KGB: Silvercrest's Patrick Chovanec

Silvercrest Asset Management's chief strategist says China has been riding a credit fuelled investment boom for several years, but as investments fail to generate returns resources are increasingly being locked up in rolling over bad debt.

Silvercrest Asset Management chief strategist and China analyst Patrick Chovanec tells Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:

- Around half a trillion US dollars in shadow credit in China was issued in the first quarter of this year on long-term projects, many of which may never pay off.

- A lot of the strategies Beijing is talking about for rebalancing are still "on paper", and the "actual policy" has been to try to boost credit including shadow banking to try to keep investment up.

- The old recipe for boosting China's growth is no longer working, and GDP has further to fall.

- Australia's mineral exports to China cannot continue at the same pace.

- Reluctance to actually open up China's banking system is related to bad debt being brushed under the rug, and liberalisation will involve recognising losses that have already taken place in the Chinese economy.

- There will be winners and losers from China's rebalancing, and the criteria for investment opportunities has shifted.

AK: Patrick, thanks for joining us and welcome to Business Spectator.

PC: Oh, it’s my pleasure.

AK: Now, the last GDP numbers from China said 0.7 per cent for the first quarter which shocked the markets. It led to a bit of a crunch in commodities in particular. Firstly, were you surprised at those numbers? And do you think the market actually reacted correctly to it?

PC: Well, I was a little bit surprised in the sense that we saw a lot of cash flow into the Chinese economy, a lot of new credit and I expected that, while that wouldn’t really be sustainable, it wouldn’t necessarily turn around the story of the Chinese economy, that they’d see a little bit more bump than they did. And I think that seeing a slowdown in the Chinese economy is not necessarily a bad thing if it’s happening for the right reasons, but it’s not happening for the right reasons. It’s in the face of an onslaught of credit that’s trying to prop up investment and it’s not really succeeding.

AK: So, what are the consequences of that? I mean you’ve got credit and GDP going in different directions now which is unusual. Which of them is going to break first?

PC: I think what it indicates is that there are declining returns to credit expansion in China, that China has really been riding a credit fuelled investment boom for the past several years, but that as those investments don’t generate returns, more and more of the resources in the Chinese economy are being locked up in rolling over bad debt -- and particularly rolling it over at bad debt at interest which eats up even more of the credit expansion. So, what we’re seeing is that the old recipe for boosting GDP growth is no longer succeeding.

AK: So, does that mean that you think that GDP growth has further to fall?

PC: That’s right. You know, over the past several years about half of GDP growth has come from investment, sometimes more. And that means that every year China not only has to match all the roads, bridges, highways, condos, villas, ports, airports, high speed rail lines that were built the last year, but it has to actually exceed it and it has to finance that. And if it’s not getting returns from its previous investments, it has to finance it through credit expansion. And so, really the problem here is that…

AK: So, China is a Ponzi scheme?

PC: Well, you know, it’s funny because, well, half the new credit is coming from these investment vehicles, trust products, and private wealth management vehicles which, I’m not calling them Ponzi schemes, but the previous head of Bank of China who’s now the top securities regulator compared them in China Daily -- the government publication -- to Ponzi schemes. So, it is worrying.

RG: Patrick, we’ve had the most wonderful times selling minerals to China, particularly in the last four years. Can that continue?

PC: Not at the same pace. So, it was a windfall and Australia rode that windfall, but it’s not the new normal going forward.

RG: How far will it go down? What are you talking? Ten per cent, 20 per cent, 30 per cent?

PC: You know, it’s really hard to say. I think China’s behind the curveball already in terms of this economic adjustment away from relying on investment to a greater balance between consumption and investment. China’s investment story doesn’t have to end, but it does have to strike a better balance with the rest of the economy. A soft landing, which a lot of people hope for, I think would mean that investment would just flatten out and that it wouldn’t necessarily be contributing to GDP growth and so we wouldn’t necessarily see that much growth. But a hard landing could mean that we actually see, well you know, when we see booms and busts around the world, especially in investment or real estate, we don’t see investment level off, it just falls off. And that could really have a serious impact.

