” some funds from which have been invested very riskily when the buyers thought they had minimal risk); and an export squeeze due to rising wages for Chinese workers and a rising currency. My belief is that most of the financial challenges are containable, at least for a few years. Crucially, the authorities are able to move money between the central government, which has huge funds at its disposal, and local governments and the state-owned enterprises, which among other industries dominate banking, energy and telecoms. This allows the government to offset many of the short-term pressures that China is currently experiencing. Some of those predicting a sharp and painful slowdown for China are wrongly projecting onto its economy the constraints of western democracies, which often behave very differently to China. I believe using only western experiences to predict the future in China is dangerous.
To my mind, China’s real challenges lie more in the medium term and stem from social and political pressures. Above all, an absence of political reform could spell trouble for the Communist Party. The stance that the government has taken abroad, on human rights, in its propensity for territorial disputes and an overall touchiness in international relations, has done much to complicate its standing with other capitals. But its fate will be decided at home. The ruling party’s strength has come to be predicated on its ability to deliver broad economic growth—but now that this growth has been achieved, and many households own cars, apartments and consumer goods, people are more eager to obtain greater liberty and say in future. The government must reform—however, achieving the necessary reform, which I believe it knows is necessary in the long term, will not be easy, as it strikes at the heart of vested interests in the most powerful institutions.
That was clear from the Third Plenum meeting of the Chinese Communist Party in November, the forum at which the new government traditionally sets out its reform agenda. The full details came out a few days later in a paper titled “Decisions on major issues concerning comprehensive deepening reforms.” The release was indeed comprehensive, covering 60 items in 16 areas, and in its breadth and boldness probably represents the most significant reform package in China for 30 years.
Possibly the biggest headline reform is the change to the one child policy, the restrictions that broadly set out to deter all but farming families from having more than one child. Now, couples will be allowed two children if one parent is a single child. Although it will take many years for this to have any real effect on the economy, it has great symbolic significance as this rule had been unique to China and was given great importance by the authorities.
The November reforms also give the market a greater role in the pricing of resources particularly fuel, gas and electricity, the setting of interest rates and currency convertibility (allowing people to move money in and out of the country). They pave the way for private banks and more bond financing—China has only had a small local domestic bond market, and the government wishes to broaden this in order to expand businesses’ access to finance. The reforms promise to level the playing field between state-owned enterprises and private companies by, for example, making the enterprises pay out 30 per cent of their earnings by 2020 in dividends to their shareholders.
The proposed changes will establish more market-orientated state holding companies, which may make many of those companies more responsive to what consumers want. They will reform land rights for farmers, potentially a change of enormous significance as in the past farmers have had minimal ownership rights to the land they farm. They will relax the hukou registration system in smaller cities, whereby citizens are eligible for some social services only in the place of their origin. They also give China’s hundreds of millions of migrant workers more access to welfare and social security. They will streamline government, abolish forced labour for offenders, increase the independence of the judiciary, and accelerate new business approvals and capital projects. In creating new measures of success for government officials beyond simple GDP growth, they may help to give incentives to curb pollution. They will create more open competition for government tenders and rebalance the tax system between local government, which accounts for most of government spending, and central government, which collects most tax revenue.
Perhaps the most daring move is the establishment of a new central group to oversee all aspects of reform, headed by President Xi Jinping himself. As is often the case in China, the full detail and importantly the timetable is lacking; it would be wrong, however, I believe, to underestimate the long-term impact of the Third Plenum, particularly on the economy. It is true that there was very little reform of an explicitly political nature. Some of the changes announced on this front, such as a return to communist values and controls on online “rumour-mongering”—a phrase that can be expanded to cover any type of political criticism—may appear to be a step backwards. An experienced political observer said that understanding reform in China is a bit like watching a conjurer: you are persuaded to look at his left hand but the interesting developments are going on in his right hand. The question now is how strongly these apparently illiberal new policies are really implemented.
