china popular western illusions debunked

Misunderstanding China Popular Western illusions debunked

Special report May 2012

China macro strategy

2 [email protected] May 2012

Contents Executive summary ............................................................................ 4

This report debunks 16 Western misperceptions about China. Based on data and our own research, we assert the following:

1. China is not export-driven .......................................................... 10

2. World’s best consumption story ................................................. 15

3. Entrepreneur-driven economy ................................................... 22

4. Banking crisis unlikely, near term .............................................. 25

5. RRR cuts are not easing ............................................................. 27

6. Party plans 8-8.5% GDP growth ................................................ 29

7. Local-govt debt not a time bomb ................................................ 31

8. Land sales are not key ............................................................... 36

9. Political instability very unlikely ................................................ 38

10. World’s best privatisation story ................................................. 40

11. Even the poor are homeowners .................................................. 41

12. There is no property bubble ....................................................... 42

13. No “shadow” banks .................................................................... 46

14. RMB is not grossly undervalued ................................................. 49

15. RMB not a key issue for USA ...................................................... 52

16. Manufacturing still competitive .................................................. 56

The real worry: The rule of law ........................................................ 61

References ....................................................................................... 65

Need more understanding?

Andy Rothman China Macro Strategist [email protected]

Julia Zhu [email protected]

SinologyChina Macro Strategy

http://www.clsa.com/member/reports/467612866.pdf




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Introduction China macro strategy

May 2012 [email protected] 3

Introduction Given how long China has been a focus of attention for global investors, journalists, economists and government policymakers, it is amazing how poorly informed many remain. The Chinese economy faces many issues, but the biggest problem may be that it is misunderstood.

Fortunately, the Chinese economy has not become depressed about being misunderstood. While moving a bit more slowly these days, it continues to outperform globally. But misunderstanding China has caused problems for many people. Take pity, for example, on the investors who mistakenly believed that the Chinese economy was export-led and would therefore crash as demand collapsed in the USA and Europe in 2009.

Have some sympathy for those who argue that consumption is weak, simply because the household spending share of GDP is low. China is actually the world’s best consumption story, with incredible growth in sales of everything from soft drinks to SUVs.

Do not be too harsh on the columnist who decries the “resurgence” of Communist Party control over the economy. He just misunderstands that the share of urban workers employed by state firms has fallen to only 19%, from 60% two decades ago, and that almost all new jobs are created by the country’s entrepreneurs.

Feel free, however, to taunt the public official (especially in America) who blames the renminbi for his country’s economic woes. He does not understand that China’s currency has appreciated by more than 30% since 2005, or that its current account surplus/GDP ratio is now well below the US Treasury Secretary’s benchmark of 4%. And he fails to grasp that US exports to China rose by more than 500% during the past decade.

We all know someone who misunderstands China. This report is for them.

Andy Rothman China macro strategist

The biggest problem may be that the economy

is misunderstood

China is the world’s best consumption story

Almost all new jobs are created by the country’s

entrepreneurs

Such misunderstandings have hurt investors

Those who blame the renminbi for their

problems are ignoring reality

Executive summary China macro strategy


Misunderstanding China This report debunks 16 commonly held misconceptions about China. We also highlight the most serious risk to the country’s long-term outlook: its lack of the rule of law. In reality . . .

China is not export-driven This is the biggest misunderstanding about the Chinese economy, and it easy to see why most people think the country is dependent on exports. After all, almost everything in your neighbourhood shop does come from China. But many of those goods are just processed or assembled there, adding very little value and contributing very little to its GDP.

During the decade prior to the global financial crisis, China averaged about 10% annual GDP growth, with only about 1ppt of that growth contributed by net exports. Today, China is even less export-dependent: last year net exports produced a -5.8% drag on GDP growth, and in the first quarter of this year, net exports provided a -9.4% contribution to growth.

Our message is not that exports do not matter. They do, especially to the tens of millions of workers assembling iPads and other gadgets. But it is important to understand that China is a continental, domestic investment and domestic consumption-driven economy, where exports play only a supporting role. The overwhelming majority of goods made in China stay in China.

It’s the world’s best consumption story China is already the world’s best consumption story: urban household consumption rose 12.3% YoY in 1Q12, while rural household cash consumption expenditure rose 17.6%.

Unprecedented income growth is the most important factor supporting consumption. Over the past decade, real urban income rose 151%, while real rural income rose 111%. Much of the increase was driven by government policy: the minimum wage in Shanghai, for example, rose 171% over the past 10 years.

But for those who are waiting for the day when the household consumption share of GDP begins to rise and the investment share begins to fall, that day has arrived. China’s transition away from investment-led growth will begin this year, as fixed-asset investment growth will slow a bit below the roughly 25% YoY pace of the past nine years.

With an entrepreneur-driven economy The Communist Party maintains significant control over China’s economy, but this control is exercised primarily via macro policy rather than through state-owned enterprises (SOEs). SOEs and state-controlled firms continue to dominate the financial industry and many of the capital-intensive sectors, such as telecoms, aviation, oil & gas and petrochemicals, but state firms are far less important than they once were. China’s economic growth is increasingly driven by entrepreneurial small- and medium-sized enterprises (SMEs).

Back in 1958, 86% of urban workers were employed by state firms, and that share remained above 70% through 1989. But between 1995 and 2001, the Party laid off 46 million state-sector workers - equal to sacking the entire combined workforces of France and Italy in six years. As a result, the state

Everything does come from China, but it isn’t really made there and contributes relatively

little to China’s economy

Household consumption is a small share of GDP, but

that does not mean Chinese consumers

don’t spend

The role of state-controlled firms has been steadily shrinking, while

private companies create almost all new jobs



share of urban employment fell from 60% in 1994 to 28% in 2002. In recent years, almost all new job creation came from private firms. Similarly, the state-firm share of fixed asset investment has fallen from 58% in 2004 to 32% in 1Q12.

A banking crisis is unlikely in the near term The economy may be largely in private hands, but the Party still controls the largest industrial firms and the financial sector. While the Party no longer micromanages financial institutions on a day-to-day basis, it continues to control the personnel process, including at banks where the majority of shareholders come from the private sector. And Party control of the financial system extends well beyond the banks.

Party control does not, on its own, mean that China’s banks are incompetent or insolvent, but it means that the Party does not have to rely on open-market operations to manage the economy. Interest rates and reserve requirements are somewhat symbolic tools when the Party can pick up the phone and assign a monthly loan quota to every bank.

Aside from trade finance, China does not borrow money overseas and, because of the non-convertibility of the renminbi, offshore investors are overwhelmingly excluded from the domestic capital markets. There is simply no way that offshore speculators, investors, hedge funds or others can get at China’s domestic debt obligations and challenge the Party’s valuation of these obligations. In short, the closed nature of China’s financial markets suggests a deliberate strategy based on a particular understanding of past international debt crises. China’s financial system is an empire set apart from the world.

RRR cuts are not easing In a real banking system, regulators use the required reserve ratio (RRR) to manage growth of lending and money supply. But China does not have a real banking system. All Chinese banks are controlled, via the personnel system (even down to the branch level), by the Communist Party. This enables the Party to set loan quotas for each bank, governing the level of lending above and beyond the RRR limitations.

In China, the RRR is primarily a tool for the central bank to sterilise foreign-exchange inflows.

The RRR will continue to come down from historically high levels, but this has, on its own, a neutral impact on monetary policy and will not result in a material change to credit and liquidity in China.

The Party is planning for 8-8.5% GDP growth Premier Wen Jiabao, in his March speech to the National People’s Congress, said that his target for GDP growth this year is 7.5%. But he didn’t really mean it. During each of the previous five years, Wen said he expected 8% annual GDP growth. But full-year growth rates never slowed to anything close to Wen’s target. During that period real annual GDP growth actually averaged 11.2%.

Wen’s lower targets reflect that the Party is comfortable with slower growth. This year, we forecast 8.5% GDP growth, and we believe the Party will be comfortable with anything in the 8-8.5% range (down from 9.2% last year and 10.4% in 2010).

China’s banking system is not Mexico of 1994,

Argentina of 1999, or today’s Greece

In a banking system where lending is

controlled by quota, cutting the RRR has a

neutral impact on credit and liquidity

Premier Wen didn’t really mean it when he said his

target for 2012 is 7.5%



Local-government debt is not a timebomb . . . Local-government debt represents a significant financial burden for the Party, but it is far being from a ticking timebomb for the following reasons:

Local debt is, ultimately, national (or Party) debt, so it needs to be considered in a national fiscal context.

Prior to 2009, the growth rate of local government debt was roughly in line with growth in national fiscal revenue.

The huge leap in local debt in 2009 was a one-off response to the global financial crisis, and was withdrawn as quickly as it was implemented.

The use of bank loans to local governments to finance public infrastructure, particularly the huge 2009 stimulus, has created a serious fiscal burden for the Party. But because we expect continued strong revenue growth, and because all local debt is backed by the Party and is held by Party-controlled banks (no private institutions, no foreigners), this is not a looming disaster.

Local debt of Rmb10.7tn (US$1.7tn) is not pocket change, even for Beijing, but it is far from a fiscal crisis given the strong revenue growth and healthy fiscal position we described earlier.

Infrastructure-spending growth is decelerating and local borrowing has slowed, while fiscal revenue is likely to continue growing faster than nominal GDP. This should enable the Party to grow out of the local debt burden.

In sum, the Party has the political will and the fiscal resources to ensure that local governments do not default on their bank loans.

. . . and land sales are not key to local-government revenue Revenue from land transfers is a fairly small part of local government budgets. Last year, local governments were ultimately only able to keep 28% of the revenue they collected from land transfers, and some of those funds must be set aside for low-income housing. Gross revenue from the sale of land-use rights was equal to 25% of local-government revenue last year, but on a net basis, after accounting for all of the costs associated with clearing and transferring land, land revenue accounted for only 9% of total local-government revenue.

Political instability is very unlikely The dismissal in March of a senior Chinese official is unlikely to have a concrete impact on the country’s economic or political policies, and was not the result of a struggle within the Communist Party over the direction of reforms.

This is a transition period for the Communist Party leadership, but given than the two new leaders have been part of the small group running the country for the past five years, this is not a lame-duck government.

It’s also the world’s best privatisation story The development of China’s commercial housing market is one of the world’s greatest and least recognised privatisation success stories. In just 20 years, the country went from one of the world’s lowest urban homeownership rates to one of the highest.

In China, local debt is, ultimately, national (or Communist Party) debt

Net revenue from land sales account for only 9%

of local budgets

The sacking of Bo Xilai will not derail day-to-day

management of the economy or longer term

reform prospects

The Communist Party has been willing to make

bold moves



The turning point came in 1998, when the Party ended the practice of government work units (danwei) providing public housing for their workers, in tandem with the momentous decision to radically shrink the state workforce. Over a six-year period, 46 million state-sector workers were laid off - the equivalent of sacking the entire combined workforces of France and Italy.

Many state workers, including some of those who lost their jobs, were allowed to buy their government-provided flat at a steep discount to the market value (which was, at that point, very low). This was the largest one-time transfer of wealth in the history of the world, as most of China’s urban-housing stock was handed over to its occupants, and it helped create the liquidity to fuel China’s brand-new commercial-housing market.

Even the poor are homeowners . . . Almost all income groups have benefited from the privatisation of China’s housing market. The overall homeownership rate was 82% in 2007 (compared with 68% in the USA), and while the rich were more likely to own their own home, even the lowest 10th percentile of income groups had a 73% homeownership rate.

We note that with 40% of homeowners living in housing stock built by government work units - typically small and of poorer quality than commercially built flats - this population will continue to drive new home upgrades.

. . . and there’s no property bubble From 2006 to 2011, new home prices in China rose at an average annual pace of 9.7%, while urban income rose by an average of 13% per year.

China’s home market is driven by owner-occupiers, not speculators. Our own study of sales managers at new residential projects across the country found that in March, only 7% of buyers were investors. Our study also reveals that in February, 17% of first-time homebuyers paid all cash, down from 23% a year ago, as mortgage availability has improved and interest rates have declined. Among investors, 20% paid all cash. Buyers who use mortgages have a lot of skin in the game: the minimum cash downpayment is 30% for owner-occupiers and 60% for investors. Chinese banks have not been permitted to offer subprime mortgages.

The fact that the average residents of Chinese cities, like the average residents of most major cities around the world, cannot afford to buy a downtown home does represent a significant social problem, which is why the Party has embarked on a major programme to build low-income housing. But this social problem is not evidence of a bubble, or of a shortage of buyers who can afford what is currently on the market.

There are no “shadow” banks The Party still controls all of China’s financial institutions, including all commercial banks and the 70 trust companies.

It may also be useful to put the scale of China’s trusts into context. In 2011, the total assets of the trusts was Rmb4.8tn (US$764bn), equal to only 5.9% of total deposits (or 8.8% of total loans outstanding) in the formal banking system. This is in sharp contrast to the US shadow-banking system, which in March 2008 had a gross size of nearly US$20tn - significantly larger than the liabilities of America’s traditional banks.

