InvestmentsAug 8 2013

Awakening dragon

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It was the reliance on other economies in this export-led mechanism that left it to the mercy of global demand, creating high cyclicality in downturns.

The second issue was having a part investment-led economy due to resource constraints. It is home to 19 per cent of the world’s population and consumes 20.3 per cent of its energy, yet it has only 1.1 per cent of the world’s oil resource.

As such, a movement away from this export and investment led growth was needed.

Growth

The ruling Communist Party realised, through the lessons of other emerged states, such as Korea and Taiwan, that the creation of a consumption-orientated economy was the only pathway to sustained growth.

Cutting through the red tape and other regulatory barriers to entry would aid the proliferation of private industry in a country dominated by state-owned enterprises.

Furthermore, the government realised that income disparity, fuelled by corruption and nepotism, needed subversion to avoid social unrest. The effective implementation of this transition, through freeing capital and labour, could create an efficient and somewhat self-sufficient society, giving any ordinary citizen the opportunity to create wealth for themselves.

The challenge: to make this transition smoothly. It is an enormous economy. To give an idea of scale, the Cypriot banking crisis, much publicised in the press for fear of contagion, has an economy worth around $25bn (£16.2bn). China grows by this amount every week. As such the reforms and the way in which they are implemented are key, and the list is long.

In the near term there are two under focus; first is reducing the influence of lumbering SOEs – they encapsulate all that is inefficient.

Historically, they have been necessary in capital-intensive industries; they represent 5 per cent of total enterprises, use 20 per cent of the working population, but swallow 50 per cent of the nation’s corporate debt and have performed very badly. In the first four months of this year SOEs profits grew 2.7 per cent year-on-year whereas private industry profits were up 17.9 per cent.

Over the whole of 2012, SOEs profits actually declined 5.1 per cent compared with private growth of 20 per cent.

Liberalisation

Of critical importance are the market based reforms to liberalise the private sector ranging from interest rates to utility tariffs, freeing up access to banking and finance, and cutting the regulatory red tape to lower barriers to entry and enable private investment for industries currently dominated by SOEs. As the profit ownership of large industrial firms shows, the liberalisation is well on its way.

The second focus is the Hukou reform – an archaic system nestled into a transformed economy, a mismatch that makes no sense.

Hukou, or household registration, was not uncommon in Asian countries and introduced in the 1950s by the Communist Party as a way of keeping the 85 per cent of the population based in rural China away from urban areas. These citizens were to produce food, feeding the remaining 15 per cent in the cities who would be building industry.

Initially migration was strictly controlled, but this waned during the 1980s as party attitudes towards it started to change.

The mid-1980s saw around 8m rural citizens in cities; by the end of 2012 it would be a staggering 234m. Unfortunately this paved the way for the creation of an underclass as city citizens gained access to much better social, economic and cultural benefits than the rural citizens.

The migrants would live in cramped accommodation called “handshake houses” on account of being built so close to one another you could shake hands with the next-door neighbour.

Some worried. Would changes to this system involving the provision of a much fairer treatment of all citizens, mean China would lose its edge? Would the cities struggle under the weight of migration?

It is true the changes need careful implementation – the party will roll out reform over an extended period of time – but the effect on the supply of labour should have a positive impact.

It should reduce the risk of social unrest and instability by creating greater equality and fairness. Indeed, this is meant to be part of the Communist mantra.

It should provide a supply of migrant labour into a workforce that has suffered deteriorating demographics on account of the one-child policy. Within the workplace it should have the effect of reducing turnover and increasing productivity.

Finally, and perhaps most important, it should increase the perception of safety to rural citizens which should, in turn, reduce the need for precautionary savings and so boost consumption.

So what does this mean for investors? Opportunity on the back of change. Keeping the 19 per cent of the global population in mind, it has just 5.7 per cent of global healthcare, 9 per cent of air traffic, 6 per cent of railways and 5 per cent of insurance premiums. The balance on a more domestically focused economy means these areas must, and will, grow to provide; and the government is making it clear this is to be done competitively through private and efficient enterprises. Politically it is risky and difficult to implement as proved by failures in the past.

In 2009 the stimulus lending was unsuccessful, encouraging the investment side of the economy and creating a property bubble. That said, the government resolve for the rebalance is strong, as is the investment case over the coming decade. Enter the dragon; part two.

Michael Kerley is fund manager of Henderson Far East Income as well as the Asian portfolio for The Bankers Investment Trust

All figures are from the following sources:

CLSA; China Macro Strategy; May 2013

CLSA; Sinology; May 2013

BoA Merrill Lynch; February 2013

Key Points

China is, and has been for some time, enacting change.

A movement away from this export and investment led growth was needed.

The effective implementation of the transition, through freeing capital and labour, could create an efficient and somewhat self-sufficient society