Unease in the East

Out in the sticks, or should I say steppes, of inner Mongolia, the local government authority of Ordos, a wealthy coal-mining town near the world's biggest coal reserves, has built on its outskirts a spanking new city called Kangbashi from our iron ore and nickel.

Five years and some $5 billion later, out of a projected population of more than 1 million, only 28,000 people live there.

That's the official count. The true population, journalists and others who have seen the empty three-storey McMansions say, wouldn't be 2800.

Nobody, except officials of the local government authority, can afford to live there and even they mostly prefer nearby Ordos, where there are shops and restaurants.

This, along with perhaps another dozen modern ghost cities like it, reveal a different side to the Chinese economy, and perhaps its fate.

Foremost is the power of local authorities that vie with each other to meet - or, better still, beat - Beijing's annual growth target.

It is a story every Australian business person who visits China tells - the financial clout of local government authorities run as self-contained businesses in what is supposed to be a centralised system.

These authorities derive their wealth from property speculation, either auctioning Crown, er, People's, land or using it as collateral for bank loans. So building a city nobody can afford, or probably wants to live in, kills two birds with one stone.

Building prosperity

All that building creates growth and jobs, so looks good in Beijing, as well as raises money. It has created a property boom based on borrowed money. If China's real estate is as geared as was the case in the US - which triggered the global financial crisis - or as Japan's, before it entered a decade-long recession, then watch out.

No wonder economists say one of the biggest risks to the booming Chinese economy would be the property bubble bursting.

Not only would this bankrupt many local governments, it would also reduce private wealth - and spending.

In the property hot spots of Beijing, Shanghai and other large cities, prices are already slipping. But it's not panic stations yet.

Prices elsewhere are still climbing, though at a slower rate.

Besides, "property price increases have lagged income growth over the last 10 years," says the head of investment strategy at AMP Capital Investors, Shane Oliver.

Perhaps a bigger worry is that China is developing the debt problem afflicting the West. A working paper by the Australian Treasury estimates government debt, when you take into account local authorities, is running at 60 per cent to 70 per cent of GDP. Some China experts say it is more like 80 per cent.

Fortunately, that's below the basket cases of Europe and the US and, in any case, hasn't been borrowed from foreigners. Even so, on Treasury's figures, 23 per cent of the loans are duds or what bankers call "non-performing" and it says this is "likely to increase".

An even bigger problem is that China went on fiscal steroids to counter the GFC and it's still trying to come off them.

Ordos is typical of what happened. Unlike the West, where households got the handouts, in China they went to local authorities, who ploughed everything into infrastructure.

In addition to ghost cities, there are four-lane highways going nowhere and new bridges that replace perfectly good old ones that were torn down.

Mind you, when Sydney builds a cross-city tunnel nobody uses, it's not as if fiscal folly is unique to China.

This investment boom accounts for almost 70 per cent of its GDP, twice the level Japan reached during the height of its industrialisation.

The Western norm is closer to 20 per cent. Goodness knows how productive the building binge will prove over time but about half of China's GDP is estimated to depend in one way or another on real-estate values.

The demand for steel and concrete, for example, relies on a booming property market.

A tricky transition

Switching spending from infrastructure and curtailing exports for building a domestic market is easier said than done, especially for an economy that keeps the exchange rate against the US dollar artificially low.

That favours exports, naturally, although it appears the problem might be solved by rising wages, itself a result of inflation caused by the low exchange rate.

Wage increases are running at 15 per cent to 20 per cent annually, undermining China's reputation as a cheap factory to the world.

Evidence suggests production is shifting out of China into cheaper areas. "Factories are even looking to relocate to Mexico and even the US," says the regional economist at Asian business consultancy IMA Asia, Glenn Levine.

Still, the longer it takes China to move from an investment-export oriented economy to one based more on domestic consumption, the better it is for us. Producing plasma TVs requires a lot less steel and coal than building roads, offices or even ghost towns.

