Braking China Without Breaking The World: Blackrock Investment Institute

Braking China Without Breaking the World
BlackRock Investment Institute April 2012
[2] Braking China Without Breaking the World
What is inside
First Words and Summary China inc: Bull, Bear and Bottom line introduction: Why China Matters A Matter of Timing 3 4 6
Joel Kim Head of BlackRock Asia-Pacific Fixed Income
Credit: too Much, too Quickly 8 The Great Credit Leap Forward Bad Debt? Just Roll It Over No Banker Will Come Clean This Year A Less Offensive Four-Letter Word real estate: Can a Bubble Be deflated? 13 Somethings Got to Give A Mens Shirtmaker Diversifies A Quiet New Year for Realtors Breaking a Vicious Circle investment and Consumption: looking for Balance 17 A Case of Diminishing Returns Go Buy a Refrigerator! A Blueprint for Rebalancing Success Bankers Are Shooting Fish in a Barrel Wanted: Carefree Spenders In Search of Luxury Goods Politics: Change is hard 23 The Emperor Is Far Away Vested Interests and Paralysis 300 Million Publishers From Small Piles of Rocks to Oil Shock Tit for Tat in Trade Wars Competiveness: Beyond Cheap labor Of Robots and Old People 27
Mark McCombe Chairman, BlackRock Asia-Pacific
Neeraj Seth Head of Asian Credit, BlackRock Fundamental Fixed Income Group
Jeff Shen, PhD Head of Asia-Pacific and Emerging Market Equity, BlackRock Scientific Active Equity Group
Ewen Cameron Watt Chief Investment Strategist, BlackRock Investment Institute
Blackrocks China Forum

About 50 leading BlackRock portfolio managers and external experts from around the globe recently exchanged views on Chinas economic trajectory at the BlackRock Investment Institutes China Forum. Many went in bullish and came out still bullish but with much less complacency and certainty. This publication summarizes their ideas. The Blackrock investment institute leverages the firms expertise across asset classes, client groups and regions. The Institutes goal is to produce information that makes BlackRocks portfolio managers better investors and helps deliver positive investment results for clients. Lee Kempler Ewen Cameron Watt Jack Reerink Executive Director Chief Investment Strategist Executive Editor
Markets: Counting on China 29 Equities and Corporate Bonds: A Growing Addiction Commodities: An Outsized Influence Government Bonds: A Big Overhang
The opinions expressed are as of April 2012, and may change as subsequent conditions vary.
BlaCkroCk inveStMent inStitute
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First Words and Summary

China is at a crossroads. Investment-driven growth has spun an economic success story without equal since the country opened for business in 1978. This has come at a cost: Unbridled credit growth, overbuilding, environmental damage and a widening divide between the haves and have-nots. It has become clear Chinas old playbook of invest and grow no longer works so well. But a shift to a consumption-driven society is tough for a command economy and wrought with pitfalls. The countrys upcoming once-a-decade leadership change brings both opportunity and uncertainty. The downfall of princeling Bo Xilai, the former charis-matic leader of Chongqing, shows tumult below the surface. This changing of the guard will reverberate well beyond its own population, as China has become the globes growth engine. We are optimistic on Chinas economic trajectory in the short term. A nagging worry: Markets already factor in a soft landing this year, leaving potential downside risk. The leaders walk a tightrope, and have lowered the official growth target to 7.5% for 2012. We are concerned about Chinas ability to keep up its economic march in the long run. Challenges are big and solutions are not easy. This publication discusses key factors driving Chinas economy this year and beyond, signposts for change and implications for investors. Examining the financial system, the deflating real estate bubble, the tricky shift to a consumption economy, politics and competitiveness, our main findings are: } n explosion in credit growth resulting from Beijings 2009 A stimulus has made the financial sector the economys Achilles heel and its biggest long-term threat. The country can pave over problems this year, but the bills will come due. China will have to charge borrowers real money and give savers a real return to create a healthy financial system in the long run. } The real estate slump is the biggest threat to economic growth and confidence this year. The sector is interwoven with the entire economy and has been a key growth driver. A governmentengineered slowdown has brought down prices to more affordable levels, but also has created ghost cities. Urbanization and growing incomes should balance supply and demand eventually. The question now is: Can Beijing break a vicious circle of falling prices and sales (when it is ready to do so)? } Chinas economic miracle was built on an undervalued currency, lots of investment, and subsidized energy and credit for
The opinions expressed are as of April 2012, and may change as subsequent conditions vary.
manufacturers. Domestic savers financed China Inc.s master plan by accepting savings rates below inflation, wage increases that lagged economic growth and a minimal social safety net. This is changing, but powerful interests are stacked against a true shift to a consumption economy: exporters, state enterprises and local governments. } Chinas new leadership could take the tough measures needed to engineer a shiftliberalizing interest rates, opening capital markets, market pricing of resources, and building out social services. But Beijing is not almighty; local governments tend to go their own way and a desire for consensus has often resulted in political paralysis. Risks of a popular revolt or foreign conflicts are low as the one-party state has kept a tight lid on dissent and is focused on fulfilling its domestic social contract. } Real wage growth, rising materials costs and environmental restrictions are changing the workshop of the worldfor the better. Some labor-intensive industries are moving elsewhere and automation is increasing. There is room for more productivity growth even as the easy gains have been harvested. Protection of intellectual property is still weak and global brands have yet to emerge, but we believe chances are China will remain competitive and confound the doomsayers.
So What do i do With My Money?tM

} global consumer companies and high-end machinery makers are likely to be good long-term bets. } energy, precious metals and agricultural commodities prices should be underpinned by the countrys insatiable demand, and boost companies in those areas. } Most Chinese companies are likely to report poor earnings this year, but valuations look cheap. } Chinas demand for basic materials such as cement and steel should peak soon, hitting key suppliers and resource currencies in those markets. } Chinas buying of uS treasuries may slow over time, but a fire sale does not look to be in the cards. More investment implications on pages 29 to 31.
China Inc: Bull, Bear and Bottom Line

Factor
A Sickly Financial System
Bull Case
It is easy to pave over financial problems in the short term, Beijing has plenty of firepower for bailouts. Growth in local government debt has come to a screeching halt. China has proved many times it can fix its banks when needed. The same team that engineered a doubling of annual credit to 14 trillion RMB during the financial crisis can pull the strings in a different direction.
Bear Case
Banks non-performing loans have fallen by 97% in the past decade, but this masks a poisonous reality: Unpaid loans are rolled over. Debts of state enterprises and, to a lesser extent, of local governments appear to be ticking time bombs. Banks are bleeding deposits and luring customers with asset-backed securities. (Hmmm, what kind of assets?) Banks are lending to all the wrong people: lumbering state giants and developers. Banks are bad at risk management. Local governments, banks and companies all bet prices would keep rising and are overexposed. Real estate has been the driver of economic growth. Homes are too expensive for average earners. Overbuilding has resulted in ghost cities and a huge inventory of unsold properties. Beijing may not be able to arrest a vicious cycle of lower prices and lower sales.
A Deflating Real Estate Bubble
Urbanization and the desire for upgrades provide steady demand. Affordability is improving due to falling prices and rapid real wage growth. Buyers pay a majority of the purchase in cash, so price declines will not hurt the financial system. Savers have few other places to park their cash. A push on low-end social housing will keep the construction industry busy.
Too Much Investment and Too Little Consumption
Is there such a thing as too much investment? Capital stock is not yet excessive by international standards, and China needs investments in infrastructure and automation to keep up productivity growth. Consumption is rising rapidly, and half of households will soon classify as middle income. Rural wages are growing faster than urban ones, making for more balanced development. Building out a social safety net would unleash a pile of precautionary savings for illness and old age. The Communist Party arguably is built for stability: It knows internal strife can result in Cultural Revolution-type horrors. Regimes historically have faced popular revolts only when incomes reach the worlds median: China has a long way to go there. Beijing has kept a tight lid on internal dissent and has not had a major overseas confrontation in the last 30 years.
Investment is a case of diminishing returns: It takes $5 to generate $1 of GDP growth. The model is based on an undervalued currency, low real wage growth and financial repressionfactors that policymakers are loath or unable to change. Chinas command economy appears ill-equipped to stimulate consumption. Much industry would collapse without below-cost energy and interest rates. Vested interests will work hard to torpedo a shift to a consumption model. Commodities demand is at risk. Watch out, Australia. All politics are local. It is an uphill battle to effectively steer the country toward a new course. China has not done enough to improve the environment, curb corruption, address the widening inequality gap and stimulate consumption. The leadership often is paralyzed because it is pulled in too many directions. Chinas military build-up could set up the world for a major confrontation down the road.
Political Risk
Competitiveness
Chinas value-added exports are increasing and industries are investing in automation to stay competitive and improve quality. China is filing more patents and is now dominating industries of the future such as solar power. The country has a first-class infrastructure. The migration of labor-intensive industries to Vietnam, Cambodia and elsewhere is a good thing.
Heavy subsidies have thwarted competitiveness and innovation. Violations of intellectual property rights still occur. The easy productivity gains have been harvested, and wage growth is a problem. China has yet to develop real brands.
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Bottom line
We expect a soft landing in 2012. Longer term, the financial system represents the biggest risk to the economy, we believe. The sheer magnitude and pace of credit growth does not pass our smell test.
Signposts (What to look for)

} } } } } } } Reserve ratio changes Deposit outflows and sales of wealth management products Bank cash flows and operating cash levels Credit growth and non-performing loan trends Corporate bond issuance and trading Gradual moves toward market-driven deposit and lending rates Demand for gold and other hard assets
Bull
Bear
} } } } } } } Inventories, sales volumes and price trends Ratio of new construction vs. sold floor space Debt and stock prices of major developers and consolidation in the sector Policy actions such as property taxes or, conversely, more curbs Sales of construction machinery and durable household goods Sales and volumes in secondary and tertiary cities Granting migrant workers urban residency permits so they can own homes
Real estate is the No. 1 threat to Chinas growth this year because the sector is so interwoven with the rest of the economy. Supply and demand should balance out in the long run. The lack of leverage is a big positive.
Bull
Bear
} } } } } } } } Monthly retail, auto and luxury sales Consumption share of GDP and GDP growth, and real wage growth Raw materials imports, energy subsidies and commodities prices Import/export trends (beyond one-month aberrations such as this February) Loosening the currency peg and opening capital markets Privatizing state enterprises and liberalizing interest rates New sources of local government financing Macau gambling revenues and capital flows
A pullback in consumption in the wake of falling real estate prices and slowing export growth is a major risk this year. Longer term, a big worry is that a rush to rebalance could lead to an economic implosion.
Bull
Bear
} } } } } } } Political unrest beyond local flare-ups Food price inflation, unemployment and rising inequality Efforts to curb corruption, protect the environment and ensure food safety High-profile casualties of the upcoming leadership change such as Bo Xilai Restrictions on social networks such as Weibo Confrontations in the East China Sea with other Asian countries or the US Increased secessionist and religious militancy
A one-party system is geared to retain its hegemony and ensure stability. The upcoming once-a-decade leadership change is hairy. Bo Xilais downfall is the tip of the iceberg, and one that is freezing policy for now.
Bull
Bear
} } } } } } Productivity and real wage growth High-end machinery orders R&D spending and patent applications Trends in returns of Chinese who have studied abroad Emergence of domestic and global Chinese brands Protectionist actions by Chinas trade partners
Loss of competitiveness is the lowest risk to the economy this year and beyond. China already is moving up the value chain.
Bull
Bear
Introduction: Why China Matters

