Is China the source of the next crash? - Notes from a long stay in Shenzhen

Karl Hunt, of the TAMIM Global High Conviction strategy, spent a month living in a district in Shenzhen, in an attempt to better understand what was happening in the world’s second-largest economy, and to gauge what the locals were doing. Here is his report.

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The Shenzhen Special Economic Zone bordering Hong Kong is the epitome of the Chinese economic “miracle”. First established by Deng Xiaoping in 1980 as China sought to establish economic reform, Shenzhen, once a fishing village of 30,000 people, has grown to have a population of 12m+ covering an area of 790 sq.miles, and a GDP of USD $284bn and GDP per capita of USD $27,230. By comparison the USA has a US$GDP per capita of $51,638 (2015, Source: Trading Economics).

It is the “Silicon Valley of China” with the Shenzhen stock exchange akin to NASDAQ, home to hi-tech stocks such as Tencent (internet search, payment, chat,etc) , ZTE (telecom equipment), Huawei (electrical goods), and BYD (electric cars). It is estimated that over 20% of China’s PhD holders work in Shenzhen.

Economic success produces asset price and wage increases. Shenzhen property prices have now surpassed Beijing as being the highest in China, with areas like Nanshang (new hi-tech central business district) boasting prices of RMB 150,000 per sq. metre (psm) – USD $2,016 per sq,ft.. To put this in to a London perspective only Knightsbridge would be higher at USD $2,430 psf and on a par with Chelsea!  Reminiscent of the boom times in the West, in the suburb of Shenzhen in which I stayed, nearly every shop was a real estate agency, staffed by smartly dressed eager youngsters!

The prevalence of ostentatious wealth with premium European cars on the road (Ferrari, Maybach, Porsche, etc) abounds and puts most Middle Eastern cities like Abu Dhabi in the shade. (Though you will have to pay double the European prices for these cars due to hefty import duties).

The well-heeled also do their grocery shopping at foreign branded supermarkets like Walmart, Metro, etc where prices are above those in the West given that most of the produce is imported – it appears the middle classes often mistrust Chinese food quality/standards. Western brands and quality for everything from cars, clothes, electrical items and food are highly desirable for locals – an encouraging sign for Western companies and their aspirations to grow in China.

There is more to come. As you move from the coastal areas of Shenzhen to the interior, and the manufacturing areas, there is a stark contrast. Infrastructure becomes notably inferior – poor roads, street lighting, housing, etc. Factory workers live in rundown properties next door to chemical and plastic manufacturing plants. Here the most common form of transport is scooters (I didn’t see one person wear a helmet) or bicycle. Here you are in no doubt that you are in a 3rd world country.

Inequality is high with many professional occupations, anecdotally, appearing to earn salaries higher than those in the West in Shenzhen. By contrast semi and unskilled salaries still remain low – though they have been rising. They still have one big advantage over the West – they don’t have much of a welfare system to fund!

The question of course is, are the high growth rates and exorbitant property prices sustainable? Will capitalism continue to penetrate the interior or will government intervention and/or a crash in asset values cause a reappraisal? Even if the growth continues how can we make money as investors?

As always there are nuances to consider. A number of factors have come together to create this massive boom in house prices.  The main driver is the wealthy speculating on property in the belief that the government will back stop any fall and that the migration from rural to urban areas will continue. How could this be?

This is a country that has never seen a property price crash and people have come to view property as a one-way bet. In a country where they believe the government controls everything, so too they believe that the government won’t allow property prices to fall. 

China has strict currency controls and it is difficult for most people to buy overseas assets so they are forced to invest locally. They have seen volatility in stock markets and many have been burnt; so property is the staple investment for most. It is not uncommon to see large numbers of apartments, and houses that remain empty in China – they are simply bought for speculative investment.

The government has tried to curb the speculative nature of the property market so that now people can no longer buy outside their residency permit area. It hasn’t stopped prices rising so the government may need to introduce more measures. But the speculative nature of the market clearly is a cause for major concern should some event trigger a rush for the exit. Household debts are not too high at 40% of GDP, and home buyers still needing a substantial deposit to buy a house, so this may continue to persist for now.

Arguably, a more worrying near term risk is in the corporate sector where the debt has been piled up. China’s gross total debts (government, corporate and personal) now stand at an eye watering 277% of GDP at the end of 2016 up from 254% in 2015 according to UBS. The Debt/GDP ratio of the corporate sector is estimated to be 160%+ alone.

The massive increase in the number of companies, the factories – capital formation – has been financed by debt. Each industry in the West – railways, cars, chemicals, tech, etc – emerged and evolved at different times in history and the debt was accumulated across many years in lock step with GDP growth. But in China since the introduction of private enterprise in the 1970s, all sectors have seen a simultaneous expansion in the number of companies and total production capacity. So when you look at each sector, there are many more car companies, chemical companies, tech companies etc than currently exist in Western Europe for example. With cheap and plentiful availability of capital there have been far too many companies being set up and too much capacity.

When this happens, returns invariably fall.

Much of the debt is likely to turn bad. Some companies go bust, weaker ones get swallowed up, industries consolidate and a far fewer number of bigger companies emerge at the end. This process took decades to achieve in the West in most industries. But just like the rapid expansion in China the consolidation may be equally dramatic. When this disruption happens – the fallout – people lose their jobs, confidence falls, investment declines, uncertainty rises and this invariably affects property prices. Which would then have 2nd round effects as wealth falls and consumer spending gets reined in.

Ironically, without this capacity write down and consequent debt write-off, the situation for many industries looks poor because with so much capacity, there is no pricing power.  

We are aware that pundits have called the “top” on China’s economy many times over the last 10 years. Although Chinese policy makers seemingly evade the question of excess capacity and continue to meddle and muddle, the government does have over $3tn in reserves which can substantially help to smooth over future bumps in the road and help to fill in “black holes” created by losses in either local government or State Owned Enterprises (SOEs). There are also fiscal programmes now in place such as “One belt one road” to improve connectivity in China and help the interior to grow and provide cheaper labour.
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However, with so much over-investment, returns on capital can only come down. No government in history has yet stopped market forces eventually taking control of asset prices.  It seems to me then that it’s case of “damned if you do and damned if you don’t”. Chinese companies may restructure but cause some closures and defaults or they don’t, but endure sub-par profitability for a while.
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Consequently, this side of that restructuring we are staying out of cyclical basic industries in China. Without any restructuring, we are definitely staying away from Chinese companies and also those that compete against them since global pricing is likely to remain irrational. This is also known as ‘dumping’ and has been a major impediment to Western companies’ profitability and a source of political friction.