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Guinness Atkinson Asia Brief
February 2005
Edmund Harriss
Fund Manager Asia Focus Fund, China & Hong Kong Fund
China – The Opportunity of a Lifetime
We believe that China’s economy, which has grown on average by 9% a year, will sustain a growth rate of around 8% for the next 20 years. Twenty years of infrastructure investment, deregulation and reform have given rise a buoyant manufacturing sector. This has resulted in raising the standard of living for millions of people and creating wealth. We have not seen anything on this scale since the early days of American industrialization at the end of the 19th century and beginning of the 20th century.
In upcoming Asia Briefs we will look at these changes in more depth together with implications for investors. In this month’s commentary we will examine just how far China has gone toward a market-based economy – and how much further it has to go.
Why has China’s overheating not led to a bust?
When China last went through period of overheating in the 1990’s the resulting crash prompted the most painful restructuring yet seen. Tens of thousands of State Enterprises were closed cutting the number of industrial enterprises from 80,000 to 40,000 and 25 to 30 million workers were laid off. Macro-economic conditions could hardly have been worse.
Ten years on policy makers are now technically able and are armed with relatively high quality monthly statistics as well a range of market policy tools such as interest rates, open market operations, reserve requirements and tax and spending policies that did not exist before. They have also learned from experience and become much more proactive in applying administrative tools such as lending guidance to banks and restrictions on investment approvals.
More than anything else this explains why China has been able to manage the period of overheating in 2002-4 without a repeat of the downturns in the 1990’s.
How much of a liability is the State Owned Enterprise sector?
In most developing economies the state-owned sector is often the major drag on economic development with continuing losses sucking up vast chunks of government revenue. This is not the case in China.
China’s modern reform program began 20 years ago. At that time almost all economic endeavor was owned by the State and the State set almost every price in the economy. By the mid 1980’s market elements were brought in such as liberalization of prices, taking SOEs off the government budget and introducing profit and loss accounting. By the early 1990s the government gave up on the idea of full state ownership and opened up the economy to new investment by foreigners and non-state entities. In the mid-1990’s the economic costs of the charge for growth in the bubble period became apparent. Closure of hopelessly unprofitable enterprises followed.
The result of this process has been the narrowing down of the state-owned sector into a group focused on capital intensive, rather than labor intensive, industries that is profitable and is no longer a drain on government resources. The domestic marketplace is now fiercely competitive where most product and service pricing is set by the market. There is a very low industrial concentration. Even in the most capital intensive areas such as telecommunications, airlines, energy or steel one will still find at least five major companies operating – and often dozens. But the government no longer directly underwrites these businesses and all operate under the threat of closure if they cannot pay their bills.
So where’s the problem?
It’s in the banking sector. While the state-owned industrial sector has returned to profit and is generating improving returns on investment the same is not true of the banking sector. The state owns the majority of banking sector and rigidly controls pricing of both loans and deposits. Importantly, they keep the price of deposits low, 1-2%, and this keeps lending rates artificially low. At the same time there is very little control over banks’ lending operations. This combination is conducive to over-investment and is a major reason for China’s volatile economic cycle.
What happens next?
China’s reform program is running to a schedule. By 2007, under the terms of its admission to the World Trade Organization, China MUST open up its market to foreign entities. This means full liberalization where foreign businesses can set up their own operations without requiring a local joint-venture partner and be able to operate without restriction. This includes the banking sector.
So Chinese businesses are going to have to compete with outsiders and the local banks are going to find that foreign commercial banks such as Citigroup and HSBC are going to blow them out of the water unless they change. Therefore, the government is in the process of recapitalizing the big four local banks. They are improving the management, allowing/encouraging foreign banks like Citigroup and HSBC to take strategic stakes and they are preparing them for stock market listing.
The success of financial sector liberalization, and hopefully stability, will pave the way to the last step which is the floatation of the Renminbi Yuan.
What this means for investors?
- Politically, China is communist but economically it is the capitalist ideology that is supreme. The ideological debate is long past; the problem now is one of implementation.
- China’s state owned sector is therefore now run on commercial lines with closure awaiting those businesses that cannot generate profits.
- The risk of the state-owned sector to overall economic stability is no longer an issue.
- The banking sector, and ultimately the currency, is the key remaining obstacles to long term sustainable growth.
- At last we see a way out for the banking sector – and the looming deadline of liberalization in 2007.
The state still has significant shareholdings in businesses across China but as commercial imperatives have superseded ideological ones, this is no longer necessarily bad for investors’ health.
At the same time these same commercial imperatives have given rise to a substantial and growing private sector that is creating the new jobs to replace those lost in the shrinking state sector. From here comes a rising middle class that will power China’s growth for the next 20 years.
The Guinness Atkinson Asia Focus Fund and China & Hong Kong Fund invests in foreign securities which involves greater volatility, political, economic and currency risks and differences in accounting methods. The Funds are non-diversified meaning they concentrate their assets in fewer holdings than diversified funds. Therefore, these Funds are more exposed to individual stock volatility than diversified funds.
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