The Real Picture Behind 'China Crisis'

There are basically two groups of investors in their opinion of China's economy. In one camp are those who are optimistic on the economy’s strength and its ability to thrive in an otherwise bleak global environment.

The most recent economic data release showed a sharp rebound in the Chinese export sector has further enhanced the positive sentiment

In the other camp are an increasing number who believe that China’s economic
miracle is nothing but a mirage and that 2010 will be a year of painful reckoning. Some analysts are claiming that China’s growth model is fundamentally flawed and the massive stimulus measures adopted since late 2008 have only intensified the economy’s structural imbalances, which will make the inevitable downside adjustment even bigger. The usual worrying features of the economy such as asset bubbles, “mis-investment”, an inefficient banking system, growing social unrest and corrupt governance - some are predicting an imminent economic crash and even social chaos. Some prominent hedge fund managers have reportedly even begun shorting the “China story” in recent months. Well, for every buyer, there has to be a seller... so the story goes.

Is the economy headed toward a sudden collapse, as expected by the “house of cards” camp? The answers to these questions obviously weigh heavy in investors’ decision making. There has never been a lack of skepticism toward the Chinese economy. Even 5, 10, 15 years back, there were the usual China-bashers and permanent-bears who have been proven wrong over and over again by the country’s enormous economic success and social progress over the past three decades. However, the question marks about the country’s fundamental growth model deserve careful assessment. The core argument of this bearish camp is that the Chinese economy is mainly driven by capital spending and exports, both of which have exhausted their potential. The economy is bound to slow sharply due to a lack of new sources of growth. Or is that the full picture?



While there is always a chance of a major collapse in any economy, I think China is going to chug along just fine. I do not think that China’s capital spending is excessive. China’s capital spending boom has mainly been driven by profit incentives rather than government direction. Those who think that China’s capital spending is terribly inefficient and will face an imminent crash will be proven wrong. If you take the data and extrapolate on internal capital returns on the country's projects - China's figure is very much in line with other developing countries.

Second, one may argue that the U.S. consumer sector has entered into a prolonged period of deleveraging, and that its demand for Chinese products will never recover to pre-crisis levels. However, an important fact is that China’s export market has become increasingly diversified. If you refer to the chart, even though the U.S. remains the largest market for Chinese overseas sales, its market share has shrunk from a peak of 22% in the late 1990s to 17% today. In fact, Chinese sales in some of the nontraditional export markets such as Australia, Latin America, Africa and the Middle East have experienced much faster growth in recent years than sales to other developed markets.

Meanwhile, China continues to reduce trade barriers with emerging Asian countries. At the beginning of this year, China and the 10-country Association of South-East Asian Nations (ASEAN) formally established one of the largest regional free-trade zones in the world.

Over the years, the Chinese authorities have worked to boost domestic consumption in an attempt to reduce the economy’s dependence on exports and capital spending. In this sense, slowing capex and exports should be taken as a positive sign, as it means that policy makers’ consumption-boosting initiatives have finally begun to bear fruit.



The Chinese authorities still have a lot of room to boost growth. Infrastructure in the country’s rural regions is still grossly insufficient and needs tremendous government input. Massive domestic savings and the very low public sector debt burden means there is a lot of financial resources the government can utilize to buy a lot of growth, similar to what they have done over the past year. This kind of growth-boosting campaign is of course unsustainable over a prolonged period of time, but China is among the few countries in the world that are most capable of dealing with a crisis scenario with extraordinary policies – and have a significant war chest to do it with.

Hence we should not see a crash or a major crisis of any sorts in 2010. Yes, the markets will have to experience some bumps here and there, in particular when Beijing tries to tighten the screws on lending and rein in liquidity a bit every now and then - but its for the betterment of the economy, not a noose around the economy's neck.

Currently, the authorities are beginning to tighten policies again. The risk factor is the country’s bubble-prone asset markets and potential damage to its banking system. Specifically, as a result of China’s massive household sector savings and highly pro-cyclical global capital inflows, Chinese asset prices are prone to boom-bust cycles. So far the extreme volatility in asset prices, such as the 70% crash in the domestic A-share market and housing price declines in some major metropolitan areas between 2007 and 2008, has inflicted little damage on banks’ overall asset quality, as the above chart would indicate clearly. This is because policymakers have maintained a significant buffer between asset markets and the banking system - banks’ mortgage lending practices have been very conservative, with a mandatory down payment ratio of 20-40% for real estate purchases. Banks’ direct exposure to the stock market is also negligible, as leveraged investments are not allowed.

Recently, the authorities announced that index futures, margin trading and short-selling in the A-share market have been officially approved. Even though it may take months for these instruments to be developed and deployed, and they are undoubtedly positive in terms of improving the efficiency of the domestic capital market.

Structurally, China’s economic performance will most likely continue to outpace that of the rest of the world. This warrants a more positive stance on Chinese assets over global benchmarks, especially as current valuations of Chinese assets are comparable to global and emerging market averages. Have a look at the chart above on China's valuations - its very reasonable still. From a cyclical point of view, it’s important to recognize that there is a disconnect between a country’s economic performance and its stock market. One does not need to be super-bullish on an economy’s immediate growth outlook to be positive on its financial asset prices.