Another reason to be cautiously optimistic about China’s ability to bring about internal change is that its centrally-run economy has longer planning cycles than those of western democracies where politicians face elections every four or five years at most. New policies are often tested first in one or two cities or provinces. In the late 1970s, Deng Xiaoping took the first steps towards China’s unique form of socialist capitalism with the creation of a special economic zone across the border from Hong Kong in Guangzhou province—a measure that ultimately led to the transformation of a small village into a “Tier 1” city, Shenzhen, that is now home to more than 10m and is one of China’s leading technology hubs. The technique continues today with the creation of a new free trade zone in Shanghai. If these experiments are successful they get rolled out across the country but if they are not they are quietly dropped (such as the trials of mobile telephone number portability which have not been extended nationwide). This approach reduces the risks of reform.
In my view, China has very competent leaders especially at the centre. The long road to the top, usually by way of positions in different provinces, means that only the best survive, although the technocratic focus means you don’t need charisma to get there. This has produced a very capable current leadership team which is acutely aware of the challenges that China faces. Leaders are generally loath to make the mistake they believe Mikhail Gorbachev did in Russia by not letting economic reform precede political reform. The Standing Committee of seven, the core of the leadership, is drawn from the 25 members of the Politburo; this current committee could be called politically conservative while economically liberal. However, Xi Jinping’s ascent to the top was not without hiccups and the few weeks before last year’s Standing Committee meetings saw major rivalry between different factions. His challenge now is that a failure to reform will significantly increase social tensions, particularly among the new middle class.
Reform means tackling some of the biggest vested interests in local governments and state owned enterprises. Xi’s supporters took most of the places on the Standing Committee last year, and that power may explain the extent of the reform plans revealed in November. He may not be in such a favourable position four years from now when five of the committee members change (only his position and that of the Premier Li Keqiang continue for the full 10 years). Xi has spent his first year in office consolidating his political power. He has taken full control of the military and very recently announced that he will set up a National Security Council in China for the first time, something that previous leaders have tried to do without success. He holds more power than his predecessors—one reason why I believe the current leadership now has a good chance of pushing through reform.
Most agree that one of his most competent Standing Committee members is Wang Qishan, whose official title is Secretary of the Central Commission for Discipline Inspection—in other words, the head of the anti-corruption campaign. Several high level arrests have been made of officials or company directors who actively supported Xi’s rivals such as Bo Xilai. Wang Qishan has also started a “you tell me what I should know” campaign with top officials and business leaders of state owned enterprises. In time, this approach combined with a proper tender system for public work contracts (in the past these were a great opportunity for rake-offs) should significantly reduce corruption. This is partly him getting at his rivals, but there is also a genuine effort to clear up business practices. The corruption campaign has gone after more senior people than in the past. I expect we will hear of more headline arrests of senior officials in the months and years ahead.
One advantage Xi has today is that the middle class in China is generally optimistic about its future and loyal to the party, although this could change if the economy deteriorates. The attitude of successful and wealthy entrepreneurs is different, however; many can’t wait to get part of their wealth outside China and a number want to emigrate, although sometimes this is driven by their children’s education. The fact that the elite has less faith in the future than the rest of society is definitely worrying.
China certainly has some troubling social aspects. The one child policy has created a very unusual society of insulated family units without the normal interactions of brothers and sisters, aunts, uncles and cousins that is universal in every other society. These units of one child, two parents and four grandparents put huge focus on the single child.
China has one of the most competitive societies in the world where children are in school each day for over eight hours in classes with an average size of 60 pupils. The Gaokao exam that will allow about half of school leavers to progress to university lasts for nine hours over two days. With a system that has no other exams or continuous assessment, passing this exam for many is the difference between two very different futures. Even the six million who graduate from university each year will not necessarily find it easy to get the job they are seeking. This creates a world of insulated but highly ambitious and very hard working workers. The question is whether China’s pressurised education system can serve it well as it attempts to shift further up the value chain, moving from low value manufacturing exports to higher value-added services.
In answering these questions, there are no good precedents to help. No economy of this size has ever made the transition from a developing to a developed economy. None has attempted to combine a centrally-run command and control economy with, on the street level, one of the most capitalistic and competitive societies. This is, moreover, happening in the internet age when 600m people are interconnected by computers and mobiles in a way that makes it more difficult to hide the truth from them.