Over 80% urban homeownership rate

Homeowner leverage is low and residential prices

have risen in line with income

The Communist Party still controls all Chinese

financial institutions



It is also important to note that China’s trusts are not permitted to leverage their investments, a far cry from the seemingly unlimited leverage available, pre-crisis, to the five big American broker-dealers. Leverage is quite limited across China’s financial institutions and is available only for a few activities.

In 2Q11, our national study of SME manufacturers found that only 6% of their capex was funded by informal borrowing, down from 13% three years ago.

The RMB is not grossly undervalued One thing that is clear is that the renminbi has appreciated significantly since Beijing broke its currency peg in the summer of 2005. According to the Bank for International Settlements (BIS), between January 2005 and March 2012, the yuan appreciated 32% on a real basis and 24% on a nominal basis.

US policymakers have emphasised one metric for evaluating China’s exchange-rate policy: the current-account balance/GDP ratio, and Treasury Secretary Geithner has argued that a 4% ratio is a ‘benchmark for the future’. Based on this metric, the US should be satisfied that the renminbi is close to its equilibrium rate, as China’s current-account surplus/GDP ratio fell last year to 2.8% from the 2007 peak of 10.6%.

Nor is the RMB a key issue for USA Goods labelled “Made in China” make up 2.7% of US consumer spending, but only 1.2% actually reflects the cost of the imported goods. Thus, on average, of every dollar spent on an item labelled “Made in China,” 55 cents go for services produced in the United States. In other words, the US content of “Made in China” is about 55%.

The fact that the overall import content of US consumer goods has remained relatively constant while the Chinese share has doubled indicates that Chinese gains have come, in large part, at the expense of other exporting nations.

Another common misconception is that China is closed to US exports, and that an undervalued currency has kept Chinese from buying American goods. In fact China is the third-largest buyer of US exports after Canada and Mexico. And China is, by a huge margin, the fastest-growing market for US goods. Between 2000 and 2011, US exports to China rose 542%. In contrast, its exports to the rest of the world rose only 81% during that period.

Manufacturing is still competitive Chinese manufacturing wages have been increasing at an amazing rate for a very long time - 14% annually since 1987. Much of the increase has been driven by government policy: over the past decade, the minimum wage rose 152% in Shenzhen, and 171% in Shanghai.

How did Chinese manufacturing remain competitive, despite the rapid wage growth? The answer is that productivity also rose at a very fast pace. China’s industrial value-added rose by 13.4% annually in real terms between 1997 and 2010, while real manufacturing wages rose by an average of 11.2%.

China continues to have a structural labour surplus with significant unemployment and underemployment. At an aggregate level, it still appears that wage pressures are mostly being absorbed by productivity gains; manufacturing unit labour costs are rising only slowly and corporate profit margins are not being compressed by rising costs.

The renminbi has appreciated by more than 30% against the US dollar

since 2005 . . . . . . and the current-

account surplus/ GDP ratio is now below Geithner’s benchmark level

Chinese goods make up less than 3% of US

consumer spending - and half of that goes on services produced

in the US

US exports to China rose over 500% during the

past decade

Strong wage growth has been matched by rapid

productivity gains



The real worry: The rule of law Having suggested what not to worry about, in this final section we discuss the most important longer-term risk to China’s continued economic growth and social stability: its legal system. This is also, not coincidentally, the biggest long-term risk to any investment in China.

This is already the source of many of problems. Corruption, weakness in commercial sectors dependent on intellectual property rights, and the widespread theft of farmers’ land - the main cause of protests across the country - are all consequences of the lack of the rule of law.

In the near term, China can continue to thrive, as people continue to find ways to navigate corruption and the opaque system. But, as the pace of economic growth slows over the coming decades, can China’s unique form of authoritarian capitalism continue to support the rising standard of living Chinese citizens have come to expect?

This problem is already increasingly visible in rural China, where local officials often violate farmers’ property rights, leading to protests and sometimes to violence. Changing China’s legal system and institutions to prevent this problem from becoming more widespread, and to support continued economic growth, is the Party’s chief challenge in the coming decades.

The most important longer-term risk to

China’s continued economic growth

1. China is not export-driven China macro strategy


1. China is not export-driven Everything does come from China, but it isn’t really made there and it contributes relatively little to China’s economy

This is the biggest misunderstanding about the Chinese economy, and it easy to see why most people think the country is dependent on exports. After all, almost everything in your neighbourhood shop does come from China. But many of those goods are just processed or assembled there, adding very little value and contributing very little to its GDP.

Although the share of China’s exports that are just processed there has been declining, it still accounts for 44% of the total, down from 55% in 2001.

Figure 1

Structure of China’s exports

Source: CEIC

A good example of processed exports is Apple’s iPad, which, famously, is assembled in China but creates little value there. Last year, the Personal Computing Industry Center (PCIC) of the University of California, Irvine took apart an iPad and worked out its value chain.

Figure 2

Distribution of value for Apple’s iPad

Source: PCIC, UC Irvine

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15%

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Unidentified profit5%

Input costs: materials

31%

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2%

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5%

The biggest misunderstanding about

the Chinese economy

Apple’s iPad is a good example of China’s processed exports

China takes a very thin slice of the Apple pie

Processed exports still account for 44% of total



Here are a few excerpts from the UC Irvine study:

In the case of the iPad, Apple keeps about 30% of the sales price of its low-end US$499 16GB, Wi-Fi only model (and more if the unit is sold through Apple’s retail outlets or online store).

The next biggest beneficiaries are Korean companies such as LG and Samsung, who provide the display and memory chips, and whose gross profits account for 5% and 7%, respectively, of the sales price for the iPhone and iPad. US, Japanese and Taiwanese suppliers capture 1-2% each. But overall, the story remains the same, with Apple’s success benefiting its shareholders, workers, and the US economy more generally.

It is a common misconception that China, where the iPad is assembled, receives a large share of money paid for electronics goods. That is not true of any name-brand products from US firms that we’ve studied.

First, our assignment of profits (which exclude wages paid) to first-tier suppliers is based on the location of their corporate headquarters. There are no known Chinese suppliers to the iPhone or iPad. The iPhone and iPad are assembled in mainland China factories owned by Foxconn, a Taiwan-based firm.

That means that the main financial benefit to China takes the form of wages paid for the assembly of the product or for manufacturing of some of the inputs. Many components, such as batteries and touchscreens, receive their final processing in China in factories owned by foreign firms. Although hard facts are scarce, we estimate that only US$10 or less in direct labor wages that go into an iPhone or iPad is paid to China workers. So while each unit sold in the US adds from US$229 to US$275 to the US-China trade deficit (the estimated factory costs of an iPhone or iPad), the portion retained in China's economy is a tiny fraction of that amount.

What these data illustrate is that the US-China trade deficit reflected in the trade statistics for electronic goods is comprised of China’s small direct labor input plus large inputs of parts and components (including the labor) from the US, the EU and other countries in Asia.

This study also confirms our earlier finding that trade statistics can mislead as much as inform. Earlier we found that for every US$299 iPod sold in the US, the US trade deficit with China increased by about US$150. For the iPhone and the iPad, the increase is about US$229 and US$275 respectively. Yet the value captured from these products through assembly in China is around $10.

You will remember from Econ 101 that GDP equals investment plus consumption plus exports minus imports. This formula, which applies to all economies, is designed to ensure that GDP excludes, for example, the value of a hard drive that is made in Japan, imported into China and snapped into an iPod which is then sold overseas. That hard drive costs US$73 and accounts for half of the factory value of an iPod, but it was not made in China and did not contribute directly to the Chinese economy. (The indirect contribution - including the jobs assembling and testing the iPod - adds up to US$7.50 and is counted in the net export calculation.)

During the decade prior to the global financial crisis, China averaged about 10% annual GDP growth, with only about 1ppt of that growth contributed by net exports. Today, China is even less dependent on exports. In 2007, prior to the last slowdown, net exports accounted for 18% of GDP growth. Last year, however, net exports contributed a -5.8% drag on GDP growth, and in the first quarter of this year, net exports provided a -9.4% contribution to growth.

Koreans the biggest gainers after Apple

Main financial benefit to China is wages

Trade statistics can mislead as much

as inform



Figure 3

Contribution to GDP growth by expenditure approach

Source: CEIC, CLSA forecast

From the perspective of GDP, as opposed to GDP growth, net exports also play a relatively small role. In 2007, net exports accounted for 8.8% of China’s GDP, but this share fell to only 4% in 2010. (The 2011 details are not yet available.)

Figure 4

Share structure of China’s nominal GDP by expenditure approach

Source: CEIC

Along similar lines, Figure 5 illustrates the relatively small role that exports play in China’s manufacturing sector. During the last global recession, China’s exports collapsed, from a 26% YoY growth rate in 2007 to 17% in 2008 and -16% in 2009. But fixed-asset investment growth in the manufacturing sector slowed far less dramatically, from 35% YoY in 2007 to 31% in 2008 and 27% in 2009. This is because most Chinese manufacturers are targeting domestic demand, not exports.

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Manufacturing FAI slowed far less dramatically

than exports in the last global recession

China is even less dependent on

exports now

Net exports accounted for only 4% of GDP in 2010



Figure 5

Growth rates of FAI in manufacturing and total exports

Source: CEIC

More recently, as export growth has once again slowed, manufacturing FAI has declined, but at a much gentler pace. This is consistent with the statistic that the delivery value of China’s exports accounted for only 12% of its total industrial sales revenue in 2011.

Figure 6 shows that China’s consumers also do not pay too much attention to the health of the nation’s exports.

Figure 6

Growth rates of retail sales and total exports

Source: CEIC

Our message is not that exports do not matter. They do, especially to the tens of millions of workers assembling iPads and other gadgets. But it is important to understand that China is a continental, domestic investment and domestic consumption-driven economy, where exports play only a supporting role. The overwhelming majority of goods made in China stay in China.

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China is a domestic investment and

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China’s consumers also do not pay too much attention to exports



Finally, it is worth noting the key role foreign firms play in China’s exports. While the share of total exports coming from foreign-owned companies has declined from the 2005-06 peak of 58%, last year more than half (52%) of China’s exports were produced by foreign firms.

Figure 7

Exports by foreign-funded enterprises as a share of China’s total exports

Source: CEIC

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Last year more than half of China’s exports were

produced by foreign firms

2. World’s best consumption story China macro strategy


2. World’s best consumption story Household consumption is a small share of GDP, but that does not mean Chinese consumers don’t spend.

Household consumption accounts for a small share of China’s GDP: 34% in 2010, down from 46% in 2000. This is quite low when compared to the USA, where household spending is 71% of GDP, or the UK, where the share is 64%. The OECD average is 63%, and in India, household consumption is 58% of GDP.

Although China’s consumption numbers are not fully accurate - private spending on services and housing is clearly undercounted - we are happy to stipulate that the household consumption share of China’s GDP is very low.

The misunderstanding concerns the reasons that the share is low, the impact on the Chinese economy and listed companies, and the policy steps that Beijing should take to raise that share. These misunderstandings have led a parade of world leaders and prize-winning economists to urge China to “rebalance” its economy.

Consumption is already strong . . . By most metrics, private consumption in China is already exceptionally strong. In 1Q12, retail sales rose 15.2% YoY, after rising 17.1% last year. During the period from 2005 to 2010, retail sales increased at an average annual rate of 17.6%.

Figure 8

Nominal and real retail sales growth

Source: CEIC

China’s retail sales data is not directly comparable to that in developed countries because it includes purchases by government offices and excludes consumer spending on services such as healthcare, education and entertainment. Urban household consumption expenditure, based on a quarterly survey by the National Bureau of Statistics, provides a better picture by excluding purchases by government offices and other organisations, as well as construction materials bought by individuals, and by adding spending on many services that are not covered by retail sales.

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The Chinese are spending

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better picture



Urban household consumption rose 12.3% YoY in 1Q12, up from 10.7% a year earlier. Rural household cash consumption expenditure, driven by increasing nonfarm wages and farmgate prices, rose 17.6% in 1Q12, compared to 22% a year earlier.

Figure 9

Urban and rural retail sales/consumption

Source: CEIC

This strong spending trend is also visible when we look at specific categories of goods. Computer sales, for example, rose 15% YoY last year and by a 15% Cagr during 2007-11, according to data from Access Asia-Mintel. Fast-food sales rose 19% last year (13% Cagr), while sales of white goods rose 9% (11% Cagr) and cosmetics increased by 10% (9% Cagr). China is the world’s fastest growing market for everything from carbonated soft drinks (14% last year) to SUVs (100%).

Figure 10

Urban and rural household consumption by category

Source: CEIC. Note: ‘Household facility’ includes appliances and services; ‘residence’ refers to spending on housing and utilities.

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Food Clothing House facility Healthcare Transport andcommunications

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Fast-food sales rose 19% last year

Urban household consumption rose

in 1Q12 . . .

. . . and rural spending saw bigger increases



. . . supported by strong income growth This strong growth in consumer spending is driven by several factors: healthy consumer confidence; the absence of household debt; rapid income growth; moderate inflation; and growing demand for goods and services from the large number of Chinese who have only recently earned enough money to move into the consuming class - in part through the urbanisation process, which allows millions of people to make the transition from subsistence farming to salaried jobs. The proportion of Chinese living in urban areas has risen from 11% in 1949 to 51% in 2011, and we expect another 15 million people to make the migration annually for the next few years.

