Every time I’ve written about China lately, I’ve received this question from readers: “So are you a bull or bear on China?”

I understand the reasons behind the question. It’s hard for me to write positively about Chinese stocks right now without a caveat or three. And I can’t, on the other hand, say that investors should shun all Chinese stocks.

So put me down as ambivalent. My answer to the question of whether I’m a China bull or bear is a resounding yes, I’m afraid. I’m bullish or bearish on China depending on the time frame I’m looking at.

In the short term, as China’s leaders re-accelerate the country’s economic growth rate, I’d have to say I’m bullish. In the long term, I find it hard to ignore evidence that China’s economy is heading toward some kind of readjustment.

The pickup has started

I think September did mark a growth bottom in growth of gross domestic product. The economy looks likely to show a pickup in growth from 7.4% in the third quarter to something like 8% in the fourth quarter, then move modestly higher in the first quarter of 2013.

But for the long term, logic argues that the big loans from state-owned banks to unprofitable state-owned enterprises at artificially low interest rates (which are being used to finance projects that won’t generate a positive return on investment) will catch up with lenders, state-owned enterprises and the government (the real source of the funds).

That readjustment could be relatively orderly if China’s leaders move on reforms to the banking sector and bloated state-owned enterprises. It will be chaotic if the country’s leaders dig in their heels against all change and the country has to wait until a crisis forces either reforms or a crackdown on even the current pockets of market capitalism and patriotic dissent. So far, I’d have to say, the proceedings of the 18th Party Congress, which began Nov. 8, don’t show much in the way of reforms.

But let’s start with the short term, OK?

Signs of a turn

Data for October, released Friday, make a solid case — when combined with earlier numbers — that September did indeed mark the bottom of China’s growth slowdown.

The National Bureau of Statistics announced that industrial production rose 9.6% year over year in October. That was up from an annual increase of 9.2% in September and 8.9% in August.

Retail sales climbed at a 14.5% annual rate in October, up from an annualized 14.2% in September. Investment in fixed assets — infrastructure, industrial facilities and commercial and residential real estate — was up 20.7% in the first 10 months of 2012 over the same period last year. That’s a slight uptick from the 20.5% growth rate in the first nine months of 2012.

These numbers, Australia’s ANZ bank calculates, are consistent with 8% GDP growth in the fourth quarter. That would be a substantial step up from the 7.4% annual growth rate recorded in the third quarter and the 7.6% growth rate in the second quarter.

I’m of the firm belief that you can never be too cynical about any government’s economic statistics — and especially China’s. That these improved growth numbers are arriving just as the Communist Party is installing a new set of leaders isn’t a coincidence. But recent numbers don’t seem to be made up. They’re confirmed by big increases in the production of steel and cement (roughly doubling from levels during the summer) and of electricity (a rough triple). Those statistics are tougher to fake — which is why they are so often used as a check on government growth data. From this perspective, it looks as if the Chinese economy really is accelerating — relatively modestly, it’s true — from a bottom in September.

We’ve seen this pattern before, most spectacularly in the huge stimulus package put together by China’s national and local governments and its state-owned banks in a successful effort to keep the country’s economy growing right through the global financial crisis. This time around, Beijing hasn’t announced a high-profile stimulus package, as it did in 2007 — but the program has been the same: lots of lending from China’s banks and lots of spending by China’s national and local governments.

The lower profile has been a response to criticism, inside and outside China, that the stimulus of 2007 led to an overheating of China’s economy and a spike in inflation that had to be brought under control by stomping on the economic brakes in 2011 and 2012. This time, the country’s new five-year plan said, growth would be more balanced: The country wouldn’t rely so much on infrastructure spending and exports but instead would work to increase domestic consumption. Big double-digit wage increases in every year of the plan and increased spending on health care, pensions and education were part of that re-balancing.

But it appears that when push came to shove, when growth threatened to fall below 7%, the government went back to the tried and true. The railway ministry, for example, got a big increase in its debt ceiling so it could increase its spending on China’s railroads, not one or twice but three times in 2012. Beijing announced that China would build dozens of new airports. Local governments went back into the business of competing to build the most miles of new subways or give the biggest subsidies to companies in targeted industries such as wind and solar.

The big winners have been China’s 145,000 state-owned enterprises. These companies have had access to plenty of capital at low interest rates from China’s big state-controlled banks even as privately owned companies have been starved of capital. Because those low interest rates are essentially a subsidy that pumps up the bottom line, state-owned companies are significantly more profitable — on paper anyway — than private companies. (It doesn’t hurt, either, that the government has ensured that big sectors of the economy are off-limits to private competitors. That lets state-owned enterprises charge more for their products than they could otherwise.) State-owned enterprises make up about 35% of China’s economic activity and, officially, generated 43% of the economy’s profits.

The long-term problem

If you look at the costs of this current round of stimulus, it’s clear why some of China’s leaders were initially reluctant to go down this path.

Just take a look at the balance sheets of China’s big state-controlled banks. Those banks recently have been on a lending spree that puts the cherry atop of the mountain of loans that these banks have extended in the past five years. According to Fitch Ratings, on current trend, by the end of this year, Chinese banks will have expanded their balance sheets by an amount equal to the combined balance sheets of all U.S. commercial banks. That’s a heavy load for an economy that, on purchasing power parity measures, is only half the size of the U.S. economy.

There is good reason to believe this loan-powered growth isn’t sustainable, because the returns being earned by the investments financed by this borrowing are falling. According to Fitch Ratings, the ratio of loans outstanding to the size of China’s economy held steady at about 1.2 in the years before the global financial crisis. But that ratio has been on an upward march since that crisis, and this year, loans are equal to 1.9 times China’s GDP.

