Note: I am travelling in Asia until April 24. Limited equipment and different time zones will limit the frequency and depth of my postings.
Visiting China almost at the same time, The Economist editor and KKR’s Head of Global Macro differ markedly on their assessment.
The Economist:
Xi Jinping’s misguided plan to escape economic stagnation It will disappoint China’s people and anger the rest of the world
(…) Mr Xi’s plan is fundamentally misguided. One flaw is that it neglects consumers. Although their spending dwarfs property and the new productive forces, it accounts for just 37% of gdp, much lower than global norms. To restore confidence amid the property slump and thereby boost consumer spending requires stimulus. To induce consumers to save less requires better social security and health care, and reforms that open up public services to all urban migrants.
Mr Xi’s reluctance to embrace this reflects his austere mindset. He detests the idea of bailing out speculative property firms or giving handouts to citizens. Young people should be less pampered and willing to “eat bitterness”, he said last year.
Another flaw is that weak domestic demand means some new production will have to be exported. The world has, regrettably, moved on from the free-trading 2000s—partly because of China’s own mercantilism. America will surely block advanced imports from China, or those made by Chinese firms elsewhere. Europe is in a panic about fleets of Chinese vehicles wiping out its carmakers. Chinese officials say they can redirect exports to the global south. But if emerging countries’ industrial development is undermined by a new “China shock”, they, too, will grow wary. China accounts for 31% of global manufacturing. In a protectionist age, how much higher can that figure go?
The last flaw is Mr Xi’s unrealistic view of entrepreneurs, the dynamos of the past 30 years. Investment in politically favoured industries is soaring, but the underlying mechanism of capitalist risk-taking has been damaged. Many bosses complain of Mr Xi’s unpredictable rule-making and fear purges or even arrest. Relative stock market valuations are at a 25-year low; foreign firms are wary; there are signs of capital flight and tycoons emigrating. Unless entrepreneurs are unshackled, innovation will suffer and resources will be wasted.
China could become like Japan in the 1990s, trapped by deflation and a property crash. Worse, its lopsided growth model could wreck international trade. If so, that could ratchet geopolitical tensions even higher. America and its allies should not cheer that scenario. If China was stagnating and discontented, it could be even more bellicose than if it were thriving.
If these flaws are obvious, why doesn’t China change course? One reason is that Mr Xi is not listening. For much of the past 30 years, China has been open to outside views on economic reform. Its technocrats studied global best practice and welcomed vigorous technical debates. Under Mr Xi’s centralising rule, economic experts have been marginalised and the feedback leaders used to receive has turned into flattery.
The other reason Mr Xi charges on is that national security now takes precedence over prosperity. China must be prepared for the struggle ahead with America, even if there is a price to pay. It is a profound change from the 1990s and its ill-effects will be felt in China and around the world.
KKR (Henry McVey) (my emphasis)
We left Beijing thinking that the economy in China is finally getting a bit better, on a cyclical basis. Easy comparisons certainly matter, but the asynchronous nature of the current global recovery is starting to feel at least a little more synchronized than in prior trips. For example, several logistics companies suggested that demand from the U.S. is picking back up.
However, the real structural story on which to focus, in our view, remains the acceleration in intra-Asia trade. Asia is becoming more Asia centric as trade within the region rises – in 1990, just 46% of Asian trade took place within Asia, but by 2021, that figure had reached 58%. Our estimate is that this ratio increases another 10% in the coming years, which would put China and its peers in the region much more in line with Europe and North America.
In terms of what is working, the growth of a greener economy remains robust. Though it is only 10% of China’s GDP, we estimate this segment is growing around 20% year-over-year. At the manufacturing level in China, there are three areas of focus around decarbonization.
First, there is the intention to reduce the carbon footprint of manufacturing. As one example, the recycling of key inputs such as cobalt is seen as critical.
Second, there is a focus on the transportation of goods, with a greater emphasis on the efficiency of onboarding and logistics (including tangible stories about companies using AI to improve optimizations).
Finally, there is electricity, with renewable energy capacity already reaching 1.45 billion kilowatts in 2023, accounting for more than 50% of the total installed power generation capacity.
There is also a huge focus on ‘upgrading’, especially as it relates to China’s industrial footprint, but also the housing market. On the industrial front, China now boasts over 50% market share in the installed global robot industry and has reported having 10,000 provincial-level digital workshops and 5,600 national-level green factories. Said another way, high quality, lower emissions, and better technology are all a focus.
Utilizing ultra-long-term government bonds, China is launching an equipment replacement and upgrade scheme (RMB 5 trillion or $700 billion plus per year), mostly focusing on energy efficiency, automation, and digital transformation.