Indeed the internet is one of the key catalysts for reform. Because the internet age started later there than in the west, China has been able to leapfrog some steps in its development. In retailing, particularly in the Tier 3 and 4 cities where the bricks and mortar of shops, warehouses and delivery systems has yet not been developed, shoppers are going straight to the internet to make purchases. Once they experience the convenience and choice this provides, they are unlikely to be as interested in offline shopping. Several of the most impressive companies that I’ve met in China, like Tencent and Alibaba, are internet-based and they are of a size able to make an impact on a world scale. China’s equivalent of WhatsApp has 270m active users in China and is of a scale that will be extremely difficult to replicate anywhere else. Companies like Tencent and Alibaba have the potential be among the biggest listed companies in the world and to become household names like Amazon or Google. At the centre of my investment thesis is the view that the key drivers of Chinese growth are changing as the reform progresses. In the past, economic momentum was driven by exports (for example, the low value type of exports that turn up in western department stores) and infrastructure (over half the world’s consumption of cement takes place in China—a totally unsustainable situation). I have sought to invest in all the areas that should benefit from this change, such as car manufacturing, food, drink, travel, entertainment and retailing companies. I have also focused on service companies; the Chinese are spending more on education, healthcare and financial services.
I have sought out the smaller private companies in these areas rather than the large state owned enterprises. These are more entrepreneurial in their outlook and the recent policy changes favour them. In making those investments, I have met thousands of business people. Although a small minority can’t be trusted I find many to be very impressive. It’s their pragmatism and flexibility that particularly strikes me. They are very willing to try new things and get out of areas of activity where the prospects have deteriorated. The senior management of these private companies come from a wide range of backgrounds—some are self-made with only a basic education but most have a college degree and a few have been educated overseas. Generally I have favoured management teams who have studied or even worked abroad as they are more aware of what is expected from the management of a listed company and have wider business experience. The ones who don’t have this experience can be more naïve when it comes to working with outside shareholders.
I have said many times that the worst companies in China are a great deal worse than their counterparts in the west, and I have had to adapt my investment approach to some degree to accommodate greater levels of due diligence. This is carried out by talking to competitors, ex-employees, suppliers and so on. Just relying on written prospectuses and what management tell you can be dangerous: there are some excellent Chinese liars, as a number of foreign companies doing business in China have found out to their cost. Working out who one can trust and who one can’t has been an important part of my job. But the best Chinese companies are the equals of their rivals in the developed world. In general the average age of management is younger, and a number of companies I meet are run by women. There are a higher number of successful businesswomen at the top of Chinese companies than I ever experienced in the UK.
In the domestically-focused businesses that I have mainly concentrated on, the outlook for demand generally is excellent. GDP per capita in China has reached a stage where, on the evidence of other developing economies in recent decades, we should expect demand for many consumer products and services to go through a growth spurt for a decade or so. The key, though, is to find areas where supply is limited or where there are strong barriers to entry because the market environment in China is extremely competitive. In my view, China is a market in which thorough analysis, an on-the-ground presence and a stock-picking approach are likely to lead to significantly better returns in the long run than a passive investment approach that simply attempts to track the performance of the Chinese stock market as a whole.
The China growth model is not broken but it is changing, a process that is likely to take a number of years. During this time, the growth rate of China’s economy will undoubtedly slow; the rapid growth of recent years cannot be maintained. However, in my view, growth based on domestic consumption rather than low value exports and unsustainably large investment in infrastructure will be of better quality than what preceded it. I believe that this move to consumption and services and to more value-added manufacturing will produce many attractive investment opportunities for domestic and foreign investors. China has shown an amazing ability to adapt and change over the years and despite the undoubted challenges ahead, you write off China at your peril. It is worth remembering that 35 years ago the country was still mired in the wreckage of the Cultural Revolution and the remarkable economic and social transformation since then was by no means a foregone conclusion.
My view of the investment potential is anchored in the belief that the current Chinese leadership recognises the need for political reform and is capable of bringing it about. It is worth dwelling on the words of Premier Li Keqiang in a recent speech: “The key is to reap a reform dividend. We need to make public finances more transparent, liberalise interest rates, cut wasteful government spending and allow small businesses to flourish. Of course, reform will hurt vested interests, but the interests of the vast population are the top priority of the government. I am ready to cut through the vested interests to carry out the much needed changes.” Quite a statement for any leader, let alone one of a communist country.