RG: So, on the optimistic scenario, consumption of minerals would roughly stay steady.

PC: That’s right. That’s right.

RG: And that any growth from the GDP will come via services and consumption.

PC: That’s right. Although, I don’t think that we’re necessarily talking about the same levels of GDP growth. You know, the good part of that story is that the China consumption story benefits a lot of other sectors other than raw materials, but for the raw materials sector that has been really relying on this surge in Chinese demand, you know, that was a product of a very unique strategy to try to boost credit and ultimately an unsustainable one.

SB: Patrick, the former premier of China in his final speech described the Chinese growth model as unsustainable. You clearly from your comments agree with that. Can you see a path, a transition path, to a new model? And what would that new model look like?

PC: Well, I think any path really involves a correction in either the property market, in the allocation of credit or recognition of lawsuits that have taken place in the banking system that are now being rolled over to try to clear that out of the system so that productive lending can take place. The problem is that the Chinese want a correction without having a correction. And so, while a lot of the leadership, both the old leadership and the new leadership, has been talking the right game in terms of an economic adjustment, very little has come out of that; that a lot of the policies that they’re talking about for rebalancing the economy are still on paper and the actual policy has been to try to boost credit including shadow banking to try to keep investment up. And unfortunately if you try to squeeze that investment growth for all it’s worth, I think you do end up in a hard landing scenario.

SB: There’s something like, I think it’s $4 trillion US dollars in that shadow banking system or 40-something per cent of GDP.

PC: Nobody really knows.

SB: No one really knows. Can you have a correction of the kind you’re referring to which is anything other than violent?

PC: Look, I think that even a soft landing means a very serious adjustment in terms of who the winners and losers are in the current Chinese economy and for people outside of China who have been piggy-backing on their growth.

RG: But this might take a long time to happen.

PC: I think it’s happening. I think it’s already happening. The growth squeeze took place last year. There were the beginnings of a serious meltdown in the property sector beginning really the summer of 2011. It was rescued by a new injection of credit. It’s all really credit driven. The property market has been credit driven and, rather than having a soft landing last year, what actually took place was they were coming in for a landing. And it looked like it was going to be a hard one and they waved off and they injected a lot more credit in, but they didn’t get much of a bump out of it. They just got a modest bump.

RG: But Ronnie Chan says look, we’ve got a huge program of urbanisation ahead of us in China, therefore mineral demand will hold up.

PC: Yeah. I think that a lot of people -- including Chinese officials -- are thinking about urbanisation wrong. Urbanisation throughout the world has not always led to economic growth. Very frequently in developing countries, their people have moved to the cities and ended up in squalor. So, the key to successful urbanisation is that taking people from a rural environment and putting them in an urban environment has to lead to productivity gains, real productivity gains. And those productivity gains that pay for all of that supporting infrastructure that makes urban life liveable. So, a lot of these things -- subways, water treatment plants, all these investment projects -- they’re actually costs and they have to be supported through real productivity gains which means economic reform in China. The problem is that most Chinese officials, when they talk about urbanisation, they say ‘well people are moving to the cities and that’s good because we get to build stuff and building stuff adds to GDP’. But what pays for that stuff that’s being built? Right now, what’s paying for it is they’re issuing high yield bonds, promising 10-12 per cent returns. And they’re selling them to private wealth management vehicles and investment products.

AK: But are they getting 10 per cent and 12 per cent income to service those bonds?

PC: No, they’re not and that’s why the new securities regulator, Xiao Gang, called them Ponzi schemes because they’re paying out based on new inflows.

RG: Who is issuing these bonds?

PC: Banks are the main conduit, but banks are not always the issuers, so there are trust companies. Essentially they’re just investment products and they’re being sold to companies and they’re being sold to retail investors and often on a very short-term basis. So they roll over every 45 days or 90 days. So, you’ve got a liquidity mismatch between people who think that they’ve got essentially…

AK: Bloody hell.

