China: Mounting Macro Paradox

China: Mounting Macro Paradox

By Henry H. McVey, Head of Global Macro & Asset Allocation, CIO of KKR Balance Sheet, Kohlberg, Kravis, Roberts & Co. LP

May 10, 2016

A recent visit to China gives us more assurance that there is a base rate of economic growth that the government — using a variety of monetary and fiscal tools — will work hard to achieve in 2016. As such, we have boosted our 2016 GDP forecast for China to 6.5% from 6.3%. However, our bigger picture conclusion remains that the Chinese economy is structurally slowing, driven by disinflation, declining incremental returns, demographic headwinds, and the law of large numbers. If we are right, then China needs not only to bring nominal lending growth more in line with nominal GDP, but it also needs to start to shift its existing debt load away from the corporate sector and towards the consumer sector. How these transitions unfold have major implications not only for China, but also for a world economy that now relies on one country, China, for almost one-third of total global GDP growth.

When my colleague Frances Lim and I arrived in Beijing in late April, it just felt different than recent visits to China. Sentiment was generally upbeat, corporate executives talked constructively about their business outlooks, and even the smog overhang had subsided.

Without question, this positive backdrop stood in stark contrast to the downbeat and somewhat overwhelming experience I had with some of my KKR colleagues in the country’s capital at year-end 2015. During that visit both investors and CEOs talked begrudgingly about their business prospects, and one needed a heavy duty environmental mask to even walk out of the hotel to fight the dense smog and winds afflicting China’s capital city before the holidays.

Overall, our most recent time in both Beijing and Hong Kong was well spent, and we walked away with what we believe are important short-term and long-term investment conclusions. They are as follows:

  1. As it relates to the short term, we are lifting our 2016 GDP forecast for China to 6.5% from 6.3%. This change represents our first uptick in forecasted Chinese GDP growth since we arrived at KKR in 2011. The primary catalyst for the increase is the government’s renewed commitment to achieving its 6.5% growth target for 2016 via robust liquidity injections into the economy. As one might sense, the recent decision to substantially boost more credit creation appears to run counter to the government’s original reform agenda of targeting a less levered, more market-based economy. Meanwhile, our inflation forecast for 2016 in China moves to 2.0% from 1.7%. The primary driver of the change is the aforementioned slightly higher growth, which results in slightly higher core inflation.
  2. Longer-term, however, we do not think that the recent stimulus can help the Chinese economy to re-establish a higher sustained growth rate. In fact, growth in residential property and infrastructure – both areas that are already suffering from excess capacity in many parts of the country – were the two primary stimulants of growth during 1Q16 (Exhibit 1). Including liquidity added to these two areas, a total of RMB 7.5 trillion (U.S.$1.2 trillion) of stimulus was injected into the economy during the first quarter, which fully equates to 47% of total GDP on an annualized basis, according to work done by Goldman Sachs in April of this year. Not surprisingly, we view these types of stimulus initiatives as unsustainable for an economy that already has a total debt to GDP ratio of 245%.
  3. Corporate credit growth remains outsized relative to GDP, which has implications for – among others – the country’s banks, insurers, and brokers. Investors hoping for a “big bang” write-off in the banking sector, however, are likely to be disappointed in the near-term. From what we can tell, it’s not coming. Rather, during our visit there was a lot of discussion amongst bank executives, investors, and CEOs around more measured approaches. For example, there was quite a “buzz” about the proposed introduction of debt to equity swaps for corporations with large loans outstanding, which should theoretically provide some form of equity capital relief for banks. Another big initiative to improve the situation in the banking sector is a program that allows debt from local government funding vehicles (LGFVs) held by banks to be refinanced through the municipal bond market at lower rates and capital charges as well as for longer durations. Unfortunately, we view both the debt for equity swap strategy and the replacement of LGFV debt with municipal debt somewhat more cautiously than the consensus because neither actually represents a true injection of external equity. Moreover, we still wrestle with the fact that credit is growing more than 13% year-over-year, which is nearly twice the pace of nominal GDP (Exhibit 24). If current trends persist, my colleague Frances Lim forecasts that debt to GDP will reach 300% or greater by 2020.
  4. There is no “One China” anymore, as the country’s economy is undergoing a massive transition. Importantly, though, we are not talking purely about the transition from manufacturing towards services. In our view, this economic “hand-off” has been somewhat overhyped. The reality is that fixed investment as a percentage of GDP is now higher than any period in recent memory – largely the compliment of outsized government stimulus in recent years. Rather, we are talking about the significant transition that China’s millennials, many of whom are quite Internet savvy, are driving across the economy, particularly in the country’s retail, travel and leisure, consumer finance, sports, and healthcare/wellness sectors.
  5. To offset the slowdown in global trade and flows, China is also repositioning its export economy to take market share in higher value-added services. Some of this transition is linked to internally building a “fast follower” strategy in certain sectors, but the lion’s share of executives with whom we spoke indicated that the number one priority was to acquire overseas firms with customer knowledge, global supply chains, distribution networks, and superior intellectual property. If we are right, then we should expect more outbound global M&A by China in the near-term as well as more global pricing cuts in the long-term.
  6. China Inc.: Coming to a theater near you. Without question, this trip’s dominant view centered on the desire by many Chinese business leaders to acquire companies, properties, and experiences outside of China. Getting assets outside of China is clearly a major focus after the August devaluation. There is also some sound industrial logic too. For example, there is clearly a growing desire to shift excess capacity from the country’s domestic economy to new markets, the U.S. in particular. In addition, some CEOs with whom we spoke wanted to acquire high-end expertise across technology and healthcare. Finally, some Chinese businesses want to learn more about consumer behavior in developed markets, so that they can bring that expertise back home or be more prepared when the local Chinese market becomes more mature.

Over time, we see really only one path forward for China’s long-term prospects: It must shift some of its credit creation away from the local government and corporations towards consumers and the central government. This process has started, but – as with any process – there are lots of vested interests and roadblocks along the way. However, if this strategy is not pursued more vigorously, then we believe it will be nearly impossible for China to achieve 6.0-6.5% growth over the next five years due to ongoing misallocation of resources. Simply stated, investing more in loss-making businesses creates a notable drag on productivity, and as labor force growth slows further in China, productivity improvement will quickly become the only catalyst for boosting longer-term growth.

Read/Download the complete report below:

KKR_Insights_34-20160510

 

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