Figure 11

China’s urbanisation rate

Source: CEIC

Unprecedented income growth is the most important factor supporting consumption. Real (inflation-adjusted) urban income rose 8.4% YoY last year, up from 7.8% in 2010 and representing the 11th consecutive year of 7%-plus real growth. Real urban income rose 9.8% in 1Q12.

Figure 12

Real growth of per capita urban household disposable income and rural net income

Source: CEIC

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consumption

Rural incomes are now growing faster



Real rural income grew even faster, rising 11.4% in 2011, up from 10.9% in 2010 and representing the fifth consecutive year of 8%-plus growth. Rural wage growth outpaced urban last year, and wages for the 160 million migrant workers rose 21% YoY in nominal terms. In 1Q12, real rural income rose 12.7%.

Over the past decade, real urban income rose 151%, while real rural income rose 111%. Much of the increase was driven by government policy: the minimum wage in Shanghai, for example, rose 171% over the past 10 years.

Figure 13

Minimum-wage growth

Source: CEIC

Consumption is rising By some metrics, private consumption is growing more rapidly in China than in other countries.

Figure 14

Household consumption growth in local-currency terms

Source: CEIC, CLSA estimates

And if we convert China’s private consumption into US dollars, the growth rate far outpaces that of American consumers in recent years.

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Real urban income rose 151% in the past decade

. . . far outpacing that of American consumers in

recent years

China leading the charge in private

consumption . . .



Figure 15

Private-consumption growth in US-dollar terms


So what’s the problem with consumption? Analysts who worry about consumption do not pay much attention to the data we have just described. They focus instead on the low share of household consumption in the overall economy, emphasising that this accounts for only about 34% of China’s GDP - a very low level, as we noted at the opening of this section.

But we do not believe this is the most important metric for the consumption story. The reason that household consumption is a small share of China’s GDP is not because consumption is weak. On the contrary, as we have just outlined, Chinese consumers are experiencing dramatic income growth and spending freely. Private consumption is a small share of GDP because the Communist Party has over the past decade dramatically ramped up its spending on public infrastructure. Infrastructure has accounted for about one-third of overall investment, which has been a major driver of GDP growth.

By building out in one decade the modern infrastructure that now-developed countries required many decades to create, the Party pushed GDP growth up into double digits, with most of that growth coming from investment, squeezing out the share of GDP (or GDP growth) that could come from private consumption.

In other words, the “problem” was not due to weak household consumption: it was because fixed-asset investment boomed as the Party built basic infrastructure, manufacturers modernised and privately owned housing was permitted. FAI rose at an average annual pace of 25.8% from 2003-11, compared to a 12.5% rate from 1995-02.

Fixing the “problem” In our view, there is little the government can or should do to accelerate the rate of household-consumption growth (which is already rising at a double-digit pace). The government can, however, broaden the base for household consumption by strengthening China’s social safety net, which will lead to a gradual reduction in the relatively high savings rate.

(5)

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Household consumption is a small share of GDP because investment

accounts for so much

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Analysts who worry about consumption do not

pay much attention to the data

Building in a decade what took other countries

many decades

Strengthening the social safety net will broaden the base for household

consumption



This process is underway. Last year, government spending on education rose 28% YoY, healthcare spending increased by 33%, social security was up 22% and spending on low-income housing jumped 61%. Over the past five years, healthcare spending increased 382% and education spending rose 237%.

What about rebalancing? The Chinese government is often pressed by pundits and politicians to “rebalance” its economy. Usually “rebalancing” is simply a code word for currency appreciation - a topic we address in Section 14.

But for those who are waiting for the day when the household consumption share of GDP begins to rise and the investment share begins to fall, that day has arrived. China’s transition away from investment-led growth will begin this year, as fixed-asset investment growth will slow a bit below the roughly 25% YoY pace of the past nine years. The FAI slowdown will be led by a significantly slower rise in spending on public infrastructure, reflecting that the Communist Party does not want to build bridges to nowhere and is comfortable with slightly slower GDP growth. Slower FAI growth (we forecast 21-22% this year) is a positive development, not cause for alarm.

There are several consequences of slower FAI growth. First, GDP growth will slow to about 8.5% from 9.2% last year and 10.4% in 2010. This marks the end of double-digit growth in China. Second, with GDP growth and FAI both slowing while consumption remains robust, the long-awaited rebalancing process will begin as, by default, the consumption share of GDP will gradually increase.

Are Chinese consumers repressed? Chinese consumers clearly suffer from financial repression, because the Party controls interest rates and has deliberately kept real returns on bank deposits negative or very low. Throughout 2010 and 2011 - and during half of the prior decade - interest on one-year deposits was less than the rate of inflation. This has a significant impact given the size of household savings deposits in China: the renminbi equivalent of US$6.1tn, greater than the combined GDPs of Russia, Brazil and India.

But if real deposit rates had been modestly positive in recent years, as they are today in most Asian markets, would urban household consumption have risen significantly faster than the 9-12% experienced in China (a much faster pace than seen in countries where real deposit rates were higher)?

We are not suggesting that continued financial repression is a good thing. It is clearly unsustainable over the long run. But it is also clear that providing Chinese savers with the same real rate of return offered to households in neighbouring countries would be unlikely to spark significantly faster growth in consumption or lead to “rebalancing” of the Chinese economy.

It is worth noting the findings of Peking University economists Huang Yiping and Wang Xun, in a paper on financial repression in China published last year by the Oxford Bulletin of Economics and Statistics:

Despite more than 30 years’ economic reform, the Chinese economy still possesses typical characteristics of financial repression: heavily regulated interest rates, state-influenced credit allocation, frequently adjusted reserve requirement and tightly controlled capital account. In the meantime, China achieved very strong gross domestic product (GDP) growth, averaging 10% during the reform period. These at least suggest that China’s repressive financial policies did not seriously jeopardize its growth performance.

China’s transition from investment-led growth

will begin this year

Household savings in China are greater than the combined GDPs of Russia,

Brazil and India

Findings on financial repression in China



China’s experiences inject further controversy into this discussion. Compared with its East Asian neighbours, China has a more repressive financial system but enjoys stronger growth. China successfully avoided financial meltdown and economic recession during the Asian financial crisis and the US subprime crisis, mainly on account of its repressive financial policies and closed capital account.

We concur that repressive financial policies are generally efficiency-reducing. Equally important, however, financial repression or financial restraint could probably promote growth through maintenance of financial stability and resolution of market failure. The net impact, therefore, depends on the relative importance of these two opposing effects, which may change over time.

First, despite continued financial repression in China, the financial repression index fell from 1.0 in 1978 to 0.6 in 2008. This decline is strong evidence that China has come a long way in financial liberalization, although China’s financial liberalization lagged behind that in many other emerging market economies but also behind reform of its own goods market.

China’s cautious reform approach - avoiding premature financial liberalization - probably provides an appropriate model for other developing countries. However, our evidence suggests that China should now pursue financial liberalization more forcefully, including, in particular, improving credit allocation between state and non-state sectors, abandoning frequent reserve requirement adjustments, introducing market-based interest rates and liberalizing the capital account.

A more repressive financial system but

stronger growth

China has come a long way in financial

liberalisation

A possible model for other developing countries

3. Entrepreneur-driven economy China macro strategy


3. Entrepreneur-driven economy The role of state-controlled firms has been steadily shrinking, while private companies create almost all new jobs

The Communist Party maintains significant control over China’s economy, but this control is exercised primarily via macro policy rather than through state-owned enterprises (SOEs). Macro policy includes everything from control of monetary and fiscal policy to loan quotas, the minimum wage and subsidised access to land and utilities.

SOEs and state-controlled firms continue to dominate the financial industry and many of the capital-intensive sectors, such as telecoms, aviation, oil & gas and petrochemicals, but state firms are far less important than they once were. China’s economic growth is increasingly driven by entrepreneurial small- and medium-sized enterprises (SMEs).

Private firms employ 81% of urban workers Back in 1958, 86% of urban workers were employed by state firms, and that share remained above 70% through 1989. But between 1995 and 2001, the Party laid off 46 million state-sector workers - equal to sacking the entire combined workforces of France and Italy in six years. As a result, the state share of urban employment fell from 60% in 1994 to 28% in 2002.

Figure 16

Employment by firm ownership

Source: CEIC

Even in 2009, when most of the massive economic stimulus was channelled through state firms, their share of employment fell to 19%, versus 20% in 2008. As of 2010, the state share of total urban employment remained only 19%, leaving 81% of Chinese workers at private companies.

In recent years, almost all new job creation in China came from private firms. Between 2005 and 2010, employment at state firms rose at an average annual rate of 0.1%, while employment by private firms rose 6.2% per year.

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Almost all new job creation in China came

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Private firms drive corporate investment We can also see the declining role of state firms when we look at fixed-asset investment. In 2004, the first year where we are able to break out FAI data by firm ownership, SOEs and other state-controlled firms accounted for 58% of total FAI. That share fell to 43% in 2008 and rose only slightly to 45% in 2009 as a result of the stimulus. But with the stimulus quickly withdrawn, the state-firm share of FAI fell to 42% in 2010 and 36% last year. In 1Q12, private firms accounted for 68% of total FAI.

Figure 17

FAI by firm ownership

Source: CEIC

Figure 18 illustrates that for the 25 consecutive months through March 2012, investment by private firms grew faster than investment by SOEs.

Figure 18

YoY growth rate of monthly FAI by SOEs and non-SOEs

Source: CEIC

Private firms drive industrial production and exports The SOE share of China’s industrial production has also declined steadily, from 80% in 1999 to 44% in 2005 and 34% in 2011. And the SOE share of China’s exports has shrunk from 56% in 1997 to 18% in 2007 and 14% in 2011 (although 52% of all exports are produced by foreign-owned firms).

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Most FAI by private firms

Private investment growing more rapidly



Figure 19

SOEs’ share of exports

Source: CEIC

From 2000 to 2009, total tax revenue in China rose 373%, but the SOE share of that revenue was only 16% in 2009, down from 43% at the start of the previous decade.

Misunderstanding these trends leads to understating the important role of Chinese entrepreneurs, who are the most dynamic part of the economy and drive its growth.

The Communist Party has shrunk significantly the number of SOEs and reduced the number of sectors where they operate, while scaling up the size of the remaining state firms and limiting competition in those sectors from private and foreign-owned companies. While the Party still plays an outsized role, especially through its control of the financial system, it has turned over most of the economy to entrepreneurs.

The state sector is unlikely to shrink much more in the near term, but most of the country’s economic growth will continue to come from privately-owned firms.

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SOE share fell from 43% to 16%

An increasing role for entrepreneurs

4. Banking crisis unlikely, near term China macro strategy


4. Banking crisis unlikely, near term China’s banking system is not Mexico of 1994, Argentina of 1999, or today’s Greece

‘The economy may be largely in private hands, but the Party still controls the largest industrial firms and the financial sector.’

We penned those words in our May 2005 report China’s Communist Party: Sharpening the tools, and they remain true today.

The Central Organisation Department of the Party may be China’s most powerful financial group, as it has the authority to appoint and supervise senior officers at the central bank and the regulators, as well as at key commercial financial institutions. In his recent book, The Party, Financial Times reporter Richard McGregor writes: ‘The best way to get a sense of the dimensions of the [Organisation] department’s job is to conjure up an imaginary parallel body in Washington. A similar department in the US would oversee the appointment of the entire US Cabinet, state governors and their deputies, the mayors of major cities, the heads of all federal regulatory agencies, the chief executives of GE, Exxon-Mobile, Wal-Mart and about 50-odd of the remaining largest US companies, the justices on the Supreme Court, the editors of the New York Times, the Wall Street Journal and the Washington Post, the bosses of the TV networks and cable stations, the Presidents of Yale and Harvard and other big universities, and the heads of think-tanks like the Brookings Institution and the Heritage Foundation.’

Even bank branch managers across China are subject to Party supervision. While the Party no longer micromanages financial institutions on a day-to-day basis, it continues to control the personnel process, including at banks where the majority of shareholders come from the private sector. And Party control of the financial system extends well beyond the banks. In China’s stock markets, the Party controls the IPO process and the majority of the listed companies. The stock markets, as my colleague Fraser Howie and his co-author Carl Walter note in their recent book, Red Capitalism, ‘do not trade securities that convey an ownership interest in companies. What these securities do represent is unclear, other than that they have a speculative quality that permits gains and losses from trading and IPOs.’

The debt markets ‘are captive both to a controlled interest-rate framework on the one hand, and, on the other, to investors that, in the end, are predominantly banks.’ ‘What makes China’s bond markets “primitive,”’ Howie and Walter write, ‘is their lack of the engine that drives all major international markets. That engine is risk and the market’s ability to measure and price different levels of it. Risk, in market terms, means price; like everything else, capital has a price attached to it. In China, however, the Party has made sure that it alone, and not a market-driven yield curve, provides the definitive measure of risk-free cost of capital and this measure is based ultimately on the funding cost for bank loans, the one-year deposit rate.’

