“Here be dragons” was the phrase that medieval map makers used to describe uncharted territories. Despite China’s massive economic opening and growth over the past three decades, many commentators seem to retain this attitude to China. Headlines scream about property and debt bubbles. But the real story is more nuanced. Is this an opportunity for investors?
“Goldman Sachs slashes China growth outlook” shrieked a CNBC headline on 19 March. Two paragraphs into the story it’s revealed that the investment bank has slightly reduced its 2014 GDP growth projection from 7.6% to 7.3%. Not exactly a slashing. More of a light trimming, and close to the Chinese government’s target of 7.5%.
The way this stuff is reported you’d think that China was already in meltdown. But GDP growth above 7% a year is something that most country governments would die for, especially heavily indebted and low growth developed countries.
I’ve written before about how I fully expect China’s average growth rates to trend downwards in coming decades. (See: No need to panic as China slows.) No country can sustain growth rates above 10% a year forever.
The first time I visited China was in 1998. But I really started learning about the country back in 2001.
At the investment bank where I worked there were certain board members who sensed that China would offer a huge opportunity in the future.
Back then the immediate opportunities for profit were still small, as foreign involvement was strictly limited by regulations. But fortunately there were at least a few top managers who had the vision to realise it was worth getting in early.
At the time it wasn’t much of an exaggeration to say the bank’s presence in the mainland China consisted of one guy with a typewriter. Although there was already a huge office in Hong Kong.
I was dispatched to find out more and draw up a comprehensive entry plan across all businesses. The proposals were accepted, and then I moved to Hong Kong to implement the plan, and to work on the bank’s strategy across the whole region.
Lower levels of management were sceptical about the potential. But within a few years the bank had moved from making around $10 million a year of revenues in China to well over $100 million a year, and the business was still growing fast. The potential was vast.
Ever since then I’ve consistently heard arguments that China was about to crash. None of them have turned out to be correct. Most are based on Western political ideology: people just can’t accept that countries can be economically successful without a democratic political system. China has consistently proved this dogma to be wrong.
But what about now? Is there something going on in China that means it’s genuinely on the cusp of a financial meltdown? And what does it mean for investors in Chinese shares (stocks)?
The two big concerns that most people have are that China has a real estate bubble and that debt levels have spiralled out of control. Either of these things, if true, has the potential to crash the economy, as we’ve seen throughout the Western world in recent years.
The latest Knight Frank Global House Price index, released recently, reports that Chinese residential real estate prices jumped 28% in 2013, second only to Dubai (up 35%).
Sounds bubbly, right? This is just the kind of dramatic statistic that headline writers seize hold of.
But look at the fine print and you see that this figure is based only on prices in Beijing and Shanghai, the political and financial capitals of a vast and diverse country.
That’s like assessing US house prices by looking only at Washington DC and Manhattan, in New York. It’s not representative of the country as a whole, as it only looks at where the richest and most powerful movers and shakers are based.
China has something like 160 cities with over 1 million residents. In short, Beijing and Shanghai are not representative of the overall Chinese property market.
This chart from the Economist shows how Chinese real estate prices have changed from first quarter 2000 to third quarter 2013, adjusted for inflation. According to this they’re up 46%, in real terms. Again that looks like a bubble.
Chinese Real Estate Prices
But now I’ll show you a chart which tells a completely different story. Again from the Economist this shows Chinese property prices compared with average incomes over the same period.
Chinese Property Prices Compared with Average Incomes
The point here is that Chinese wages have been increasing at a rapid clip (which in turn fuels domestic consumption growth, and corporate profits). So in fact houses are now much more affordable than they were in year 2000, down 55% in relation to incomes.
Evidence suggests that there could be isolated property bubbles in cities such as Shanghai and Beijing. But in relation to wages, across the country, properties look more affordable than ever. So although there’s always a risk of prices falling it appears that concerns are overplayed by many commentators.
A much bigger issue in my mind is the rapid expansion of debt levels in recent years. But even this needs to be put into context.
The growth in debt levels is captured by this next chart from the Financial Times. It shows government, household and corporate debt as a percentage of GDP between 2007 and 2012 (the figures have surely risen further since then).
Debt has gone from under 150% of GDP in 2008 to close to 200% of GDP in 2012, driven mainly by an increase in lending to companies.
But let’s put that into perspective. It’s still significantly below the levels seen in other parts of the world. Equivalent figures for most developed countries fall into the 250% to 300% range, with Japan around 400% (this excludes debts owed by the financial industry, such as banks).
The ratio of Chinese household debt to disposable income rose from 31% in 2008 to 53% in 2012. In the USA, even after years of people reducing their debt burdens and with interest rates still pinned to the floor by central bank policy, just the interest on household debt is 9.9% of disposable income according to Federal Reserve data.
Assuming average interest rates of, say, 5% that points to US household debt being nearly 200% of disposable incomes, or four times the level of China.
And US household debt was 81% of GDP at the end of third quarter 2013, down from 98% in 2009. But it was just 31% in China at the end of 2012. (I couldn’t find more recent and reliable data for China, but this figure is unlikely to have changed much.)
So debt has certainly gone up fast in China in recent years. And much of it will go bad. But it doesn’t currently look to be at the insane levels that many analysts claim. And it doesn’t necessarily mean that China is staring down the barrel of a big debt crisis gun.
Also China has over $3.8 trillion dollars of foreign exchange reserves, much of it parked in US treasury bonds. That’s an awful lot of firepower to bail out the banks if they get into trouble. This is exactly what they did at the beginning of the last decade, handing tens of billions of dollars worth of treasuries to each of the “big four” Chinese banks to bail them out after an earlier round of losses. (I know this from my work in China.)
(The “big four” Chinese banks are Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China and Bank of China. Measured by size of assets they rank 1st, 9th, 11th and 13th in the world, respectively.)
Is China about to crack?
Because of the risks, real or perceived, the Chinese stock market looks cheap today. It has a P/E of just 6.2 and dividend yield of 4.8%, making it one of the cheapest and highest yielding markets in the world.
Much of that can be put down to the big four banks themselves. I calculate that their shares have an average P/E ratio of 4.5, price-to-book (P/B) ratio of 0.9 and dividend yield of 7%. This is despite them making an average return on equity of 20%.
(Return on equity refers to net profits as a percentage of net assets, also known as shareholders’ equity or book value. P/B refers to the ratio of the market value of the company in relation to net assets.)
The average ratio of gross assets to equity, a measure of leverage and hence riskiness, is 15.6. For comparison this is similar to Bank of America, the 12th largest bank in the world, which is leveraged 14 times.
Yet Bank of America generates a much lower return on equity of 11%. Also its shares trade with a P/E of 11.2, P/B of 1.2 and dividend yield of just 0.2%. Despite Bank of America’s much lower profitability its shares are much more expensive, plus they pay a negligible dividend.
There are certainly risks in China. I don’t deny that it could crack up.
But the stock market is already pricing in those risks in my view. If the country continues to defy the doomsters and gloomsters then the upside potential for investors is substantial, as and when P/Es start to rise again. In the meantime owners of Chinese shares will collect an attractive dividend yield of 5%.
Stay tuned OfWealthers,