China's bears and raging bulls

China once evoked mysteries of the orient: opium, corruption and the ineffable other. Today it is more substantial, its economic might visible in the endless ream of steel it rolls out for itself and the world, as well as in the huge iron-ore developments of the Pilbara.
By · 25 Sep 2013
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25 Sep 2013
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China once evoked mysteries of the orient: opium, corruption and the ineffable other. Today it is more substantial, its economic might visible in the endless ream of steel it rolls out for itself and the world, as well as in the huge iron-ore developments of the Pilbara.

Yet it remains a conundrum. How long can it sustain its extraordinary rise? How long can it keep churning out infrastructure and housing? And, perhaps most particularly for us over here, how long can it keep buying Australian bulk commodities hand over fist?

The bearish school, led by Professor Michael Pettis of Peking University, argues that to keep its high growth rates going, China has had to engage in a form of long-term "financial repression".

By that he means interest rates have been held at artificially low levels for a very long period to enable banks to keep lending to unproductive enterprises and governments, especially those engaged in building infrastructure.

This has led to surging investment and very high levels of growth. But ultimately, it's unsustainable, and evidence for its eventual undoing can be found in the declining growth on each borrowed dollar China receives.

The more optimistic school of thought sees China's high investment as the natural course for an economy in the early stages of capitalist reform. High rates of urbanisation and infrastructure investment, the bulls argue, will moderate as the economy moves up the value chain.

So who's right, and what does it mean for Australian investors? Let's start by taking in some history.

The rise of China began in the 1970s with the embrace of capitalism. The reform era, as it is known, brought private-sector dynamism from the West together with the most abundant and cheap labour in the world. What followed was an explosion of economic growth that persists to this day.

This was not some miracle, however. In fact, China simply followed a script written by Japan and then Korea decades earlier. Open up to trade and inwards investment, allow labour to be mobilised by foreign capital, and invest heavily in urbanisation and infrastructure to modernise the economy and unleash its productivity potential.

In short, it is not difficult to evoke powerful growth in an underdeveloped economy. Many nations have succeeded at various times, including much of South America, southern Africa and most of Asia. But after a certain point, when labour supply gets tight and incomes have risen materially, it gets much harder to keep things going.

Rising wages reduce competitiveness and formerly dynamic but labour-intensive export industries begin to wane before the economy has made the jump to the more sophisticated value-adding activities in exports and services that are the hallmark of developed economies.

Far fewer nations have made the leap from fast early-phase development economics to fast post-middle-income development. Japan and Korea are outstanding examples, but many more have failed.

The secret sauce for those that made a successful transition was that they liberalised capital markets. These in turn prioritise returns on investment, shifting it to soft infrastructure like education and health, thereby driving labour to higher value-adding industries.

Returning to our central question then, the two schools of thought are much closer together than they appear. Whichever way you look at it, the next phase of Chinese development requires the same basic reforms - most particularly liberalised finance and a shift to soft infrastructure investment.

The difference lies in how well people think it will work. The China bears see growth falling quickly to developed economy levels, while the bulls see growth at 7 per cent or more for another decade.

Importantly, however, for Australian investors, the outcome is more clear cut. If the pessimists are right, Chinese growth will slow, along with infrastructure investment, and commodity prices will fall. If the optimists are right, fixed-asset investment will still fall, to be replaced by other forms of less commodity-intensive growth.

Either way, China will need less commodities; and, either way, Australia and its miners will lose.

So, is it a no-brainer to sell miners? Not quite. China is sending very mixed signals about when it intends to seriously embark on the reform process. The nation appears to be bitterly divided between the reform-minded new government of Li Keqiang and those interests aligned with former president Jiang Zemin. Zemin is heavily associated with the Shanghai elite that benefited spectacularly from the old development model, and will lose if economic liberalisation is embraced.

If the reformers win and the rebalancing project begins, China might continue to enjoy high or moderate growth, but (combined with the existing supply deluge already pushing prices down) we're likely to see large falls in bulk commodity prices from mid-2014.

If the reformers lose, China will lurch from stimulus to stimulus, supporting demand and prices for bulk commodities for another few years, before it ends in a Chinese financial crisis.

Predicting the timeline for these events is impossible. If China postpones its adjustment, earnings for the miners could still be good for another few years and, given low valuations, a decent rally is possible if markets focus on the cyclical over the structural. The Australian dollar might also stabilise at present levels until China's structural challenge reasserts itself.

But in the medium and long term, the probable outcome is that the Chinese reformers will prevail - either that or crisis will ensue sooner or later. Either way, the outlook doesn't look bright for our mining industry, our economy and our Aussie dollar.

As always, though, economic strife can be the source of opportunity rather than disaster for your investment portfolio, so long as you take appropriate precautions - as we've been recommending to our members.

We can't put it better than the legendary Chinese philosopher Confucius: "Success depends on previous preparation, and without such preparation there is sure to be failure."

This article contains general investment advice only (under AFSL 282288).

David Llewellyn-Smith is the editor of MacroBusiness. This story is run in conjunction with Intelligent Investor Share Advisor.
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