China mattersa lot. The country has rapidly become the secondlargest economy in the world. It will likely contribute two-fifths to global growth this year, twice as much as the United States. See the chart below. Resource-hungry China has an outsized influence on most commodities markets, and is the largest foreign holder of US Treasuries. GDP per capita jumped more than 20-fold to $4,400 in the 30-year period ended 2010. Ports, bridges, airports, expressways and entire cities have been built in record time. China is now the largest market in the world for cars, computers, mobile phonesthe list is endless. Wine sales have more than tripled in just five years. The big questions are how the current government will navigate the domestic real estate slump and the global economic slowdown, and whether the future leaders will be able to solve a ticking bad debt time bomb and deliver on promises to rebalance the economy toward consumption and sustainable growth. Add in challenges of maintaining a harmonious society in a place with rapidly growing expectations, corruption, a long history of regionalism and world-beating income inequality, and you have a troublesome brew. This is before you even consider artificial pricing of money and a financial system that subsidizes borrowers at the expense of lenders. Or ponder environmental despoilment, deteriorating demographics, water shortages and a growing addiction to imported energy. It is a wonder the place works so wellor at all. There is enough fodder for a fierce debate between panda haters and panda huggers. Now read on
A Heavy Burden
Chinas Share of expected 2012 global economic growth
China 40% Rest of Asia 24% Other Emerging Markets 17% US 17% Other Developed Markets 2%
a Matter of timing
Real reforms to rebalance Chinas economy are on hold this year because of the once-a-decade leadership change. An imminent collapse is unlikely, we think. The current leadership will not go out with a bang, but certainly does not want a train wreck during the final stages of stewardship. Business cycles exist in China as elsewhere but we expect a soft landing in 2012.
Source: Deutsche Bank (January 2012). Note: Assumes global economic growth of 3.2% in 2012.
Flattening Out
Sales of heavy Machinery and autos 100
UNITS (THOUSANDS)
250%
UNITS (THOUSANDS)
2,000 1,500 1,000 500 0 2002 2004 2006 2008 2010

Monthly Auto Sales Y-O-Y GROWTH (%)
150% 120
Y-O-Y GROWTH (%)
80 60 40 20 0 2008 2009 2010 2011

Monthly Machinery Sales
200 150 100 50 0 -50 -100 2012

YoY %
90 60 30 0 -30 -60 2012

YoY %
Sources: Bank of America Merrill Lynch, China Construction Machinery Institute and China Association of Automobile Manufacturers. Notes: Machinery sales data through January 2012. Auto sales data through February 2012.
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In this interim period, it is important to read the economic tea leaves. Real estate prices, sales and construction are important ones. Politically sensitive food inflation is another one, as are manufacturing gauges such as the various purchasing manager indexes (PMIs). At the start of 2012, the data were both conflicting and skewed by the effects of the early lunar New Year holiday. Real estate and key consumption indicators pointed down, while other gauges pointed up. For example, sales of heavy machinery used in construction, such as excavators, crashed. Auto sales flattened, pointing to a general slowing in the wider economy. See the charts on the previous page. By contrast, transport volumes are strong. And a gauge of small business activity has been ticking up. See the chart below. This is important because small businesses employ 60% of Chinas workers and make up 90% of companies. The rebound could indicate the governments easing policy on liquidity has started to work. Bank credit enabled large companies to pay their supplier bills. Secondly, it could mean the bottom has not fallen out of exports because many small companies are exporters.
Like some corporate chieftains, China likes to manage expectations by under-promising and over-delivering.
Premier Wen Jiabao set a 7.5% annual growth target for 2012 in Marchthe lowest rate in almost a decade. Most China watchers, however, believe the country will want to achieve at least 8.5% a year. Official targets exist to be beaten. Like some corporate chieftains, China likes to manage expectations by under-promising and over-delivering. It is realistic to expect China to move toward economic growth of 6%-7% a year this decade versus the 10%-plus clip in the old days, we believe. Five reasons: } The political leadership appears to understand the drawbacks of too much credit. } Slow growth in the debt-ridden developed world likely means slack demand for exports. } The real estate boom has ended because tightening measures have taken hold. } Infrastructure spending is slowing as policy shifts from favoring bridges for the masses to pills for the people. } Savings ratesthe fuel of deposit and loan growthare likely to remain flat or drop from mind-blowingly high levels. Beijing is expected to arrest this years slowdown in growth
A Ray of Light
Chinas Small Business PMi, 2011-2012 60 58
SMALL BUSINESS PMI
with all sorts of administrative and fiscal measures, while at the same time trying to keep a lid on inflation and prevent more bad debts that eventually could overwhelm the banking system. Most people, perhaps too many, believe Beijing will walk this tightrope. At US investor gatherings in late February, one Wall Street firms China strategist polled the audiences and found just one bear among roughly 1,000 people. This lonely creature contrasted with a host of cubs the previous year. Beyond 2012, the picture becomes very different. It is now clear Chinas 2009 stimulus was too much, in too short a time. Beijing overestimated the US recessions fallout. The result is a pile of debtwhich looks ready to fall over in the next few years (or
56 54 52 50 48 46 44 42 40 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Feb 12
stay shaky forever).
Source: China Federation of Logistics and Procurement. Note: Data through February 2012.
Most people, perhaps too many, believe Beijing will walk this tightrope.
Credit: Too Much, Too Quickly

For a poster child of financial repression, pick any of Chinas one-billion-plus consumers. They have been bankrolling the countrys infrastructure boom and manufacturing machine and have lost money in real terms in the process. (A cynic would say the West now is importing this made-in-China concept.) Consumers who park their savings at banks have received negative returns after factoring in inflation, an average loss of 0.54% a year since 2004. See the chart below. What changed in 2004? China had started to rack up huge account surpluses because of bumper exports and an underappreciated RMB currency. The surplus hit an unprecedented 10% of GDP at its peak in 2007. The central bank started to offset, or sterilize, the flood of foreign currency by selling bills at very low rates. For bankers, these were bills you cant refuse. To keep the banks profitable, authorities set deposit rates low. Low deposit rates and high reserve ratios also would put a brake on inflows of hot money speculating on appreciation of the RMB. The result: an effective tax on consumers who kept their savings at banks. Financial repression worked well because consumption took a back seat in Chinas investment-driven master plan. More on
Average Interest Rate = 3.04%
Dont Take It to the Bank!

real return on household one-Year deposits, 1997-2011 8% 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 97
REAL INTEREST RATE (%)
Chinas hard-pressed consumer and unprecedented investment boom later. In this chapter, we review the credit boom these savings helped create.
the great Credit leap Forward

Average Interest Rate = -0.54%
Armed with a reliable supply of cheap deposits, banks went on a lending binge. The biggest beneficiaries were state-owned enterprises (SOEs) and local governments.
99
01
03
05
07
09
11
The first group revved up exports and capital expenditures even more, supported by cheap credit and subsidized energy costs. It was a lifeline to many enterprises that had no business staying in business.
Source: Peterson Institute for International Economics. Note: Data through December 2011.
Debts Have a Way of Piling UpEven in China

Credit growth in Billions of rMB and as a Percentage of gdP, 1993-2011
CREDIT GROWTH (RMB BILLIONS)
15,000 12,000 9,000 6,000

% GDP
50%
CREDIT GROWTH TO GDP (%)
40 30 20 10 0 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Other
3,000 0
New RMB Loans Corporate Bonds
New Foreign Currency Loans
New Entrusted Loans Insurance Claims Paid
New Trust Loans
New Bank Acceptances
New Stock Issued by Non-Financial Enterprises
Insurance Company Real Estate
Sources: Carl Walter, Su Ning, China Bank Statistics and Peoples Bank of China.
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The second group financed infrastructure works, office towers, conference centers and an array of faux landmarks, from Chengdus Dorchester-inspired British town to Venetian canals and a replica of St Marks bell tower at the New South China Mall in Dongguan. This helped inflate an emerging real estate bubble. Credit grew and grew ... until a great leap forward in 2009. Worried the world financial crisis and subsequent US recession would hit China hard, Beijing engineered a huge monetary stimulus. Credit doubled to a clip of at least 14 trillion RMB a year. See the chart on previous page. Credit grew at an compounded annual growth rate of 36% in the period 2004 to 2010. As a result, the total value of bank loans and bonds quickly exceeded GDP. See the chart below.
It is unlikely China will let the market collapse. Nobody wants to see a local government default or a big state firm go belly up.
A bank CEO in a coastal city may say his operation is lending 100% of deposits, no problem. He gets away with it because his bank is part of a national network that (still) has enough deposits in the interior to make up for shortfalls on the coast. The government may abolish this cap because it has many other ways to control loan growth, notably its stranglehold on interbank market. Everything appears just hunky-dory for Chinas banks: Nonperforming loans (NPLs) fell by 97% over the past decade and now average just 1% of the loan book. See the chart below.
A Likely Sad Ending

outstanding loans and Bonds, 1996-2010
LOANS AND BONDS (RMB BILLIONS)
Too Good to Be True

non-Performing loan ratios of Major Banks, 1998-2011 140%
LOANS AND BONDS TO GDP (%)
60,000 50,000 40,000 30,000 20,000 10,000 0 96 98 00 02 04 06 08 10
35%
NON-PERFORMING LOANS (%)
120 100 80 60 40 20 0
30 25 20 15 10 5 0
Bank Loans Loans/GDP
Bonds
Loans and Bonds/GDP
98 99 00 01 02 03 04 05 06 07 08 09 10 11 Sources: UBS, Peoples Bank of China, China Banking Regulatory Commission and CEIC. Note: Data before 2002 only cover the Big-4 state-owned banks.
Sources: Carl Walter, Peoples Bank of China and Wind Information.
This is where the problem lies: Take a machine that runs along at a steady pace, suddenly inject adrenaline and order: Go lend. The sheer magnitude and pace of this unbridled credit growth does not pass our smell test. It suggests to experienced investors there has to be trouble somewhere, sometime.
This is dangerous, especially because both local authorities and SOEs are already deep in debt. It is unlikely China will let the market collapse, though: Nobody wants to see a local government default or a big state firm go belly up. There is nothing subtle about the government guarantees of these entities. High-profile bankruptcies just do not fit into China Inc.s master plan of economic growth and employment. And banks are very much part of the plan. Banks are, after all, an extension of the fiscal policy. This is also the reason they trade at such low valuations.
Bad debt? Just roll it over

