China has its problems, but prices are tempting

Here’s a quote from the 2013 annual report of Yurun Food Group, a pork producer based in Jiangsu in China: “In 2013, domestic food and beverage consumption slightly declined, while household demand for meat consumption remained flat and the growth of overall pork consumption slowed down.”

I suspect you’ll think it isn’t very interesting. Think again. Anne Stevenson-Yang of Hong Kong based J-Capital considers it a rather “shocking statement”, because it starkly marks the “end of an era in China”.

For the last 30-odd years, China’s GDP has been growing at a phenomenal speed. The world has become used to the idea that when it is growing fast, it is growing at more than 10%, and that when it isn’t growing fast, it is growing at 7%.

Until a year or two ago, no article on China was complete without a run down of just how much less meat the Chinese eat than Americans (120 pounds per person per year against 230 pounds a year), and how much the price of protein would have to rise for that to equalise.

Yet today, it seems the process has stalled. You can find similar numbers for most categories of consumption.

But these numbers aren’t the only danger signs in the world’s miracle economy. Look to the property market. I’ve written before about the crazy extent of China’s residential bubble. Until now, every time it has looked about to crack, the government has dived in with stimulus of one kind or another.

Not this time. Much of the research I see tells me that prices are only falling in minor cities and that the famous Chinese ghost towns – built, but abandoned – are mostly a figment of bearish imaginations.

Go back to Ms Stevenson-Yang’s note, however, and you find that just isn’t so. She writes of a trip around China looking for bonkers buildings and ghost towns. There was no shortage.

Go to Hangzhou, home of Mao’s favourite summer house, and you drive past “kilometre after kilometre of empty residential and mixed use buildings” before you get to his much-loved West Lake. Elsewhere you will spot “four Little Manhattans, a British village, a Loire Valley château, a Florence in Tianjin, and a Paris in Anhui”.

It turns out that no town has been immune from the omnipresent over-developed ghost-town trend nor, for that matter, from the collapsing prices trend. Not long now before the go-to statistic for those writing about China will change from “230 pounds of meat” to “a 40% fall in house prices”.

And growth? The government is targeting 7% plus. Most fund managers will tell you their internal forecasts are for 5%. But look at the less publicised numbers and it might be reasonable to assume it is rather closer to zero than to five or 7%.

Chinese growth over the past 30 years has come from two things: catch-up and debt. China’s GDP is now something in the region of $10,000 per head. That’s been largely achieved by using low labour costs to out-manufacture the rest of us.

The next bit is rather harder: other countries have found it hard to move beyond $10,000 without finding some new competitive advantage. If you aren’t going to stagnate, you need an abundance of natural resources or an environment that actively encourages productivity growth.

For productivity to grow, you need things such as the rule of law, democratic accountability, absence of corruption and rising middle class rights. That’s something of a problem in China.

Then there’s the debt. China’s growth hasn’t just been about cheap labour. It’s been about the largest credit expansion in modern history. Even before the financial crisis, debt was rising fast, but China’s response to recession in its key export markets was more credit and a huge increase in domestic investment.

So, there is now a second fundamental problem in the Chinese economy – too much capital expenditure (and too many blocks of flats) paid for with too much debt and a nation covered in useless infrastructure projects.

According to Fathom Consulting, non-performing loans as a percentage of GDP are now about 17% (that’s up from 8% in 2008 and compares to an official number of 1%).

Every industry from cement to wind power and shipbuilding is plagued with overcapacity and some $10trn has been wasted along the way.

What could happen next? There are two possibilities. The first involves a controlled deleveraging of the economy alongside a gradual write-off of bad loans. Little growth, but no huge crisis.

The second has the authorities not getting it quite right, contagion spreading, banks failing, lending collapsing and consumption falling. Like everyone else, I’d like to think China has a plan, but we also all know that getting out of credit bubbles isn’t easy.

The question for investors is how much of all this uncertainty is priced in. The Shanghai Composite index is down 67% from its 2007 peak. That’s a proper bear market. And if China has a financial crisis, who’s to say that prices won’t fall a lot further?

But on the plus side, we know that economic growth and market returns are not correlated. If you want to know what markets might do you have to look to money flows, valuations and things such as corporate governance.

On that score, I’m intrigued about a round of reforms at China’s big state-owned enterprises (SOEs); the ministry of finance has just announced that it is raising the dividends it takes and it is also beginning to endorse more privatisation as a way of improving performance. Privatisation is almost always good for investors.

And Chinese valuations are just fine – the MSCI China index comes with a price/earnings ratio of only 8.8 times (although the number rises if you remove the banks). When the US stood on the edge of its financial crisis, investors were in total denial.

This is different: everyone, policy makers included, accepts and to varying degrees has priced in China’s troubles. That means China is entering its period of expected crisis with a cheap stock market that is almost entirely unowned by foreign institutional investors. That’s something I find rather attractive.