Richard Sneller, Baillie Gifford’s head of emerging markets and manager of the Emerging Markets Growth fund, writes for What Investment on why investors are being too negative on China
After a truly remarkable 30 years during which high levels of economic growth have run in parallel with dramatic social change and surprising – to many – political stability, the notion that there might be any alternative to this other than economic collapse along with social and political instability is increasingly remote amid the cacophony of amateur and short-term prognostications.
This brief note posits that China is undergoing a strategic reorientation that will cause damage in numerous parts of the economy with significant near-term economic, social and political costs. Fortunately, the scale of the economic, social and political goodwill that the country has generated over this period is such that it is likely to emerge with the potential to escape the middle income trap, become a global political pure-power with increased reach and influence and deliver economic returns to shareholders in some of its most significant companies. I refer readers to my piece on China’s political transition for some of the background as this will be assumed: the conclusion remains unaltered as the path trodden thus far is that which was expected.
Although it is widely known that China has grown at 8 per cent per annum over the past 30 years and we have all experienced or benefited from its ascent in terms of cheaper ‘stuff’, less well known are some of the structural alterations to the following four factors of production that hint at a further prolonged period of growth, albeit of a more moderate scale given the size of the ‘upfront’ investment made in a large number of areas: land; labour and entrepreneurialism; capital; and communication and markets.
It is fashionable to return to Deng Xiaoping’s reforms of 1978 in which he decollectivised agriculture and encouraged household responsibility, resulting in increased agricultural output and improved living standards for many hundreds of millions of farmers. But while this was instrumental in providing incentives and guarding against a repeat of the famine of 1959, it is one other, less discussed, reform – relating to property rights – that arguably underpins a growth rate of high magnitude in the past and duration into the future.
Historians still squabble over the existence of private property rights in Imperial China, but we do know that significant land tenure during the Republic of China (1912-49) was private. The period of China’s land reform in the early 1950s saw vast quantities of rural land redistributed to peasant families who were organised in collectives and urban land became state-owned after the concurrent nationalisation of industries and companies.
As the initial rural changes took place under Deng, and urbanisation and private enterprise developed in urban areas, urban housing development was slow to take-off. By the late 1990s, the security of China’s new path was such that developers and home buyers felt sufficiently comfortable in de facto ownership of their private property that they sought to increase their investment in it, in spite of limited de jure title. The boom in residential investment and increase in new urban households thus eventually brought about change to the Constitution in 2004 which provided explicitly for the ‘inviolable, lawful private property of citizens subject to expropriation as necessitated by public interest with the payment of appropriate compensation’. For those of us living in societies where the notion of private property ownership is deeply embedded, the sheer magnitude and scale of mindset shift resulting from this one change is particularly difficult to grasp.
Labour and entrepreneurialism
In parallel with the gradual but immensely significant changes occurring in land tenure, we have arguably seen even greater changes in the many facets of China’s labour force. The focus of much attention has rested on the size and age of the workforce – the fact that it has grown consistently over this period and aged to the extent that we are now on the cusp of declines in the absolute size of the workforce and thus a tailwind to economic growth will now become a headwind.
A more sophisticated observer would also remark upon the increased levels of female participation rates in the workforce, with the multiplicity of positive contributions made by this along with the widely renowned increased levels of education at all ages and stages. None of this is in the least bit inconsequential, but as a strong believer in the power of the mind to empower the human being to remarkable levels of creativity, industry and ‘economic output’, my mind turns more to the reforms of the rigidities enshrined in the ‘hukou’ and ‘danwei’ systems.
You may be familiar with the ‘hukou’ system, which registers residents in a particular area, provides – particularly urban dwellers in times past – access to food and subsidies, and allows the government to control the pace of urbanisation and also the migration of specific individuals. As with land ownership laws, illegal migration led the way, resulting in a situation where urban areas where overwhelmed with ‘illegal migrants’ to the extent that it made political and social sense in the early 2000s to allow the rural residents to buy temporary urban residency and to do away with custody and repatriation laws.