Party control does not, on its own, mean that China’s banks are incompetent or insolvent, but it means that the Party does not have to rely on open-market operations to manage the economy. Interest rates and reserve requirements are somewhat symbolic tools when the Party can pick up the phone and assign a monthly loan quota to every bank. This

Party still controls the largest industrial firms

and the financial sector

Even bank branch managers are subject to

Party supervision

The Party does not have to rely on open-market operations to manage

the economy




4. Banking crisis unlikely, near term China macro strategy


control was evident back in early 2009 when the Party quickly succeeded in directing banks to dramatically raise lending to fund the infrastructure stimulus, and again later that year when it directed banks to begin withdrawing the stimulus.

‘The behaviour of Chinese banks was instructive compared to their counterparts in the developed world,’ McGregor explains. ‘Many western banks were by that stage controlled directly by their respective national governments. In Washington and London, the US and UK administrations were imploring financial institutions to restart lending to revive their respective economies, but they possessed few concrete tools to force them to do so. In China, by contrast, the banks were both state-owned and state-controlled. When the Party directed the banks to lift lending, the senior executives had a political duty to comply.’

Party policymaking is therefore the biggest near-term risk in China’s financial system. A systemic crash is extremely unlikely, as the Party is probably the world’s most liquid financial institution, but the high level of control leads - as it does in any bureaucracy - to high-frequency interference or intervention. And the more likely bureaucrats are to intervene, the higher the risk of mistakes and policy decisions that deliver significant, short-term, unexpected negative consequences. A few years ago, for example, the Party decided that halting lending to developers would be a good way to slow the growth of new-home prices. That worked as well as one might expect in a market where the fundamental demand for new homes remains strong: prices fell a bit; then a year later, as demand exceeded supply, they rose 25%.

Even the relatively pessimistic Howie and Walter argue that ‘None of this means that China is in danger of default or even of a slowing in economic growth. If properly managed, there is no reason why China’s use of debt can’t continue for a long time.’ In Red Capitalism they explain how China differs from Mexico of 1994, Argentina of 1999 and Greece and Spain today:

Aside from trade finance, China does not borrow money overseas and, because of the non-convertibility of the renminbi, offshore investors are overwhelmingly excluded from the domestic capital markets. Nor are foreign banks competitive in the domestic loan and bond markets, given their need to make an adequate return on capital. As a result, foreign banks rarely contribute more than 2% to total financial assets in China; after the lending binge of 2009, they now stand at 1.7%. The only other major entry point into the system, QFII, is a China Securities Regulatory Commission product that is directed at the stock markets rather than bond markets. In any event, the current total quota allocated is, at US$17.1bn, a relatively small amount. Even if fully invested in bonds, this would still pale by comparison with outstanding bond obligations of US$1.87tn. There is simply no way that offshore speculators, investors, hedge funds or others can get at China’s domestic debt obligations and challenge the Party’s valuation of these obligations. In short, the closed nature of China’s financial markets suggests a deliberate strategy based on a particular understanding of past international debt crises. China’s financial system is an empire set apart from the world.

All the banks are state controlled

China is in no danger of default

‘China’s financial system is an empire set apart

from the world’

5. RRR cuts are not easing China macro strategy


5. RRR cuts are not easing In a banking system where lending is controlled by quota, cutting the RRR has a neutral impact on credit and liquidity

In a real banking system, regulators use the required reserve ratio (RRR) to manage growth of lending and money supply. Banks only influence the supply of money in an economy when they lend, and a lower RRR raises the share of deposits which can be lent.

But China does not have a real banking system. All Chinese banks are controlled, via the personnel system (even down to the branch level), by the Communist Party. This enables the Party to set loan quotas for each bank, governing the level of lending above and beyond the RRR limitations. The system works, because any banker who ignored his quota would soon be unemployed.

Primarily a forex-sterilisation tool In China, the RRR is primarily a tool for the central bank to sterilise foreign-exchange inflows. This year, with foreign exchange reserve accumulation set to slow, the Party has no need to keep the RRR at historically high levels and it could come down by a couple of hundred basis points, depending on the pace of forex-reserve accumulation.

Figure 20

RRR and forex reserves

Source: CEIC

These RRR cuts, however, will not on their own result in a material change to credit and liquidity in China. Last year, for example, the RRR was increased by 250bps, yet new lending came close to the upper end of our forecast range, because lending is controlled by a Party-issued quota.

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China does not have a real banking system

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sterilise forex inflows

Lending is controlled by a Party-issued quota

5. RRR cuts are not easing China macro strategy


Figure 21

RRR and growth of loans outstanding

Source: CEIC

In March of this year, when central bank governor Zhou Xiaochuan was asked at a press conference if the most recent RRR cut should be interpreted as government support for the equity and property markets, he said no.

Zhou also explained that the RRR is primarily a forex sterilisation tool, ‘and in most cases, RRR adjustments do not indicate monetary policy is tighter or looser.’ This is consistent with comments from deputy governor Hu Xiaolian last year: ‘We need to point out that raising the RRR is mainly for offsetting the newly increased liquidity from foreign exchange inflows, and does not have a large impact on the normal availability of money to financial institutions. The general effect is neutral.’

So while we continue to expect the RRR to be reduced from its historically high level, this does not signal new easing of monetary policy, nor does it signal that new lending will go beyond the Rmb8-8.5tn we expect for 2012.

Conceptually, cuts in the RRR could lead to a higher money multiplier and lower interest rates, but in reality this will depend on how the Party uses its other administrative tools to manage liquidity and credit. It would be a mistake to interpret the coming RRR cuts as signals of continued monetary-policy easing.

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Mistake to interpret coming RRR cuts as a sign

of continued easing

6. Party plans 8-8.5% GDP growth China macro strategy


6. Party plans 8-8.5% GDP growth Premier Wen didn’t really mean it when he said his target for 2012 is 7.5%

Premier Wen Jiabao, in his March speech to the National People’s Congress, said that his target for GDP growth this year is 7.5%. But he didn’t really mean it.

During each of the previous five years, Wen said he expected 8% annual GDP growth. But full-year growth rates never slowed to anything close to Wen’s target. During that period real annual GDP growth actually averaged 11.2%.

Figure 22

Wen’s GDP targets versus China’s real GDP growth

Source: CEIC

Wen’s GDP target was not a real target then, and it is not real today. What Wen was doing was reducing his target in line with the slower growth targets in China’s current five-year plan, which began in 2011. The current plan calls for 7% GDP growth, down from 7.5% in the prior plan. But this is also not a real target: as noted above, actual annual GDP growth during the prior plan averaged 11.2%.

Figure 23

GDP targets in five-year-plans versus real average GDP growth

Source: CEIC

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averaged 11.2%

6. Party plans 8-8.5% GDP growth China macro strategy


The lower targets reflect that the Party is comfortable with slower growth, but this is not news, as the leadership has voiced this intention often in the recent past, and it seemed comfortable when real GDP growth cooled from 10.4% in 2010 to 9.2% last year.

This year, we forecast 8.5% GDP growth, and we believe the Party will be comfortable with anything in the 8-8.5% range.

The Party is comfortable with slower growth

7. Local-govt debt not a time bomb China macro strategy


7. Local-govt debt not a time bomb In China, local debt is, ultimately, national (or Communist Party) debt

Strong growth in fiscal revenue collection and a freeze in new lending support our view that China’s local-government debt is far from being the ticking time bomb some fear.

Local is national Our fundamental starting point is that in China, local debt is, ultimately, national (or Communist Party) debt, so it needs to be considered in a national fiscal context. The Party has always stood behind the debt of its local governments, and has regularly topped up local budgets.

The big-five banks, where loans to local government financing vehicles accounted for 10% of total loans outstanding as of 1H11, reported non-performing loan (NPL) ratios of 1% or less for those loans. We assume these NPLs reflect restructuring as we are not aware of any of those loans having been written-off.

National revenue growth is strong . . . National fiscal revenue collection rose strongly last year, supporting Beijing’s capacity to fund local spending.

Figure 24

China’s total fiscal revenue growth and as % of GDP

Source: CEIC

Total fiscal revenue rose 25% YoY in 2011 after a 21% increase in 2010, and central-government collected fiscal revenue rose 21% YoY last year after an 18% increase in 2010. The fiscal revenue-to-GDP ratio was 22% in 2011, up from 14% in 2000, and the fiscal deficit was about 2% of GDP.

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Fiscal revenue collection rose strongly last year



Figure 25

Growth of local-government debt and total fiscal revenue

Source: CEIC

. . . as is local revenue growth Fiscal revenue collected directly by local governments also rose strongly last year, up 29% following a 25% increase in 2010.

Figure 26

Local-level fiscal revenue and expenditure

Source: CEIC

As Figure 26 illustrates, even though local spending rose more slowly than revenue collection (spending was up 25% last year and 21% in 2010), local governments spend a lot more than they collect directly. This does not, however, mean they cannot pay their bills. A lot more money comes into local coffers from Beijing.

Central government funds most local spending Most central-government spending in China is a transfer to local governments. Last year, 71% of central-government expenditure was in the form of tax rebates and transfer payments to local governments, and that was equal to 43% of total local-government fiscal revenue.

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rose strongly last year



For example, central-government spending on education rose 28% last year, and 69% of that spending was in the form of transfers to locals. Central-government spending on healthcare rose 18%, with 96% of the funds transferred to locals. And central-government spending on low-income housing rose 53%, with 81% of the money handed over to locals.

Overall, central government spending rose 17% last year, while transfers to local governments rose 23%, up from a 13% rise in 2010. (See Section 8 for further discussion about local government budgets.)

Figure 27

Net increase in national debt and annual fiscal revenue

Figure 28

Net increase in national debt, annual fiscal revenue and growth rates

Source: CEIC

Where does the money come from? Value-added tax on goods and services is the single largest source of tax revenue in China, accounting for about 30% of the total. Corporate taxes contribute another 20%. Individual income tax accounts for only about 7% of

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(Rmbbn) (% YoY)

Central government funds local spending on

education and healthcare

Personal income tax accounts for only 7% of

total tax revenue



total tax revenue, despite real urban income rising 151% and real rural income 111% over the past decade. An increase last year in the threshold for paying personal taxes allowed 60 million Chinese to drop off the taxman’s books, according to the government.

Almost no new net lending to LGFVs last year At his annual press conference in March, Premier Wen indicated that there was roughly no increase in local-government debt last year. That is a huge change from the 19% YoY increase in 2010 and the 62% stimulus-fuelled rise in 2009. From 2002-07, the average annual increase in local government debt was 26%.

Figure 29

Growth rate of local-government debt

Source: National Audit Office

Our banking contacts confirm that while many loans to local-government financing vehicles (LGFVs) were rolled over last year (and will continue to be rolled over in the future), regulators put heavy pressure on banks to not make new loans.

Bomb or burden? Local-government debt represents a significant financial burden for the Party, but it is far being from a ticking time bomb for the following reasons:

Local debt is, ultimately, national (or Party) debt, so it needs to be considered in a national fiscal context.

Prior to 2009, the growth rate of local government debt was roughly in line with growth in national fiscal revenue.

The huge leap in local debt in 2009 was a one-off response to the global financial crisis, and was withdrawn as quickly as it was implemented.

The use of bank loans to local governments to finance public infrastructure, particularly the huge 2009 stimulus, has created a serious fiscal burden for the Party. But because we expect continued strong revenue growth, and because all local debt is backed by the Party and is held by Party-controlled banks (no private institutions, no foreigners), this is not a looming disaster.

24.82

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Regulators put heavy pressure on banks to not

make new loans to LGFVs

A serious fiscal burden for the Party, but not a disaster in waiting

Almost no increase in local-government debt

last year



Local debt of Rmb10.7tn (US$1.7tn) is not pocket change, even for Beijing, but it is far from a fiscal crisis given the strong revenue growth and healthy fiscal position we described earlier.

Figure 30

Government debt as a % of GDP

Source: CEIC

Infrastructure-spending growth is decelerating and local borrowing has slowed, while fiscal revenue is likely to continue growing faster than nominal GDP. This should enable the Party to grow out of the local debt burden.

In sum, the Party has the political will and the fiscal resources to ensure that local governments do not default on their bank loans.

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Far from a fiscal crisis

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8. Land sales are not key China macro strategy


8. Land sales are not key Net revenue from land sales accounts for only 9% of local budgets

The Ministry of Finance reports that local-government revenue from the transfer of land-use rights rose 13% YoY last year, on top of a 105% increase in 2010 and 46% in 2009.

Figure 31

Land-transfer revenue and growth

Source: CEIC

The 13% rise in land revenue may seem surprising given that land sales were roughly flat YoY in area terms. But as Vanke, China’s largest property developer, explained to us recently, reserve prices for land remained high despite weaker sales, so there was ‘limited room for adjustment in actual transaction price.’

Land is a relatively small part of local budgets It is important to note that revenue from land transfers is a fairly small part of local government budgets. Local governments are able to keep little of the money they take in from land “sales”, because, as Figure 32 illustrates, most of the revenue has to be spent on compensating and relocating the original occupants of the land, demolishing existing structures and other expenses.

Last year, local governments were ultimately only able to keep 28% of the revenue they collected from land transfers, and some of those funds must be set aside for low-income housing. (As the central government has raised compensation levels for land expropriation, the share of revenue from land sales that local governments can keep has fallen steadily.)