China has plenty of rules to keep credit growth in check. But they are loosely enforced. For example, Chinese banks are supposed to lend up to 75% of deposits. But banks need to show a 75% loan-to-deposit ratio only at the months endgiving them about 30 days each month when they can lend more.
Take a machine that runs along at a steady pace, suddenly inject adrenaline and order: Go lend.
[ 10 ] B r a k i n g C h i n a W i t h o u t B r e a k i n g t h e W o r l d
no Banker Will Come Clean this Year

The practice of rolling over loans worksas long as banks have enough deposits to play with. It is like a bath filling up faster than it empties out. But companies and consumersfaced with cash flow needs and fed up with negative real returnsare starting to vote with their feet and are pulling deposits. Banks, especially in coastal areas, are trying to fight these outflows by offering asset-backed securities that carry higher interest rates. About 10% of deposits has flowed into these wealth management products. See the chart below.
have deteriorated across the industry in the past three years, with many second-tier banks already facing shortfalls, according to ratings agency Fitch Ratings. Do not expect any banks to come clean this year. Bank chieftains angling for government positions in the leadership change will want their records to remain squeaky clean. Put yourself in the position of a bank CEO. You have been presiding over five years20 quartersof profit increases. Now you are gunning for that position in the State Council. Are you going to bring down your profits this year by increasing provisions? Just to be prudent? Chances are you will not. You leave it for the next guy to deal with.
Looks Familiar?
investment in asset-Backed Securities Quadrupled, 2007-2011
ASSET-BACKED SECURITIES (RMB MILLIONS)
To be sure, there are plenty of deposits. They are just not for lending. One example: To recycle the inflows of foreign exchange and prevent the RMB from appreciating, the central bank obliges banks to hold vast quantities of reserve bonds yielding only 1.5%. This deflates the money multiplier and kicks sand into the engine of a credit-led economy.
8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2007 2008 2009 2010 2011
Bank chieftains angling for government positions in the leadership change will want their records to remain squeaky clean.
In all, the Triple R (Required Reserve Ratio) and other measures tie up some 10 trillion RMB of deposits. This has given the central bank the means to provide stimulus when the economy needs it. Every cut in the Triple R pumps some 380 billion RMB into the system (provided the cuts are not offset by capital outflows). This doesnt mean SOEs and other politically connected players have a tough time getting credit. Not at all. They are issuing bonds like there is no tomorrowforced down banks throats at slightly higher rates than one-year deposit rates. The result is a huge debt capital market where very few trades take place. Why? If a bank sells these bonds, it is almost guaranteed to take a loss because nobody wants them at the price the bank paid for them. Bottom line: The corporate bond market is bank lending in disguise. The bulls believe China has proved again and again it can fix these problems. The basic argument goes like this: Chinese banks go bust every decade, but the country has just found a much better way to deal with it than the West. Conclusion: Any weakness in the financial system will be dealt with quietly.
Index-Linked Asset-Backed Bills
Asset-Backed Other Asset-Backed Loans
Sources: Carl Walter, Wind Information and Fitch Ratings. Note: Data through June 30, 2011.
Deposits from corporations under cash flow pressure (and with the ability to export capital by padding overseas invoices) dwindled to near zero in the first nine months of 2011, compared with growth of 3.7 trillion RMB in 2010. In the third quarter alone, corporate deposits of an estimated 1 trillion RMB vanished into thin air. Combined with the strangle of rising reserve ratios, growth in the M1 money supply has dwindled to a clip of 3%-4%. Moreover, deposit outflows have triggered a slow-motion cash crunch. Smaller banks in particular are vulnerable, partly because their loans are coming due earlier. Operating cash reserves
Deposit outflows have triggered a slow-motion cash crunch.
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Acronym to Watch: LGFV

Structure and Mechanics of local government Financing vehicles (lgFvs) How LGFVs Come To Be
Central Government
Typical LGFV Structure

Local Government
23 Provinces 5 Autonomous Regions 4 Municipalities (Beijing, Shanghai, Chongqing, Tianjin) 2 Special Administrative Regions Incorporated 6,500-8,200 LGFVs
Equity/Loan Injection
Ownership of Local Enterprises, Land and Tax Subsidies
Repayment LGFV Cash Loan Bank
Profit 333 Prefectures
Cash Investments
2,858 Counties
40,858 Townships
Activities (Infrastructure, Utilities, Transportation, Land Development)
Sources: Deutsche Bank and China Statistical Yearbook 2010.
a less offensive Four-letter Word

Local governments cannot borrow unless they have specific approval from the State Council, the countrys highest executive administrative body chaired by the premier. This doesnt happen very often. It is not meant to happen often. Think of it as a company requiring CEO sign-off for all travel and entertainment. T&E costs will go down very quickly. Where there is a will, there is a way, thoughespecially in China. Local authorities have set up special entities to pay for infrastructure and other projects. This is perfectly legal. The chart above shows the mechanics of these so-called local government financing vehicles (LGFVs).
time bomb, especially at a time a main source of local government revenuesland saleshas dried up amid falling real estate prices.
Where there is a will, there is a wayespecially in China.

Others are optimistic. LGFV net debt barely increased in 2011 because regulators discouraged banks from making new loans, according to research firm CLSA. This compared with a 19% rise in LGFV net debt in 2010 and a 62% stimulus-fueled jump in 2009. CLSA says. Local governments can pocket an increasingly smaller share of land sales because of higher spending on compensation and relocation. As a result, local revenues from land fees equaled just 9% of total national spending on infrastructure in 2011, CLSA notes. In any case, all local debt is an explicit liability of the central governmentwhich saw a 30% jump in tax revenues in 2011. Beijing can pay a lot of bills.
The bulls believe China has proved again and again it can fix these problems.
LGFVs have taken out trillions of RMB in loans backed by land sales. China bears have long argued this represents a ticking
Get Out of Debt Tomorrow

a Possible Solution for Bad lgFv debts 3,000
2,550 600
Over the Refinancing Hump

Maturities of local government debt 3,500
30.2%
35%
2,500
RMB BILLIONS 600 TOTAL DEBT (RMB BILLIONS)
3,000
24.5%
30
2,000 1,500 1,000 0 Local Govt. Revenues Asset Sales Over-Provision for NPLs Recoveries on Projects Potential NPLs Local Govt. Bond Central Govt. Support
600
2,500
25
PERCENT DUE (%)
260 120 245 125
2,000
17.2%
20
1,500
11.4% 9.3% 7.5%
15
Write-Offs
1,000
10
500
0 2011 2012 2013 2014 2015
0 2016 and Beyond
Source: Deutsche Bank estimates. Notes: Assumes 30% of LGFV loans default. Assumes local governments sell 10% of assets and divert 2% of revenue.
Sources: Deutsche Bank and National Audit Office. Note: Data as of year-end 2010.
Even if 30% of all LGFV loans default, the problem is manageable, according to Deutsche Bank. Local government bond issues, asset sales and diverting 2% of government revenues would solve most of the problem in its view. See the chart above.
In addition, most LGFV debt is spread out after scaling a renewal hump last year, with almost a third due only after 2016. See the chart above.
[ 13 ]
Real Estate: Can a Bubble Be Deflated?

The City Beckons
urbanization and Migration
22 Cities 71 Cities 121 Cities 214 Cities > 5 Million 2-5 Million 1-2 Million = 180 Million = 216 Million = 175 Million = 571 Million Harbin 552 mln 962 mln 1,307 mln 1,427 mln
100%
Shenyang SHARE OF POPULATION (%) Beijing Tianjian Xian Nanjing Shanghai Chengdu Wuhan Chongqing Guangzhou Hangzhou
80
745 mln
467 mln
60
490 mln
790 mln
40
960 mln
20
62 mln 172 mln
562 mln
1950
1978
2005
Rural
2025
Urban
Sources: ISI Group, CEIC and National Bureau of Statistics. Note: Numbers in millions of people.
Rapid urbanization drove Chinas housing boom for much of the 2000sand is likely to do so in the future. China is expected to have almost one billion urbanites by 2025. It already has 214 metropolitan areas with more than one million people, four times as many as the United States. See the chart above. Many Chinese already owned their homes, but often these were shacks or rural dwellings. There was definitely a need to upgrade, and many households did just that. Then savers desperate for yield and hard assets started to snap up apartments. Where else could they go? Banks offered negative real interest rates. The stock market was perceived as a big high-roller table at best. And offshore markets wereand arepretty much shut.
Somethings got to give

Some 40%-45% of all residential properties sold in early 2009 were for investment purposes, according to think tank Peterson Institute. Other speculative bubbles built in jade, art and gold prices, but there was nothing like real estate. Beijing inadvertently made it the preferred asset class, egged on by powerful interests that cashed in on this state-sponsored freebie.
Other speculative bubbles built in jade, art and gold prices, but there was nothing like real estate.
Local governments did their part to support the boom by providing infrastructure and sponsoring grandiose projects. They bought farmland at artificially low prices and sold it for a profit to developers. Over time, local governments became addicted to these land sales as a source of revenues. And the practice to appropriate land became the root cause of periodic local outbreaks of social unrest. Real estate has been a great wealth creator, for companies, local governments and individuals alike. The top source of wealth among Chinas richest 1,000 people is real estate, according to the latest ranking by Hurun Report Magazine (which was appropriately sponsored by the Hainan Clearwater Bay luxury development). No wonder those feasting want the banquet to continue.
The risk to housing in China is not so much its imminent collapse, but how ubiquitous other segments of the economy are exposed to it.
Sales volumes and prices fell after government measures to dampen speculation and prevent prices from spiraling beyond the reach of the emerging middle class. There are some tentative signs of bottoming (see the charts below), especially in secondand third-tier cities where people buying homes for themselves are a more important source of demand than investors.
a Mens Shirtmaker diversifies

