Rise of the Dragon
On January 23, Chinese around the world ushered in the year of the dragon under the Lunar Calendar. The dragon is an auspicious and mythical creature in the Chinese culture. It is a symbol of power such that emperors in the historic days were regarded as the dragon’s ‘sons’ and many Chinese still call themselves “descendants of the dragon.”
With the debt situation in Europe continuing to further unravel and dim economic prospects in the U.S., many have come to believe that the star of the “dragon descendants” has the potential to rise even further in the coming years. China’s GDP growth is expected to moderate to around 8.2% in 2012, which is high compared to developed economies. 1
Exports are expected to fall in 2012 in light of the global slowdown and investors have raised concerns about the potential impact on China. However, there remains a common misperception of China being predominantly an export-driven economy. As I’ve written previously, this is not actually true; in 2011 domestic investment and local consumption together contributed US$6.8 trillion as compared to US$2.1 trillion from exports. The export of goods and services as a percentage of GDP is also expected to fall from 38% in 2007 to an estimated 28% in 2012. 2
In this highly connected world, China is unlikely to be immune to the global slowdown, but I believe the Chinese government will utilize their substantial reserves and banking system to stimulate the domestic economy, as they did in 2009. This time around, the stimulus may focus on:
1) Consumption; such as further reduction of personal income tax, coupons, continuation of subsidies on small size cars and home appliances.
2) Infrastructure; such as resuming the railway construction and nuclear power plants, investment in the irrigation system, investment in the power grids.
3) Public housing.
There is no guarantee that these measures will be successful in stimulating the Chinese economy to the government’s growth targets. All of these are fiscal expansionary measures which cannot be used indefinitely.
If the weak U.S. & European economies continue to drag global growth much longer, the Chinese government may need to be content with its economy growing at a slower pace. However, on the structural side, there are still many things the Chinese government can do to increase productivity. That includes, for example, more incentives for investments, better intellectual property protection to encourage greater product innovations and further privatization of the state-owned sectors.
Many investors are concerned about inflation and property bubbles in China. We believe there are some property bubbles mainly in first-tier cities such as Beijing, Shanghai, Shenzhen, Guangzhou, and some second-tier cities like Chengdu, Chong Qing, Wuhan and Changsha for example. In third- and fourth-tier cities, our current judgment is that affordable housing is still accessible and property price increases are not excessive.
As the Home Purchase Restriction policy is expected to continue, without the support of investment demand, the possible downside of the property prices now will depend on affordability levels for buyers. In first-tier and second-tier cities, the current price/income ratio is quite high at around 14x (i.e. the price of a home is 14 times the GDP per capita) and 19x respectively. In third- and fourth-tier cities, the current price/income ratio is much more reasonable, at below 7x. 3 These latter cities account for the majority of total property transactions in China. 4 That said, we do believe the average property price for the whole of China may correct by around 20%. While it would be painful, we don’t see this as sending a broader ripple effect through the mortgage market. We believe any negative impact will likely be small because those who bought the properties in first-tier cities in 2010 and 2011 are more likely to face the possibility of a significant price correction. These risky mortgages only account for a very small part of the total mortgage market.
In actuality, property prices in Beijing and Shanghai are about the same as other major Asian cities. Just like Manhattan and London, places like Shanghai and Beijing attract wealthy families from all over the country to their property market; hence the market is not really a local city market but a country-wide market. Therefore, even with a short-term correction, we expect demand for real estate in these markets to remain high.
Importantly, 2012 will mark the transition of leadership at the top Chinese echelon. We believe the transfer of power will most likely go smoothly as planned. We believe the Chinese leadership has the organizational skills and policies that could potentially help China continue to achieve one of the highest GDP growth of any major country in the world. An advantage of the one-party system is the ability to have long-term planning and policy continuity across more challenging market cycles. We expect that the renminbi will continue to fluctuate within a designated range. However, there is danger of trade protectionism if economies become more severely impacted with slower growth than expected. Investors have also raised concerns about rising income inequality and an aging population derailing China’s growth. These same concerns plague a number of countries elsewhere around the world. But we do not see these factors significantly impacting China’s growth prospects for 2012.
In the Year of the Dragon, China might catch some sniffles, and the side effects are likely to be felt by countries that have depended on the dragon’s appetite for commodities such as iron ore and coal. With fixed asset investment growth likely to slow down from 23% in 2011 to 17% in 20125, commodity-heavy economies like Brazil, Russia and Australia are likely to be negatively affected. There could be a lot of market volatility globally in 2012 but we think the dragon is unlikely to be distracted from its long-term race.
1 Source: EIU, Jan 2012
2 Source: EIU, Jan 2012.
3 Source: CEIC
4 Source: CEIC
5 Source: Deutsche Bank