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The Keys to China’s Fortune

Thirty years of constant growth is making it difficult for China to transform an economy too reliant on investment and exports. Maybe a crisis will help.

Peng Chen, 11/30/2011

China’s economy has grown on average by around 10% per year for the past 30 years, and it is predicted to surpass United States as the world’s largest economy within the next two decades. This impressive growth has not gone unnoticed by investors. However, China is facing many challenges; currency valuations, an overreliance on fixed-asset investments, and a real estate bubble all have investors wondering if China’s long streak of growth is coming to an end.

To get a sense of the state of the Chinese economy, where it’s headed, and what it will mean to investors, we invited Zhiwu Chen, a Yale professor of finance, to participate in this issue’s Morningstar Conversation. Chen, the author of nine books on China, is one of the world’s foremost scholars on the Chinese economy and investment markets. Our discussion took place on Oct. 24 and has been edited for clarity and length.

Peng Chen: Let’s talk about the long term. We’re seeing a number of organizations predicting that China economically will soon overtake the United States as the world leader. What do you see? Do you agree with these predictions?

Zhiwu Chen: For the most part, all these predictions and analyses assume that some steady growth rate will go on forever without any setbacks. Clearly, such an assumption is hardly supportable. There was a book titled Finance in China published in 1913 in Shanghai, just before the First World War and right after the end of the Qing Dynasty in China. It predicted that China would take over the West, because China had a much larger population than all the Western countries combined and because labor was much cheaper than it was in the West. Then, with the same aptitude for imitation that the Chinese population was known for at that time, media commentators and economists made the same prediction—that pretty soon after 1913, China would take over the West. But, of course, after 1913, we know what happened: the First World War, then China was invaded by Japan, the Second World War, the civil war in China that went on for many years, and then the Cultural Revolution.

I’m not saying that this time the prediction will be proved totally wrong. Instead, what I’m saying is that first of all, we cannot linearly extrapolate the past 30 years of economic growth into the next 30 or 50 years. The past 30 years of growth has taken place because of some historical reasons, but those historical reasons will not necessarily give China another 30 years of growth.

I think the next 30 years may look more like the following. Within the next five to 10 years, there will be some significant financial/ economic crisis that will set Chinese economic growth back. The total size of the Chinese economy will be dented. But that will set the stage for major institutional, political, and privatization reforms, and such reforms are really necessary to prepare China for another two decades of steady, but not as fast, growth rates.

So, it may take until 2027–28 for the Chinese economy to exceed the U.S. economy based on purchasing power parity. But in nominal terms, it may have to wait until 2049–50 for China really to catch up with the United States in terms of economic size.

Unless there are major revolutions in China, it will be inevitable that the size of the Chinese economy will exceed the U.S. economy. The reason is not based on the past 30 years of growth experience in China. Rather, it’s the very long-term trend of correlation between population size and GDP size. In the 17th century, roughly speaking, there was a 98% to 99% correlation between a country’s population size and economic size. By 1820, the correlation was still high at 97%. But by 1870, roughly one century after the Industrial Revolution started in England, the correlation dropped to 83%. In 1950, the correlation dropped to 39%, and during the peak of the Cold War period, 1970–73, the correlation between population size and economic size reached a bottom of about 35%. But in the late 1970s, China started opening up and conducting reforms, and then pretty soon after that, in the 1980s, many countries all around the world started privatization and reforms and so on. As a result, the correlation between population size and economic size reversed its direction. It’s now about 62%.

This trend will probably continue, so that large countries like China and India, both of which have more than 1.3 billion people, will benefit. For this reason, unless China would really mess it up, its economy will exceed the U.S.’.

This long-term historical trend is not likely to change. There are many reasons behind the rise in correlation between population size and economic size. Let me focus on two macro reasons.

The first is the industrial revolution or industrialization. After more than two centuries of development, industrial technologies for production have become so mature and mobile that any country that has a large enough labor force and low enough cost of labor can now get into manufacturing pretty much overnight. Today, it’s no longer just China, but also Vietnam, Cambodia, and many other more-underdeveloped countries. If they really want to, they can attract investment and set up factories within a few months and engage in exportoriented production.

But this was not possible going back to the 19th century, when industrial technologies were just starting to emerge and progress. In those days, the innovator countries would first have to benefit from the newly emerging and developing technologies. Also the technologies were not easily movable across borders. The more populous traditional societies, like the Indias and Chinas, could not take over manufacturing so fast because of the training and sophistication requirements that were needed. But today, everything is so mobile, so mature. You can engage in manufacturing overnight.

