Dylan B. Minor PhD, MS, CFP, ChFC, CLU, CIMA
I just returned from China by means of a delegation consisting of myself and a few other faculty from the Kellogg School of Management. It proved a fascinating and illuminating trip. Much is heard, but little is actually seen in China. This visit finally provided me the latter through access to top Chinese government officials, faculty from one of its top two universities (Peking University) and senior executives, both of locally domiciled firms and some major US multinational firms doing business in China. I will be providing a brief recap of some of my findings, both in terms of where China is, and, more importantly, where it seems it is going.
My visit began by receiving recent insights from Peking University faculty on how the Chinese government operates. As a point of fascination, students attending Peking University typically come from candidates that must place in the top 10 out of approximately 1,000,000 students in their district. So they are not “1 in a million,” but pretty darn close. Although China is a communist government, over the past 15 years, it has become increasingly less centralized. In fact, it currently has a bit of a Federalist nature in terms of governmental competition. For example, the highest level of government first sets an annual target growth rate, say 7.8%. In turn, top officials for each provincial government will then set a target, usually above this average, say 8.5%. Officials in provincial governments that are then most successful increase their odds of moving up the government hierarchy. To reach for success, these provincial governments often engage in both helpful infrastructure projects and wasteful ones. Creating automobile companies has also been a common example of a means to bolster growth; this has resulted in over 100 small Chinese auto companies, which is not a model for economic efficiency. Competitive pressures also support corruption as a means of (apparent) increased economic performance to rise on the governmental ladder. Although some do not succumb, all too many do.
With such incentives, it is not surprising, then, that much of China’s past growth has come from infrastructure growth and investment. Although some has been good, some has not. Consequently, as would be expected from a developing economy, most of the financial system (over 90%) consists of banking. Thus, one of the most important regulators in China is the CRBC, which regulates its banking system. This is headed by the son-in-law of former Premier Wen, who just stepped down as Chinese Premier this March. He shared with me some of the inefficiencies currently found in Chinese banking and some new areas the CRBC is attempting to manage, such as following systemic risks in the banking system akin to the US, and adopting new Basel III standards. In short, the banking system is rapidly maturing. I also met with the People’s Bank of China, which is China’s equivalent of our Federal Reserve.
Their current stance has moved from monetary easing, as is the current position here in the United States, to neutral, as their economy continues to mature and stabilize. As its economy matures, China is continuing to incentivize rural workers to move to the city, where their income triples, on average. China has also just relaxed its much criticized one-child policy; couples that both come from one-child families can now have more than one child. Finally, we are continuing to see China’s (often inefficient) state-owned-enterprises (SOE) transition to privatization. I met with one such firm— a large wool producer—that has successfully made the transition and has subsequently become quite profitable. The net result of these changes should be that China’s nascent middle class becomes an increasingly important part of its country. This should result in transitioning their economic growth from relying so heavily on investment to instead growing from individual consumption, a transition needed for any developed country to sustain long-run economic growth.
I was also able to meet with China’s equivalent of our SEC. Interestingly, the Chinese stock market is akin to the US stock market back in the 1920’s; it is rife with speculation and overwhelmingly used by individual investors. In fact, China is filled with clubs of people that spend away their days talking about mythical stock tips and making foolish trades. Meanwhile, China wants to increase its use of equity markets so that markets over government can choose the winners of industry. China is increasingly understanding the futility of trying to pick the winners. One recent embarrassment includes their support of solar power. This resulted in one man in just five years going from starting a solar company to becoming the richest man in China, only to shortly thereafter go bankrupt. As I discussed with them, to successfully transition, they will also need to increase transparency and also take international intellectual property rules more seriously. Although they are taking steps on the former, they are still in need of making any serious progress on the latter, in my view.
For much of China’s desired progress, they are looking to the West on how to move forward. Indeed, they are closely studying our capital markets, trying to emulate our success and history. They are also having Western experts work alongside Chinese ones so that they can learn our ways—in areas ranging from capital markets to architecture. This is in stark contrast to years ago when doing such a thing would be equated with gross unfaithfulness to China. In sum, it seems China is poised for slower but more mature and broader growth going forward.
China’s culture is also changing; the next generation seems to becoming more individualistic and consumer-minded (i.e., more Western). A senior executive at Nike China shared with me how some of these recent culture shifts have allowed them to further participate in China’s growth. McDonalds and General Mills shared similar sentiments. It seems that US consumer goods multinationals that are adept at sufficiently “following the rules” can increasingly succeed in China. In addition, Western infrastructure firms should also continue to find opportunity in China.
In terms of investment consequences for our clients, China is a market that we should have exposure to, as it already represents the second largest economy, and in this next decade will likely become the largest economy, exceeding US economic output. Not having adequate exposure to so much of the economic world will almost for sure cause disadvantage. Nonetheless, China seems to be in the midst of a major real estate bubble and its stock market is immature. This suggests there is currently a need and opportunity for strategic asset management in China. Although we will participate in its growth, there will most certainly be bouts of massive market volatility and speculation as China stumbles its way into maturity. So stay tuned…
**The author does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does the author recommend that the information serve as the basis of any investment decision and it has been provided to you solely for informational purposes only and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.