Stock markets are highly sensitive to policy shifts, which is a lagging response to economic performance. Weak growth leads to policy easing, which is stimulative for the stock market. Similarly, strong growth normally leads to tightening policy, which bodes ill for equity prices. In some cases, good economic news turns out to be a headwind for stocks. Currently, China’s strong growth recovery is pushing policymakers to tighten, a critical juncture that is typically associated with heightened volatility in equity prices. While the Chinese A-share market will continue to struggle in the coming months, investors should not take this as a sign of pending economic troubles. These tightening measures are good problems to have.


p/s photos: Gu Chen

The Hype Surrounding Black Swans

No, we are not talking about the beer. Investors who read a lot would have come across the quite audacious yet thought provoking book by Nassim Nicholas Taleb. You can summarise the book with the line: The Impact of The Highly Improbable.


The Nobel Laureate Daniel Kahneman proposed the inclusion of Taleb's name among the world's top intellectuals, citing "Taleb has changed the way many people think about uncertainty, particularly in the financial markets. His book, The Black Swan, is an original and audacious analysis of the ways in which humans try to make sense of unexpected events."

Before the discovery of Australia, poeple in the Old world were convinced that all swans were white, an unassailable belief as it seem completely confirmed by empirical evidence. The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single black bird.

Consider these factors: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. We amble through life, in our careers, personal life, investing, etc... and these are punctuated by "black swans" - the humdrum would not kill you or make you rich and wealthy, its the black swans that turns everything around, be it in relationships or investing.

The central idea of this book concerns our blindness with respect to randomness, particularly the large deviations. In other words, we do not see the big picture but base our decision making process on what has happened in the past.

For those of you who attended my talk, I have spoken on how most of us make decisions: anchor & adjust. That in effect is one way to make sure we will never see or predict black swans in our analysis. When you anchor & adjust, you fixate on what happened recently and make your guesstimates from that point of reference. When Malaysia's GDP growth last year, say was 3%, to predict GDP growth the following year, we would anchor at 3% and make adjustments according to how we view FDI, unemployment, currency, interest rate differentials, blah-blah... Hence 99% of the predictions would be plus or minus 100-200 basis points from 3%. A black swan effect would be tantamount to something like two major banks collapsing in Malaysia overnight, and the resulting GDP growth was a contraction of 8% - now, that's a black swan effect - most did not see it coming because they never figured in our calculations.

Its not just in investing, you can be dating a girl for 5 years and planned to marry next year, and wham, she turned into a lesbian - turning your world upside down, what a black swan.

It is easy to see that life is the cumulative effect of a handful of significant shocks. It is not so hard to identify the role of Black Swans. Consider the significant events, the technological changes, and the inventions that have taken place in our environment since you were born and compare them to what was expected before their advent. Look into your own personal life, to your choice of profession, say, or meeting your mate, your sudden enrichment or impoverishment. How often did these things occur according to plan?

Taleb appeared to be vindicated against statisticians in 2008, as he reportedly made a multi-million dollar fortune during the financial crisis of 2007–2008, a crisis which he attributed to the failure of statistical methods in finance. Universa, where Taleb is adviser, made returns of 65% to 115% in October 2008 in its approximately $2 billion “Black Swan Protection Protocol.”

While most human thought has focused us on how to turn knowledge into decisions, ... if you follow Taleb's reasoning, we should be more interested in how to turn lack of information, lack of understanding, and lack of “knowledge” into decisions. That is because the world is always a place where information and understanding are lacking in most areas. Knowing that we will never be able to grasp all critical issues is important. The question of "what if" carries with it graver consequences when we know how to ask "what if" properly.

The LTCM collapse, with two finance gurus in the company (Nobel prize winners no less), was very Black Swannish. Using standard deviations and pricing models, they try to extract price differentials when certain factors move in a certain way. They looked at correlation between various asset classes and instruments. Well, the best minds could not explain when things that are supposed to correlate, starts diverging in a big way.

Our system of rewards is not adapted to black swans. We can set up rewards for activity that reduces the risk of certain measurable events, like cancer rates. But it is more difficult to reward the prevention (or even reduction) of a chain of bad events (war, for instance, the recent subprime crisis is a major example).

When our system of risk-reward is not geared towards detecting, spotting or preventing black swans - that put everything at risk. We can get into a very theoretical debate on black swans, but for us who are in investments, how does Black Swans apply to our senses?

The impact of black swans has been enhanced many times over due to the globalisation of markets, as well as financial firms getting a lot bigger and international (and fewer of them as a result). You can be owning very safe stocks with splendid dividend yields in Timbuktu, but due to over speculation in certain asset classes in Eastern Europe, or a maniacal over leverage by some Icelandic banks, you could have a cascading effect which hits at banks, markets, confidence ... leading to a de-rating of emerging markets, smaller currencies ... i.e. risk aversion, nobody wanting to own stocks. Hence your so called blue chips could be halved in value, to no one's fault.



The Black Swan thing should alert us to reflect that we really CANNOT adopt a buy and hold forever type of investing mentality. The markets are so different now, many things are the same, but there are critical nuanced differences now. Black Swans in investing will usually be found in over-leveraged situations, bubble type situations in certain asset classes, sovereign debt defaults, the collapse of a major financial firm, ... You may be just investing in stocks, but now you have to read and follow closer on what's happening or bubbling in other areas as well. Their bubbles will affect you in the end.

There are things we cannot control, that is external to us. We need to stay tuned to potential black swans, even though we may be laughed at initially. Take any industry or markets, think of a few really "upsetting things" can whack them out of the water - these are your potential black swans, then you start ticking things off in your research and analysis to see of any of these potential black swans are about to morph into something sinister.

Do not take things at face value, learn to ask better "what if" questions even when they appear to be silly sounding. Beware of leverage, beware of things like "value at risk" because nobody really knows VAR in reality.


p/s photos: Gu Chen