The following is an op-ed article written by Tony Gleason of Neuberger Berman. In this interesting work, Mr. Gleason studies essential history, reviews present issues, and predicts future trends, regarding business within China. It is very helpful for those of us, who have operational dealings and investments in China. Extremely worthwhile reading:
China Wakes, the World Shakes
by Neuberger Berman’s Tony Gleason - November 17, 2009
As we have all witnessed, the economic system that drove much of world trade buckled in the financial crisis of 2008. It appears that the U.S. will no longer be the insatiable source of demand for the world’s manufacturing countries. Our credit has unfortunately hit its limit with our creditors, namely China and Japan. From an investment point of view, understanding the new financial, economic and political system that is evolving from the 2008 crisis will be a key to making and preserving capital in the decades ahead. China, as I will explain, is re-emerging on the world stage and will likely play the leading role in this evolution. Within this piece I offer my perspective on China today and how I believe it will influence the investment landscape.
I’ve had the extraordinary good fortune of traveling frequently to China. Each time, I’m startled by the progress the country has made since my previous visit. The most recent trips are no exception.
Cities visited in the past few months include:
Along the way I met with over 60 companies, various government officials and many interesting people. Since the crisis began almost a year ago it’s become abundantly clear that the Chinese government recognizes they can no longer grow the country’s economy based on exports to the United States and Europe. Recognizing that economic growth is necessary for harmony and its own ability to stay in power, Beijing has shifted gears quite dramatically and so far has managed its way through one of the most significant financial crises in a century. Many will argue with how it got there, but China is on track to leave 2009 growing at a better-than-8% rate. While China has many goals, in our view, the three with the greatest implications for the investment business are to:
- Tier one cities: Beijing, Shanghai, Guangzhou, Hong Kong
- Second tier cities: Nanjing, Hangzhou and Chongqing
- Small, but important cities: Li Jiang and Macau
In the investment business, getting the big picture right is key; we believe the ability to appreciate what is going on in China—and act on it— will have a significant impact on investment results. For some perspective on where China is headed, it pays to look back a few years. Therefore I’d like to provide you with some history intertwined with my observations on this most fascinating country...
- Increase domestic consumption;
- Accelerate infrastructure; and
- Diversify away from the U.S. dollar.
History
Between the seventh and fourteenth centuries, before Europe industrialized and the U.S. colonies began to take root, China was the world’s dominant economic power and the most advanced civilization. Consider that HeZheng (1405 – 1433) commanded a naval expedition with 62 ships and 28,000 men for the purpose of trading Chinese commodities with the less developed world. Not bad for a guy who never saw his 29th birthday.
Paul Bairoch, an economic historian, estimates that at the height of its power in 1750, China accounted for almost 33% of the world’s manufacturing output. Equally surprising, India was a close second at 23% of world trade, mainly due to its vast export of cotton fabrics. Combined, China and India accounted for 57% of world trade (The U.S. would have been considered THE emerging market then.) By 1970, however, China had catastrophically collapsed, accounting for less then 8% of world manufacturing. Before its 250-year slumber, China, as so well researched by Joseph Needham and wonderfully described in Simon Winchester's recent book, The Man Who Loved China, had invented what many consider to be three of mankind’s most important inventions: the compass, gun power and the printing press (sorry, Guttenberg, you were hundreds of years too late!). Other notable inventions include silk, the wheelbarrow, paper (1 AD) and soy sauce, which in case you didn’t know, goes with everything.
Most historians attribute the dramatic decline of China to a combination of technological innovation that allowed Europe to industrialize quickly and invasions and subsequent occupations by multiple countries. Poorly structured trade agreements negotiated after the two opium wars made matters worse.
In more recent times, there were two key events that rocked China to its core and finally marked the end of a 250-year of decline. The first was the occupation of one third of the country by Japan during World War II. In my view, the trauma and humiliation brought about by this period of history cannot be underestimated. My sense is that the defeat of Japan by the United States set the stage for a very special relationship between our two countries which, while rocky at times, continues to exist to this day.
After World War II, one might have thought China was finally ready for a significant rebound but, alas, it was not to be; Mao Zedong, whose portrait looms large in the minds of Chinese and hangs in the square of the people (also known as Tiananmen Square) had two great ideas that really hurt the country’s prospects. The first was the “Great Leap Forward,” which backfired terribly and resulted in the deaths of over 20 million Chinese due to starvation. The second was the “Cultural Revolution," which purged much of China of its rich cultural heritage and destroyed what wealth remained.