I’m saying this partly because historically for researchers and scholars, we have to face the following question. China over the past 30 years has been able to develop the economy so fast, when the Chinese population is just about 20% of the global population. But in 1900, China had about one third of the world’s population. How come China was not able to take advantage of its large and cheap population then? Something else must have been going on. Of course, some people may say, “Well, Chinese people today work hard and they are more capable, they’re smarter, whereas 100 years ago the Chinese were not as laborious or diligent or smart.” I don’t think this is the case because I’m pretty sure 100 years ago the Chinese people were probably even more willing to work hard than they are today.

So, a simple willingness to work hard and abundant cheap labor are not the key causes for China’s economic growth over the past 30 years. Rather, it is because by 1978, the maturity, quantity, and quality of industrial technologies reached such a level that China only needed to say, “Now, our policy is both to reform the economy and let the market forces have their way, to open the door to foreign direct investment and to international trade.”

So, this globalization trend will continue to make countries with large and cheap labor forces able to take over global manufacturing and grow their GDP as a result.

Looming Crisis

Peng Chen: You mentioned that in the next five to 10 years you expect a crisis to occur in China. China’s economy is growing by around 9% this year—still very strong despite weakness across the world. If you look at what makes up China’s economy, around 30% is in consumption, 40% is from the investment, and the other 30% is from exports. Over the past few years, the investment portion has grown quite a bit compared with what it was before the global financial crisis. I was just reading Time magazine, and the cover article was about a bubble in China, particularly in the real estate sector. What are the imbalances that you think could trigger a financial and economic crisis?

Zhiwu Chen: The Chinese economy will be the victim of its past success, in the sense that too many policymakers, economists, and people in the business community in China are very happy and very satisfied and very proud of the past 30 years of economic growth. Their old economic growth model has worked so well that they are not going to have any incentive to change or restructure it.

Investment has been by far the most important driver of the past 30 years of economic growth. Exports for at least 20 years have also been an important driver of economic growth. But China hasn’t realized that the manufacturing- plus-WTO-dividend is more or less used up. The recent financial crisis has made it more difficult for China to continue to rely on developed countries to provide markets for the excess production capacity in China.

Let me just give you some statistics. If I divide the total fixed capital investment in China each year by the per-capital disposable income for the urban population in China, then in such relative terms, back in 1980, the total fixed investment of the Chinese economy was roughly equivalent to 200 million urban residents’ annual disposable incomes. By 2009, the total fixed investment in China was equal to 1.3 billion urban residents’ disposable incomes. Of course, China does not have 1.3 billion urban residents. It has at most 700 million or so. This shows that this totally investment-driven economic growth model, the exports-oriented growth model, can no longer continue.

As many others have commented, a major restructuring of the economic growth model is really needed. From what I can see, the major restructuring would have to include, first off, all the privatization of the remaining state-owned assets and publicly owned land—because otherwise, private citizens and households would not be able to participate in the wealth effect of economic growth. When households cannot participate in the wealth effect from economic growth, they will not be able to consume much. If they cannot consume much, then the Chinese economy will continue to have to depend on investment, and then as a result of that, it will have to depend on exports. But we know that investment dependence and export dependence are no longer sustainable.

Nonetheless, the GDP growth rate is still going to be about 9% this year, and very likely it will be about 9% next year as well. Such GDP growth rates will not incentivize the policymakers to undertake any major structural reforms. This human behavioral bias will be the reason that within the next five to 10 years the Chinese economy will unavoidably go through some major crisis, period.

The real estate bubble, high-speed train infrastructure, the big fancy airports, highways—all these projects were started as part of an effort in the past three years to help the Chinese economy get through the financial crisis. All of these things will lead to a lot of nonperforming loans.

People in China talk about the three 10 trillion numbers. The first 10 trillion is the amount of government spending as a result of the financial crisis, starting with the 4 trillion renminbi announced in October 2008, at the height of the crisis. The second 10 trillion is the amount of local government loans. It’s actually more than 10 trillion, but to make the numbers sound better, they just shrink 14 trillion to 10 trillion. The third 10 trillion is the underground private loans that have mostly occurred over the past one year as a result of the tightening monetary policy by the Central Bank and as a result of a restriction on allowing private financial institutions to emerge and develop legally. These three 10 trillions are burdens, and many of those trillions will become nonperforming loans in the next few years.

Why the Renminbi Is Overvalued

Peng Chen: What are your views on the Chinese currency? Is it undervalued?

Zhiwu Chen: I think the Chinese renminbi is actually overvalued.

Peng Chen: That’s interesting.

Zhiwu Chen: Of course, I know there are many different theories in economics that all try to come up with the right equations for determining the correct exchange rate. Most people focus on trade: As long as China maintains a high trade surplus, then that must mean that the renminbi is undervalued. So, the renminbi should be revalued in order to bring down the trade surplus close to zero.

