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Is China's Growth Sustainable?

My answer is positive. First of all, let’s look back 20 years to see where the growth mostly came from.There have been many drivers that contributed to the fast growth of China’s GDP in the past two decades. If you want me to pick some, three of them stand out – they are exports, infrastructure development, and the private sector.

By January 2010, China overtook Germany to become the largest exporter and its share of world’s exports was almost 10% vs. 3% in 1999. China’s export has seen a growth rate of 20-25% for years. In 2007 the net exports in China has represented 3% of China’s GDP growth.

The second factor behind the fast growth was China’s increased investment in its infrastructure, including energy, transportation (including rail & airports), highways and telecommunication. In 1980s, the poor infrastructure became the bottle- neck to China’s growth. Starting in 90s, China invested 30-40% of its total domestic investment each year into infrastructure.

Another remarkable driver of China’s economy is the private sector. In 1992, China was dominated by the State-owned enterprises with only 140,000 private companies. By the end of 2009, the number of private companies reached 8 million. Over 61% of companies in China are privately -owned. The private sector now hires over 70% of the national workforce and has contributed to over 60% of the GDP growth.

If China wants to maintain an annual GDP growth rate of 8-10%, where will this growth come from?

In the next 10 years or more, China may still well be able to sustain its high GDP growth rate between 8-10%.  Exports will remain one of the drivers of China’s economy. However, the model of low margin, massive and destructive consumption of natural resources and low labor price is not going to be sustainable. A lot of the merchandise is manufactured in China at a paper-thin margin. Solely relying on cost efficiency to maintain its leading position in the world market is not the answer any more. China has to move into the direction of higher added value export activities, moving up the food chain. This may happen first in the trades with less developed countries. Secondly, with the increased labor and land costs the government may take measures to encourage export manufacturing base to relocate to in-land areas of the country, helping to boost the economy of these less developed regions and keep the manufacturing from moving to other countries such as Vietnam. We may expect a migration of industrialization from the East Coast to the West.

Infrastructure development will continue to play its role as a driver of economic growth. Significant investment in road, train and air transportation will continue, particularly in the less developed in-land areas of the country.  Even if the trend of urbanization continues and the projections of 65% of the population living in cities by 2025, up from 25% in 1995, prove correct, hundreds of millions of people will still live in rural and less developed areas of the country.

The growth in domestic consumption will continue and likely accelerate, as the Chinese increasingly become a country of consumers.  Two reforms will play a vital role to stimulate the change:

The government is putting together programs that will allow farmers to trade land use right. Farmers can trade their land with each other and have opportunities to break out from the current family ownership model to create scalable farming. If these reforms work out well, we should expect to see increased productivity in agriculture with larger scale. What is more, the purchasing power in the rural areas may increase tremendously as farmer’s illiquid land assets become liquid.

In the next three years alone China is going to invest $124 billion in health care. 90% of the population shall have universal health care coverage by 2011. With the government providing basic medical services to a larger percentage of the population and making it more affordable, the average Chinese won’t have to spend as much of their own money on health care and, as a result, they will have more disposable income to spend on other items and, thus, further fuel the growth of domestic consumption.

A more efficient capital market to be established will help fuel more growth.  China is a country that has lots of money but no capital. By saying this I mean there are very few channels or instruments for the government, institutions and individuals in which to invest to manage and grow their wealth. For now, A-share markets and real estate are the major investments in China. That’s why on one hand, the government and banks sit on trillions of dollars, on the other hand, a lot of companies do not have access to growth capital and have to turn to overseas capital markets.

A more sustainable growth shall come from innovation of technologies.  One of the hurdles of innovation is the lack of IP protection. People are not keen on creating and coming up with something new because they know other people can easily steal their ideas and technologies. Only when the IP issue is addressed can companies justify the investment in R&D.  In addition, lack of supporting infrastructure such as capital resources dedicated to innovation is another hurdle to get over.

Some people are skeptical about China’s growth and alarm that China has bubbles, esp. in real estate and stock markets. They are concerned that the bursting of the bubbles will lead to the clasping of China’s economy.  

My answer is there are some bubbles in the real estate market, but not in the stock markets. The Shanghai Index was over 6000 in 2007 and 2008.   Now it’s at about 3150 and it’s 12-month forward P/E of 13+ is definitely within a reasonable range.

As far as the real estate bubble, the situation is more serious in top-tier cities such as Beijing, Shanghai, and Shenzhen, as well as the Hainan Province, where prices have definitely gone up dramatically. The Chinese government has taken some measures to avoid a bursting of the bubble and slow rising prices.  These measures include reducing the money supply; restricting unqualified developers from participating in real estate projects; stopping state owned companies from buying land for speculation; in addition, the government is planning to develop affordable rental housing. How effective these measures will be only time will tell.

For the worst case that the bubble bursts, we may expect to see the amount of bad debt will pile up in banks’ balance sheet since some developers may lose money and be forced to default on bank loans.

Government will further tighten money policy, which will lead to less liquidity and slow-down of activities in capital-intensive industries, such as infrastructure and manufacturing, ultimately slowing down the economy.

Different from the U.S.’s subprime mortgage situation, Chinese banks do not sell their mortgage to other financial institutions. In addition, the government does not run on a deficit; instead the government has over $2.4 trillion foreign reserves.  Things will not be too bad.  At least, I am confident that the government will try its best to stop the bubble from bursting.  This is something I can bet on the Chinese government, but not on the U.S. government.

A lot of people are worried about China’s deteriorating environment, a price that China pays for its fast growth. Do not forget that most of the developed countries such as the U.K., Japan, even the U.S., took a long time to address the environmental issues caused by the industrialization.  The environment problems in China resemble those in Japan in its 60s or 70s.  The Chinese government, though fully aware of the problem, puts economic growth as its priority.  If the government does not see it as a distraction to improve/protect the environment, it will be surprised to identify another growth opportunity.

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