It was a tough and sluggish 250 years. However, considering that China is the oldest civilization on earth, to sleep for 250 of your 3000-year history might not seem so meaningful. From my perspective, Mao’s most significant contribution to China was the elevation of women. His famous quote, “Women Hold Up Half the Sky,” is often cited as the reason women hold such an important status in China. This is in stark contract to both India and Japan which, in my eyes, have yet to meaningfully incorporate women into positions of power.
Many think China’s rebound began with a famous Deng Xiaoping quote from the late 70’s that stated, “To be rich is glorious.” Clearly, the evidence was in that poverty was not glorious. Deng and his successors unleashed many significant reforms related to land ownership, housing, the restructuring State Owned Enterprises (SOEs) and, eventually, the development of Special Economic Zones (SEZs), all of which set the stage for one of the most remarkable growth periods in history.
Domestic Consumption Growth
With that abrupt and rambling overview of 3000 years of Chinese history behind us, what of China’s consumption? Consumption in China is roughly one third of Gross Domestic Product (GDP), the lowest of any large country and well behind the world champion United States, which weighs in at an astounding 70% plus. While we essentially are borrowing and buying like there is no tomorrow, the Chinese have been working and saving for only tomorrow. While estimates vary, it is generally agreed that the China savings rate is approximately 25% while the U.S. savings rate hit zero a year ago. In addition, China’s consumer debt-to-GDP is 12% versus the U.S., where consumer debt-to-GDP is almost 100%. It appears that this imbalance is about to reverse and I believe the implications are enormous. To get back on track, we Americans need to think about tomorrow a little bit more and begin saving and reducing our debt. Unfortunately this would equate to a declining standard of living until we get our house in order. China’s picture is dramatically different considering the wealth that has developed in the last three decades. The table below and notes that follow are designed to help explain the powerful, sustainable upward trajectory of consumption growth in China.
China’s Emerging Wealth
China now has:
Autos
- 130 billionaires (2nd only to the US)
- 825,000 millionaires
- 1,600,000 citizens earning over $80,000 USD/year
- 4,600,000 citizens earning over $18,000 USD/year
- 300,000,000 citizens lifted from poverty
China’s total car sales now exceed those of the United States and will likely continue to do so for decades. Germany has hit a home run in the luxury car market in China and is responsible for the three leading luxury cars there. Many German auto executives believe that China will be the leading luxury car market in the world by next year. If 2009 is any indication, they are likely correct. Consider the year-to-date sales as of September 2009 for the leading luxury car brands in China compared with the U.S.:
Sales are rising at this pace despite the fact that China imposes significant taxes for imported cars and those with big engines. This can add up to a 30% to 100% higher price tag then a similar car purchased in the U.S. It likely won’t be long before you will see cars from China in a showroom near you from companies with names of Chery Automotive, Geely Auto and Great Wall Auto. It would not surprise me to see China explore buying one of the big three in the U.S.
- China: Audi YTD sales up 20% to 108,858 - USA: cars down 26%
- China: BMW YTD sales up 35% to 59,460 - USA: down 24%
- China: Mercedes YTD sales up 41 % to 45,400 - USA: down 23%
Housing
In what many consider to be the largest wealth transfer in history, the Chinese Central Government essentially gave away the entire housing stock to its citizens in the early 1980s. Most was poorly built government housing but, nonetheless, was an asset that could eventually be sold or borrowed against after financial reforms were instituted in the mid-1990s. To understand the outlook for the housing industry in China, it’s important to know a few things. First, the private housing industry is relatively new--basically 12 years old with a very long way to go. Second, mortgages have only been available in China since 1997 and, according to CLSA, more then 75% of homeowners still live in outdated government housing. Third, according to most builders I spoke with, more than 40% of all home sales are paid in cash. This is not too surprising given China’s purported 25% savings rate.
The last year has seen an impressive rebound in new home sales partly driven by China’s stimulus plan and partly due to pent-up demand from a government-induced slowdown in 2007. For the first eight months of 2009, total sales of new homes are up over 70% and most builders are running out of inventory. In Chongqing, perhaps the world’s least-recognized city of 30 million, 5,000 new apartments are being sold per month. Many showrooms I visited were filled with soon-to-be wed couples with their parents on hand to fund the down payment. According to many builders I spoke with, the ability to find a bride is significantly enhanced once you are a property owner. It seems that, in China, to be rich is to be married. According to Access Pointe founder Jiayi Li, back in the 1980s all you needed to land a bride was a bicycle and, of all things, a sewing machine.