While the system remains in place today, and illegal migrants to urban areas are thought to number in excess of 100 million people, proposals to abolish the system in smaller cities and towns are being contemplated and trialled in certain areas, the city of Chengdu being one of the first. Better access to subsidised public housing, education, healthcare, pension and unemployment benefits are all important and are often cited. In my opinion, the provision of full urban citizenship rights to these rural ‘hukou’ people over the next decade will provide them with dignity, more than anything, and eliminate the clear class divide that continues to compromise China’s potential.
The erosion of the ‘danwei’ also has far-reaching motivational implications. The ‘danwei’ was a work unit that provided ‘life’, embracing housing, schools, shops, clinics, leisure and ‘The Party’. There was nothing to fear, and nothing to hope for. Sexual activity was monitored, communal mealtimes insisted upon and travel granted (occasionally). Dissenters were penalised. Again, the way in which the erosion of the ‘cradle to the grave’ system has been juxtaposed with the growth of private enterprise and introduced the concept of risk and reward into people’s lives is far reaching and ongoing. Unlocking the tremendous talent that has been rotting within these organisations continues to contribute to the future growth potential of the country, for barely a decade has passed since workers at state-owned enterprises (SOEs) [legally] required permission to marry.
The literature on the origins of the ferocious appetite that can be widely observed amongst many Chinese people to engage in gambling and risk taking in many forms is limited. Desmond Lam has recently written an interesting tome called Chopsticks and Gambling, and I would commend it to anyone seeking greater knowledge of this area.
Fate, luck, Feng Shui and the accumulation of good deeds contributed, in that order, to the success of business, according to Pitta, Fung and Isberg (1999), and from over 20 years’ experience of dealing with thousands of Chinese businessmen running hundreds of Chinese companies, I would share this opinion. This higher illusion of control and lessened probabilistic thinking, should, in the aggregate and given asymmetric of returns to capital, lead to more optimal outcomes as more ‘tail-risk’ projects are undertaken with the consequence that forward leaps can be significant.
I would further argue, more controversially perhaps, that the combination of the extraordinary spread of Christendom (often with a sense of determinism alongside entitlement in return for good deeds), the rise of successful entrepreneurs and the increasing availability of risk capital from overseas investors should create an environment for entrepreneurial risk taking that persists for decades, and underpins the Middle Kingdom’s ascent through the middle income trap.
Capital market reforms tend to be viewed through a lens distorted by short-termists and naive ‘teenage scribblers’. A more humble and objective observer might see the transformed nature of China’s financial system from one that was closed and bank-centric to one in which the stock market is sputtering into action – and is already the world’s second largest in terms of market capitalisation – and the bond market has increased in size one-hundredfold over the past 20 years to $6 trillion. Moreover, interest rates have been progressively liberalised, private capital has been injected into various entities in the financial sector – with domestic e-commerce concerns being the latest providers – and renminbi convertibility has been an ongoing project.
From another perspective, foreign ownership of the majority of equity and bond markets around the world is often between 20 and 40 per cent. Capital controls and market access issues have restricted this to less than 5 per cent for Chinese companies. As China continues on its gradual path of integration into the global economy, foreign ownership of Chinese capital stands to increase very significantly, bringing with it, on balance, positive disciplines as some of the less appetising aspects – short-termism and inappropriate activism – are restrained by regulation. That there is appetite from foreign investors for well-run, growing Chinese business is clearly evident from the high levels of foreign ownership of some of China’s largest new private sector businesses such as Alibaba and Tencent.
Communication and markets
The speed, scope and scale of China’s investment in infrastructure is unparalleled in the history of mankind. Since 1990, China’s expressway network has grown from a mere 300km to 123,000km in 2015, with 11,000km of length being added in 2015 alone. More impressive than the scale and speed is the quality and foresight of the planning that has provided a network whose benefits are hard to articulate. The map helps to some extent, but the key point is that unlike the networks in many developed countries, which are driven by the short-term needs of drivers, this has focused on the needs of the country over the next 20 years. This network, many of whose key characteristics are replicated at highway and urban network levels, provides a fantastic canvas for the evolving transportation and commerce revolutions.
Much the same can be said of both the country’s airport infrastructure and the rail network, along with its network-optimising subdivision into freight and passenger networks. China’s high-speed track length almost exceeds 20,000km, which is larger than the entirety of the rest of the world’s track length. However, in terms of people movements and transformative potential, it is mass transit that offers the greatest potential to drive economic growth in China.