Figure 32

Where local-government revenue from land sales goes

Source: CEIC

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and resident relocation

71.8%

Developing and improving farmland, rural infrastructure, subsidising farmers

7.1%

Education0.6%

Irrgation and water-conservancy

facilities0.4%

Low-income housing2.0%

Urban development allocated 18.1%

Local governments keep only 28% of land revenue

8. Land sales are not key China macro strategy


Figure 33 illustrates that gross revenue from the sale of land-use rights was equal to 25% of total local-government revenue last year.

Figure 33

Gross land revenue as a % of local-government revenue

Source: CEIC

But on a net basis, after accounting for all of the costs associated with clearing and transferring land described above, land revenue accounted for only 9% of total local-government revenue.

Figure 34

Net land revenue as a % of local-government revenue

Source: CEIC

Similarly, the net revenue from land transfers that local governments were able to keep last year was equal to only 9% of total national spending on public infrastructure.

Local-level fiscal revenue

40%

Transfer and tax refund from central govt

30%

Land-transfer revenue

25%

Transfer from central-govt-

managed fund1%

Other revenue from local-govt-managed fund

4%

Local-level fiscal revenue

48%Transfer and tax

refund from central govt

37%

Net land-transfer revenue

9%

Transfer from central-govt-

managed fund1%

Other revenue from local-govt-managed fund

5%

Net land revenue accounts for only 9% of

local-government revenue

9. Political instability very unlikely China macro strategy


9. Political instability very unlikely The sacking of Bo Xilai will not derail day-to-day management of the economy or longer-term reform prospects

The dismissal in March of a senior Chinese official is unlikely to have concrete impact on the country’s economic or political policies, and was not the result of a struggle within the Communist Party over the direction of reforms.

One factor in his firing was his highly visible self-promotion campaign, which challenged the Party’s post-Mao policy of avoiding another cult of personality. An important result of his sacking is that it is now very unlikely that any other Party official will attempt to use this strategy, particularly Bo’s references to “Maoist” themes, which many Chinese saw as an unwelcome effort to revive the political atmosphere of the Cultural Revolution.

There is no “Chongqing model” We see no evidence to support the view that Bo’s sacking was the result of internal Party disagreement over the “Chongqing model” of economic development versus the “Guangdong model”. In our view, there is no Chongqing model: the basic economic reforms in Chongqing were initiated before Bo was assigned to the city, and they are not significantly different from the reforms underway across the country.

Chongqing has done innovative things with land financing and infrastructure development, but these programmes had their roots in Shanghai’s Pudong district during the 1990s. Mayor Huang Qifan played an important role in Pudong, and he brought his ideas to Chongqing in 2001, when he was made deputy mayor (he became mayor in 2010).

Under Huang, the Chongqing government revamped local banks and money-losing SOEs, with their profits put into social-development projects. But Huang also supported the development of private firms. According to the city, the private sector accounted for 40% of GDP when Huang arrived in 2001, but by 2009 that share had risen to 60% (on par with our estimate for all of China).

The central government supported policy innovation in Chongqing long before Bo was named Party Secretary. In June 2007, six months before Bo arrived in Chongqing, the State Council designated the city as ‘the national experimental zone for integrating rural and urban development’, as follow-up to a speech delivered three months earlier by Party chief Hu Jintao. According to Hu, Chongqing was targeted to be the ‘growth pole’ for western China and become the first city in that region to achieve the so-called “moderately prosperous society” status.

In 2010, Bo launched his campaign of ‘10 projects for improving people’s livelihood,’ with the building of public rental housing for low-income residents at the top of the list. The 10 projects also included raising rural income, reforming the hukou (household registration) system, spending more money on pensions and healthcare, and supporting small businesses. While Bo’s targets were very ambitious - such as building 30m square metres of public rental housing in three years - similar programmes are being pursued in most Chinese cities.

No evidence that Bo’s sacking was the

result of internal Party disagreement

Huang Qifan played an important role

in Pudong . . .

. . . and he brought his ideas to Chongqing

While Bo’s targets were very ambitious, similar programmes are being

pursued across China

9. Political instability very unlikely China macro strategy


In our view, Bo’s sacking was about Bo’s behaviour, not the result of conflict within the Party over the direction of the country’s economic policies.

Day-to-day economic policy management continues This is a transition period for the Communist Party leadership, but given than the two new leaders have been part of the small group running the country for the past five years, this is not a lame-duck government.

If, for example, exports were to collapse, leading to significant layoffs in southern China (which has not yet happened), we’ve no doubt that a new fiscal stimulus would once again be quickly implemented.

But if export growth holds in the mid-single digits and the far more important domestic investment and consumption cylinders continue to fire smoothly, big policy easing will remain an investor’s dream.

Since the close of the National People’s Congress in mid-March, the Party has taken a number of steps which illustrate that day-to-day economic management continues through the political transition: a programme to bring Wenzhou’s underground banking system above ground has begun; the renminbi’s daily trading band was widened; the Qualified Foreign Institutional Investor quota was raised from US$30bn to US$80bn; it was announced that foreign investors will be able to take up to 49% equity stakes in domestic securities joint ventures (going beyond China’s WTO commitment of 33%) and that foreign insurance companies will be permitted to sell mandatory auto liability insurance; and China promised to increase the number of SOEs that pay dividends as well as to increase the amount of dividends actually paid.

10. World’s best privatisation story China macro strategy


10. World’s best privatisation story The Communist Party has been willing to make bold moves

The development of China’s commercial housing market is one of the world’s greatest and least recognised privatisation success stories. In just 20 years, the country went from one of the world’s lowest urban homeownership rates to one of the highest.

In the 1980s, over 80% of urban housing was publicly owned and rented to workers for a nominal fee (often less than 1% of income) by government agencies and state-owned companies. That was much higher than the 28% share of state-owned housing in Eastern Europe. Today, over 80% of China’s urban housing is privately owned.

The turning point came in 1998, when the Party ended the practice of government work units (danwei) providing public housing for their workers, in tandem with the momentous decision to radically shrink the state workforce. Over a six-year period, 46 million state-sector workers were laid off - the equivalent of sacking the entire combined workforces of France and Italy.

Many state workers, including some of those who lost their jobs, were allowed to buy their government-provided flat at a steep discount to the market value (which was, at that point, very low). This was the largest one-time transfer of wealth in the history of the world, as most of China’s urban-housing stock was handed over to its occupants. A recent study of this transfer estimates that the value of this wealth redistribution was about US$30bn in just eight cities, including US$9bn in Shanghai alone. Given that those eight cities accounted for just 8% of China’s total population at the time, the scale of the national transfer was clearly unprecedented.

In addition to transferring the existing housing stock, the Party ordered its surviving agencies and companies to stop providing public housing and instead offer cash subsidies to workers. These subsidies, along with the value of the formerly state-owned housing - which the new private owners could soon sell - created the liquidity to fuel China’s brand-new commercial-housing market. At the same time, the Party also set the stage for banks to offer, for the first time, mortgages to individual homebuyers and financing to property developers.

World’s greatest and least recognised privatisation

success story

A government-provided flat at a steep discount to

the market value

Creating the liquidity to fuel China’s brand-

new commercial- housing market

11. Even the poor are homeowners China macro strategy


11. Even the poor are homeowners Over 80% urban homeownership rate

With the homeownership rate in China now among the highest in the world, it is interesting to see who owns those dwellings. Researchers at Tsinghua University and the National Development and Reform Commission have analysed results of the 2007 National Bureau of Statistics (NBS) large-sample urban-household survey, which covered formal housing in more than 600 cities.

One of their most interesting conclusions is that almost all income groups have benefited from the privatisation of China’s housing market. The overall homeownership rate was 82% in 2007 (compared with 68% in the USA), and while the rich were more likely to own their own home, even the lowest 10th percentile of income groups had a 73% homeownership rate. The middle-income group was at 84%, while the richest 10% of Chinese had an 87% rate, just 5ppts above the average. In contrast, in the USA, the lowest 10th percentile of income groups had a 35% homeownership rate in 1997, the median group 63% and the richest 10% was at 89%.

Figure 35

Owner-occupier homeownership rate by income group in China in 2007 Income group Owner-occupier

homeownership rate (%) Average floor area

(m²) Lowest 10% 72.9 67.8 2nd 10% 77.6 72.2 3rd 20% 80.5 77.5 4th 20% 83.5 83.6 5th 20% 86.0 89.6 6th 10% 86.2 96.3 Highest 10% 87.4 107.3 National average 82.3 84.5 Source: Joyce Yanyun Man (editor), China's Housing Reform and Outcomes

According to an NBS survey conducted last year, 89% of residents in Chinese cities own their own home. The survey found that 40% of these homeowners had bought on the market from commercial developers, 40% owned a former government work-unit flat and 12% owned a private home inherited from family members (most likely units that were nationalised in the 1950s and then recently returned by the government).

We note that with 40% of homeowners living in housing stock built by government work units - typically small and of poorer quality than commercially-built flats - this population will continue to drive new home upgrades. At some point in the next several years, however, the housing market will mature, and the share of families living in commercially built homes will be high enough that the growth rate of new home sales will slow and secondary sales will dominate the market. This shift should be gradual: our own study of sales found that 34% of new homebuyers in March were upgrading from one flat to another, while 58% were first-time buyers and the remainder (only 7%) were investors.

Homeownership rate in China is now among the

highest in the world

Almost all income groups have benefited

Some 89% of residents in Chinese cities own their

own home

China’s housing market will mature

12. There is no property bubble China macro strategy


12. There is no property bubble Homeowner leverage is low and residential prices have risen in line with income

Economists have trouble agreeing on the definition of a bubble, but it is useful to keep in mind a couple of comments from Allan Meltzer:

The first lesson about bubbles is that all explosive movements are not bubbles.

In my words, “bubble” is a name we assign to events that we cannot explain with standard hypotheses.

We’ll add one more idea, which is that often the “bubble” tag is used by people who are unfamiliar with China’s residential property market. In this section, we clear up some of the key misconceptions.

Prices are rising in line with income From an American or European perspective, China’s 10% annual growth in residential property prices may appear to be the hallmark of a bubble. But this assessment would fail to put the data point into the context of similarly rapid income growth - a rise in wealth that may be difficult for residents of developed countries to comprehend.

With average annual nominal income growth of 13% over the past six years, the 10% annual appreciation in house prices is far less worrying. Although the 25% rise in prices in 2009 - the consequence of a 2% decline in the previous year, caused by a government policy blunder - was more than excessive, the rate of price growth cooled to 6% last year and is likely to remain in single digits this year.

Over the past decade, inflation-adjusted urban income rose by 7% or more every year, while real rural income increased by 7% or more during each of the past five years. In contrast, over the past decade real income rose at an average annual pace of 1.1% in the USA and 1.9% in the UK.

Figure 36

Per-capita urban household income and average property-price growth

Source: CEIC

(5)

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(% YoY) Average selling price/m²Urban household disposable income (nominal)

Defining a bubble

Nominal income growth averaged almost 13% pa

over past six years

House prices and income remain in step



From 2006 to 2011, new home prices in China rose at an average annual pace of 9.7%, while urban per capita income rose by an average of 13% per year.

Most buyers are owner-occupiers China’s home market is driven by owner-occupiers, not speculators. Our own study of sales managers at new residential projects across the country found that in March, only 7% of buyers were investors. The share of buyers who were investors has been about 10% for the past year, and has been below 20% since 2Q10. The government measures designed to curb speculative buying have clearly had an impact.

Figure 37

Sales managers’ estimated breakdown of home buyers

Source: CLSA Asia-Pacific Markets

In March, 93% of new homebuyers were owner-occupiers, up from 79% in 1Q10. Of these, 58% were purchasing their first commercially built home, while a further 34% were upgrading from another home they owned.

Homeowner leverage is exceptionally low In our view, an important precondition for a bubble in any asset class is a high level of leverage, because in the absence of high leverage, the consequences of a sharp price decline are limited. In China there is extremely low leverage among homebuyers because many pay all cash, while for those using mortgages, the loan-to-value (LTV) ratio is low.

Our own study reveals that in February, 17% of first-time homebuyers paid all cash, down from 23% a year ago, as mortgage availability has improved and interest rates have declined. Among investors, 20% paid all cash.

Buyers who use mortgages have a lot of skin in the game. The minimum cash downpayment is 30% for owner-occupiers and 60% for investors.

Last year, we asked buyers about the source of their cash for their downpayments. They told us that 79% of the funds came from their own savings, while 18% was borrowed from family and friends and 3% came from company funds.

53 5746 44 41 39

47 43 43 43 42 45 45 50 49 46 48 48 45 46 49 5359 59 58

2528

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In March, 93% of new homebuyers were

owner-occupiers

Extremely low leverage among homebuyers

High downpayments still required

China’s home market is driven by

owner-occupiers



We also note that Chinese banks have not been permitted to offer subprime mortgages, option adjusted-rate mortgages and other loans that allow borrowers to defer interest or principal payments. Home-equity loans are rare, so Chinese cannot use their house as an ATM. And because Chinese banks still follow the traditional model of holding loans until they are repaid, and there is almost no securitisation.