But that’s just one aspect. The second, perhaps more important, theory for exchange-rates determination is purchasing-power parity. What that means is that if you have the same hamburger or the same shirt, ideally it should cost the same amount based on the exchange rate in the U.S. and in China, after you take out the transportation costs and so on.

But the reality for those of us who travel between China and the U.S. a lot is that common, midlevel brands of clothing, appliances, and things we use here in the office are actually way more expensive in China than they are in the U.S. Whenever I receive a delegation from China, all of them want to go to shopping malls in Connecticut and New Jersey to buy many bags of clothes, even though most of them were made in China. The exchange rate for the renminbi is so messed up that Chinese tourists in the U.S. find the prices of American goods made in China incredibly attractive.

I think if China let the renminbi exchange rate be totally determined by market supply and demand the renminbi would go lower instead of higher.

So, I think the bill in the U.S. Senate introduced by Chuck Schumer (D-N.Y.) is misplaced, based on the purchasing power of the renminbi versus the dollar. The renminbi is overpriced right now, rather than underpriced. I also think it’s very dangerous for U.S. politicians and trade associations to put too much pressure on China to try to revalue the renminbi and make the renminbi priced higher—because at this point, China does not need any more foreign direct investment from the U.S. or other countries. In fact, China has too much capital. So, the U.S. really doesn’t have much leverage with China on the investment front. If anything, China has the upper hand. So, for Chuck Schumer and others to put pressure on the Chinese government on the renminbi exchange rate, besides starting a trade war between the two countries, I don’t see much of an outcome.

That is why this pending bill would have to rely on tariffs imposed on Chinese goods. But increasing tariffs on many Chinese goods is bad for both the U.S. and China. China, of course, would definitely retaliate, so when that happens, American families will have to pay higher prices for the same goods they buy at Walmart and Target. I don’t think that is good for American families at this point, when the unemployment rate is 9.1%.

Peng Chen: What’s the mind-set of Chinese regulators and the Central Bank on exchange rates?

Zhiwu Chen: From what I know by talking to friends inside the government and outside the government but who have some influence over the official policymaking, the vast majority of them really think the renminbi is overpriced. There are a few, but a very small minority, who would like to see the renminbi revalued and go to a higher exchange rate as a way to contain or limit the tendency by Chinese policymakers to rely on the export market to provide further economic growth.

I do agree with them. Being the world’s factory comes at a huge price to the environment and to the health of the Chinese population. Air pollution, the overexhaustion of natural resources, and the environmental damage—all of these things are not priced into the export goods prices from China.

American policymakers should focus more on putting pressure on China over labor rights and to increase environmental standards. Such pressure will make the prices of Chinese goods go higher, even without the exchange rate going higher. I think that’s a much better way to rebalance global trade than just simply relying on the exchange rate.

Investing in China

Peng Chen: For investors in the United States, how would you suggest people look at China from an overall allocation perspective, as well as in terms of selecting specific securities and so forth?

Zhiwu Chen: I think that the best way to benefit from China’s economic growth is to invest in U.S. and Western multinational corporations that have a lot of business exposure to China. You get the benefit of both worlds: China’s economy and the U.S. legal and institutional infrastructure. Japanese companies, too. Big Japanese multinational stocks have performed pretty much the same as big American multinational stocks. Japanese multinational firms get most of their revenue now from outside of Japan, so they have been able to benefit from the opportunities in China.

The second way to benefit from China growth is through the state-owned enterprise stocks. Last year, I had some students do some quick research on SOEs versus private firms from emerging-markets countries. In countries like

China and Russia, the SOEs performed better for investors than private companies. You know, I’m opposed to governments owning enterprises, but as an investor, if you become a shareholder in a large SOE, you’re on the government’s side. Government agencies help the SOEs whenever they are in big financial trouble. Of course, when they’re doing too well, the government agencies will try one way or another to allocate some of the profits away. But on balance, if you like stability and low volatility, SOEs are not a bad way to go. I know some U.S.-based hedge fund managers just love to hold the shares of the big Chinese SOEs because they think the dividend yields are typically higher and their stock prices are more stable.

Also, executives at the SOEs have much less incentive to manipulate their accounting numbers because, for them personally, they don’t benefit at all from the upside of their stock prices. So, why would they do it? Private business executives are the opposite. They have too much incentive to manipulate the accounting numbers. So, as a result, we have seen companies in China that have fabricated their accounting books.

Now, if you want wealth creation and are willing occasionally to be exposed to some accounting fraud risk, the Chinese Internet industry and the consumer-oriented businesses have a lot of growth potential—the hotels, leisure, tourism, restaurants, food industry, pharmaceuticals, e-commerce, Internet lifestyle-oriented industries. They all have great potential, but at the same time, there’s the risk of accounting fraud.

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