A Look at China's 'Real Story'

 | Feb 28, 2014 | 11:00 AM EST  | Comments
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The fixation on growth in China is all-consuming at the moment, not surprisingly with weak growth in western economies. Name one other economy that is both large and growing 7% a year! More importantly, the fixation on China also reflects its use as a proxy for economic direction in the west, since so much of its economic output is really export products returning to the west.

To get the "real story" on the direction of the Chinese economy, a couple weeks ago during my swing through Asia I ducked into a presentation by the dean of a leading business school in Beijing, the Guanghua school of management at Peking University. (I was there because it was a joint event with my business school – Kellogg -- which has a partnership with Guanghua.)

The presentation was enlightening because he refuted some myths that circulate in the western media --as well as the eastern media -- regarding the need for a consumption economy in China. The argument is that China needs to "rebalance" its economy to more domestic consumption and less export in order to sustain its breakneck growth.

Dean Hongbin Cai asserts that the perception of unbalanced growth (too little consumption) is a myth, in part due to misinterpretation of how statistics are compiled. For instance, housing is 14% of GDP in the U.S. and 20% of household consumption, whereas in China it is 3% of GDP and 8% of consumption. China would in theory be "under consuming" housing. The housing stock there indicates there is clearly room to grow. However, there are also differences in how each country calculates imputed rents -- which is a real source of controversy here in the U.S. as it impacts CPI.

China, too, is accused of having a diminutive service economy, with only 45% of GDP in services vs. 70% or more in "developed" countries. However, the reason may not actually be that attractive. In the U.S., we spend 18% of GDP on healthcare, vs. 5% in China. I would argue that we overspend and waste a lot, and this comparison is probably worse for the U.S. than China. Much of the Chinese service economy is notoriously hard to track, due to the heavy use of cash and chronic under-reporting.

Cai cited other statistical issues as well. There is "creative accounting" that moves much consumption into business expenses, such as cars and meals. Investment is also overstated due to double counting and an inability to correctly track provincial investment. The net of his argument is that no matter what the ratio of investment to consumption, it is probably lower than reported, and there is no "right" ratio anyway. The U.S. could just as easily be low at 17%.

The implication is that a misguided policy to push economic activity away from export and to consumption could be dangerous for their economy in its current phase. Discouraging saving in China would not be useful -- not only do they still need capital formation, there is not the same sort of social safety net as seen in the west. People need savings just to have some sense of security in their lives.

The country needs export businesses to build the capital infrastructure that can ultimately produce for its own populace. Shifting to consumption now would require shifting to high end production for the wealthy, reducing opportunity for the masses to move into the middle class over time. The general principle that works in all economies is that more private investment leads to higher GDP growth.

Cai did point out that consumption in China is likely to increase organically over time, so does not need to be "encouraged" by government policy. A higher birth rate post though the easing of the one child policy will help, as will better health care.

For U.S. investors, the key takeaway is to not take the comparisons of our respective economies at face value. Despite still being a nominally socialist economy, in many ways the Chinese are freer to act economically than are we in the west. I am still a believer that more economic freedom will produce more economic growth, so I think China is still positioned to help drive the global economy in the years to come.

For us, the key is whether there are good investment opportunities to tap into their growth. For instance, an A share ETF is coming soon, but Chinese A shares have languished for years despite good economic growth. Conversely, many US-traded Chinese companies can provide good exposure, although the occasional land mine is still out there waiting to be stepped upon (look up recent news in Montage Technology (MONT) for an example).

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