The real estate market is the biggest risk to Chinas economic growth this year. The tipping point will likely come in the second quarter, when downside risks to the entire economy will start to outweigh inflation and affordability considerations. Or will they? Our assumption is Beijing wants to take real estate prices down 25%-30% from their highs. With a 10% fall already, there is a painful additional 15%-20% to go. This is dangerous. The biggest risk is stagflationwhen activity drops off a cliff while prices stay high. In that case, the government may stick to its tightening policy. How big is the real estate sector? It makes up 20% of fixed investments, translating into a 10% share of GDP. But the sector looms much larger in reality. We suspect land is collateral for more than half of loans. Real estate is interwoven with the entire economy. In other words: The risk to housing in China is not so much its imminent collapse, but how ubiquitous other segments of the economy are exposed to it.
Sales volumes and prices fell after government measures to dampen speculation and prevent prices from spiraling upward.
Bubbles involving real estate are quite common. This seemed to have all the signs, including the endemic involvement of local governments and the corporate sector. It is clear the boom cannot last. (Nor does Beijing want it to last.) Consider: } Chinas residential housing construction equaled almost 10% of GDP in 2011, compared with 6% for the US economy during the height of the boom in 2005. } Real estate accounted for 40% of urban household wealth in 2010, double the proportion in 1997, according to Peterson Institute. It is hard to imagine it doubling again in the next decade.
That Sinking Feeling

real estate Prices and Sales volumes in Major Cities 12,000 10,000
RMB PER SQUARE METER Y-O-Y SALES VOLUME GROWTH (%)
150% 120 90 60 30 0 -30 -60 -90 2007 2008 2009 2010 2011 2012 2010 2011 2012
Volume Growth Weekly Sales Prices
8,000 6,000 4,000 2,000 0
Sources: Deutsche Bank and Soufun. Notes: Price and sales volume trends in 39 major cities. Volumes represent year-over-year growth in four-week periods. Data through March 2012.
[ 15 ]
Clearing Out Inventory

Months to Clear real estate inventory at Current Sales rates 40 35 30 25 20 15 10 5 0 2008 2009 2010 2011 2012
Inventory
Can We Finally Afford It?

housing Prices as a Factor of annual household incomes 12
11
FACTOR OF HOUSEHOLD INCOME
MONTHS TO CLEAR INVENTORY
10
6 2007 2008 2009 2010 2011 2012

Housing Affordability -1 Standard Deviation
+1 Standard Deviation
Source: Deutsche Bank. Note: Weekly data through March 18, 2012.
Source: Deutsche Bank. Note: Estimated data through end 2012.
One example: The CEO of a mens shirtmaker says he expects 100 billion RMB in revenue in three years, with the core shirt business making up just 1%. It is tough to make money in the apparel business, so the CEO is building a 400-meter office towerthe highest in his cityand outlet malls. This particular CEO is not alone. He illustrates how real estate runs through the entire economy. It is not about a few developers going bust. It is about local governments. It is about the entire corporate sector. It is hard to see a happy ending here. We struggle to find a precedent in history where the bursting of a property bubble did not lead to financial distress.
Anecdotal evidence abounds: Coffers with cash in Macau and Hong Kong. Record real estate prices in Vancouver. Australian mines and vineyards snapped up by Chinese buyers. Once people start believing prices will keep falling, they stop buying. Just 19% of people expected housing prices would go up in the first half of 2012, down from around 45% in 2009, according to a December Peoples Bank of China quarterly survey. The same survey showed 21% expected prices to fall and 46% anticipated a flat market. Things looked pretty grim in the first quarter. For example, not one transaction closed in Beijing, a city of 20 million, during the entire Chinese Year of the Dragon celebrations, according to JPMorgan. Overall, transactions have plummeted and inventory has risen to 15 months worth of sales. See the chart above on the left. The inventory may be understated as the gap between floor space under construction and the amount sold is huge: 1.9 billion vs. 1.1 billion square meters in 2011. The gap is slowly closing, but there is a big overhang. And new construction usually lags six months behind trends in real estate sales.
a Quiet new Year for realtors

A slowdown or, worse, a crash in the real estate market also would hurt consumer spending. If the US experience is any guidance, ever-increasing real estate prices can drive consumption. Take them away, and consumption plummets. Some money is already fleeing the country. China had capital outflows in the fourth quarter of 2011the first time since the Asia crisis in the late 1990s. Speculative inflows betting on an RMB revaluation dried up as it became clear Chinas economy was slowing. This put the spotlight on the wealthy taking money abroad.
Once people start believing prices will keep falling, they stop buying.
Commercial real estate is hit hardest, especially in second-tier cities. Chongqing, for example, will have nearly 800,000 square meters of new commercial space in 2012, whereas the annual take-up has been just 150,000 square meters. The government has started to offer incentives for first-time home buyers, including lower mortgage rates combined with guidance to banks to lend to this group. It could ax deed taxes and even cut mortgage down paymentsalthough it would not resort to the latter measure lightly.
The question we ask ourselves is: Suppose the government took its foot off the brake; could it reignite demand in housing?
population, or 200 million people, live in cities but do not have a proper registration. Another avenue is the push toward low-end social housing. This will not do much for prices of high-end private homes, but it does serve the dual purpose of creating affordable housing for the masses and keeping the construction industry going. Expect social housing construction to almost double to more than seven million units this year, according to Bank of America Merrill Lynch. The market is starting to believe the magic of policy. Bonds and shares of Hong Kong-listed developers rose sharply at the start of the year. One company even raised new equity. The triumph of hope over experience? Only time will tell. It is clear the government is not ready yet to reverse its housing policy. Premier Wen Jiabao in early March emphasized house prices were still too high and that relaxing existing curbs could cause chaos. This dampened investor hopes for a policy reversal and caused stocks to post their biggest daily loss in months. The questions we ask ourselves are: Suppose the government took its foot off the brake; could it reignite demand in housing? And suppose the paralysis in policymaking lasts long enough to destroy confidence in real estate as an inflation hedge?
Breaking a vicious Circle

Some fear it is already too late to re-engineer a real estate turnaroundeven in a command economy such as Chinas. These bears predict a vicious circle of lower real estate prices and lower activity. On the positive side, China has had much shorter real estate cycles than the West. Policy measures reversed a downturn at the end of 2008 in six months, for example. In the current climate, affordability is improving fast. If prices were to fall 20% from their peak and real wages were to grow 13%, affordability would improve by one third in one year. In the US market, this would take about a decade. See the chart on the previous page. One way to boost the housing marketand consumptionis reforming or doing away with the hukou system that bars migrant workers without proper urban registration from essential services such as schooling and healthcare. As much as 15% of the
[ 17 ]
Investment and Consumption: Looking for Balance

China is about investments. Ports, multi-lane highways, dams, bridges, high-speed trains, nuclear reactors, office towers, entire cities pop up seemingly overnight. The worlds workshop has renewed its plumbing, has redone its floor plan and is better connected with customers around the world than ever before. The result is an export juggernaut with productivity growth more than three times that of competitors. China is not unique in following an investment model. Germany did it in the 1930s; the USSR in the 1950s and 1960s; Brazil in the 1960s; and Japan in the 1970s and 1980s. Most of these efforts produced short booms but ended on ugly notes: war, debt drama and stagnation.
The country is becoming less efficient in turning credit growth into economic growth. It needs ever more gasoline in the tank to make the car go down the highway at the same speed.
You might ask: Is there such a thing as too much investment? (Especially if you live in a place in desperate need of an infrastructure upgradeand many of us do.) The answer is: Yes. It has taken China $5 of investment to generate $1 of GDP growth since 2001, 40% more than Japan or South Korea in their takeoff periods, according to the International Monetary Fund. The country is becoming less efficient in turning credit growth into economic growth. It needs ever more gasoline in the tank to make the car go down the highway at the same speed. We believe this is unsustainableand a real worry. This is even truer if you accept some analyst views that Chinas subsidies and production input advantages represent more than half of the return on invested capital. Demand for raw materials, especially cement and steel, may peak earlier than many expect. See the table below. China is now using 590 kilos of cement for every $1,000 of capital formation, compared with 155 kilos in South Korea and just 29 for the United States, according to Deutsche Bank.
a Case of diminishing returns

Like Japan and others, China enabled investment through repression of consumption in three main ways: } An undervalued currency essentially taxed imports } Increases in real wages lagged GDP growth } Deposit rates were artificially low What is extraordinary is investments are still increasing their share of Chinas economy. In most places, consumption kicks in and investment tapers off because of diminishing returns. Not so in China. See the chart below.
Topping Out Investment: Too Much of a Good Thing?

investment Share of gdP, 1997-2010 50% expected Peak demand for Selected raw Materials Material 2010 Chinese consumption (in kilos per capita)
Average = 44.1%
Cement 1,396 13,939 23,382 2015 1,633 17%
Steel 448 3,348 9,449 2017 657 47%
Copper 4.8 37 147 2025 10.8 125%
INVESTMENTS TO GDP (%)
45
Accumulated Chinese consumption to 2010 Accumulated consumption peak in Japan and United States
40
Average = 37.1%
Projected peak consumption year Projected peak year consumption Projected increase from current levels to peak year (%) Source: Deutsche Bank. Note: All data in kilos per capita except where noted.
35
30 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Sources: Peterson Institute for International Economics and National Bureau of Statistics.
Building, Building Building

Spending on infrastructure in Billions of rMB, 2005-2010 high- highways & urban Water Conventional Speed express- transit & Waterways Pipelines & electricity, Conserva- environrails rails ways Subways airports & Ports Storage gas & Water tion ment 93 110 98 130 246 294 878 26% 17 64 98 231 377 442 1,212 92% 548 623 649 688 967 1,148 4,075 16% 53 80 107 127 203 236 754 35% 21 31 46 57 59 65 258 25% 69 87 89 99 106 117 497 11% 39 51 79 112 177 224 643 42% 725 820 907 1,048 1,348 1,454 5,577 15% 82 95 109 142 216 275 837 27% 33 42 60 73 120 153 449 36% total Spending (rMB Billions) 1,680 2,004 2,242 2,707 3,820 4,407 15,180 21%
Year 2005 2006 2007 2008 2009 2010 Total (2006-2010) Growth Rate (2006-2010)
Sources: ISI Group and CEIC. Notes: Conventional rails exclude rolling stocks & locomotives. High-speed rails include new capital construction. Airports exclude aircraft and other special vehicles. Growth rates are compounded.
To be sure, investment in infrastructure is still needed to secure energy, conserve water and connect Chinas interior to the coast and the world. In the past decade, about 50% of investments have gone into transport. Expect less spending on transport in the future, especially on high-speed trains after recent mishaps, and more on nuclear power and water conservation. See the table above for past spending trends.
In addition, Chinas capital stockthe countrys highways, ports, rail tracks, airports and factoriesis still far below that of the United States, Japan and South Korea on a per capita basis. Even as a percentage of the relatively small economy, capital stock has not been excessive. See the charts below.
And Building More

