Aditya Rana On China and Comparing Diets – Part II!

From: aditya rana
Date: Sat, May 25, 2013 at 2:35 PM
Subject: On China and Comparing Diets – Part II!


The bearish sentiment towards China abounds, with concerns ranging from a potential debt crisis to an overinvestment bubble. While these maybe legitimate concerns, it is unlikely that China will experience a “hard landing” as some of the China bears have been expecting for several years. A recent report by Chen Zhao, Chief Investment Strategist at the well respected independent research firm BCA, provides a persuasive riposte to the various arguments put forward by the China bears. To summarise:

The bearish case rests on the following two key arguments:

1)The rapid growth of the unregulated lending sector (“shadow banking”) since 2009 , with current estimates being as large as $3.4 trillion (see chart below).

2) The persistently high levels of investment (see chart below) leading to diminishing returns and an overinvestment bubble characterised by “ghost towns” and “empty skyscrapers”.

-To address the above two concerns it is important to first understand the underlying fundamental causes behind the high levels of debt in the economy.

-Debt occurs when an economy transforms its savings into investment, and this can take place either through the equity or debt. In a closed financial system like China, with a significantly higher reliance on debt rather than equity financing, the high levels of savings will automatically translate into high debt levels. The contrast between the U.S. , and both Europe and Asia is illustrated by the chart below.

-An open low-saving country can also incur high levels of debt by borrowing from abroad and build-up foreign liabilities, while a high-savings country would normally lend their excess savings abroad and build-up foreign assets. There is a historical tendency for debt built on borrowed foreign savings to be more prone to financial crises than debt built on domestic savings. The contrast between East Asia and the Anglo-Saxon countries is illustrated in the chart below:

– With China saving 50% of its GDP, and this vast pool of capital being transformed into investment via debt financing rather than through the small and illiquid equity capital markets, the gearing ratio of Chinese companies is necessarily higher than in the U.S. and Europe.

-The sudden surge in the gearing ratio after 2009 resulted from an increase in private-sector savings combined with a decline in capex, forcing the government to step-in and borrow from the banks and invest on the private sector’s behalf.

-A similar phenomenon occurred in the U.S. during the financial crisis – with the stimulus package (“ARRA”) being financed by debt issuance, while in China is was financed by bank debt. The only difference was that In the case of the U.S., the borrowing was securitised by the assets financed under the programme, while in China it was not securitised and stayed on the bank balance sheets.

-This mixing of bank loans is a legacy of the old centrally planned system, and a large part of the private sector liabilities since 2009 are really fiscal stimulus and should be reclassified as such. However, the key point here is that it is a redistribution problem between the government and the private sector and not a sovereign debt problem.

-The Chinese government has accumulated net foreign assets over many years, which have far exceeded its outstanding obligations and therefore has ample resources to meet its obligations.

-While misallocation of resources is a problem in China, and non-performing loans will rise and some local government may even default, the current problem are no worse than they were in the 1990s. In 1998, hit by the Asian financial crisis, the economy slowed and non-performing loans rose to as high as 35% of bank loan portfolios. The banking sector was recapitalised in the early 2000s, and since then, banks have been generally more careful on the credit quality of loans as regulators have tightened oversight.

-If China really had an overbuilding problem (as the bears have been calling for over four years), real estate prices would have collapsed by now, but supply remains tight and, rather, the government is faced with the issue of trying to cool down prices. Few people realise that China has moved 400 million people from rural areas to cities within the last three decades, requiring a huge amount of capital investment and infrastructure development.

-With current growth at 7.7%, and inflation falling, the economy is likely to be operating below its potential rate and monetary policy will remain accommodative. In contrast to developed economies, credit in China is expanding at over 20% which suggests continued expansionary momentum and the economy is likely to grow at above 8% during the second-half of 2013 (see chart below).

– The “shadow banking” sector can actually be viewed as a necessary complement to the formal sector at this stage of financial development, as it reflects market driven activities with more realistic risk/reward characteristics. Over time, the “shadow banking” sector is likely to blend into the formal sector.

-Chinese households continue to be under-leveraged, as housing is seen to be a form of savings. For example, property prices in Hong Kong collapsed by 70% in 1998, but residential delinquency rates remained very subdued (in contrast to the U.S.) as households were less leveraged (see chart below).

-Rising wages in China, rather than cutting its competitiveness, can be seen as sign of increasing productivity and progress. Chinese firms continue to increase market share in global trade, despite wages having gone up by seven time since 2000 (see graph below).