Exports are also doing fine. In fact, despite rising tariffs and geopolitical tensions, China is still a global market share winner. The country has both shifted its product mix as well as its customer base. Importantly, though, these numbers do not include output in countries like Vietnam and Mexico, where China is increasingly viewed as a ‘local’ manufacturer.
To be sure, though, we are optimistic less so because we think that GDP growth is going to snap back quickly. Rather, as our trip confirmed, there is a playbook to both build on existing strengths as well as to tweak policies to create more stability, especially as it relates to Real Estate and consumer confidence.
In terms of what is still burdensome to the Chinese economy, three things again bubbled to the surface during our visit.
First is Real Estate, which continues to be an ongoing issue. (…) thus far, much of the correction in China has centered on volume. One developer told us that not only is the problem still big, but it is also complicated as housing liabilities extend across the private and public sectors as well as across local and central government levels. Thus, there is no quick fix.
(…) the housing market correction may be just halfway complete. (…) This ‘slow burn’ speaks to the adverse impact of not moving quickly to write-off assets within the banking system as well as to the importance of a strong monetary response aimed at improving confidence.
China’s housing prices have barely corrected in absolute terms. We think this may be partly related to statistical issues and partly to regulatory restrictions on the setting of housing prices as well as households’ understandable unwillingness to sell at a ‘low’ price. (…) we think it is likely that we see further correction pressures down the road.
By the end of 2023, China had built a huge inventory of housing, perhaps in the neighborhood of nearly 25 million units, including three million completed and 22 million units of forward housing to be delivered. And remember that household formation is only 6-8 million per year. This sizeable mismatch, we believe, means that, unless there is more government intervention to upgrade quality and/or write off assets, it will take considerable time to digest the inventories.
Second, much of the quality upgrade thesis we heard about as it relates to housing, white goods, consumer transportation, etc., is predicated on a rebound in consumption. However, savings rates continue rising, a reflection that there is still a real need for improved confidence before this upgrade cycle can become more self-sustaining, we believe.
As a result of the scarring effect from the pandemic, including a postponement of consumer upgrades and large expenditures, as well as an uptick in the youth unemployment rate, consumer confidence fell sharply over the past three years. This reality led to excess savings soaring to 15% of 2023 retail sales. However, were consumer confidence to recover and savings to return to pre-COVID levels of around 29% from its current level of almost 33%, Changchun estimates that it could add RMB 7 trillion (or nearly one trillion U.S. dollars) to the economy over a three-to-five-year period.
There is, however, good news on two-fronts consumption-wise. We note the following:
- Urbanization is still at 66%, which means, using developed market peers as a guide, that China still has 10-12% more in potential gains. This translates to 150 million or more Chinese consumers who are poised to see their incomes increase as they move towards urban hubs. At the same time, some local scholars estimate that around 170 million migrant workers who have been living in cities haven’t registered in the hukou system, a resident status that grants eligibility to access the urban social welfare system, including things like health care insurance, pension, and public education, among others. They expect that granting hukou to these residents would stimulate additional RMB 1.2 trillion or around $170 billion in consumption.
- Recent government reports show that disposable income per household increased by 6.1% in 2023, which is slightly better than overall economic growth. While conspicuous consumption is down in China, buying basic goods and services as well as modest lifestyle upgrade activity, especially in the middle to higher income range, remains solid. Indeed, this kind of economic momentum is consistent with what we see in our portfolio companies, the lion’s share of which are consumer and services focused. Top line growth is solid, margins are holding, and consumers are spending on less conspicuous items such as ‘smart homes’, pets, and recreational activities. Domestic travel is also strong. (…) We also think that there could be more appetite for higher end consumers to travel outside China in 2025, including to Japan and Europe.
Third, many locals feel that more can be done to modernize the capital markets so that foreign capital feels more comfortable both entering and exiting the country. China’s equity market is cheap by most measures, but it lacks a catalyst to enjoy some of the multiple expansion it probably deserves. At the same time, we believe the potential for domestic market reform should be embraced. Specifically, similar to what we have seen in Japan and India, we think that there needs to be policies put in place to encourage diversification of domestic savings away from property, deposits, and increasingly gold into other asset classes including local Chinese Equities and Credit.
Moreover, if we are right about lower rates at a time of 1) increasing retirement; and 2) heightened geopolitical tensions, now is the time to focus with a sense of urgency on modernizing China’s domestic asset management industry.
Where does China go from here?
We left China thinking that there are several key areas where the country intends to focus so that it can maintain its recent momentum.
