It was a luncheon speech that must have put some of the delegates at CSFB's Asian Investment Conference off their food. Newbridge Capital's co-managing partner, Weijian Shan delivered an incisive and brilliant speech (without notes) on China's current growth model and why it must change, or else fail. Here we reprint the speech in full:
I am talking today about a subject that has caught the imagination of almost every investor in the world, and that is China. China has produced the most spectacular growth in the past 25 years - in fact, no country in the world has ever been able to grow as fast for such a sustained period in world history.
In the past 25 years the average growth rate - in real terms - was about 9% per annum. The question is, in this fast growing economy, how much return would you have made from investing in arguably the best Chinese companies? These companies first came to Hong Kong to list in 1993, and if you invested in the Chinese enterprises index then you would, 10 years later - have lost about one third of your capital. Indeed, throughout that period you were underwater more than not. If you had held till today - that is if your investors had not fired you by now - the return would be 24%. During the same period of time the US economy grew about 3% per annum and if you had invested in the Dow Jones you would have made a return of about 188%. The Hang Seng index would have given you a return of 84.7%.
So what is going on? Why has the fast economic growth rate not translated into a high return for investors?
I recently read a report talking about bad loans. It said that Japan was number one in absolute terms. But in terms of the bad loan ratio, China was the worst. S&P estimates about 45-50% of Chinese loans are bad. What does that mean? I believe NPLs are a very good measure of the inefficiency in the economic system. It captures both types of inefficiency: productive and allocative.
There you have a paradox. China is the most inefficient economy producing the fastest growth rate the world has ever seen. How can this be? How can an inefficient economy continue to grow like this?
History shows there are examples of economies which are inefficient and are still able to produce rapid economic growth rates. The Soviet Union produced very rapid economic growth in the 1950s and 1960s. Was Soviet growth real?
After its collapse, the Russian economy shrank very rapidly, until it was only 10% of the size of Japan. I would argue, however, that the Soviet economic growth rate was real. There was a real economy.
If you had visited Moscow before the fall of communism you might have been interested to discover that the principal cause of fires in the city was exploding television sets. In Moscow hotels the television would have a sign covering the screen which said "Please keep a safe distance from the television because it may explode at any time".
Why were they making exploding televisions? It turned out that there were TV producers who were only producing exploding televisions. Obviously there was demand, and year after year the factories just turned out more exploding televisions. There was real supply and real demand. Everything was real until after 1990, when Sony came in. Why would you then buy an exploding television?
All those manufacturers producing shoddy products became worthless overnight. That's why the Soviet economy shrank. But it was there.
Yet why did it grow for such a long period of time? There were two necessary conditions for such an inefficient economy to grow so rapidly. One was a high savings rate, much of which was forced. The other was a closed economy. Without competition, consumers have to buy whatever is available.
Of course, I am not suggesting that China is a closed economy. In fact, trade now represents about 60% of Chinese GDP, which is far greater than that of the US or Japan. So China now depends more on international trade than America or Japan. China is an open economy as far as the trade account is concerned.
So what are the necessary conditions for allowing the Chinese economy to grow at such a rapid pace. The first condition is a high savings rate - which at 42% is among the very highest in the world. Such savings are translated into investment, which pushes the economy forward. The second condition is capital controls.
If you look at data that shows the price differentials of those Chinese companies that are listed both in Hong Kong and Shanghai, you note that the price in China is twice as much - for the same stock! That means the return on capital in China is about half that in Hong Kong. A rational investor would bring money to Hong Kong to buy the stocks there. It follows that without capital controls money will flow out of China.
With capital controls, the banks are able to channel all this capital into investments - which in turn is responsible for economic growth. Now, the question is: what is the catch?
The catch is that if the economic system is inefficient, much of the investment may be wasted or become NPLs in the banking system. And therefore you will find that the cost of Chinese growth is the NPLs in the banking system, which the country has to pay for sooner or later.
That's why I call Chinese growth, borrowed growth. Chinese economic growth is not demand-driven but supply-pulled. It is driven by capacity expansion which is financed by bank loans which came from the high savings rate.
Last year the money supply went up 20%. Local currency loans went up 21%. Foreign currency loans went up 27%. Fixed asset investment, or capital formation, went up 27%. And all this investment produced economic growth of 9.1%, with industrial output up 17%.