-Chinese firms also seem to be successfully adapting to the higher cost-structure by making the transition from low-end manufacturing towards industries with a high value added content (see chart below).

-Additionally, the new government is serious about its market-reform policies, taking steps towards breaking up state monopolies (for example, dismantling the Railway Ministry), trimming bureaucracies, encouraging completion and announcing a time-table for full currency convertibility under capital accounts. Perhaps most importantly, China still has to urbanize a large part of its 600 million rural population which will continue to require large scale investment in social and economic infrastructure.

-Chinese shares remain cheap, with a trailing P/E of 10.5 and forward P/E of 9, while banks trade at only 5.6 times earnings (see chart below). With tail risk for the global economy contained, it is highly unlikely that the Chinese economy will experience a sharp downturn like it did during the 1998 Asian crisis, the 2001 global recession and the 2008 financial crisis.

A persuasive note, and as I have reiterated in previous newsletters, China remains one of the most compelling investment opportunities across the world, and have an appropriate (8-10%?) allocation to china in a well-diversified portfolio would be prudent. The stars seem all aligned – attractive valuations, a bottoming economy and implementation of structural reforms – with the stock market already showing signs of anticipating the upside by posting higher highs and lower lows over the last two years (see chart below).

An important point which makes the likelihood of a China hard landing very low, and not directly mentioned in the above note, is the ability of the Chinese government to implement financial repression – i.e. keep low nominal and negative real interest rates. With the large pool of savings being channelled into investment via debt, and the cost of financing being very low, the low returning assets can be carried on the books of banks for a long while. Absence of a mark-to-market system also allows problem assets to be worked out over time – aided by a cyclically growing economy.

Comparing Diets – Part II:

To follow-up on last week’s serialisation of an article written by a noted proponent of a plant-based diet – Dr. John McDougall – which compares the diets (and incidence of various diseases) of different cultures around the world, incorporating both low carb/high animal protein and high carb/low animal protein diets, before the advent of the globalization of the western diet:

The Okinawans:

-In 1949, a government survey found that in Okinawa, known to have the highest concentration of centenarians in the world, found that they obtained 85% of their daily energy intake form carbohydrates (mainly in the form of sweet potatoes which were 69%, with rice at 12% and wheat and other grains at 7%), only 9% from protein (less than 4% from all animal foods (including fish) combined) and 6% from fat. The relevant figures for mainland Japan was 79% carbohydrates (mainly from rice and other grains), 13% protein (7% from animal foods) and 8% from fat. These finding were consistent with previous dietary surveys conducted in 1879 and 1919.

-Autopsies performed on 150 Okinawans in 1946, of which 40 were between 66 and 90 years, showed only 7 cases of slight atherosclerosis (clogging of arteries) and only one case of calcification of arteries. Another autopsy on 200 Okinawans performed during the same year showed similar results.

-In 1995, the observed rates of coronary heart disease and dietary related cancers, including that of the colon, prostrate, breast and ovarian cancers, showed incidence rates which were manifold lower than rates not just in the U.S. but in mainland Japan as well. Given that these are slow progressive diseases, it is likely that the traditional diet consumed many decades prior would have played a major role in the development of these chronic diseases.

The Papuan New Guineans:

-The Papuan New Guineans have traditionally consumed a plant-food diet with 90% of their caloric intake provided by various forms of sweet potatoes, and with an astonishingly high 94.6% of their daily energy requirements from carbohydrates and only 3% from protein. Pig feasts were performed a few times a times, where less than 50 grams of meat consumed. However, there was no sign of protein deficiency or anaemia and they were described as being muscular, very lean, physically fit and in good nutritional state.

-Despite tobacco being smoked by 73% of males, and 20% of females, and living in smoke-filled houses, a number of studies (1923-1934, 1969 and 1978) observed great rarity of coronary heart diseases, stroke, Parkinson’s disease, diabetes and gout amongst the population, but an increase in incidence paralleling the Westernization of the population.

-Cancer was extremely rare, and a British physician noted in 1900 that he never saw a case during a ten year period, except at the end when a single case of sarcoma (bone cancer) occurred when a local consumed a westernised diet daily for eight years, including tinned Australian meat.

-For a population which consumed virtually the highest intake of carbohydrates ever recorded, also had the lowest incidence of heart disease and diabetes ever recorded, highlighting the importance of the health benefits of quality carbohydrate rich foods.

To be continued.

Here is to staying bullish on China and consuming carbohydrates and less protein (particularly from animals)!




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