With markets being spooked by the events occurring at China Evergrande, investors are now re-thinking whether they should continue to park their money in Chinese stocks.
Most of the articles online concern an analysis of Evergrande’s situation, so this article attempts to share how a rookie investor can start thinking about China by adopting a helicopter view and applying first principles. The aim is not to predict what will happen next but to give readers a proper framework when reading news of China.
You can find the full version of this framework in Ruchir Sharma’s The 10 Rules of Successful Nations. China has done okay for seven out of the ten rules, so I will only focus on three that raise concerns about the viability of investing in China.
1) Demographics
The problem with China is that the population is no longer growing like before. Decades of forcing women to have only one child have curbed population growth, and now modernisation has permanently reduced the incentive for women to have children in China.
As you can observe in the chart below, the total fertility rate is already below the replacement rate of 2.1, and we could be looking at a shrinking workforce in the near future.
The general rule of thumb proposed by the book is that nations should maintain the working population growth should be kept at 2% for an economic boom to occur. Having children in China can no longer keep pace with this, so China needs to consider finding ways to add more women, immigrants or robots into the labour market to maintain their economic growth.
Otherwise, China becomes a mature economy and will become old before it becomes rich.
2) Political reforms
Another aspect favouring growth is that a nation should have a reformist leader with broad-based support from the ground. The pattern in many countries is that economic growth often follows a charismatic reform-minded leader who has been democratically elected. However, many of these democratic leaders find ways to entrench their power, after which economic growth stops. One clear exception to this rule is Singapore, which has sustained economic reforms for three decades, led by Lee Kuan Yew.
China had a reformist leader in Deng Xiao Ping who adopted a very Singaporean model towards economic development. However, it would be a stretch to consider president Xi Jin Ping as a reformer. He has been extending his term limits, and given the Communist system, it’s unknown whether he has any support from the ground.
It would seem that President Xi is part of the Shanghai faction of the Communist party that is currently at war against a Beijing faction. To get a deeper perspective on various factions within the Chinese Communist Party, I strongly recommend Red Roulette by Desmond Shum. The book is a superbly entertaining one that airs the dirty laundry on the Communist leadership.
Every attempt to entrench President XI’s power should raise doubts about whether he is a reformer. Even if his actions were to unite the country, stamp out corruption, and produce economic growth, the spectre of a power vacuum in the future should keep investors wary about investing in China.
3) Private debt levels
The final consideration lies closest to the China Evergrande situation. Countries with a sharp rise in private debt as a proportion of GDP are always risking a market crash. Even in the best case, investors can expect about 2% points shaved off against GDP growth in the future. The following chart shows the precariousness of China’s situation:
Another sub consideration is where are the leveraged funds going. In the author’s view, if entrepreneurs are borrowing money to start a factory or a technology firm, this will ultimately be good for the country. The problem with China is that most of the money will go into real estate. A lot of Chinese life revolves around real estate because women will not marry unless the man can afford a house.
This consideration dominates the news. You will read about non-performing loans made by state-owned enterprises and the persistence of shadow banking in China.
Your investment decisions should factor in how the Chinese government would tackle the rise of private debt levels.
Conclusion
In summary, while much news coming from China can be confusing for investors who want to know whether China is worth investing in, there is an easier way to interpret the information coming out from the country.
First, the reader needs to consider whether the news can increase the growth of the labour pool in China. Second, the reader should interpret the information and determine whether the leadership is countering reforms by consolidating their power. Finally, readers should keep a close watch on the private debts in that country.
If all three of these items is unfavourable, you would have to discount the market and enter at a much lower P/E ratio when buying into this market. Or you could choose to stick to Singapore markets and build a dividend portfolio like I did.