#1: Focus on inflation perceptions. First, policy makers will likely need to work hard to ensure that consumers do not begin to ponder the potential for sustained disinflation. (…) inflation is likely too low relative to the government’s target of up to three percent. At the moment, there is confidence within the country that inflation will bottom during the second half of the year and begin to rise, but we still think that more could be done in this area to boost expectations. Potential fixes mentioned to us include supply side reforms to monitor excess production across industries as well as moving more swiftly on remedying the housing situation. (…)
#2: Focus on productivity. China executives acknowledge that the country may need to shift from a dependence on high levels of leverage to productivity enhancements aimed at fueling growth, especially as its demographics turn less favorable and the rate of urbanization slows. (…) the economy today is relying much more heavily on leverage for growth than in the past, which ultimately lowers China’s productivity growth.
As part of this transition towards a higher level of a more levered state, China’s private ownership (of the top 100 listed companies) has also started to decline commensurately since 2020. A potential consideration to reverse this decline would be to shift capital and focus back towards the private sector to help reignite productivity growth. Consistent with this view, there is a growing local contingent that is in favor of more supply side reforms that accelerate permitting, improve processes, and reward employment growth.
#3: Focus on the perception of the public markets. While China has enjoyed material growth in recent decades, this growth has not translated into strong gains in its equity market. Importantly, as geopolitical tensions intensify around the world, the Chinese government has indicated that a strong and robust domestic capital market will be increasingly important. This effort will not be easy under its current construct, given recent uncertainty surrounding policy as well as a heavy weighting in its indexes towards financials and state-owned enterprises.
That said, we did hear two potential paths forward in this area to improve the quality of the capital markets/retirement savings in China. First, there is the potential for the country to push harder to allow more companies outside of the digitalization and green sectors to go public. China has numerous world class consumer companies, but many of them are stuck in the hands of private investors who can’t yet access the public markets.
Second, we heard about a greater desire to create a more sophisticated retirement savings market, including a focus on longer-term investing strategies as well as creating more transparent and higher quality savings vehicles for individuals.
Conclusion
Over the past year, I have spent an increasing amount of my travel time in China, Japan, and India. Without question, this region is undergoing a fundamental repositioning, including both more interconnected trade as well as increased geopolitical rivalry.
(…) Within China, the story is changing materially, with Green initiatives and Industrial Automation now driving incremental growth in the local economy. (…) Against a more sluggish structural growth backdrop as well as heightened geopolitical concerns. China will likely look to create a strong domestic market that entices both domestic and foreign capital to support its growth in a more consistent manner.
Not surprisingly, as geopolitical tensions continue to rise against more challenging demographics, we are seeing this type of framework also being embraced in India, Japan, and even the United States.
Overall, we left Beijing somewhat encouraged. To be sure, though, we are optimistic less so because we think that GDP growth is going to snap back quickly. Rather, as our trip confirmed, there is a playbook to both build on existing strengths as well as tweak policies to create more stability, especially as it relates to Real Estate and consumer confidence. If done properly, these policy shifts could reward investors across the region who have positions in Equities, Credit, and many parts of Real Assets
The Economist talks the old playbook (more stimulus to boost consumer demand), in a U.S. centered world, and faults Mr. Xi’s “centralising rule” as well as his character flaws (“unrealistic”, “unpredictable”, “self-centered”).
It makes no sense to throw money to shocked, wary and worried consumers. They will save it until confidence returns, always a slow process, particularly when real estate values are concerned.
With all his flaws, Mr. Xi is a very smart man. Based on his more recent actions, he seems to have learned much in recent years, including the necessity for China to reduce its dependance on the U.S.. An engineer, he is very analytic and systematic and he gets technology. KKR’s analysis reflects the reengineering of China’s growth within a completely new global environment. Like it or not, China has a plan. Like it or not, the plan will be implemented by this centralized regime.
Currently in Singapore and having read its history, I can appreciate the results of a smart, thoughtful, centralized social and economic plan. To be sure, China is no Singapore, but time will tell if Xi Jinping ends up close to being another Lee Kwan Yew in framing the right vision for China amid numerous significant challenges.
In my book, China was long an un-investable growth market, mainly for political/ethical reasons, but also because other investable markets were offering enough opportunities to profitably invest capital without the “China risk”.
Given how relative valuations have evolved and how Western politics have devolved, I find myself rethinking my thinking.
BTW, to KKR’s point about the acceleration in intra-Asia trade, this CrossBorderCapital chart shows how Asia-Pacific trade has recovered well above total world shipping volumes and above its levels of the past 20 years.
Americans bought a record 1.2 million EVs in 2023, according to Cox Automotive’s Kelley Blue Book. That’s 7.6% of the total U.S. new-vehicle market, up from 5.9% in 2022.