Chinas Capital Stock to gdP and Per Capita 350% $150,000
325
CAPITAL STOCK PER CAPITA ($) CAPITAL STOCK TO GDP (%)
120,000
300
90,000
275
60,000
250
225
30,000
200 78 82 86 90
China
0 94
US
98
02
06
10
1995
China
2000
US
2005
Japan
2010
South Korea
South Korea
Sources: HSBC, CEIC, Bureau of Economic Analysis and Japans Cabinet Office. Note: Per capita figures in constant 2005 US dollars.
[ 19 ]
go Buy a refrigerator!
The mirror image of the investment boom is subdued consumption. Consumption has grownwe have all heard about the excesses but not as fast as GDP. As a result, it made up barely a third of the economy in 2010. To many economists, this number is surrealit is something you just never see. The contribution of consumption to GDP growth also remains extraordinarily low. See the chart below.
a Blueprint for rebalancing Success

rebalancing the economy is a multi-year project. nobody wants to upset the delicate equilibrium holding Chinas economy together now. the ingredients of rebalancing are well known: } iberalizing interest rates: given the economys torrid L growth, interest rates should be in the double-digit range to allocate capital efficiently and offer savers real rewards. the trick is to go slowly: local governments and state enterprises would go bankrupt if rates became real overnight. } xchange rate flexibility and opening of capital E accounts: another multi-year project, but one that is very necessary to address global imbalances. } rivatizing state-owned companies: Would cut bad P debts and reduce reliance on exports. assets could go into the underfunded social security fund. } uilding out a social safety net: Would help turn at B least some precautionary savings into consumption. } ew sources of local financing: Would lessen the N reliance on land sales. a possibility is recurring real
Consumption Growth Is SurrealIn Its Modesty

Composition of gdP growth, 1996-2012 15%
CONTRIBUTION TO GDP GROWTH (%)
12 9 6 3 0 -3 -6 96 98 00 02 04 06 08 10
Exports
12
estate taxes pioneered by Shanghai and Chongqing. } arket pricing of resources: electricity prices are M artificially low to protect manufacturing, which uses the brunt of electric power. expectations for reform are massive, but do not hold your
Consumption
Investment
Sources: CLSA and CEIC. Note: 2012 data is estimated.
Highly unusual? Yes. Damaging? Probably. The internal imbalances are reflected externally, with Chinas trade surplus and foreign currency pile ever increasing. Leaving prescriptions for debtor nations such as the United States aside, everybody agrees China has to rebalance its economy toward consumption. Can a command economy successfully make such a shift? It is tough. A command economy is very good at investing. The order build a highway comes down, and it gets done. It is much harder to say go buy a refrigerator, and get much traction. Any moves toward a consumption society are likely to be gradual and slow. This is a good thing. Suddenly taking away industrial subsidies such as below-cost loans and electricity, for example, would create a train wreck. Similar to how a July 2011 deadly accident near Wenzhou upended Chinas ambitious plans for a high-speed rail network, a big economic downturn could set back the clock on any moves made to favor consumers over manufacturers.
breath this year. the once-a-decade leadership change is putting the big decisions on hold. it is more about what Beijing wont do than what it can do for now. the February 2012 China 2030 World Bank report hits many of the right buttons. Many recommendations have been on the agenda for years, but nothing has happened. the main reasons are twofold: Powerful forces, including local governments, exporters and banks, support the investment model. and a consensus-driven leadership tries to placate too many interests.
Similarly, a rush to rebalance could trigger a spike in inflation around the world. For years, China exported deflation by providing consumers elsewhere with goodies that became cheaper and better over time. The secret sauce consisted of low wages, a low exchange rate and investment-driven jumps in productivity, such as better and cheaper transport. Change the sauces ingredients, and the world is looking at a very different dish.
Bankers are Shooting Fish in a Barrel

In our view, rebalancing the economy should start with a gradual interest rate liberalization. The 11th and 12th five-year plans (2006-2015) stressed this but nothing has happened. One way to make progress would be to slowly expand the band of deposit rates. Banks would not like it, but they are in much better shape than a decade ago. Fat lending spreads helped banks ring up a combined profit of 1 trillion RMB in 2011which is close to half of all private sector profits. They are shooting fish in a barrel! This has created tensions between bankers and the real economy. Banks make money hand over fist while small businesses are cut off from credit and consumers lose money on deposits. This situation has raised the possibility of an asymmetrical rate cut: reducing the lending rate while leaving deposit rates alone. Until recently, the governments sole focus was to keep a lid on
food price inflation triggered by surging pork prices. The CPI short for Consumer Pork Index in Chinahit 6% last year but has receded since. The governments 2012 inflation target of 4% on March 5 beat expectations, leaving more room for fiscal and monetary stimulus. In other areas, China is slowly making progress. For example, Beijing has deliberately been punching (small) holes in its Great Wall of capital controls. All companies authorized for foreign trade can now settle payments in RMB; qualified foreign investors can invest in Chinese securities; and central banks from Japan to Nigeria are adding RMB and Chinese bonds to their reserves.
Wanted: Carefree Spenders

We have talked a lot about under-consumption in relative terms. As a part of a fast-growing economic pie, its size is miniscule. In absolute terms, it is breathtaking. The growth in the number of Chinas wealthy and their spending poweris huge. Half of Chinas households will have income of 100,000 RMB or more a yearclose to Mississippis GDP per capitaby 2015, up from less than 15% in 2010, according to Deutsche Bank. See the chart on the left.
Middle Kingdom of Middle Income

households With annual income over 100,000 rMB, 2005-2015 400,000
Total income of households in top bracket in 2005
This is a huge middle income class with money to spend. Supposedly, the most popular phrase in China is: New Louis Vuitton opening soon. There may be some truth to this.
350,000
300,000
ANNUAL HOUSEHOLD INCOME (RMB)
Total income of households in top bracket in 2010
A Sweeter Home on the Farm

income growth in rural vs. urban growth areas, 1997-2011 15%
Y-O-Y INCOME GROWTH RATE (%)
250,000
200,000
12 9 6 3 0
150,000
Total income of households in top bracket by 2015
100,000
50,000
0 0% 20
2005
40
2010
60
80
2015 (Forecast)
100
97
99
01
03
05
07
Urban
09
Rural
11
POPULATION (%)
Source: Deutsche Bank. Note: Income figures are nominal.
Sources: CLSA and CEIC. Note: Income growth rates in real terms. Rural is growth in net income. Urban is growth in disposable income.
[ 21 ]
Incomes are now growing faster in rural areas, reversing a long trend of faster rising urban wages. See the chart on the previous page. This caused many coastal employers this year to anxiously await the return of migrant workers from visiting family over the New Year holiday. Some never did. Nearby family, low costs of living and now faster wage growth are big attractions of the interior. This trend bodes well for a more geographically balanced economy.
Income is one thing. Getting people to spend is another. China has become a lot richer, but savings have gone up even more. See the chart on the left. Financial repression is one reason for the high savings rates, as we have seen. In addition, people set aside buckets of money to pay for retirement and illnesses. The lower the interest rate on deposits, the greater the amount of savings needed to create a selfdirected social safety net. Building out social security programs would reduce the need for these precautionary savings.
Spending Is Not a National Duty Yet

household Savings to disposable income, 1997-2008 45%
SAVINGS TO DISPOSABLE INCOME (%)
There are plenty of other reasons to establish provisions for the elderly. China is grayingfast. The country will have 300 million people aged 65 and over by 2050. See the table below.
40
Average = 36.4%
A Country of Old People

Population by age Bracket, 1995-2050 Population 1995 2000
Average = 29.4%
0-14 years 327 328 293 287 278 287 211
15-64 years 808 845 956 989 989 950 962
65+ years 76 87 104 173 214 252 300
35
1,211 1,260 1,353 1,449 1,481 1,489 1,473
30
2010 2020 2030 2040
25 97 98 99 00 01 02 03 04 05 06 07 08 Source: Peterson Institute for International Economics.
2050
Source: World Bank. Note: Population figures in millions of people.
Sagging Confidence = Sagging Sales

Consumer Confidence index and retail Sales growth 120
MONTHLY Y-O-Y RETAIL SALES GROWTH (%)
40%
MONTHLY CONSUMER CONFIDENCE
30
110
20
100
10
90 95 97 99 01 03 05 07 09 11
0 94 96 98 00 02 04 06 08 10 12
Sources: ISI Group and National Bureau of Statistics. Notes: Retail sales consist of all purchases by individuals, organizations and government. Consumer confidence data through January 2012. Retail sales growth through December 2012.
in Search of luxury goods

It is clear the real estate downturn has spread throughout the economy. Consumer confidence plummeted in late 2011, triggering a decline in the growth of retail sales. See the charts on the previous page. Remember the economic bar is high in China. Sales are still rising at a rate retailers in the developed world would kill for. Overall retail sales increased almost 15% in the first two months of this year, although this was less than forecast and less than the previous clip of 18%. One way to jumpstart consumption is to cut duties. China has relatively high duties, especially on luxury goods. See the table on the right.
LuxuryAt a Price
tax rates on luxury goods in Selected Countries China Coach Handbag Porsche 911 Rolex Watch Lancme Perfume 27% 82% 47% 57% uS 8% 11% 15% 8% hong kong 0% 90% 0% 0% Singapore 7% 134% 7% 7%
Sources: Deutche Bank and Central University of Finance and Economics. Note: Tax rates include import consumption tax, VAT/GST and import tariffs.
Chinese tourists mob upscale department stores around the world because prices are cheaper overseas (and you have a better chance of buying the real thing). Some 70 million mainland Chinese traveled outside the country in 2011, spending about $70 billion, according to the China Outbound Tourism Research Institute. Duty cuts on luxury goods would serve to boost consumption, give domestic retailers a shot in the arm and reduce the trade surplus. It is a bit of a political football, though, as duty cuts are seen as only benefiting the very wealthy.
The economic bar is high in China. Sales are still rising at a rate retailers in the developed world would kill for.
[ 23 ]
Politics: Change Is Hard

China is in the midst of a once-a-decade leadership change. The change starts at the top, where seven of nine members of the all-powerful Standing Committee of the Politburo are slated to change in October or November this year. The newcomers will likely include political scientists and economists, making it a more diverse crowd than the engineering-dominated current group. A system of patronage causes the changes to trickle down, not just to ministries, provinces, mega cities and the armed forces, but to the humblest townships and courts. In a country where policy and government influence every walk of life, the leadership handover is the topic du jour. This explains why
The leadership change is a complex game of musical chairs that is likely to last well into 2013.
municipal politics such as the events in Chongqing discussed earlier can take on national and international significance. The leadership change is a complex game of musical chairs that is likely to last well into 2013. The clear aim is to have the process take place with caution and consensus building rather than prolonged and public tree shaking. That said the markets will watch closely to see if this morphs into policy delays and subsequent changes in investment risk.
An Almighty Party
Chinas Political and leadership Power Structure
Communist Party of China
Discipline Committee
Politiburo
Party Elders
Military Affairs Commission
National Peoples Congress
State Council
Armed Forces
Courts & Prosecutors
Ministries & Agencies
Provinces & Townships
Influence
Control
Source: ISI Group.
Nobody ever really knows the whole picture in China.

