Why China will remain strong

The press always carries questions about China’s perceived risk, thus they are on peoples’ minds. Though we have addressed many of these questions and concerns in previous letters, we are happy to explain our fundamental optimism about China.

We hear three main questions:

Question 1: China has been an export driven country in the past, how can they make it without exporting as much?

Answer: It’s an undeniable fact that exports account for a decreasing percentage of China’s GDP each year. China’s exports have fallen in the past year or two and the countries and sectors to which they export have changed as well. Their exports are primarily to non-Japan Asia, Japan, and Europe. The U.S. is no longer the primary export destination for China.

Conceiving of the Chinese economy as entirely dependent on exports is overly simplistic. The Chinese economy can be likened to a three legged stool in which exports, infrastructure building, and consumer spending all serve to support the economy.

It is worth noting that China’s imports come from commodity producing countries like; Australia, Brazil, Canada, Indonesia, Malaysia, and many others. To invest in China’s growth, we suggest investors buy stocks in countries that export to China.

Question 2: How can China slow down real estate speculation without causing a collapse in the economy such as what was seen in the U.S. and Europe? Why are real estate prices rising so fast in the big cities?

Answer: In most of the world, there are four major investment outlets: stocks, real estate, bonds, and commodities. By far, the largest securities markets in the world are in bonds. Bonds are conservative low-yielding investments and they consume a large amount of the capital of investors around the globe.

However, in China, bonds are not widely available. A Chinese investor has only two outlets for investment capital: stocks and real estate. As a result, a great deal of capital flows into stocks and real estate that would likely go into bonds, if they were available.

Consider how the U.S. bond markets works. There are several levels of bond investments. There are U.S. government bonds, which include government agencies that are state tax exempt, corporate bonds on which investors pay taxes, and finally, municipal bonds that are state and federal tax exempt.

Now, put yourself in the shoes of a Chinese investor. You have no option to buy municipal bonds, no option to buy government bonds in quantity, and most corporations do not sell corporate bonds. There is a very limited pool of investment choices for a wealthy person to store money and to protect their assets from inflation. He or she can buy stocks and real estate. More recently Chinese savers have been able to buy gold and silver bullion.

As massive wealth has been created by many enterprising Chinese, they are looking for a way to invest their surplus of cash. They prefer an investment which is close to home so they can keep and eye on it, and one from which they can perhaps get some income.

They buy apartments in their home areas. Since most wealthy Chinese live in the big cities like Shanghai, Beijing, etc., they typically buy their 2nd, 3rd, and 4th apartments in these cities to diversify their assets. These real estate purchases are driving prices higher; and prices do sometimes rise to unreasonable levels.

The significant difference between U.S. and European real estate investors and their Chinese counterparts is that the Chinese do not buy these apartments on high leverage. By law, Chinese investors must put down 50 percent of the purchase price in cash and pay higher interest rates when they borrow to buy a second apartment.

This keeps leverage low. Because leverage is low and because, in many smaller cities, there is a shortage of apartments, we do not see the overvaluation and sky-high prices of luxury apartments in the four or five big cities as a longer term problem. There is huge demand for reasonably priced apartments, and currently the only over-built area is high priced, high status apartments, which will have to be marked down to sell.

Though luxury apartment prices may need to fall, this will not create a long-term problem for the banks who have lent to build some of these overpriced apartments for three reasons:

Reason A) The apartments are not a huge percentage of the banks’ total loans.

Reason B) The banks increased their capital after the Chinese government criticized their over-lending in this area and demanded that they raise more capital. Contrast this with the U.S. and in Europe, where there was minimal government criticism and no government requirement to raise more capital. In fact, the governments of the U.S. and Europe encouraged and even subsidized a good part of the unwise lending in real estate, only after the collapse and bail out were banks forced to raise more capital.

Reason C) Real estate debt derivatives are not ubiquitous in China like they were in Europe and the U.S. It was clearly these real estate derivative debt instruments that caused much of the problem in the West.

In conclusion, bad real estate loans may become a problem in China, but it should be a well contained problem.

Question 3: What about special investment vehicles set up by provinces for infrastructure building in their province? (These supported many kinds of infrastructure including apartments.)

Answer: Remember when we mentioned that there are no municipal bonds in China? In other countries, municipalities and provinces borrow money from the public with general obligation [unsecured] or secured revenue bonds. China’s provinces are unique in that they borrow directly from banks and secure their loans with provincial property, therefore secured debt. In addition, they are limited in scope because they are from the banks, not from the more easily manipulated, less sophisticated investing public.

If the provinces do not pay their loans, the banks can repossess their property and sell it to recoup their losses. In addition, taxes are fairly low in China and provinces do not tax citizens and businesses as much as they do in much of the rest of the world. Therefore taxes can be raised by provinces to pay off these loans.

SUMMARY

In summary, we do not think China will melt down in the near future, as some fear.

We hope these answers explain satisfactorily to our readers why we remain essentially optimistic about China in the near future. This does not mean that problems will not arise, but we believe it may be in five or six years. We believe that investors selling today will watch Chinese stocks rise for years before a major problem arises in the Chinese economy. Investors who pull out of China today are, not unlike those investors who sold U.S. tech stocks in 1995…instead of 2000, leaving a lot of money on the table.

Guild Investment Management, Inc., a registered investment advisor. All material presented herein are solely the opinions of Monty Guild and Tony Danaher. Investment recommendations and opinions expressed in these reports may change without prior notice. Read Monty and Tony’s past periodic market and economic commentary articles by going to the Commentary Archive on www.guildinvestment.com.