Officially, the bad-loan ratio at China’s banks is extraordinarily low, at a little more than 2%. That figure seems unlikely to be accurate now, and it certainly is headed higher in the future.

China has dealt with a bad-loan crisis before, in the aftermath of the 1997 Asian currency crisis. Then, the government set up new financial companies that bought bad loans from the big banks using a combination of government money and capital raised by selling bonds (backed by these bad loans) back to the state-controlled banks. Ten and 15 years down the road, those bonds themselves were buried through the reorganization of those financial companies or, in some cases, when those financial companies went public.

I’m not sure that solution would work again because 1) there’s too much leakage in the financial system and 2) banks are significantly more leveraged than they look.

China has kept the interest rates its big banks pay to depositors extremely low so the big banks can make money on the not-quite-so-low-interest loans they make to state-owned enterprises. In effect, China’s savers subsidize those loans because they earn so little on their deposits.

Because of that, a second financial market has grown up for wealth-management products managed by banks that pay more than savings accounts do. The amount of money in bank-managed wealth management accounts had climbed to 6 trillion yuan ($963 billion) by the end of June from just 1.7 trillion yuan ($273 billion) in December 2009.

Big money leaving China

You can certainly understand why China’s savers would want to move to higher-yielding wealth-management accounts. But why would banks want to encourage a product that costs them more in higher interest payments? Because, the answer goes, China’s banking regulators have created a massive incentive for banks to push the new products.

Banks, the regulators have said, don’t have to put aside any reserves against potential defaults in wealth-management accounts. So banks can invest the money in these accounts in loans to risky corporations, speculative real-estate investments and the favorite projects of local governments that, on paper, will earn back the higher rates paid to these accounts — without having to set aside money in case these investments go bad. With loan-loss reserve ratios for other accounts set by regulators in the neighborhood of 20%, that’s a big incentive. (Another incentive is that regulatory scrutiny of wealth-management account investments is minimal, although it does seem to be increasing.)

Rather than answering the question of why banks push such projects, though, the incentive created by regulators for wealth-management accounts only pushes the question back a level. Why would regulators, some of whom have to know the dangers in the system, put those incentives in place?

Here I’m entering the realm of speculation, but see if this explanation makes sense to you. China’s banking authorities have a big and growing problem: China’s rich are increasingly taking their money out of China. That’s illegal, but the rules are easily evaded by anyone with political connections. That leakage of China’s wealth is a problem now, and it will become a bigger problem as the country ages and requires more of its wealth for domestic needs. Wealth-management accounts are a way that China’s banks can compete to keep some of this money at home. Regulators could, of course, try to stem the flow of money abroad by tightening regulations and enforcing them more strictly. But I think most government regulators understand that taking steps like that against China’s wealthy elite would hardly constitute a career-enhancing move.

If you think this sounds as if it has the makings of a gigantic Ponzi scheme, you wouldn’t be the first to have such thoughts. Even some of China’s banking regulators have voiced worries that the lack of transparency (in the investment pools in which wealth-management accounts are invested) invites fraud. If no one knows what the pool is invested in, no one can tell if the fund’s reported returns are real or fiction created by paying out part of what new investors put in as investment “returns” to older investors. Regulators are trying to increase transparency to reduce this possibility, but I think they’ve got a long road to travel.

How many good years left for investors?

So here’s the crux of my ambiguity about China. Faster economic growth — even if it’s engineered by unsustainable bank lending and government spending — will produce significant returns to holders of stocks linked to China’s exporting and infrastructure sectors. I’ve mentioned some of those stocks before: Jiangxi Copper (JIXAY) and Aluminum Corporation of China (ACH) in China, for example, and Vale (VALE) and Freeport-McMoRan Copper & Gold (FCX) outside of China. I think you can see the beginnings of that trend over the past couple of weeks or so.

But at some point, the lending and spending that sustain this economic growth aren’t sustainable. At some point, the Ponzi-like elements in China’s wealth-management accounts do blow up. At some point, the flows of cash leaving the country do become a significant drag on growth.


I think the catalyst for when is demographic. A recent Organisation for Economic Co-operation and Development report, “Looking to 2060: Long-term Global Growth Prospects,” projects that by 2045, China will have the same dependency ratio as the United Kingdom (39). The dependency ratio compares the number of people either too young or too old to work with the working-age population. A higher dependency ratio is bad, because it means fewer workers and more dependent youngsters and oldsters. In 2045, the OECD projects the dependency ratio in the United States will be a relatively lower 35.

History shows that, all else being equal, a higher dependency ratio goes along with a lower economic growth rate. On the basis of demographics, the OECD argues that India and Indonesia will be growing faster than China within the decade. And that China’s growth rate will slow to 2.3% a year from 2030 to 2060. (The U.S. growth rate is projected to be 2% a year in that period.)

How does this relate to an answer to “when?” It certainly doesn’t say that “when” won’t arrive until 2030 or 2045 or 2060. If China’s current risky economic policies are in large part a reaction to fears that growth might fall below 7% in 2012, think what pressure China’s leaders will feel as they have to fight against demographic trends that are pushing the country toward 2.3% growth by 2030? The risk of a mistake with big consequences will certainly increase, as will trends, such as the flow of money out of China, that make the problem worse.

That doesn’t suggest that “when” is 2013 or 2014 or even 2015. But it does suggest that China’s growth rate and potential investment returns will likely become more volatile as the demographic clock ticks.

Even after the first bounce to “stimulus” stocks fades later this year or in early 2013, I’m still bullish enough on China to want to own the best of the country’s domestic companies, such as Home Inns and Hotels Management (HMIN) or Tencent Holdings (TCEHY).

But the increasing volatility that I see as China’s leaders struggle with a truly tough set of problems means I don’t want to treat even those stocks as “buy and forget.”


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