Shopping
Shopping in China can be one of the most interesting adventures whether you’re looking for live scorpions on a stick or something more mundane like clothes. The one thing you can’t help but notice is just how important brands are. For whatever reason, the Chinese are extremely brand conscious. At the Golden Eagle mall in downtown Nanjing, you find them all: Armani, Ferragamo, Hermes, Versace, Coach, Polo, L’Oreal, Estee Lauder, Givenchy, Shiseido, Vera Wang and Vertu phones with an $8,000 U.S. dollar price tag. Luxury retailing in China is ramping up at an amazing rate. For example, Versace recently closed all of its Japan stores and is in the process of opening 18 more in China.
Of greater interest to me was the evolution of grocery shopping. Small stores are giving way to large supermarkets and hypermarkets with significant success and speed. Suguo, a prominent and rapidly growing grocery store chain concentrated in Nanjing, had hundreds of customers waiting outside for the early morning specials. I was struck by the assortment and quality of merchandise. Of notice was how well-represented Johnson and Johnson was in the personal care aisle. A little less hygienic: the “wet” meat department where every piece of unwrapped pork was handled by hundreds of picky shoppers.
The most recently reported data on consumption comes from the Chinese government. Overall, retail sales were up a strong 15%. Department stores and hypermarkets were standouts, reporting sales increases of 40% and 33%, respectively. I believe this reflects the strong market share these retail formats are taking. U.S. retail sales, on the other hand, have been crawling back towards zero growth after posting declines for the last year.
Internet
One is reminded of China’s immense size when considering that the country now has 340 million Internet users, up from 100 million in 2005. That’s an average addition of 60 million new users per year. This is an area where we need to do more homework. Companies such a Baidu, Taobao and The 9 might not sound familiar now, but they likely will in the years ahead.
Gaming
Think of 1.3 billion people with a propensity to gamble, one legal location and plenty of capital and you have Macau, a modest-sized island off the coast of the Mainland and approximately one hour by boat from Hong Kong. Macau was the first AND the last European colony in China. Portuguese traders first settled on the island in the 16th century; in 1999, the Chinese government assumed sovereignty over it. Like Hong Kong, Macau has a policy of “one country two systems” that is guaranteed for 50 years after the transfer.
Macau represents a focal point for discretionary consumer consumption, the likes of which most have not seen. For many centuries, Macau was a backwater gambling enclave with a checkered past. In 2003, the island was opened up for serious casino building. In six short years, Macau’s gaming revenue has gone from a fraction to twice that of Las Vegas. In case you can’t carry home all your winnings, Porsche has a dealership on the casino floor and, while you’re waiting for the floor mats, Cartier and Louis Vinton are next door. Macau now appears to be similar to where Las Vegas was in 1980. It has undergone quite a transformation in recent years. I imagine it’s not exactly what the Jesuit priests had in mind when they set up shop on the island in 1550.
Infrastructure Build Out
Infrastructure spending in China is something one can only marvel at. The Financial Times recently ran two articles side by side, the first highlighting China’s infrastructure and the second about California’s efforts to build a high-speed rail link between Los Angles and San Francisco. The two articles could not better represent my observations on the current state of infrastructure in both countries. China has responded to the current economic crisis by putting forward a long term plan to expand its existing rail system by 50% in the next three years and to triple its high speed rail mileage by 2020. To achieve this, China has committed to spend $100 billion U.S. for each of the next three years, at which time it will have more high-speed line the rest of the countries in the world combined. The U.S. government, meanwhile, has allocated $8 billion for the entire nation’s high-speed rail system, less then 10% of China’s planned expenditure for the year. California, as the article points out, is lobbying for $4.5 billion to build its 800 miles, a project that has been on the drawing board for almost 10 years. No word yet on where California, (currently insolvent) would come up with its $10 billion share of the cost. Upon return from China (the emerging country?), one can’t help but be startled by the embarrassing state of infrastructure in the U.S.