The party, which claims some 80 million members, controls every level of society, including the Peoples Liberation Army and the State Council, which oversees ministries and provinces. It was split by internal strife in the 1970s with the Cultural Revolution as a disastrous result. These days, it appears it is built for stability. At least, most investors like to believe so.
vested interests and Paralysis

If all politics are local, it makes sense central government initiatives take time to gain traction and in some cases never do. Local officials will take their concerns to Beijing, adding to a cacophony of voices proclaiming what needs to be done. The result can be political paralysisespecially if the leaderships penchant is to seek consensus rather than to rock the boat. Some measures are opposed by the same groups across the nation. The drive to rebalance the economy, for example, is opposed by vested interests, industries and people who have the most to lose. The investment model is supported by exporters, heavy manufacturing, banks and many local government chieftains. The powerful Peoples Liberation Army has commercial interests, too. All this makes change a poor second choice, and is one reason reform happens slowly. Beijing always overdelivers on five-year plan goals that relate to investments. And why not? Investment is easy to command and there are no budget constraints. It is a different story when it comes to objectives that cannot be achieved by investing alone: things like tackling corruption, increasing consumption and improving the environment. This is where Beijing barely passes or is at risk of getting a failing grade.
the emperor is Far away

Is the political leadership all-knowing? Far from it. For one, the country is too big and too diverse. There is an old saying in China that roughly translates as: The mountains are high and the emperor is far away. The country has a long history of provincialism, and the central government has always looked to tighten its grip on the regions. Nobody ever really knows the whole picture in China. This is why the national statistics bureau uses satellite pictures: It is to understand land use and double-check data from local governments. Another example: Some people believe GDP is underestimated by 30% due to a huge black market, whereas others contend it is overestimated by 30% because investments have generated a pile of non-performing loans. There is actually an upside to this opaqueness: Policymakers have more time to adjust to whatever picture emerges. This is partly why Chinas political system has had resiliency. Keep in mind regional differences: Every province, city and township is competing for resources in the top-down economyor trying to stave off changes that may upset its business model. The government in Guangdong, for example, is deeply uninterested in incentives to develop the inland provinces if it comes at the expense of Guangdong. And every cadre owes his or her position to the ability to pursue a growth agenda. China may not be a formal democracy, but the Communist Party has a clear social contract with the population to deliver growthand a deep institutional memory of what happens when this is broken, as in the Tiananmen Square protests of 1989. Do not underestimate local officials. They often are smart and well-informedand in a position to move the needle. The vice mayor is a must-see stop for investors visiting one of Chinas 200 lesser-known cities with more than one million inhabitants.
300 Million Publishers

Internal conflicts are unlikely to spin out of control. Beijing has kept a tight lid on religious, ethnic and secessionist sentiments. And protests typically only turn into social unrest when a countrys income hits the worlds median levelwhich will take at least another decade for China. At the same time, corruption, illegal land appropriations and growing inequality are flash points for popular anger. The surplus of young males resulting from the one-child policy can aggravate these simmering tensions, especially if unemployment were to mount. The latter would be a breach of the countrys social contract: employment and rising wages in return for obedience. The recent stand-off at the fishing village of Wukan illustrates the pointand is the tip of the iceberg. It is difficult to see an Arab Spring-type scenario for China, though, especially if Beijing plays it smartly and tackles corruption. The web allows activists unprecedented means to broadcast their messages. SINAs Weibo (or microblog), a cross between Facebook and Twitter, has 300 million members. This means China has 300 million publishers. The government works very hard to control the web, but is likely fighting a losing battle in the long run.
China may not be a formal democracy, but the Communist Party has a clear social contract with the population to deliver growth.
[ 25 ]
From Small Piles of rocks to oil Shock

The risks of external conflicts appear small at this time, we believe. The re-election of President Ma Ying-jeou in Taiwan in early 2012 lessened the risk of a Cross-Straits flare-up and will likely strengthen ties between the renegade province and the mainland. Mas re-election also adds fuel to Chinas project to develop a Greater China economic zone, taking in not just Taiwan and South Korea, but an entire String of Pearls of ports across the Indian Ocean. This would link China to growing interests in Africa that are a crucial part of the incoming tide of natural resources. Stand-offs between China and Japan, Vietnam and South Korea over small islands in the East China Sea are likely to remain just that: flare-ups over small piles of rock that mostly involve fishing boat captains.
In the immediate term, two risks loom large: First and most important is a potential oil price shock. Sustained high oil prices would kill global growth and simultaneously drive up Chinas production costs and energy subsidies. A trigger could be an Israeli attack on Irans nuclear installations. Or it could be something we have not yet thought about.
tit for tat in trade Wars

The second risk is trade wars brought about by new protectionist and populist politics in the run-up to elections in key countries. French President Nicolas Sarkozy, for one, has dusted off a Buy European slogan (which really means: Buy French) as the election campaign heats up. Chinas exports have been slowing in the wake of the European debt crisis. The countrys biggest trading partners are the European Union, United States, Japan and Hong Kong, with the latter mostly a half-way station for goods on their way to US and European markets. See the table on the next page. Expect trade brawls to flare up more often, and China to stand alone more often. The rare earths dispute is a good example. It pitted China against the United States, European Union and Japan all at once. This tells us three things: 1) Chinas trade adversaries are finding the political will to act together. 2) China cannot have a trade war with all three simultaneously, so it must start to provide concessions while trying to save face (not easy). 3) The World Trade Organization and other global bodies meant to resolve trade disputes remain a sideshow: Governments engage in hand-to-hand combat while regulators look on. Tit-for-tat strategies will cause casualties. Case in point: China recently struck back at Europe by suspending a large Airbus order (supposedly because of emissions standards). In such an environment, the risk of policy miscalculations driven by domestic needs is high. And some companies will end up as collateral damage.
Expect trade brawls to flare up more often, and China to stand alone more often.
The rest of Asia is viewing Chinas military built-up warily, however. Chinas military budget is expected to double to $238 billion a year by 2015, according to HIS Janes Defense weekly. This is still less than half the (shrinking) US defense budget, but Chinas increasing military prowess is causing anxiety among its neighbors. In addition, US President Barack Obama recently turned his focus to the Pacific, potentially setting the superpowers up for conflict. The longer-term risks are competing adversarial power blocks in the region, warns one of the architects of the opening of China, Henry Kissinger, in a 2012 article in Foreign Affairs. This need not beif both countries set aside rivalries and make genuine efforts at cooperation, Kissinger believes. Another long-term risk is conflict with India over water. Both countries derive much of their fresh water from the Himalayas.
A Global Trade Web

Chinas trade Partners in 2010 China's trade With the eurozone rank
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Germany Netherlands Italy France Spain Belgium Finland Greece Portugal Ireland Slovakia Austria Malta Slovenia Cyprus Luxembourg Estonia Eurozone EU
exports to
$68,088 $49,717 $31,143 $27,659 $18,177 $14,306 $5,507 $3,959 $2,514 $1,993 $1,959 $1,854 $1,843 $1,385 $1,348 $988 $677 $233,118 $311,342 4.3% 3.1% 2.0% 1.8% 1.2% 0.9% 0.3% 0.3% 0.2% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.0% 14.8% 19.7% Germany France Italy Belgium
imports From
$74,391 $17,107 $14,006 $7,828 $6,479 $6,227 $4,237 $4,034 $3,409 $1,790 $754 $569 $390 $258 $177 $177 $17 $141,851 $168,484 5.3% 1.2% 1.0% 0.6% 0.5% 0.4% 0.3% 0.3% 0.2% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 10.2% 12.1% Germany
total trade
$142,480 $56,196 $45,149 $44,766 $24,403 $22,134 $9,541 $6,091 $5,402 $4,350 $3,749 $3,268 $2,413 $1,562 $1,366 $1,246 $854 $374,969 $479,826 4.8% 1.9% 1.5% 1.5% 0.8% 0.7% 0.3% 0.2% 0.2% 0.1% 0.1% 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 12.6% 16.1%
Balance With
Netherlands Italy Spain France Belgium Greece Portugal Finland Cyprus Malta Slovenia Luxembourg Estonia Slovakia Ireland Austria Germany Eurozone EU $43,239 $17,137 $11,950 $10,552 $6,478 $3,569 $1,760 $1,473 $1,331 $1,274 $1,209 $730 $500 $168 ($1,417) ($2,383) ($6,303) $91,267 $142,858 23.4% 9.3% 6.5% 5.7% 3.5% 1.9% 1.0% 0.8% 0.7% 0.7% 0.7% 0.4% 0.3% 0.1% -0.8% -1.3% -3.4% 49.5% 77.4%
Netherlands Italy France Spain Belgium Finland Austria Ireland Greece Slovakia Portugal Malta Slovenia Cyprus Luxembourg Estonia Eurozone EU
Netherlands Spain Austria Finland Ireland Slovakia Portugal Malta Greece Luxembourg Slovenia Estonia Cyprus Eurozone EU
China's trade outside the eurozone rank

