Challenging the 5 Biggest Misconceptions About China’s Economy

CHALLENGING THE 5 BIGGEST MISCONCEPTIONS ABOUT CHINA’S ECONOMY

China has become the epicenter of investors’ concerns about the world economy. While some of the concerns have some grounding, we have found that most of them are exaggerated. The results of our observations during 4 years of visiting businesses in more than 70 mainland cities indicate that China is a largely misunderstood story. Below we consider five major misunderstandings: four tactical, namely debt and ghost cities; capital outflows; slowdown; and stock crash, and one strategic – transition from low to high added-value manufacturing.

The latter is of particular significance – first, it is likely to fundamentally change the landscape for manufacturing industries around the globe. Automotive, aerospace, and many other industries will be directly affected - similar to how Japanese electronics and Chinese shoes had a dramatic impact on their global competitors in the past. Second, the transition is already causing a structural shift in the banking sector, as the world trade finance system is adjusting to the new trade patterns. Third, the combined effect of these structural transformations is likely to drive revaluations across most asset classes.

The transition is already at advanced stage. Among major recent manifestations are the ChemChina’s Syngenta acquisition, and pending HSBC’s relocation from London to Hong Kong.

The main source of the misunderstandings is a lack of holistic approach – it is common to consider one particular isolated parameter at a time, without analyzing the system as a whole. Another equally important source of confusion is ignoring China’s idiosyncrasies and directly applying the rules and standards of typical western economies to China’s economy, which is

fundamentally and structurally different.

It is as if a veterinarian would treat birds and reptiles equally, without taking into account that the former are warm while the latter are cold-blooded, and apply the same principles, standards and treatments to the animals of both groups. China is structurally different from a typical free-market economy, and directly applying the free-market principles leads to inaccurate conclusions.

We begin with four tactical misunderstandings.

[pic 1]

The main reason of the misunderstandings is a lack of systematic approach.

LONG JING CAPITAL VLADIMIR@LONGJINGCAPITAL.COM

2

I. TACTICAL MISUNDERSTANDINGS 1) Closeto300%debt-to-GDPmakesChinaareincarnationoftheUSin2008.

What is missed here is that a very sizeable part of the debt is double counted. This debt is internal - it is given by the government banks to the government companies to finance infrastructure. In fact, this is the government’s direct investment into infrastructure, and to a lesser extent residential construction. But because of the Chinese economic structure’s idiosyncrasies, it was reflected as debt. It is as if a company’s cash register transfers money to same company’s construction department, but records it as if it were a loan. If

consolidated at the government level, the debt figure becomes significantly lower.

[pic 2]

The actual debt is overestimated. Capital structure is a stabilizing factor.

[pic 3]

Photo: A typical residential compound under-construction, funded with bank capital. Wuhan, Hubei province in central China.

The infrastructure and residential construction was mainly financed with people’s deposits at the state banks. The entire banking monopoly was designed to provide the country with virtually free capital to build the infrastructure. The banks will eventually require some recapitalization, but this will be made through gradual inflation taxing (money printing), which typically goes unnoticed by the capital holders.

Most importantly is that unlike the US credit crunch of 2008, China’s bank recapitalization is not forced and not urgent. Because of a state semi-monopoly on

LONG JING CAPITAL VLADIMIR@LONGJINGCAPITAL.COM

3

savings, deposits are stable and servicing them is cheap. Savers simply have no other alternatives. Chain reactions of credit defaults or bank runs are unlikely.

The only victims in this situation may be holders of the developers’ debt denominated in foreign currencies. Some foreign high-yield seeking investors took disproportionate market risk by lending capital to those developers, who were rejected by the local capital providers. Often times, they were rejected because of problematic real estate portfolio. On the positive side, the size of foreign currency denominated debt

appears to be controllable – less than 5% of China’s overall debt.

In addition, based on observations in more that 70 mainland cities, most of the recently constructed infrastructure and residential buildings have substantial real value. The entire “ghost cities” theme is largely overstated in our opinion – enormous new

housing supply meets equally enormous demand. The only significant area of capital misuse is commercial real estate, as the local developers lacked necessary expertise. However, the invested capital, on average, was not wasted and will generate an adequate return on investment.

To sum up, contrary to common belief, China does not appear to face acute credit problems – total effective debt volume is overstated, and China unique debt structure to some extent insulates the credit system from external shocks and chain reaction effects.

2) Chinafacescapitaloutflowsandshrinkingforeigncurrencyreserves.

Since summer 2015 it has been commonly believed that capital has been fleeing China, and the authorities are forced to sell foreign currency reserves to prop up the falling yuan.

However, there is an alternative explanation. It is possible that the capital outflow is an indication of China exiting the second Mississippi System. The first Mississippi System was implemented in late 1710s in France. At that time, the French government had enormous debt that had been accumulated during the decades of wars with Great Britain. Until the early 1710s, so- called visa restructurings were typically used as debt management mechanisms – large portions of debt were simply defaulted on a regular basis. As a result, interest rates were chronically high, which as contemporary economists believed,

was the main reason for the depressed economic activity.

LONG JING CAPITAL VLADIMIR@LONGJINGCAPITAL.COM

[pic 4]

Foreign currency denominated debt may be problematic, but its volume is not significant.

[pic 5]

The new infrastructure has value. Capital was not wasted.

[pic 6]

The Mississippi System and Quantitative Easing may give clues to the shrinking foreign currency reserves.

4

The government came up with a revolutionary financial innovation. It appeared that the new mechanism could simultaneously achieve two goals – decreasing the interest rates and repaying the debt.