These high levels of cash create a low LTV ratio. A low LTV means the owner’s equity stake in his home is high, providing a buffer that absorbs the initial loss from a fall in house prices. For example, a low LTV meant that when Hong Kong property prices fell by close to 50% during the Asian Financial Crisis, mortgage delinquencies peaked at only 1.4%.

Mortgages low relative to GDP The use of mortgages by homebuyers has been increasing as they have become more readily available, especially in central and western China, but mortgages remain a very small part of China’s financial system. The ratio of mortgage loans to GDP is only 15%, compared with the US peak of 85% in 2007.

Figure 38

Mortgages as a share of GDP

Source: CEIC, US Census Bureau

Affordability is a social problem Based on average income for Beijing, no one in the city can afford to buy a new home. While true, that data point is as helpful as stating that based on average income for London, no one there can afford to buy a house, or that based on average income, Porsche should not be able to sell a single car.

The housing markets in Beijing and London are not targeted at average income groups. This creates social and political problems in both locations, but is not evidence of a housing bubble.

In China, the market for commercially built urban homes, which has been in existence for just over a decade, is focused primarily on the middle class and wealthy, who are a relatively small share of the nation’s population but number in the hundreds of millions of individuals. Some of the data we have cited earlier in this report - notably that 17% of first-time homebuyers pay all cash, and that the minimum cash downpayment for those using a mortgage is 30% - reflect that for the target population, housing is affordable.

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(%) USA China

Chinese banks have not been permitted to offer

subprime mortgages

Owner’s equity stake in a home is high

Focused primarily on the middle-class and wealthy



The fact that the average residents of Chinese cities, like the average residents of most major cities around the world, cannot afford to buy a downtown home does represent a significant social problem, which is why the Party has embarked on a major programme to build low-income housing. But this social problem is not evidence of a bubble, or of a shortage of buyers who can afford what is currently on the market.

Shanghai is not China One common misunderstanding is the view that China is Beijing, Shanghai, Guangzhou and Shenzhen, the well-known tier-one cities. But this is akin to assuming that the property markets in New York City and San Francisco are representative of the entire US market.

Those four tier-one cities last year accounted for only 9% of China’s urban population and 4% of total residential property sales (by floor space). There are more than 150 other Chinese cities with a population of at least one million, and they account for the vast majority of the nation’s property sales. Last year, for example, new residential sales in Zhengzhou were greater, by volume, than in Beijing. Sales in Chengdu were greater than sales in Shanghai. And in all of the tier-two cities, which account for 29% of national sales, average prices were 56% below average prices in tier-one cities in 2011. Prices in tier-three cities, which account for 67% of total sales (and 57% of the urban population), were 72% below tier-one prices.

Average prices in tier-three cities were 72%

below average prices in tier-one cities in 2011

13. No “shadow” banks China macro strategy


13. No “shadow” banks The Communist Party still controls all Chinese financial institutions

One recent panic-button issue is China’s “shadow” banking system. Many commentators, however, misunderstand the structure, scale and leverage of these institutions.

In 2009, at the same time the Communist Party ramped up bank lending to fund its infrastructure stimulus (in that year, half of all new mid- and long-term loans by the major banks went to infrastructure projects), it also allowed nonbank financial institutions to expand. This is clear in Figure 39, based on data from the central bank.

Figure 39

Outstanding balance of aggregate financing


The intent was to provide new channels to finance riskier business ventures and to offer higher but riskier returns to high-net-worth investors, while keeping this activity ring-fenced from the commercial-banking sector. (Sound familiar?)

Party animals But it is very important to understand that the Party still controls all of China’s financial institutions, including all commercial banks and the 70 trust companies. (Yes, there are individuals running informal credit shops, as Chinese have been doing for centuries, but this is a very small share of the total.) The trust companies are not evidence of China’s financial system run amok: they are Party animals.

Figure 39 shows that total credit flows have been clearly managed by the Party. The growth rates of both outstanding aggregate (or “social”) finance and outstanding bank loans (which account for about 60% of the aggregate) rose sharply in 2009 to fund the massive stimulus, and then fell quickly in the following two years. The growth rate of outstanding aggregate finance decelerated from 36% YoY in 2009 to 26% in 2010 and then 19% last year, close to the 2006 pace.

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(% YoY) Outstanding aggregate financing growthOutstanding Rmb loan growthNominal GDP growth

Party has clearly been managing credit flows



Figure 40 illustrates that in 2009, the stimulus year, new aggregate credit rose by almost 100% YoY. In 2010, when the Chinese economy was booming (GDP growth was 10.4%), new aggregate credit was basically flat YoY. How could that have happened unless the Party was controlling all credit flows? Last year, when GDP rose 9.2% and demand for credit was strong enough to drive the informal (curb) market rate in Wenzhou up to 60% APR, new aggregate finance fell by 10% YoY. In 1Q12, new aggregate finance declined 7% YoY.

Figure 40

New aggregate finance in China

Source: CEIC

No shadows in China One reason for the mounting concern about a shadow banking system in China is that anything in the shadows sounds scary. But what is a shadow banking system? In a country with a real financial system and the rule of law, “shadow banking” refers to credit intermediation outside of the regular banking system by institutions that are lightly regulated and generally do not have access to central-bank liquidity or public-sector credit guarantees. But this definition is not very helpful in China, which has a fake banking system (the Party controls all the banks, sets credit quotas and key rates, and controls the capital account). Because the Party controls the main players in the shadow system – including the trust companies - it is hardly in the shadows. Perhaps China’s shadow banking system would seem less scary if we referred to it by the more descriptive phrase ‘Communist Party-controlled nonbank financial intermediaries’.

Trusts in context It may also be useful to put the scale of China’s trusts into context. In 2011, the total assets of the trusts was Rmb4.8tn (US$764bn), equal to only 5.9% of total deposits (or 8.8% of total loans outstanding) in the formal banking system. This is in sharp contrast to the US shadow-banking system, which in March 2008 had a gross size of nearly US$20tn - significantly larger than the liabilities of America’s traditional banks.

About 15% of trust assets are invested in the real-estate sector, 22% in infrastructure, 20% in companies and 9% in the capital markets. One external auditor tells us he believes trusts manage risk better than China’s banks.

0

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(Rmbbn) OtherStock financing by nonfinancial institutionsEnterprise bondsBank acceptance billsTrust loansEntrusted loansForeign-currency loansRmb new loans

Communist Party-controlled nonbank

financial intermediaries



Leverage It is also important to note that China’s trusts are not permitted to leverage their investments, a far cry from the seemingly unlimited leverage available, pre-crisis, to the five big American broker-dealers. Leverage is quite limited across China’s financial institutions and is available only for a few activities.

Underground lending Underground (informal or curb) lending has been a feature of China’s coastal economy for generations, most famously in Wenzhou, the country’s private-sector heartland.

Wenzhou’s curb market predates the founding of the Communist Party, and has grown rapidly in recent years as the Party allowed SMEs to expand. And while similar informal lending goes on in other areas, particularly along the coast, it is a very small part of China’s total credit flow. In 2Q11, our national study of SME manufacturers found that only 6% of their capex was funded by informal borrowing, down from 13% three years ago.

Curb lending is generally small-scale, short-term and secured by physical collateral, and there is usually a personal connection between lender and borrower. It is also worth noting the State Council’s 28 March decision to start a pilot programme in Wenzhou, designed to bring its underground banking system above ground, as well as recent comments from Premier Wen expressing an interest in injecting more competition into the Party-controlled banking system. These moves may be a hint that the incoming Party leadership is prepared to accelerate financial-system reform. The Party seems to understand that the current financial system does not serve the small, privately owned firms that generate most of China’s economic growth and all of its new jobs.

But we do not expect an abrupt change to the status quo. First, because the Party-controlled financial system performed well during the global financial crisis; second, because the Party's practice has been to move very cautiously when reforming the financial system; and third, because absent both the rule of law and a large, well-tested regulatory and supervisory system, the Party should not rush into allowing a massive expansion of privately-controlled financial institutions or give up control over key rates.

Longer-term, if the new leadership moves ahead with financial-sector reforms, China's banking system could look very different. But that will not happen quickly.

China’s trusts are not permitted to leverage

their investments

Underground lending a feature of China’s coastal economy for generations

For now, all of China's banks will remain under

Party control

14. RMB is not grossly undervalued China macro strategy


14. RMB is not grossly undervalued The renminbi has appreciated by more than 30% against the US dollar since 2005 and the current-account surplus/GDP ratio is now below Geithner’s benchmark level

An honest discussion of what a fair or equilibrium exchange rate for the renminbi might be must begin by acknowledging that ten economists would likely come up with at least a dozen different answers to that question. As a 2010 academic paper by Yin-Wong Cheung et al explained:

The current state of exchange rate economics, apparently, offers little guidance - there is little consensus on what constitutes the right exchange rate model in each circumstance, and different models might be relevant over different time horizons . . . Empirical studies on RMB valuation adopt different exchange rate models, implement diverse statistical methodologies, and incorporate data encompassing different time periods. A misalignment finding will depend, to varying degrees, on choices made over these three dimensions. Not surprisingly, various studies yield a wide range of misalignment estimates - anywhere from RMB being undervalued by 15% to 50%, to being overvalued.

A 2006 IMF working paper on this question concluded:

There are serious questions regarding the robustness of estimates of equilibrium real exchange rates across the various methodologies typically used. Relatively small changes in the specifications of equations, definitions of variables, or time periods for estimation can lead to very large differences in equilibrium real exchange rate estimates. . . All of these results indicate that estimates of a country’s equilibrium real exchange rate need to be treated with a great deal of caution.

The IMF’s 2011 China Article IV consultation staff report said that the Fund’s three methodologies for assessing exchange rates found that the renminbi was undervalued by 3%, 17% or 23%, although the Fund is in the process of reviewing those methodologies.

A December 2010 paper by the US Congressional Research Service informed Members of Congress that ‘There are numerous estimates of the RMB’s undervaluation against the dollar, although the results vary widely depending on the methodologies and various assumptions used.’ The paper reported that ‘relatively recent estimates of the RMB’s undervaluation’ ranged from 12% to 50%.

One thing that is clear is that the renminbi has appreciated significantly since Beijing broke its currency peg in the summer of 2005. According to the Bank for International Settlements (BIS), between January 2005 and March 2012, the yuan appreciated 32% on a real basis and 24% on a nominal basis. And the US Treasury, in early May, acknowledged that ‘China’s exchange rate has appreciated and is up about 13% against the US dollar when accounting for differences in inflation since June 2010, and 40% since 2005.’

Renminbi has appreciated significantly since Beijing

broke its currency peg

Current state of exchange-rate economics

offers little guidance

Estimates of equilibrium real exchange rate need

to be treated with caution



Figure 41

BIS effective exchange rates since January 2005

Source: BIS

So, how much appreciation is enough? US policymakers have emphasised one metric for evaluating China’s exchange-rate policy: the current-account balance/GDP ratio. The Peterson Institute for International Economics, a think-tank that dominates the discussion in Washington on this topic, says a current-account balance/GDP ratio of +/-3% would reflect a ‘fundamental equilibrium exchange rate’. Treasury Secretary Geithner has argued that a 4% ratio is a ‘benchmark for the future’.

Based on this metric, both Geithner and the Peterson Institute should be satisfied that the renminbi is close to its equilibrium rate, as China’s current-account surplus/GDP ratio fell last year to 2.8% from the 2007 peak of 10.6%. In 1Q12, the ratio was 1.4%, although this is likely to rise a bit later in the year. In our view, the ratio is likely to remain in the 3-4% range in the near future. (The World Bank forecasts roughly 3% this year and next, while the IMF has just cut its forecast to 4-4.5% by 2017, down from 7%.)

Figure 42

China’s current-account surplus as a share of GDP

Source: CEIC

(20) (10) 0 10 20 30 40 50 60 70 80

Australian dollar

Canadian dollar

Euro

Japanese yen

Mexican peso

Swiss franc

UK pound

US dollar

Brazil real

China renminbi

(%)

Real

Nominal

0

2

4

6

8

10

12

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1Q12

(%)

The renminbi is close to its equilibrium rate, based

on one metric



Unfortunately, because it is an election year in America, neither Geithner nor Peterson’s economists seem prepared to acknowledge that Beijing has brought its current-account surplus/GDP ratio down to the level targeted by the USA.

Some US economists say they expect the ratio to rise rapidly again, despite its steady downward trajectory over the past four years. But even if the ratio might rise again in the future, not to acknowledge that, at least for the moment, the renminbi may no longer be significantly undervalued serves only to confirm that US officials are treating this as a domestic political issue.

Politics or economics?

15. RMB not a key issue for USA China macro strategy


15. RMB not a key issue for USA Chinese goods make up less than 3% of US consumer spending, and half of that goes for services produced in the US; and US exports to China rose over 500% during the past decade

The impact of Chinese imports on the US economy is not nearly as big as most people think. A research note published last summer by the San Francisco Fed concluded that ‘Goods and services from China accounted for only 2.7% of US personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to US businesses and workers transporting, selling, and marketing goods carrying the “Made in China” label.’