The benefits of mass transit systems compared with private transit systems are widely underestimated. At one level, they require far less ‘labour’, they are far more energy efficient and they require considerably less materials and are thus much cheaper. From another perspective, they allow greater labour mobility and thereby allow businesses a greater choice of potential employees and employees a better quality – and ‘quantity’ – of life, and they can require relatively minimal alterations to existing infrastructure.
If the Industrial Revolution revolved around the harnessing and distribution of energy, the media revolution that we are in the midst of is concerned with the harnessing and distribution of data, and the critical importance of a ubiquitous, leading-edge, domestically manufactured distribution network was appreciated by the Chinese leadership in 2006 with the award of a controversial and expensive TD-SCDMA mobile telecom licence to China Mobile. This set the company on a path whereby it would be able to extricate itself from dependence upon foreign technology – the value of which (to China) we are starting to appreciate in the light of the Snowden revelations – carve out a path of easier 4G and 5G network upgrades in time, and, by virtue of being a dominant player in the market, be compelled to provide a strong, nationwide network.
On top of this fantastic network, Baidu has been inserted as a near dominant search engine, Tencent as the dominant instant messaging platform, and Alibaba and JD.com as the consolidations in the e-commerce space, each in a reflection of the value to the nation of its own data. As a brief aside, it is worth reflecting on the technology and services of these private companies compared with the best that the US has to offer insofar as it might provide insights into China’s future abilities in other areas when left to the private sector. Each of these companies understands that the pie is not advertising.
The pie is where commerce predominantly occurs – the marketplace – and this is driven, particularly in China, by more and more local service purchasing with the twin advantages of limited incumbents – who are more often barriers to adopting disruptive technology – and consumer demand shifting away from goods and towards services as incomes rise and trigger exponential demand for more and more new and local good and service offerings. The challenges revolve around creating ease of transaction – in terms of search, payment and delivery – and the use of historical user data to maximise execution and future spending (more commonly referred to as marketing via the power of artificial intelligence).
The large and eager rural labour force within urban areas only adds to the frisson of excitement about the rapid adoption of these new technologies. While a lot of discussion has been focused on restaurants, travel, entertainment ticketing and food delivery, these all pale into relative insignificance compared with financial services, education and healthcare, where the power of big data will have significant benefits.
And while mentioning the rural labour force, those of us who are rapidly adopting new technologies such as Airbnb, Uber or HelloFresh need to take a step back for one moment to remember that we need to distribute the benefits of the internet far more broadly lest we produce a society of technophiles and technophobes: speech recognition, natural language processing and visual search could do a lot to enhance the user interface with the internet in its broadest sense, and the proliferation of market access to the widest number of consumers in the economic sense.
Few investors delight in falling stock markets, and fewer still are thrilled by the prospect of slower economic growth. The pessimists will be captivated by the fact that the Shanghai ‘A share’ index has almost halved from its high in June last year, the optimists by the fact that the market is some 30 to 40 per cent higher than the levels it was trading at during much of 2014. Those prone to the half-empty will have been crying into their glasses at the sub-7 per cent GDP growth print for 2015, while those still seeing half the beer in the glass will be thrilled with 6.9 per cent compared with the sub-2 per cent pace of growth seen in the US. But a very few investors find this sort of stock market (whose constituents are predominantly the financial and energy behemoths of yesteryear) and headline economic analysis to be little more than a near complete waste of time.
I believe that the cyclical economic and market factors that are the typical obsession of market participants, economists and central bankers are of lesser relevance to stock valuations than the structural factors that will enable the next generation of successful companies in China. I’ve touched on the manner in which the factors of production have been aligned to prepare China for the next two extraordinary decades in its ascent, and strongly believe that it is both very well placed to attract the most talented, productive and entrepreneurial people in the world and making significant preparations to become one of the most alluring investment destinations in the world for a wide range of potential investors.
Having made heavy investments in the Chinese export manufacturing sector in the 1990s, the Chinese materials processing sector for much of the 2000s, and the Chinese ‘internet’ sector since the mid-2000s, we are now actively making investments in new sectors from where we anticipate that new businesses of significance will arise, including pharmaceuticals, electric vehicles, telecom hardware and media content, in particular in the digital space.