That's just the average. The growth is much more spectacular by sectors. If you look at personal computer production, it grew by 83.2%, sedan car sales by 80.7% and air-conditioning units by 47.4%. The growth in such areas is truly explosive.
This is all driven by large amounts of investment in these industries. I would argue that most of the impetus for the money supply increase came from outside China, due to the inflow of foreign capital. The central bank is obligated to buy dollars or whatever currency and convert them into the local currency. So every dollar that comes into China translates into an increase in the money supply of Rmb8.3.
The increase in fixed asset investment last year was 27%. I saw data for the first two months of 2004, that it was up 53%. That is hot.
What does that imply for an investor? There is a debate as to whether the Chinese economy is overheating. Usually overheating is accompanied by inflation. But last year the CPI rate was 1.2%. In January it rose to 3.2%, but then in February it came down to 2.1%. So it seems that inflation is not a serious threat.
But China is an economy of such diversity. The average doesn't really tell you anything. My analogy is that if a person has one foot in a fire and one foot in ice, before you know it he is dead, but his average body temperature looks normal.
That's what you see in China today. I call it bi-flation. There is both inflation and deflation in the market. If you look at the prices of raw materials and intermediate goods they all went up in price substantially last year. We're talking about 30%.
At the same time, investment has created so much overcapacity in the system that prices for finished products have become depressed. Therefore you see the price for durable goods come down 4.6%, for telecoms equipment and electronics 6.5% and for cars 10%. And the trend is continuing.
What does this do to your business? On the one hand the price for all your materials goes up 30%, on the other hand the price for your finished products have come down 10%. Your margin is severely squeezed.
And you have borrowed from banks to make all this investment. Now, without the cashflow, you are becoming more dependent on banks, just as your ability to service those debts has diminished. This increases the risk of adding to the stock of NPLs in the system.
NPLs are thus the cost of economic growth in China. And also, by bidding up commodity prices, China is paying a higher price for its raw materials from abroad, while Chinese companies are selling their products at a lower price worldwide. So China buys dear, and sells cheap. Thus China's terms of trade have significantly worsened in the past year or two. That means China is really subsidising the rest of the world.
You may be asking me what is Newbridge doing in a country like this? I do believe there are places that can make money, where overcapacity and over-competition will not harm your profits. If you are careful enough there are still a lot of good investment opportunities.
For example, between 1949 and 1996 it took China 47 years to reach a production capacity of 100 million tonnes of steel from 50,000 tonnes in 1949. The next 100 million tonnes were added in six years, and by the end of the year China will reach 300 million tonnes.
That's very rapid growth. Why would you invest in the steel industry in China? But look at Baosteel - it supplies 60% of China's steel plates for cars. With that kind of technology and market share, you know that company cannot be easily imitated.
Another example is milk. The consumption of milk has been growing at more than 100% for the past three years. The supply of milk has increased so much that the margins have become very thin. But to my knowledge there is only one company making the paper cartons for milk. This particular company is doing extremely well.
There are 47 mobile handset makers in China. They don't make money. But China Mobile does.
So there are pockets of opportunity in China for foreign investors. But you need to be careful.
The question is: can the current pace of economic growth in China be sustained, given all the problems? I don't think that this type of growth is sustainable, if nothing is done, particularly in regard to the banking sector.
In 2007, China will have to open the banking sector to foreign banks. By that time, depositors will have a choice. The foreign bank is not likely to loan their money without regard to cashflows. Regardless of the savings rate a lot of money will be diverted away from all these capacity expansion projects. And therefore this type of growth cannot be sustained.
And in five or six years China has said it will make the capital account convertible. Then you will see an outflow. You will not be able to capture all of the capital for capacity expansion purposes.
In the longer term, the Chinese population will age precipitously and in the next 10 years money will be withdrawn from the banking system by those retiring. That's because the social pension system is underfunded.
Therefore sooner or later, this type of growth will not be sustained.
Fortunately the Chinese leaders have the wisdom to tackle the problems. I was pleased to hear Wen Jiaobao say that this year China faces a bigger challenge than SARS, when he talked about the need to readdress macro-economic policies.
The government has taken measures to clean up the banking system. That will put Chinese growth on a much sounder footing and is welcome news for investors.