Diversify Away from the U.S. Dollar
The irony that Communist China now possesses the single largest pool of capital might cause Karl Marx to raise an eyebrow, were he alive today. As an investor, I believe it’s important to understand China’s intentions for its $2.4 trillion in foreign exchange assets. My sense is that China is purchasing commodities for two purposes. First, the country is desperately short several key commodities. Second, commodities purchases would serve to diversity some of China’s reserves as a hedge against the U.S. dollar. In the last 12 months, China dramatically stepped up purchases of what it doesn’t have and needs desperately, namely oil, copper, iron ore and metallurgical coal (used for steel). Despite a slowing economy, imports of all these raw material surged from 20% to 200% in that time period. These are all key ingredients for an economy that is mid-stage in a 30-40 year build out. Further steps are being taken with various trading partners through currency swaps (i.e., getting paid for oil in Chinese currency (Renminbi (RMB)) and, in turn, buying Chinese manufacturing goods with it). No U.S. dollars involved. Over the next three years or so, the RMB appears to be heading from a closed, controlled currency to being part of world trade.
Hong Kong presents an interesting laboratory for this possibility. The Hong Kong dollar is “pegged” to the U.S. dollar but Hong Kong is now part of China. In effect, Hong Kong monetary policy is being driven by the United States. This has made for a volatile ride in the past year and what served as a stabilizing factor for Hong Kong in past decades appears to have outlived its intent. To test my hypothesis that the RMB will be a growing part of world trade, I have done my best to pay for things while in Hong Kong using Chinese RMB. What was a rarity years ago is now becoming commonplace. Taxi drivers and independent merchants now appear to view the RMB as an appreciating asset, with many now preferring to take it instead of the Hong Kong dollar. With the purpose no longer served, I suspect the Hong Kong and U.S. dollar peg will be a thing of the past, which I believe could have positive implications for Hong Kong stocks.
Gold is also playing an increasing role in China’s move from the U.S. dollar. With $2.4 trillion in foreign exchange assets, China’s gold holding of approximately 1,054 tons amounts to less then 2% of assets. Many experts in China suggest that 5% would be more prudent. This is likely the reason China is reported to be bidding on the 400 million tons of gold currently on offer through the IMF. China has indicated it will pay in RMB, potentially ensuring the RMB has a larger stake in IMF affairs. If the 5% number is close, China may be back in the market for another 400 tons. Another interesting development I witnessed during my travels: TV commercials in several cities encourage individuals to purchase gold. According to China Construction Bank, they sold over nine tons in the first nine months of this year. China just surpassed South Africa to become the largest gold producer in the world. Our long-standing positive position on gold remains: Few themes have stood the test of time longer than China and gold.
Looking Ahead
The list of problems and challenges facing China is enormous. Healthcare for many is terrible. In many cities taxi drivers make more then doctors. Corruption abounds and the divide between the haves and the have-nots continues to grow. With so many people spread across so much land, civil unrest often percolates somewhere in the country. Further, Beijing actions can be unpredictable. Despite the fact that China invented paper over 2000 years ago, Beijing still tightly controls what’s printed on it. However, from my perspective, China has awoken and now has an economic model and an entrepreneurial drive that has already lifted 300 million of its citizens out of poverty; it has the largest sum of capital ever collected and has succeeded in greatly enhancing its stature both politically and economically during the worst financial crisis in a century. While wealth and economic growth has primarily been concentrated in the south and coastal regions, the real growth going forward will likely be in the western regions where the majority of the population lives. Most importantly, China now appears to have a vested interest in the peaceful growth of both its own and the world economy.
I believe Napoleon had it right when he said more then 200 years ago, “Let China sleep for when she awakens she will shake the world.”
Neuberger Berman believes China’s operating principles will likely provide many investment opportunities over the long term as it continues to build out its infrastructure, spur domestic consumption and diversify away from the U.S. dollar.
The Neuberger Berman website: Neuberger Berman LLC
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My personal experience in working in China leads me to predict a different future for China compared with Mr. Gleason’s. I believe that the pendulum will swing. China will stumble, similar to the historic decline of Japan, due to cost increases from unfavorable currency changes, productivity declines, wage increases, and social unrest. China's low birth rate and aging population are two additional factors that will negatively affect its economic growth. Capital will be diverted from infrastructure and commercial investments, to solving intractable environmental conditions.
