By Zarathustra, who is the founder of Hong Kong blog Also sprach Analyst. He was educated at the London School of Economics and the Chinese University of Hong Kong and was once a Hong Kong-based equity research analyst focusing on Hong Kong real estate (which he did not really like), with a secondary coverage on China real estate sector (which he actually hated). Cross posted from MacroBusiness
People in Hong Kong have a long history of mistrust of China. This city, after all, was a colony of the British Empire for more than a century, and has only been under Chinese rule (under one country two system, to be precise) for a mere 15 years. In this city, you seldom hear anything bad about Britain (because most have no idea), but you hear a lot of bad things about China, particularly the Chinese Communist Party. We just don’t trust them.
While the mistrust of the political class of China continues in Hong Kong (and will certainly continue for much longer), the doubts on the strength of the Chinese economy and the doubts on the ability of the political class to manage the economy have more or less evaporated after 15 years of Chinese rule.
It used to be that Hongkongers would go to China to purchase really cheap stuff. Now, it is the Mainland Chinese who come to Hong Kong to buy really expensive stuff. Places in China which were farmlands are now full of modern buildings. Infrastructure in large cities is getting better, sometimes even better than Hong Kong. Before the transfer of sovereignty, Hong Kong was already a rich city while China was a very poor country. China used to be poor, dirty, relatively uncivilised, you name it. Today, it’s almost as if this city would have died if the Chinese economy did not grow at the rate it did in the past decade. China today, especially for big city like Shanghai, is just like Hong Kong: modern, international, classy. You can’t say many things bad about cities like Shanghai.
No one would ever dispute the achievement of the Chinese economy. What we see in China now, on the surface at least, is progress. And the progress was huge indeed. For 30 years or more, the Chinese economy has defied “gravity”, has never been in a recession, and has lifted enormous numbers of people out of poverty. Predictably, perception of the Chinese economy has changed very dramatically over the past decade, from a market that you wanted to stay away from to a market that no one wants to miss.
But this is not the whole truth. Before the story of “China as the forthcoming greatest economic power”, many held the impression that Chinese companies were either not well run, or were run by crooks, who cooked up their books and/or produce very inferior products simply to rip people off. On top of that, the Chinese government cooked up statistics, and doubters spun that in their own favour, suggesting that the economy could not have grown that fast. Meanwhile, corruptions was rampant. Businessmen bribed government officials in order to profit, while government officials got rich through taking massive amount of bribes.
If you insisted on that grim view on China in early 2000s (right after the Chinese government lied about SARS, as a reminder of who were the type of people who ran the government), although you would have missed the bull market in stocks, you would not have been inaccurate. Since the beginning of time (well, that’s an exaggeration of course), China has had the creativity and necessary skills to create fake and low quality products beyond anyone’s imagination. We also knew that corruption in China was horrible since the beginning of time (and this is not an exaggeration, as that has been a recurring theme of the rise and fall of different dynasties ever since Imperial China). Banks loaned to whoever had connections to government officials (i.e. those who have bribed government officials) so that it required extra faith for investors to believe in banks’ books. And as a businessman, as long as you had the great connections with government officials, banks would probably still be willing to lend to your company cheaply even though you were cooking your own books.
These are the problems of China’s past. But if they sound familiar to you, that’s because they are what increasing numbers of people are talking about now. These are not just history, but current reality. China is still full of businessmen who make crap products that are dangerous for human consumption. Corruption is as serious as it was, if not more so. You still have to bribe officials to achieve your goals (and the costs of bribing officials to achieve your goal, as I understand, is getting ever higher), and government officials cannot have a successful career without being corrupt. Banks have not changed their practices in determining who to lend money to and there is still no one who is willing to believe in Chinese statistics in full at face value.
The only difference between the recent years and ten years or so ago is that people just ignore it now, because the extraordinary bull market and the seemingly unstoppable economic growth has created a China cult, a cult among the investing community that China is the best place to invest. Just as hedge fund manager Hugh Hendry said “10 years are enough to create a cult in capital market”. In fact, China has not seen any year with negative growth for more than 30 years.
Despite the fact that the Chinese stock market bubble has gone bust in 2007, the China cult continues to attract new followers. After the bubble went bust and the Lehman crisis hit, quite a number of people were confident that the stock market would surpass the 2007 peak very soon because the Chinese economy has been strong. The view that China became the best place to invest has become ever more popular as the Western economies looked mortally wounded after the crisis (while they are not). The ever more popular idea that the economic weight has shifted from the East to the West, or the idea that we are back in a bipolar world for the first time since the end of the Cold War, and among many other ideas, have reinforced many people’s belief that China is the place to go. Even to this date, we understand that there are a lot of European companies which are still looking to invest in China apparently because China looks “safer” relative to Europe. An entire country, in Australia, joined the cult.
In the beginning of the recovery of the global economy, investing in China did pay off well relative to many markets in the rest of the world, reinforcing the idea, once more, that China is invincible. The same doubters who did not invest in Chinese stocks 10 years ago because they thought companies cook up their books started to buy in 2007, 2008, 2009, 2010, 2011, and 2012. The same doubters who did not invest in Chinese stocks because of worries about corruption are now accepting corruption as a reality and that it is something which determines whether a company can make money. The same doubters who thought Chinese banks have understated non-performing loans started to believe that buying Chinese banks is like buying HSBC in the 1980s, which will give you a return in the order of hundreds of times over the next 3 decades. Investors have also been much less careful about frauds as the cult reaches its climax. But instead of identifying the problems related to poor governance, frauds and corruption, some insist that these are isolated cases and have nothing to do with the culture of how businesses are done in China. Also, while Chinese statistics are not reliable, more and more people are trying to spin the unreliable data to fit their own bullish arguments. Instead of suggesting that growth is overstated, now they say consumption is understated, and the China consumption will be the biggest investment story of the era.
But Chinese equities outperformance did not last long: first in Shanghai, then in Hong Kong (and Australia), they have turned from two of the best markets to markets doing even worse than Europe. Bears (like me) started to be ever more vocal about the structural problems in the Chinese economy: namely, the real estate bubble, over-capacity across the economy, over-investment and the associated unsustainable increases in debt etc. And I am getting ever more concerned about issues that we did not mention much: corruption and its link of over-investment, and the consequence of lack of inflation. Bears have got it right for almost 2 years now as far as stock investments are concerned, and the economy is now slowing down rapidly while the real estate market cools, just as the bears predicted. Unfortunately, people increasingly blame short-sellers instead of admitting that they have been wrong.
Still, the cult has not yet died. The past few years have produced an impression of the Chinese government as invincible, and it has miraculous control over the economic machine, that the slowdown is “intentionally” engineered by the government and everything within the economy is still very much under control. Unfortunately, most who use this argument to justify that the slowdown is not a big problem have all invariably forgotten that most economic slowdowns in recent memories started with central banks tightening monetary policy to control inflation and slow down the economy, and most, if not all, of the cases ended with recession that they did not want to get into. Many have also not realised how difficult it is for China to boost its way out of a debt deflation.
As the economic slowdown becomes a reality and a hard landing looms, more of the problems we have identified will surface. The cult will surely die within the next few years. The only question is when and whether that death will be violent death or slow.