PC: …a near cash investment that’s locked up in very long-term projects and many of those long-term projects may never actually pay off.

AK: So, we should run for our lives.

RG: But how many of these bonds have been issued? How many bonds are being issued?

PC: Right now, it’s about half a million credits are being issued in China and in the first quarter of this year that was $1 trillion US dollars. So about half of that, so half a trillion US dollars in new shadow credit was issued.

RG: OK.

SB: What you’re talking about, Patrick, is misallocation of capital on a grand scale. The Chinese have surprisingly moved quite quickly to liberalise the currency, but they haven’t done much at the back end deregulating their own financial system. Is that a necessary next step for China if it wants to actually get its finances in order?

PC: It’s an important step down the road for China to be able to discover new competitive advantages.You know, China relied on cheap labour and it relied on a lot of little hanging fruit for bringing people from the rural areas and putting them in a factory. You got lots of productivity gains. So, increasingly China’s going to have to find new sources of competitive advantage and one of them has to be more efficient allocation of capital. So, it’s very important to China’s future. 

However, one of the reasons why I think you see a reluctance to actually open up the banking system is because a lot of bad debt is being brushed under the rug and hidden there. And, you know, we saw this with Japan in the 1990s.  In the early ‘90s Japanese banks just sat on a lot of bad debt. You didn’t have a financial crisis.  They just sat on bad debt. You had zombie banks.  When they tried to reform the banking system, a lot of this came out of the woodwork and they had to recap the banks. And so, it’s a question of when you recognise the losses that have already taken place in the Chinese economy.

AK: But fundamentally the Chinese economy is being rebalanced. The leadership understands it and what they’re doing is they’re reforming the labour market to ensure an incomes rise. And they’ve seen that the currency rises and that is leading to an increase in consumption.  In the last figures consumption actually did exceed investment I think for the first time in a long time.

PC: Consumption exceeded investment as a contribution to GDP growth, but both consumption and investment fell in terms of their contribution to GDP.  So, one way of rebalancing would be for investment simply to collapse and then you’d be left with the consumption that you’ve got and that’s rebalancing, but I don’t think that that’s what most people think of…

AK: That’s not what everyone has in mind.

PC: Right.  What most people think of is that consumption is going to rise dramatically and in fact what we’ve actually seen is that consumption is growing, but the contribution to GDP growth has actually been declining over the past two years.

AK: So, is that because in order to get the consumption to rise they need to reform their social welfare system, so that people don’t have to save as much?

PC: That’s part of the equation, but it also really means putting more resources in the hands of households.  You know, China’s export by growth model is based on supressing domestic consumption, channelling as many resources as possible to investment.  Now, that would normally lead to a highly imbalanced economy, but they make up the difference by selling abroad. 

The problem is that that external demand isn’t there anymore.  It isn’t there in terms of providing growth.  And so, they need to have consumption drive it, but that means channelling resources back to the household sector.  That means changing tax policy which channels resources away from the household sector.  It means changing the exchange rate policy because a cheap renminbi means lower buying power for Chinese consumers and in exchange for a competitive advantage for Chinese producers and it also means changing the way the banking system works. Because low interest rates, artificially low interest rates, especially in an environment where people have to self insure means that people have to save more in order to hit their savings targets while in exchange for companies getting cheap credit.  And so, you know, normally people think oh well if you want to boost your economy, cut interest rates.  Well, cutting interest rates in China just boosts investment and actually hurts consumption.

SB: Last year the authorities actually widened the band of rates that banks were allowed to offer. Has that had any impact?

PC: You know, I think that there are people in the PBOC, China’s central bank, who really do want to move towards a more liberalised not just exchange rate, but also flows of money in and out of China.  And I think they’re right.  In the long run this is something that is very important for China’s future.  But, you know, it’s like what we see is a lot of preparation, right.  It’s kind of like when you go swimming.  You know, you get your towel.  You get your slippers.  You get your floatation device. You get ready.  Do you jump in the pool? And jumping in the pool means that you open up the capital account and you allow free flows of capital in and out of China. And for all the reasons we’ve been talking about I think there are a lot of obstacles to that actually taking place.