1 2 3 4 5 6 7 8 9 10 US HKG Japan Korea India UK SGP Taiwan Russia Australia Total China
exports to
$283,375 $218,380 $121,156 $68,818 $40,920 $38,790 $32,374 $29,693 $29,615 $27,234 $890,355 18.0% 13.8% 7.7% 4.4% 2.6 % 2.5% 2.1% 1.9% 1.9% 1.7% 56.4% Japan Korea Taiwan US Australia Malaysia Brazil Thailand
imports From
$176,785 $138,423 $115,649 $102,060 $60,340 $50,396 $38,038 $33,201 $32,862 $25,814 $773,569 12.7% 9.9% 8.3% 7.3% 4.3% 3.6% 2.7% 2.4% 2.4% 1.9% 55.5% US Japan HKG Korea Taiwan Australia Malaysia Brazil India SGP Total China
total trade
$385,435 $297,941 $230,650 $207,241 $145,341 $87,575 $74,216 $62,504 $61,787 $57,053 13.0% 10.0% 7.8% 7.0% 4.9% 2.9% 2.5% 2.1% 2.1% 1.9% HKG US UK India UAE Malaysia Australia Japan Korea Taiwan
Balance With
$206,109 $181,314 $27,481 $20,053 $16,863 ($26,577) ($33,106) ($55,629) ($69,605) 111.7% 98.3% 14.9% 10.9% 9.1% (14.4%) (17.9%) (30.1%) (37.7%)
Saudi Arabia Russia Total China
($85,956) (46.6%)
$1,609,744 54.2% $2,972,356 100.0% China $184,538
$1,578,447 100.0%
$1,393,909 100.0%
Sources: ISI Group; CEIC; General Administration of Customs. Notes: Figures in millions of US dollars. Percentages are the share of Chinas total.
[ 27 ]
Competitiveness: Beyond Cheap Labor

A visitor to the port city of Ningbo soon after Chinese New Year was struck by how little traffic this large port city had. Employers were anxious to see if migrant workers would return from visiting their families in the interior. The citys mayor had called an emergency meeting with local business leaders because exports had plunged in January. This illustrated the plight of Chinas coastal region. Wage growth is currently outpacing productivity. This is good for consumption, but hurts Chinas competitiveness in laborintensive industries. Many of the latter, including garment makers, have already moved to cheaper countries such as Vietnam and Cambodia. This is a good thing for China. The country wants to move up the value chain, and this is one way to achieve it. It is starting to work, evidenced by the share of processed exports slowly diminishing. These are exports of basic products using mostly (imported) raw materials or simple assemblage where China adds little value. See the chart below.
of robots and old People

The easy productivity gains have been harvested, but there is room for more. The work of Tsinghua University professor Gavriel Salvendy, for example, shows it is easy to rack up double-digit productivity increases by introducing basic management techniques to minimize waste and stop staff churn. New highways and rail tracks have opened up the countrys interior. Companies have moved inland to take advantage of lower wage and real estate costs. Apple supplier Foxconn, which employs more than one million in China, has already made a big push into Chengdu from its Foxconn City base in Shenzhen. It is going one step further: Chairman Terry Gou plans to put to work one million robots in the next three years, up from 10,000 in 2011. Vietnam, Indonesia and Bangladesh are just not in the same league. These are smaller economies without the enterprise, scale and infrastructure of China. With productivity growth running at a much higher clip than that of the developed world, China is not about to lose world trade share. Also remember there is no average in China: Income levels and minimum wages vary greatly by city and province. See the table on the next page. This means relocating to the interior can lead to easy productivity gains. Productivity will need to keep growing to make up for the effects of a graying population: The number of people older than 65 will surpass the group of people younger than 19 by 2030. Bottom line: Chinas demographic dividenda huge working population supporting a relatively small number of dependentsis disappearing fast. See the charts on the next page. The real estate boom has arguably thwarted innovation because the government, businesses and consumers alike focused on making quick profits. On the other hand, China surpassed Japan and the United States in patent filings in 2011, according to Thomson Reuters research.
Up the Value Chain

value-added exports vs. Processed exports, 2000-2011 70% 65 60
EXPORTS (%)
55 50 45 40 35 30 00 01 02 03 04 05 06 07 08 09 10 11
Value-Added Exports Processed Exports
In all, chances are China will overcome competitive pressures. It may even emerge stronger. Competitiveness is very much part of the China storyand likely more sustained than doubters opine.
Source: Deutsche Bank.
Vietnam, Indonesia and Bangladesh are just not in the same league.
There Is No Average in China

Minimum Wages by Province in rMB per Month
Monthly Minimum Wages Province Shanghai Beijing Zhejiang Tianjin Guangdong* Shenzhen Jiangsu Fujian Shandong Liaoning Inner Mongolia Chongqing Guangxi Hunan Hebei Yunnan Hubei Henan Anhui Shaanxi Shanxi Hainan Jiangxi Sichuan Jilin Ningxia Tibet Guizhou Heilongjiang Qinghai Xinjiang Gansu National Average YoY Growth 2005 690 580 490 570 352 635 400 320 350 350 380 330 320 350 420 350 280 320 290 400 400 350 270 280 300 320 445 320 235 330 300 300 376 2006 750 640 645 660 604 755 630 542 490 497 485 500 417 475 510 480 364 400 443 480 490 497 315 485 460 417 470 500 476 450 536 378 507 39% 2007 840 730 750 670 780 755 750 650 610 590 560 580 500 600 580 540 460 480 520 540 550 580 360 580 510 450 495 550 620 460 670 430 586 16% 2008 960 800 960 820 860 950 850 750 760 700 680 680 670 665 750 680 700 650 560 600 720 630 580 650 650 560 730 650 680 580 800 620 715 24% 2009 960 800 960 820 860 950 850 750 760 700 680 680 670 665 750 680 700 650 560 600 720 630 580 650 650 560 730 650 680 580 800 620 715 0% 2010 1,120 960 1,100 920 1,030 1,100 960 900 920 900 900 680 820 850 900 830 900 800 720 760 850 830 720 850 820 710 950 830 880 750 960 760 874 23% 2011 1,280 1,160 1,310 1,160 1,300 1,320 1,140 1,100 1,100 1,100 1,050 870 820 1,020 1,100 830 1,100 1,080 1,010 860 980 830 720 850 1,000 900 950 930 880 750 1,160 760 1,013 16% 2012 1,450 1,260 urban Population 17 15 30 10 61 43 19 46 26 13 15 19 28 30 16 26 36 26 16 16 4 19 32 15 3 1 11 21 2 9 9 % of total 2.7 2.4 4.8 1.5 9.8 6.9 3.0 7.4 4.2 2.1 2.4 3.1 4.4 4.9 2.5 4.2 5.8 4.1 2.6 2.5 0.7 3.1 5.1 2.3 0.5 0.1 1.8 3.4 0.4 1.4 1.4 annual disposable income 31,838 29,073 27,359 24,293 23,898 22,944 21,781 19,946 17,713 17,698 17,532 17,064 16,566 16,263 16,065 16,058 15,930 15,788 15,695 15,648 15,581 15,481 15,461 15,411 15,344 14,980 14,143 13,857 13,855 13,644 13,189 ratio of national average 1.67 1.52 1.43 1.27 1.25 1.20 1.14 1.04 0.93 0.93 0.92 0.89 0.87 0.85 0.84 0.84 0.83 0.83 0.82 0.82 0.82 0.81 0.81 0.81 0.80 0.78 0.74 0.73 0.73 0.71 0.69
1,500
870 1,050
Sources: ISI Group, Ministry of Human Resources and Social Security, and National Bureau of Statistics. Notes: All wages in urban areas. Annual disposable income is per capita. Urban populations are in millions as of 2009. * Excluding Shenzhen.
Going the Way of Japan

Young (0-19) and old (over 65) to Working age Population, 1950-2050
JAPAN YOUNG AND OLD TO WORKING POPULATION (%) YOUNG AND OLD TO WORKING POPULATION (%)
CHINA
100% 80 60 40 20 0 1950 1970 1990

0-19 Years Old
100% 80 60 40 20 0 1950 1970 1990

0-19 Years Old
2010
2030
2050
2010
2030
2050
65 Years or Older
65 Years or Older
Sources: ISI Group and United Nations.
[ 29 ]
Markets: Counting on China

equities and Corporate Bonds: a growing addiction
Makers of luxury goods around the world have become dependent on Chinas ravenous appetite for their goodies. See the table below. Dont expect this to change in the near term. In the long run, we believe, it is crucial for China to take steps to encourage consumption to keep up the torrid growth rates. The luxury goods boom goes beyond exports to Greater China. A jump in Chinese travel and the hiring of Mandarinand Cantonese-speaking staff is keeping department stores busy from Tokyo to New York. Basic materials companies are likely to suffer as China hits the ceiling for cement and steel consumption. The country is still far from reaching peak demand in other commodities, including oil and copper as well as agricultural products such as corn and potash used in fertilizer. This has a big impact on UK, Australian and Canadian equities because of the heavy weighting of mining companies in those markets. Shale and other new sources of energy have become a focus given Chinas supply vulnerability. Investors and other stakeholders have taken note. For example, the Reserve Bank of Australia studies China given its importance to the large farm-cum-mine surrounded by beach known as Australia. The European Central Bank studies China because it needs growth. We all are China watchers. Specialized machinery makers should do well as China moves up the value chain. The country is starting to become very competitive in capital goods with big improvements in quality. Giants such as GE, Siemens and Caterpillar are worried about China stealing their secret sauce, but should be okay for now as they are capturing share in a booming market. At the same time, disasters such as the high-speed rail crash and mining accidents have dented Chinas ambitions in some areas. And hazardous industries with heavy capital equipment needs and high potential for disasters (the oil and gas industry, for example) are becoming less likely to take risks on Chinas quality control. China Inc. can quickly wipe out whole sectors by mass producing high-quality goods. Case in point is the solar industry. European, US and Indian companies cried foul over unfair subsidies for Chinese makers, but the coup still happened. This doesnt mean emerging Chinese players in these industries are good investments. Just check the implosion of stock prices of (lossmaking) Chinese solar makers.
China Inc. can quickly wipe out whole sectors by mass producing high-quality goods.
Medical device and agricultural equipment makers are likely beneficiaries from a population that is getting richer and living longerbut not necessarily healthier. Spending on these sectors, as well as on water conservation, should grow at twice the rate or more of Chinas overall budget spending, we believe. Chinas cement makers, aluminum smelters and building materials companies saw business implode only in the fourth quarter. Full-year 2011 results mask this implosion, and more pain is likely to come in 2012. Even successful womens shoemaker Belle International reported a slowdown in same-store sales to the high single digits. The only companies that report sales growth in the 20% range are mass consumer plays such as Yum!, the owner of the KFC fast food restaurants. Chinas banks remain cheap for (good) reasons described earlier. Chinas companies will likely see profits hit this year, we believe. SOEs already reported an 11% drop in profit in the first two months of the year. That said, Chinese equities look cheap by historical valuations. It is reasonable to expect gains of 25% or more this year after a horrible 2011.
My Best Customer Is China