Figure 43

Geography of US personal consumption expenditure (PCE)

Source: FRBSF

This is such a widely-misunderstood topic that it is worth reading some excerpts from the SF Fed report:

Although globalization is widely recognized these days, the US economy actually remains relatively closed. The vast majority of goods and services sold in the United States is produced here. In 2010, imports were about 16% of US GDP. Imports from China amounted to 2.5% of GDP.

A total of 88.5% of US consumer spending is on items made in the United States. This is largely because services, which make up about two-thirds of spending, are mainly produced locally. The market share of foreign goods is highest in durables, which include cars and electronics. Two-thirds of US durables consumption goes for goods labeled “Made in the USA,” while the other third goes for goods made abroad.

Chinese goods account for 2.7% of US PCE, about one-quarter of the 11.5% foreign share. Chinese imported goods consist mainly of furniture and household equipment; other durables; and clothing and shoes. In the clothing and shoes category, 35.6% of US consumer purchases in 2010 was of items with the “Made in China” label.

Made in USA from US parts81.9%

Made in USA from parts imported

from other countries

5.9%

Made in US from parts imported

from China0.7%

Final goods imported from other countries

6.1%

Final goods imported from

China1.2%

US content of "Made in" other

countries2.7%

US content of "Made in China"

1.5%

The US economy actually remains relatively closed

Chinese goods account for 2.7% of US personal

consumption expenditure



Whereas goods labeled “Made in China” make up 2.7% of US consumer spending, only 1.2% actually reflects the cost of the imported goods. Thus, on average, of every dollar spent on an item labeled “Made in China,” 55 cents go for services produced in the United States. In other words, the US content of “Made in China” is about 55%.

The fraction of import content attributable to Chinese imports has doubled over the past decade. In 2000, Chinese goods accounted for 0.9% of the content of PCE. In 2010, Chinese goods accounted for 1.9%. The fact that the overall import content of US consumer goods has remained relatively constant while the Chinese share has doubled indicates that Chinese gains have come, in large part, at the expense of other exporting nations.

China’s 2011 inflation rate is close to 5%. If Chinese exporters were to pass through all their domestic inflation to the prices of goods they sell in the United States, the PCE price index (PCEPI) would only increase by 1.9% of this 5%, reflecting the Chinese share of US consumer goods and services. That would equal a 0.1 percentage point increase in the PCEPI.

However, it does not seem that so far Chinese exporters are fully passing through their domestic inflation. In May 2011, prices of Chinese imports only increased 2.8% from May 2010. This is partly because a large share of Chinese production costs consists of imports from other countries.

China is the fastest-growing market for US exports Another common misconception is that China is closed to US exports, and that an undervalued currency has kept Chinese from buying American goods. In fact China is the third-largest buyer of US exports after Canada and Mexico.

Figure 44

Growth of US exports to its top-10 markets, 2000-11

Source: US Census Bureau

And China is, by a huge margin, the fastest-growing market for US goods. Between 2000 and 2011, US exports to China rose 542%. In contrast, its exports to the rest of the world rose only 81% during that period. The second-fastest growth rate among America’s top-10 export markets was to the Netherlands, at 96%. Forty-eight of America’s 50 states registered at least triple-digit export growth to China since 2000, with 20 states experiencing quadruple-digit growth, according to the US-China Business Council.

541.8

66.8

96.1

57.0

36.7

56.3

77.4

34.6

6.1

1.9

0 100 200 300 400 500 600

China

Germany

Netherlands

Canada

France

S Korea

Mexico

UK

Taiwan

Japan (%)

China is the third-largest buyer of US exports

US exports to China up 541.8% over last 11

years



Is China stealing American jobs? One of the most compelling but also misguided reasons for pressing China to revalue its currency is the incorrect assumption that an undervalued renminbi is a significant cause of American unemployment.

The manufacturing share of total US employment began to decline decades before China became an exporter. In 1949, when the People’s Republic of China was founded, 23% of American workers held manufacturing jobs. By 1979, when diplomatic relations between the two countries were restored and before the US imported anything from China, that share had fallen to 20%. A decade later, US imports from China were insignificant but the share of manufacturing jobs had fallen to 16%. That trend has continued, and today the share is 9%.

‘Surprisingly, however, little evidence links higher import penetration directly to the loss of jobs,’ according to the nonpartisan Congressional Budget Office (CBO). ‘There is little difference between the job losses among industries that experienced particularly large increases in import penetration in that period and those where increases were smaller . . . Any simple correlation of declines in employment with increased imports from China could be misleading, however. Such calculations do not account for the extent to which imports from China displaced imports from other countries.’

Much of the decline in US manufacturing employment is due to rising productivity. ‘The long-term growth of productivity, driven by investment and new technology, has allowed manufacturers over at least the past 50 years to match the pace of overall economic growth without corresponding growth in employment,’ according to the CBO.

Studies have been published supporting the theory that Chinese imports have caused the loss of US manufacturing jobs, but they suffer from serious methodological flaws, and often were produced by organisations with a legislative agenda to reduce US imports. One of the key mistakes is to assume that imports are identical to goods produced in the USA, and thus American consumers would buy the substitute US-made product at the same price as the import. This is clearly not the case. Take televisions, for example: when Japanese-made TVs became too expensive, Americans bought TVs made in China. This faulty assumption results in overstating the number of jobs “lost” to imports.

A second error is ignoring the employment associated with imports. Some imports from China are industrial inputs and machinery, which American workers use to create finished goods. American products made with less-expensive Chinese inputs and machinery are thus more competitive in overseas markets. When the US imports goods from China, American workers finance, sell, advertise and transport them.

Finally, a focus solely on manufacturing ignores the many American jobs resulting from exports of services and agriculture to China. The US runs a trade surplus with China in both of these categories: from 2000 to 2010, its exports of services to China increased by 290%. From 2002 to 2010, China’s agricultural imports from the US rose by an average annual pace of about 31%, and by 2010 China was the second-largest market for American agricultural products. The US Department of Agriculture forecasts that China will this year pass Canada to become the No.1 market.

A key mistake is to assume that imports are

identical to goods produced in the USA

Much of this decline is due to rising productivity

Manufacturing share of US employment has been

in decline for decades



This is why, when the CBO evaluated legislation that would raise tariffs on Chinese imports if Beijing did not revalue the renminbi, it advised Congress in 2003 that ‘At best, such legislation would increase employment in manufacturing by a small amount and for a limited period. It would not have a significant permanent effect.’

The Congressional Research Service reached a similar conclusion in December 2011, informing Congress that an undervalued yuan ‘is expected to have no medium or long-run effect on aggregate US employment or unemployment. As evidence, one can consider that since the 1980s, the US trade deficit has tended to rise when unemployment was falling (and the economy was growing) and fall when unemployment was rising (and the economy was slowing).’

No medium- or long-run effect on aggregate

US employment

16. Manufacturing still competitive China macro strategy


16. Manufacturing still competitive Strong wage growth has been matched by rapid productivity gains

Manufacturing wages have risen rapidly in China for many years, and at a faster pace than in most other developing economies. During the period from 2000 to 2005, for example, average real monthly manufacturing wages rose 12.6% per year in China, compared to increases of 3-4% annually in India and Malaysia, and an average decline of 1% in Thailand, according to data from the International Labor Organization (ILO). During the next four years, Chinese wages continued to rise by about 12% per year in real terms, leaving neighbouring workers in the dust. In Indonesia, although wages rose by an average of 10% per year during the 2000-05 period, they declined in each of the following four years.

Figure 45

Average annual real growth in manufacturing wages

Source: ILO

Indeed, Chinese manufacturing wages have been increasing at an amazing rate for a very long time: 14% annually since 1987.

Figure 46

Manufacturing wage increases in China (nominal)

Source: ILO

(10)

(5)

0

5

10

15

China India Indonesia Malaysia Thailand

(%) 2000-05 2006 2007 2008 2009

0

5

10

15

20

25

30

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Average annual wage hike: 14.3%

(%)

Manufacturing wages have risen rapidly in

China for many years

Chinese manufacturing wages up 14% annually

since 1987



Much of the increase has been driven by government policy: over the past decade, the minimum wage rose 152% in Shenzhen, and 171% in Shanghai.

This phenomenal growth in wages (compare it to 8.8% real growth in manufacturing wages in the US over the past decade) would at first glance appear to signal an equally rapid decline in China’s manufacturing competitiveness. But that has not yet happened.

China’s industrial value-added rose by 13.4% annually in real terms between 1997 and 2010, while real manufacturing wages rose by an average of 11.2%.

Figure 47

Industrial-value-added and manufacturing-wage growth (real)

Source: CEIC

China’s share of global manufacturing output rose from 5% in 1995 to 8% in 2000, then 13% in 2005 and 19% in 2010.

Figure 48

Manufacturing output by country

Source: UN National Accounts Database

China’s share of global manufacturing value-added rose from 10% in 2005 to 14% in 2009.

0

5

10

15

20

25

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

(% YoY) Industrial value-added

Manufacturing wages

22.4 26.0 25.518.5 19.4 18.2

21.1 17.712.7

10.2 10.1 10.7

5.2 8.312.3

15.1 18.1 18.9

51.3 48.0 49.556.2 52.4 52.2

0

10

20

30

40

50

60

70

80

90

100

1995 2000 2005 2008 2009 2010

(%) USA Japan China Rest of the world

Over the past decade, the minimum wage rose

152% in Shenzhen

China’s share of global manufacturing output

rose from 5% in 1995 to 19% in 2010



Figure 49

Contribution to global manufacturing value-added

Source: United Nations Industrial Development Organization (UNIDO)

China’s share of global manufacturing exports rose from 9% in 2005 to 12% in 2009.

Figure 50

Share of global manufacturing exports by country

Source: UNIDO

How did Chinese manufacturing remain competitive, despite the rapid wage growth? The answer is that productivity also rose at a very fast pace.

The Conference Board has done some of the most detailed research on productivity in China, and in a report to members last year, it explained that:

. . . rapid productivity growth, rather than trade balance or exchange rate factors, has been the primary driver of China’s fast growth.

Although labor productivity growth in China slowed down from 12.5% in 2007 to 8.1% in 2009 (and to an estimated 8.7% in 2010) due to the global recession, the country still has the highest labor productivity growth rate of the major economies in the world.

9.82 14.456.40

6.17

16.7514.45

25.56 23.70

41.47 41.23

0

20

40

60

80

100

2005 2009

(%) China Germany Japan USA Rest of the world

8.76 12.18

10.810.27

6.77 5.579.52 8.62

64.15 63.36

0

10

20

30

40

50

60

70

80

90

100

2005 2009

(%) China Germany Japan USA Rest of the world

Productivity rose at a very fast pace



In 2010, Louis Kuijs, then the World Bank’s China economist, reached similar conclusions:

. . . sizeable wage increases in manufacturing over the last 10-15 years seem to have been offset by rapid productivity growth, also in recent years. As a result, unit labor costs fell between the mid 1990s and the mid 2000s and remained broadly unchanged since.

Value added in industry grew at around 9-10% in 1997-2001. It then accelerated, boosted by WTO accession and a strong world economy. Moreover, labor productivity was boosted by labor shedding in SOEs: between 1997 and 2004 (when major job shedding had come to an end), some 43 million SOE jobs, or 40%, were shed. According to our estimates, labor productivity growth in industry eased from 15-20% in 1997-2003 to still very robust 10-12% in post SOE job shedding 2005-2009.

The suggested broad absence of cost pressures from wage costs in the last 5 years after a decline earlier on is broadly consistent with data on profit margins in industry. This data, from the industrial survey, suggests that profit margins in industry trended up until 2004 and have remained at that relatively high level since then.

Like most phenomena in China, the growth rate of wages and productivity is unsustainably fast. After rising rapidly for so many years, wages in renminbi terms will soon be high enough to preclude further double-digit annual increases. Productivity gains will also slow. But that day has not yet arrived.

The Conference Board reminds us that:

Although China’s WTO entry accelerated a workforce shift out of agriculture, the share of agriculture in China’s total labor force still remains unusually high. This suggests that labor-intensive industries still have considerable room for expansion and productivity gain, provided that enough jobs can be created.

Agriculture (primary industry) still accounted for 37% of China’s total employment in 2010, while contributing only 10% of GDP. (In 1980, by comparison, the primary sector accounted for 10% of Japan’s total employment and 1% of its GDP.)

Figure 51

Employment by sector

Source: National Bureau of Statistics

68.760.1

50.036.7

18.2

21.4

22.5

28.7

13.1 18.527.5

34.6

0

10

20

30

40

50

60

70

80

90

100

1980 1990 2000 2010

(%) Primary industry Secondary industry Tertiary industry

Unit labour costs fell between the mid-1990s

and the mid-2000s

The growth rate of wages and productivity is unsustainably fast

Agriculture still accounted for 37% of China’s total employment



The IMF, in its 2011 China Article IV consultation staff report, also found that:

China continues to have a structural labor surplus with significant unemployment and underemployment. At an aggregate level, it still appears that wage pressures are mostly being absorbed by productivity gains; manufacturing unit labor costs are rising only slowly and corporate profit margins are not being compressed by rising costs.