RG: Do you think that relations between the US and China will be stable or do you think that the US and China will have great difficulty because China’s encroaching into the US area?

PC: The relationship between the US and China is very broad and it’s very rich and there are areas of cooperation and there are areas of profound disagreement. And I think that that will continue to be negotiated in the years ahead. There is a growing interdependence between the United States and China.  I think it will grow even deeper as Chinese companies invest in the United States.  I think that there is a win that comes from that. 

But obviously, you’re talking about two very different political systems.  You’re talking about a China that is feeling its influence in the region and trying to discover for itself what it really wants in terms of its role in Asia and its role in the world and that’s going to lead to some tensions.  We’ve already seen obviously tensions in the East China Sea and the South China Sea. Hopefully, those won’t overshadow the benefits to come from the relationship.

AK: Now Patrick, you’ve moved from Beijing to New York and you’re now the strategist for a global investor investing relatively conservative money. I take it from what you’re saying that you’re out of China investment wise.

PC: No, not necessarily.  You know, I think that the old China story is over and the old China story was ‘just hop on any bus because all the buses are going to the same destination’. And that’s what drove the China IPO market. It was ‘the first company that’s in this sector, this IPO and you need to be in this sector in China because it’s going to grow and it doesn’t really matter what the corporate governance, whether the company or accounts are really accurate, what the management quality is.  It doesn’t really matter because we’re going to see huge growth.’  I think going forward the new environment is going to place a premium on being selective.  You know, which companies really have resilient business models? Which companies have good management teams? Which companies have robust capital structures, so that they’re not over extended and they can survive the vicissitudes of a normal economy? 

AK: Or would it be fair to say that you are underweight -- as a China class of investment you would be underweight?

PC: I think you need to take a sceptical eye towards any China investment -- or China related investment -- because there are a lot of companies that are, you know, predicating their growth on China. And ask: can this story withstand the changes that the Chinese economy is going to go through?

AK: And does that also lead you to be underweight Australia?

PC: You know, we’re not in a position of shorting China or shorting Australia.  I mean some people do use Australia, particularly the resource sector here, as a proxy for China and even a banking sector because of the exposure to the resource sector.  You know, I would say that in any correction there are winners and losers. And even in sectors that are bearing the brunt of that correction, there are companies and there are managers who are prepared; they’ve seen this coming and they actually can benefit from the fact that their competition is winnowed out and they may even be able to pick up assets cheaply. 

So, even for instance the real estate sector in China which I think is going to see a real correction, there are companies that I like.  There are companies that I think have been very wise in their strategies.  There are companies that have cash on hand to be able to pick up distressed assets cheaply and it’s going to benefit them.

SB: Patrick, I know this conversation is about China and I suppose there’s a Chinese dimension to this question.  There’s been a lot of discussion in the states about a sort of reshoring of manufacturing activity there that was exported to China a decade or two ago.  Is that happening?  Is it real?  And how profound a change is occurring in the US economy?

PC: Some of it is happening because of rising real costs in China.  Some of that reshoring is actually moving to other places, not the United States, because it’s going to Bangladesh or it’s going to Cambodia or Vietnam.  Some of it is coming back to the United States, some of the higher value part. 

And part of it is due to lower energy costs in the United States. I mean, that is a big story in the US and it is affecting Europe.  It will affect Australia and Japan in terms of exports of LNG.  So that’s certainly going to reshape things. You know, I have a friend who is in the chemical industry in China, a head of a global company doing a lot of investment in China, and he said that for the past 20 years it was a no brainer, that if you were going to build a petrochemical plant, you would build it in China or at least in Asia. And now you would probably build it in the United States.  So, that’s a big change.

AK: We’ll leave it there.  Thanks very much, Patrick.

PC: My pleasure. Good to be in Australia.

Silvercrest Asset Management chief strategist and China analyst Patrick Chovanec tells Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:

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