Percentage of China Sales of Selected luxury Companies in 2011 Mainland China Burberry Coach Herms LVMH Luxottica Prada Group Richemont Safilo Salvatore Ferragamo Swatch Tiffany Tods Yoox 5% 3% 15% 7-8% 3% 15% 33% 1% 17% 15% 10% 5% 2% greater China 8-10% 6% 23% 12% 5% 21% 40% 3% 27% 22% 18% 12% 2%
Source: Deutsche Bank. Note: Estimated fiscal 2012 sales for Coach, Burberry and Tiffany.
Hunger for Commodities

Chinas Share of global Commodities Consumption in 2010
Cement Pigs Iron Ore Steel Lead Copper Zinc Aluminum Nickel Platinum Coal Soybeans Autos Chinas Population Corn Palladium Wheat Chinas GDP in PPP Oil Sugar Uranium
Addicted to CoalFor Now

Chinas energy Supply Sources Compared With the Worlds 80%
70% ENERGY USAGE (%)
COMMODITIES CONSUMPTION (%)
60
40
30%
37% 20%
20
7% 7% 7% 1% 4%
18%
Nuclear 0% 10 20 30 40 50 60
Hydro
Nat. Gas
China
Oil
Coal
World ex-China
Source: Deutsche Bank.
Sources: ISI Group and BP World Energy Outlook. Note: Data as of 2010.
Commodities: an outsized influence

China has an outsized influence on commodities markets. The country has one fifth of the worlds population and accounts for 11% of world GDP. Yet it accounts for about half the worlds cement and iron ore consumption. See the chart above. We expect the iron ore boom to fizzle out as China nears peak consumption in steel and cement. The countrys demand for copper, which has many uses beyond construction, should hold up better, we believe. Energy demand should also hold steady, we believe. Oil demand typically runs at 0.6 times GDP growth. So even with the economy slowing down to 7% a year, oil demand increases by 4% a year. Chinas import dependence is rising at an annual clip of 500,000 barrels a day (b/d), from an import bill of 5 million b/d in 2009, according to research firm ISI Group. China is already the worlds biggest energy consumer, with a 20% share in 2010, up from a tenth in 2000, according to BP. It still relies on coal for the brunt of its energy supply. See the chart above right. Expect a shift to natural gas and nuclear energy (Japans Fukushima accident in 2011 only temporarily halted construction). This bodes well for uranium prices in the long run. The story is different for alternative energy. Chinese manufacturers have brought down prices for wind and solar energy to levels
where these energy sources can start to compete with oil, gas and coal. A shift to a consumption-driven economy could imperil this. Similarly, a credit contraction or financial bust would likely result in the drying up of Chinese project financing that has supported the global market. The countrys commodities appetite goes beyond the obvious. China has become the second-largest importer of gold, after India. It now makes up around one fifth of world gold demand for jewelry, according to ISI Group. Gold is seen as a hedge against inflation. Policy also may drive demand for precious metals such as platinum and palladium, which are used in car catalytic converters.
government Bonds: a Big overhang

China is the single largest holder of publicly traded US Treasuries, excluding the US Federal Reserve. It has a $1.3 trillion share, or one-sixth of the total. It has slowed buying but is still a major player (the Fed trumps it). The reasons: China wants to keep its own currency in check, doesnt have many alternatives for parking the flood of export-generated dollars and would hate to see the value of its existing holdings implode. See the chart on the next page on the left China, which has additional US assets in its foreign reserve kit, has been diversifying into the euro, yen and other currencies as well as gold. It is transferring funds to sovereign wealth fund China Investment Corp, which in turn is spreading its bets across the globe and across asset classes. Talk of investment in Europe to mitigate the debt crisis is likely real.
Expect the iron ore boom to fizzle out as China nears peak consumption in steel and cement.
[ 31 ]
Chinas buying of US Treasuries illustrates the power the country holds over the US bond market. The US Federal Reserve crowded out all other buyers in the year ended June 20, 2011, so Chinas share was just 18%. Excluding Fed purchases, however, China had a 73% share. See the chart below on the right. A shift to a consumption economy would mean less Chinese buying of US Treasuriesas opposed to absolute reductions. Assuming the US government is not closing the budget gap any time soon, conventional wisdom says fewer Chinese purchases would drive up yields and pummel bond prices. Fewer buyers equals lower prices. Conventional wisdom is always dangerous, so here is an opposite view: Rates actually could go down in a sort of flight-to-safety bond rally. Why? If foreign buying dries up, simple math says private savings will have to pick up the slack (assuming the US government doesnt cut the deficit markedly). To do this, investors would have to sell risk assets. This would hammer equities, high-yield bonds, commodities and emerging market assets, in turn triggering a dash for safety. As China opens to the world, more of its debt may become available for international trading. This may coincide with a bailout of its financial system and a jump in its debt-to-GDP ratio.
A shift to a consumption economy would mean less Chinese buying of US Treasuriesas opposed to absolute reductions.
This appears a likely scenarioand does not bode well for Chinas ranking in the BlackRock Sovereign Risk Index. The country advanced three spots in the fourth quarter to rank 15thahead of the UK and France. Commodity currencies such as the Australian and Canadian dollars could take a hit as China reaches peak consumption in key industries such as steel. The currencies are a good signpost for whether Chinas economy is perking up in the short term and shifting toward consumption in the long run. Exporters and countries closely linked to the booming resources trade, such as Australia and Chile, could suffer. The Aussie dollar and bond market are just as much China plays as LVMH and Daimler. More insulated economies such as Brazil could power along, driven by domestic consumption. Asian investors appear more upbeat than those in the developed world. For US and European investors, things are about as bleak as they have been in decades. Asians, on the other hand, have overcome three economic crises in recent memory: the 19981999 Asia crisis, the 2003 SARS crisis and the 2008-2009 world financial crisis. Plus, the sheer scale of consumption and wealth is breathtaking when you are on the spot.
A Case of Too Many Greenbacks

Chinas uS treasury holdings and FX reserves, 2001-2011 $3,500 3,000
40
50%
A US Bond Market Force

Chinas Buying of newly issued uS treasuries, 2002-2011 80%
SHARE OF TREASURY BUYING (%) SHARE OF RESERVES (%)
CHINAS FX RESERVES IN BILLIONS ($)
$400
PURCHASES IN BILLIONS ($)
2,500 2,000 1,500 1,000 10 500 0 2001 2003 2005 2007 2009 0 2011 30
60
300
40
200
20
20
100
0 2002 2004 2006 2008
0 2011
China Buying of Net Issuance (%) China Buying of Publicly Available Net Issuance (%) China Buying ($ Billions)
Chinas US Treasury Holdings
Chinas Total FX Reserves US Treasuries to FX Reserves (%)
Sources: US Department of Treasury and BlackRock. Note: Data as of June 30 of each year. 2011 data based on preliminary survey data.
Sources: US Department of Treasury and BlackRock. Notes: Data as of June 30 of each year. Publicly available Treasuries are those not purchased by the US Federal Reserve. 2011 data based on preliminary survey data.
This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2012 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. This paper may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader. This material is being distributed/issued in Australia and New Zealand by BlackRock Financial Management, Inc. (BFM), which is a United States domiciled entity. In Australia, BFM is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In Canada, this material is intended for permitted clients only. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. In Hong Kong, this document is issued by BlackRock (Hong Kong) Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong. In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). In Japan not for use with individual investors. In Latin America this material is intended for Institutional and Professional Clients only. This material is solely for educational purposes and does not constitute investment advice, or an offer or a solicitation to sell or a solicitation of an offer to buy any shares of any fund (nor shall any such shares be offered or sold to any person) in any jurisdiction within Latin America in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that they have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico and Peru and Uruguay or any other securities regulator in any Latin American country and no such securities regulators have confirmed the accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America. The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.
FOR MORE INFORMATION: www.blackrock.com 2012 BlackRock, Inc. All Rights Reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES and SO WHAT DO I DO WITH MY MONEY are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. Not FDIC Insured May Lose Value No Bank Guarantee Lit. No. BII-CHINA-0312R AC6125-0412

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Braking China Without Breaking the World

BlackRock Investment Institute April 2012

[2] Braking China Without Breaking the World

Joel Kim Head of BlackRock Asia-Pacific Fixed Income

Mark McCombe Chairman, BlackRock Asia-Pacific

Ewen Cameron Watt Chief Investment Strategist, BlackRock Investment Institute

Blackrocks China Forum

BlaCkroCk inveStMent inStitute

First Words and Summary

So What do i do With My Money?tM

[4] Braking China Without Breaking the World

China Inc: Bull, Bear and Bottom Line

A Deflating Real Estate Bubble

Too Much Investment and Too Little Consumption

BlaCkroCk inveStMent inStitute

Signposts (What to look for)

[6] Braking China Without Breaking the World

Introduction: Why China Matters

2,000 1,500 1,000 500 0 2002 2004 2006 2008 2010

80 60 40 20 0 2008 2009 2010 2011

200 150 100 50 0 -50 -100 2012

90 60 30 0 -30 -60 2012

BlaCkroCk inveStMent inStitute

56 54 52 50 48 46 44 42 40 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Feb 12

stay shaky forever).

[8] Braking China Without Breaking the World

Credit: Too Much, Too Quickly

Dont Take It to the Bank!

REAL INTEREST RATE (%)

the great Credit leap Forward

Debts Have a Way of Piling UpEven in China

15,000 12,000 9,000 6,000

New RMB Loans Corporate Bonds

New Foreign Currency Loans

New Entrusted Loans Insurance Claims Paid

New Trust Loans

New Bank Acceptances

New Stock Issued by Non-Financial Enterprises

Insurance Company Real Estate

BlaCkroCk inveStMent inStitute

A Likely Sad Ending

Too Good to Be True

60,000 50,000 40,000 30,000 20,000 10,000 0 96 98 00 02 04 06 08 10

Bank Loans Loans/GDP

Loans and Bonds/GDP

Sources: Carl Walter, Peoples Bank of China and Wind Information.

Bad debt? Just roll it over

no Banker Will Come Clean this Year

Index-Linked Asset-Backed Bills

Asset-Backed Other Asset-Backed Loans

Deposit outflows have triggered a slow-motion cash crunch.

BlaCkroCk inveStMent inStitute

Acronym to Watch: LGFV

Typical LGFV Structure

Ownership of Local Enterprises, Land and Tax Subsidies

Repayment LGFV Cash Loan Bank

Profit 333 Prefectures

Activities (Infrastructure, Utilities, Transportation, Land Development)

Sources: Deutsche Bank and China Statistical Yearbook 2010.

a less offensive Four-letter Word

Where there is a will, there is a wayespecially in China.

Get Out of Debt Tomorrow