Poor planning for efficiency and productivity will prove problematic as well. A vivid example, is the current pattern of the rapidly constructed manufacturing buildings in China. These are still being built several stories high, with poorly designed freight elevators, which are far too small and slow. Surprisingly, many plant owners do not build the more proficient single story buildings. The principal reason for this lack of attention to effectual strategy, is largely due to the extremely low hourly wages. However, some in China are simply unaware of traditional low-cost manufacturing initiatives. Manufacturing knowledge remains rather poor, perhaps equal to the USA’s in the 1970s.
The eventual need to expand manufacturing arenas in China will prove difficult as well. The reluctance in moving business to the Western provinces has many factors. For instance, many plant owners will not want to locate operations further inland to the West. They seem to prefer the heavily populated, higher wage, land restricted East Coast, for all manufacturing facility locations. Simply because, so many reside in nearby Hong Kong – which is a short ferry ride from the Mainland. Most high-income owners still see Mainland China as an unattractive place for their personal residence.
Another major obstacle to maintaining growth, is the sincere lack of freight forwarding capability within the country. Although China has invested heavily in infrastructure, it does not have the trucking capability to deliver components in an economical manner. There are no real substantial Trucking Companies in China which are regularly employed in the United States, as of yet. They simply do not have the Trucking Industry potential, with common capacity sizes of a Class 6 to 8 available, (often referenced as an "18 Wheeler" in the USA). Most deliveries are made in "light to medium duty" sized vehicles– similar to a common 'one room' rental unit commonly found in the United States: closer to Classes 1 through 4 in GVWR. Also, using the Chinese Railroad for product shipment is a common problem, because of the exorbitant charges, uncertain train schedules, and costly damage rates.
Additional problems for the relocating of operations in the West, which will be essential for productive growth, is the difficulty in recruiting quality management to live far from the conveniences from the major Urban environments. Management can be persuaded to reside in a remote location, but this proves to be quite an expensive exchange. Furthermore, management has a tradition when working in the more remote areas of China to work four days per week. They will arrive Monday at 12:00 PM, and depart on Friday at 12:00 PM. The long-term commitment is often a serious concern. As wages rise throughout the Nation, to continue to maintain China’s economic engine running at this level, the need will rise to locate plants in remote areas, with more abundant and less expensive labor sources.
Poor planning for efficiency and productivity will prove problematic as well. A vivid example, is the current pattern of the rapidly constructed manufacturing buildings in China. These are still being built several stories high, with poorly designed freight elevators, which are far too small and slow. Surprisingly, many plant owners do not build the more proficient single story buildings. The principal reason for this lack of attention to effectual strategy, is largely due to the extremely low hourly wages. However, some in China are simply unaware of traditional low-cost manufacturing initiatives. Manufacturing knowledge remains rather poor, perhaps equal to the USA’s in the 1970s.
The eventual need to expand manufacturing arenas in China will prove difficult as well. The reluctance in moving business to the Western provinces has many factors. For instance, many plant owners will not want to locate operations further inland to the West. They seem to prefer the heavily populated, higher wage, land restricted East Coast, for all manufacturing facility locations. Simply because, so many reside in nearby Hong Kong – which is a short ferry ride from the Mainland. Most high-income owners still see Mainland China as an unattractive place for their personal residence.
Another major obstacle to maintaining growth, is the sincere lack of freight forwarding capability within the country. Although China has invested heavily in infrastructure, it does not have the trucking capability to deliver components in an economical manner. There are no real substantial Trucking Companies in China which are regularly employed in the United States, as of yet. They simply do not have the Trucking Industry potential, with common capacity sizes of a Class 6 to 8 available, (often referenced as an "18 Wheeler" in the USA). Most deliveries are made in "light to medium duty" sized vehicles– similar to a common 'one room' rental unit commonly found in the United States: closer to Classes 1 through 4 in GVWR. Also, using the Chinese Railroad for product shipment is a common problem, because of the exorbitant charges, uncertain train schedules, and costly damage rates.
Additional problems for the relocating of operations in the West, which will be essential for productive growth, is the difficulty in recruiting quality management to live far from the conveniences from the major Urban environments. Management can be persuaded to reside in a remote location, but this proves to be quite an expensive exchange. Furthermore, management has a tradition when working in the more remote areas of China to work four days per week. They will arrive Monday at 12:00 PM, and depart on Friday at 12:00 PM. The long-term commitment is often a serious concern. As wages rise throughout the Nation, to continue to maintain China’s economic engine running at this level, the need will rise to locate plants in remote areas, with more abundant and less expensive labor sources.