And the Conference Board concluded:

Despite China’s leadership in labor productivity growth, its level of labor productivity (output per hour worked) is still much lower than those in the advanced economies. . . In 2010, the labor productivity level in China is estimated to have been only 16% of the US level.

The large gap in the labor productivity between China and the advanced economies leaves substantial room for “catching up” to advanced economies, labor surplus absorption notwithstanding.

Finally, keep in mind that (as we noted in Section 1) exports accounted for only 12% of China’s total industrial sales revenue last year. Most of what China produces is sold in China.

China continues to have a structural labour surplus

China’s labour productivity in 2010

estimated to have been only 16% of the US level

The real worry: The rule of law China macro strategy


The real worry: The rule of law The most important longer-term risk to China’s continued economic growth

Hopefully the preceding sections have cleared up most of your misconceptions about China and eased your concerns about the current health of the Chinese economy. Having suggested what not to worry about, in this final section we discuss the most important longer-term risk to China’s continued economic growth and social stability: its legal system. This is also, not coincidentally, the biggest long-term risk to any investment in China.

China’s economy and society are increasingly based on property rights - 80% of urban families own their home; private companies generate most of GDP growth and almost all new jobs; entrepreneurs and artists are creating new intellectual property daily; and farmers have land-use rights. Yet the country lacks the rule of law, which is needed to protect those property rights and ensure a fair, rules-based commercial and competitive environment.

This is already the source of many of problems. Corruption, weakness in commercial sectors dependent on intellectual property rights, and the widespread theft of farmers’ land - the main cause of protests across the country - are all consequences of the lack of the rule of law.

In the near term, China can continue to thrive, as people continue to find ways to navigate corruption and the opaque system. But, as the pace of economic growth slows over the coming decades, can China’s unique form of authoritarian capitalism continue to support the rising standard of living Chinese citizens have come to expect?

Defining the rule of law The key principle of the “rule of law” is that no one is above the law. In more concrete terms, the rule of law limits a government’s ability to exercise power only to comply with laws that have been disclosed publicly, and in accordance with due process.

The rule of law is not a power to be wielded by officials; it is a structure designed to limit the power of officials.

The rule of law creates a transparent, fair, rules-based process for people to settle disputes, and it protects them from abuse of power by their government.

Embraced by the Party, in theory The Communist Party has, in theory, embraced the concept of the rule of law. Several years ago, Premier Wen Jiabao said, ‘The most important aspect of building a harmonious society is strengthening democracy and the legal system to promote social fairness and justice.’

And a State Council White Paper acknowledged, ‘laws that have already been enacted are sometimes not fully observed or enforced, and violations of the law sometimes go unpunished; bureaucracy and corruption still exist and spread in some departments and localities; the mechanism of restraint and supervision over the use of power needs further improvement.’

The key principle of the “rule of law” is that no

one is above the law

The Communist Party has, in theory, embraced the

concept of the rule of law

China lacks the rule of law needed to protect

property rights



The Chinese constitution already calls for a system of rules and procedures to make the government more accountable to the people, based on their constitutional rights. Article 5 of the constitution states:

All state organs, the armed forces, all political parties and public organisations and all enterprises and undertakings must abide by the Constitution and the law.

All acts in violation of the Constitution and the law must be investigated. No organisation or individual may enjoy the privilege of being above the Constitution and the law.

One key aspect of the rule of law is an independent judiciary. This does not exist today in China, but Article 126 of the constitution calls for the People’s courts to exercise judicial power independently and without interference by the executive, social organisations or individuals. And the State Council has reaffirmed that judicial agencies should not be ‘subject to interference by any administrative organ, public organisation or individual.’

That is consistent with the earlier decision to separate the work of the Party from that of the government. In 1978, the Third Plenary Session of the 11th Party Congress decided that the Party would no longer control and administer personnel affairs inside the government, and would no longer intervene in the government’s enforcement of the law. But clearly that decision has yet to be implemented.

The degree of Party interference in the criminal justice system, and the almost complete absence of due process, is illustrated in Criminal Justice in China - a new, detailed study led by Mike McConville, a law professor at the Chinese University of Hong Kong:

In China’s criminal justice system, the verdict of those cases which are prosecuted in court is never in real doubt. There may be an occasional finding of not guilty, but we did not encounter any such case and reports of such events are rare. Courts operate on a presupposition of guilt based upon the prosecution case file. What happens in the court hearing is largely incidental to verdict and the “trial” is a trial in form only or, occasionally, functions to serve a wider social or political purpose. When set against a dossier prepared by the police and prosecutor and assisted in the presentation and management of the case by the judge, defence lawyers, whenever present and of whatever level of skill or commitment, are no match.

The problem has been discussed openly Party officials and Chinese academics have long discussed the problems created by the absence of the rule of law. Yu Keping, a prominent Party intellectual and professor of political science, has written that ‘it is only by the rule of law, instead of the rule of men, that personal autocracy could be prevented and citizens’ rights would be protected. There had been a tradition of the rule of men for thousands of years in China so that it is very difficult to carry out the rule of law.’ According to Yu, ‘One of the major reasons why the great tragedy of the “Cultural Revolution” occurred is that there existed no rule of law, but the rule of men.’

Another scholar in Beijing, Pan Wei, has written, ‘Democracy produces the government, but is unable to force government to be law abiding every day. Rule of law does not aim at governing the people; it aims at governing the

An independent judiciary

In China, verdicts in cases prosecuted in court are

never in real doubt

No rule of law, but the rule of men



government.’ According to Pan, the ‘rule of law directly answers the most urgent need of the Chinese society - curbing corruption in a market economy. . . . China today needs a government in which officials should neither be Party secretaries’ pets nor the instruments of civic organisations. It needs a system to institutionally check and balance government power, replacing the authority of leaders with the authority of the law.’

The 2006 National Integrity System report written by Professor Guo Yong of Tsinghua University stated that localisation of judicial power ‘has seriously destroyed the equity and justice of the judiciary’, and that ‘Bribery is concentrated in personnel appointments, public procurement and contracts, banking and administrative monopoly industries. Corruption in personnel appointment is more and more severe, and it seriously damages the image of the government.’

And several years ago, Party chief Hu Jintao said his vision of a ‘harmonious society’ for China ‘will feature democracy, the rule of law, equity, justice, sincerity, amity and vitality.’

Will it happen? There are, at this moment, no signs that the Party is preparing to establish the rule of law. ‘The fundamental view of the state and its officials toward the legal system remains much the same as it was: the legal system is a tool of governance and control and is essentially the property of the government, not the citizenry,’ according to scholars Donald Clarke, Peter Murrell and Susan Whiting.

On the other hand, back in the mid-1980s it was not clear that the Party was prepared to relax significantly its control over people’s daily lives. But, a decade later, the Party ended its practices of determining where its citizens would live, of assigning them to “work units”, and limiting the establishment of private companies. In the mid-1990s, it was not clear that the Party would dramatically shrink the state sector and pave the way for private firms to drive the economy. Private home ownership was not on the horizon.

During the past two decades, the Party has surprised in many ways. It has taken a path that is unique among authoritarian regimes: relaxing day-to-day control over people’s lives and commercial activities while strengthening its control over the political system. This is a key reason why the Chinese Communist Party has outlived most authoritarian regimes.

Establishing the rule of law would require the Party to cede to its citizens some of its control over the political system, which is why it is far from clear the Party will be willing to take this step.

Does China need the rule of law? ‘Countries with greater constraints on politicians and elites and more protection against expropriation by those powerful groups have substantially higher income per capita, greater investment rates, more credit to the private sector relative to GDP, and more developed stock markets,’ according to a study by Daron Acemoglu and Simon Johnson.

But this conventional wisdom among political scientists and legal scholars is challenged by the extraordinary success of China’s authoritarian capitalist system. Without the rule of law, Chinese have experienced rapidly rising income growth, booming investment, falling poverty, higher grain yields and lower infant mortality.

Corruption in personnel appointments is

getting worse

Currently no signs of change . . .

. . . but the Party has surprised in the past

China challenges the conventional wisdom



‘In sum, the experience of the reform era in China seems to refute the proposition that a necessary condition for growth is that the legal system provide secure property and contract rights,’ according to Clarke, Murrell and Whiting. ‘Passably secure property rights . . . were a product of the political-economic equilibrium, in which important ingredients were the central government’s transparent desire for a growing economy rather than class struggle . . .’

It is, however, far from certain that the status quo can survive the challenges of a society that now enjoys greater personal freedom and is increasingly aware of how the rule of law protects property rights in other countries. And the current system will surely be stressed by the slower pace of economic growth that is now underway and will continue, and that stress level will rise further when China experiences its first recession to occur when most of its people are working in the private sector and are homeowners. That recession is not on the horizon, but it is inevitable.

As Acemoglu and Johnson point out, ‘When property rights institutions fail to constrain those who control the state, it is not possible to circumvent the ensuing problems by writing alternative contracts to prevent future expropriation, because the state, with its monopoly of legitimate violence, is the ultimate arbiter of contracts.’

This problem is already increasingly visible in rural China, where local officials often violate farmers’ property rights, leading to protests and sometimes to violence. Changing China’s legal system and institutions to prevent this problem from becoming more widespread, and to support continued economic growth, is the Party’s chief challenge in the coming decades.

Far from certain the status quo can survive

Changing China’s legal system and institutions

is the Party’s chief challenge

References China macro strategy


References Acemoglu, Daron and Johnson, Simon. ‘Unbundling Institutions’, Journal of Political Economy, Vol. 113, No.5, 2005

Cheung, Yin-Wong, Chinn, Menzie D and Fujii, Eiji. ‘Measuring Renminbi Misalignment: Where Do We Stand?’, HKIMR Working Paper No.24/2010

Clarke, Donald, Murrell, Peter and Whiting, Susan. ‘The Role of Law in China’s Economic Development’, GWU Law School Public Law Research Paper No. 187, January 2006

Clarke, Donald. ‘Economic Development and the Rights Hypothesis: The China Problem’, The American Journal of Comparative Law, Vol. 51, 2003

Dam, Kenneth W. The Law-growth Nexus: The Rule of Law and Economic Development, 2006

Dunaway, Steven, Leigh, Lamin and Li, Xiangming. ‘How Robust are Estimates of Equilibrium Real Exchange Rates: The Case of China,’ IMF Working Paper 06/220, October 2006

Friedman, Edward. ‘China: A Threat to or Threatened by Democracy?’, Dissent, Vol. 56, No.1, Winter 2009

Hale, Galina and Hobijn, Bart. ‘The US Content of “Made in China”’, Economic Letter, Federal Reserve Bank of San Francisco, 8 August 2011

Huang, Yiping and Wang, Xun. ‘Does Financial Repression Inhibit or Facilitate Economic Growth? A Case Study of Chinese Reform Experience’, Oxford Bulletin of Economics and Statistics, 73.6: page 833-855, 2011

Kramer, Kenneth L, Linden, Greg and Dedrick, Jason. ‘Capturing Value in Global Networks: Apple’s iPad and iPhone’, July 2011

McConville, Mike et al. Criminal Justice in China: An Empirical Inquiry, 2011

McGregor, Richard. The Party: The Secret World of China’s Communist Rulers, 2010

Meltzer, Allan H. ‘Rational and Irrational Bubbles’, keynote address for the Federal Reserve Bank of Chicago-World Bank Conference on Asset Price Bubbles, 2002

Morrison, Wayne M and Labonte, Marc. ‘China's Currency Policy: An Analysis of the Economic Issues’, Congressional Research Service, 19 December 2011

US Treasury, Office of International Affairs, ‘Report to Congress on International Economic and Exchange Rate Policies’, 27 December 2011

Walter, Carl E and Howie, Fraser JT. Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise, 2011

China macro strategy


Notes

Important notices

01/01/2012

© 2012 CLSA Asia-Pacific Markets ("CLSA") and/or Credit Agricole Securities (USA) Inc (“CAS”)

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MSCI-sourced information is the exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an "as is" basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexes are services marks of MSCI and its affiliates. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of Morgan Stanley Capital International Inc. and Standard & Poor's. GICS is a service mark of MSCI and S&P and has been licensed for use by CLSA Asia-Pacific Markets.

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CLSA Sales Trading Team Australia (61) 2 8571 4201 China (Shanghai) (86) 21 2020 5810 Hong Kong (852) 2600 7003 India (91) 22 6622 5000 Indonesia (62) 21 573 9460 Japan (81) 3 4580 5169 Korea (82) 2 397 8512

Malaysia (60) 3 2056 7852 Philippines (63) 2 860 4030 Singapore (65) 6416 7878 Taiwan (886) 2 2326 8124 Thailand (66) 2 257 4611 UK (44) 207 614 7260 US (1) 212 408 5800

© 2012 CLSA Asia-Pacific Markets ("CLSA"). Key to CLSA/Credit Agricole Securities investment rankings: BUY: Total return expected to exceed market return AND provide 20% or greater absolute return; O-PF: Total return expected to be greater than market return but less than 20% absolute return; U-PF: Total return expected to be less than market return but expected to provide a positive absolute return; SELL: Total return expected to be less than market return AND to provide a negative absolute return. For relative performance, we benchmark the 12-month total return (including dividends) for the stock against the 12-month forecast return (including dividends) for the local market where the stock is traded. 27/04/2012

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