At least its tardiness over the exchange rate is good for our resources sector, even if it is partly to blame for the debt mess the US is in.

China, by the way, is sitting on $US2.9 trillion ($2.63 trillion) of foreign exchange reserves, most of it invested in US government bonds, which is seven times bigger than the entire economy of debt-plagued Greece.

Now there's a thought. If China bought Greece and repaid its debts ...

Anyway, the low-ball exchange rate and red-hot economic growth is inflationary. China's inflation rate has already hit 6.4 per cent. How China controls it without slamming on the brakes will determine a hard or soft landing.

The economy has indeed slowed by 25 per cent from last year's 12 per cent to about 9 per cent, seemingly without harm done. Yet raising interest rates and clamping down on credit growth won't get households spending. Lifting the exchange rate so prices are cheaper would.

Most economists think this is what Beijing will eventually do - and, indeed, it has almost said as much - in which case, a soft landing is more likely.

Or not so much a soft landing as flying at a lower altitude. But there's no mistaking signs of a slowdown.

"The risks have become more pronounced in the last couple of months," says Levine, who anticipates a soft landing.

Manufacturing output is increasing at a slower rate while high oil prices, exacerbated by an undervalued currency, have pulled down the growth in car sales to single digits.

But if China takes the monetary tightening route, a crash landing would seem unavoidable.

Still, when push comes to shove, it could always revert to form and, well, just ban a recession. "People have been talking about a hard landing for years and it never eventuates," Oliver says. "The authorities have more control [in China] than in the West. If it looks like a hard landing, they can just ease up."

Fiscal tightening causes lacklustre growth

CHINA has been much kinder to the economy than investors. Come to that, as its own economy has been booming, none of the spoils have gone to shareholders there, either.

The Chinese sharemarkets have been lacklustre since early last year, about the time the authorities started to talk about tightening up.

The Shanghai Composite Index, for example, is about 15 per cent lower than it was then. In the past year, it's risen only about 7 per cent, not that our market has done any better. In truth it's done only half as well.

Along with a hardly sterling sharemarket performance has come a much stronger dollar to wipe out what little gain there may have been.

In the past year, the dollar has soared more than 20 per cent. The problem is that the yuan is tied to the US dollar, which is sinking.

No wonder the only listed managed fund that can invest in China's A shares the real McCoy mainland stocks, affectionately dubbed red chips has been going backwards.

So far, in fact, that its shares are trading below the value of its investments.

Units in the AMP Capital China Growth Fund (ASX code: AGF) are on the wrong side of 80 cents, yet its investments are worth 99?.

Although the unit price rose only 1? in the year to June 30, its book value was 11 per cent higher despite having the dollar going against it. So do you judge it by the increase in its asset value, which shows how good a job it's done, or by the share price, which is what counts in the end?

Certainly the lift in book value was much better than its listed rival, the index fund iShares FTSE/Xinhua China 25 (ASX code: IZZ), which invests in H shares red chips listed in Hong Kong did.

It invests in the top 25 Chinese stocks.

Or its unlisted managed-fund peers that invest in the Sinosphere countries such as Taiwan, as well as H shares.

None did any favours for their investors over the past year.

Still, that's water under the bridge, or down the gurgler as the case may be.

The trouble with investing in a China fund is you need two unpredictable events going the right way at the same time: the Shanghai sharemarket, a crapshoot as IMA Asia's regional economist Glenn Levine calls it, as well as the currency, which, perhaps, he also meant.

Getting both those chips up is something for which you'd deserve to be richly rewarded.

Remember you have the house against you as well: the fortunes of the dollar depend on China anyway. The better the Chinese economy does, the higher commodity prices go, and so the stronger the dollar.

But with China slowing down, it might just be possible for the two to align.

Commodity prices could ease and once the prospect of any more rate rises and credit tightening in China has diminished, its sharemarket will be hot again.

"It would only take a few signs that monetary tightening is over and it will take off. There's quite a lot of upside," says the head of investment strategy at AMP Capital Investors, Shane Oliver.

David Potts