China: Santa Claus Has Come to Town
Andy Xie (Hong Kong)
morganstanley.com
If you see queues in Hong Kong, the chances are the people are lining up for Chinese initial public offerings (IPOs). Lately, stock prices of Chinese IPOs have tended to rise by 50% on the first day of trading. Hence, if you line up patiently to fill out a form for share allocation, you might get some allocation and make a quick buck. The scent of free money is in the air again. Christmas has come early for Hong Kong.
Some of the ongoing IPOs are hundreds of times oversubscribed and potential investors number hundreds of thousands. What is taking place reminds me of Red Chip mania in 1997 and the internet bubble in 2000. Fighting for IPO allocations resembled riots then, which made political leaders uneasy both in Beijing and Hong Kong. The investment banks involved in the current wave of IPOs learned their lesson and have cut down a few more trees to ensure that application forms are plentiful.
The earliest mania for Chinese stocks was in 1993. I did not have a ringside seat then. From a quiet corner in Washington, D.C., I watched a plethora of China experts touting Chinese stocks on CNBC. Because China is opaque and the data often unreliable, opinions on China could neither be validated nor refuted, i.e., anyone could be a China expert. This, I think, is why China experts on the market change in every cycle. Let’s see how long I last.
At the beginning of the year, I wrote about China being the next big thing after the Internet (see ‘The Chinese Decade’, February 10, 2003). The Internet phase was marked by periodic excessive optimism. I thought that the same would occur with China. I advised investors to check their optimism from time to time to ensure their financial health.
China is a powerful secular story. Its industrialization is taking place so fast and on such a vast scale that the global economy is restructuring around China at a visible speed. A huge amount of foreign direct investment (FDI) has poured into China to take advantage of its plentiful, cheap, and disciplined labor, causing the prices of tradable goods to decline significantly relative to non-tradables, i.e., your haircut is becoming ever more expensive relative to the price of the jeans you wear.
This process of relative price adjustment is merely pausing now and will resume in another year or two. The last wave of China’s FDI boom was driven by the rapid relocation of the electronics industry to China, mainly from other Asian economies. China’s global market share in electronics production may have risen to 30% from almost nothing five years ago. It is natural for the pace of relocation to slow with China’s rising market share.
The next wave of China’s FDI boom is likely to be driven by the relocation of another industry to China. I believe that industrial equipment could follow the electronics industry in its relocation to China from Europe and Japan. When Chinese equipment producers become big enough, it would cause global prices for such equipment to decline. The incumbent producers in Europe and Japan would have to move to China to lower their costs.
As production shifts to China, its economy becomes more sensitive to global demand over time. As Fed policy is responsible for the growth of demand in the global economy, China has become the most leveraged economy to Fed policy, more sensitive even than the US economy itself, in my view.
As long as the WTO system remains intact, I believe the China story will remain powerful. Not only does it open up China’s industrialization itself as an investment opportunity, it presents all sorts of opportunities for investors from changes in relative prices. I have often talked about natural resources gaining pricing power over manufacturing capability, i.e., pricing of natural resources could rise even as prices for the finished products go down because China’s vast labor force reprices the value added in the production of goods.
However, the cyclical overlay on China’s secular story is equally important for investors. The Fed has kept a loose monetary policy since the Asian Financial Crisis. This led to the Nasdaq bubble. The bursting of this bubble only led to looser Fed policy. What has happened in the past five years is an unprecedented period of liquidity growth in the US. China’s exports have increased 150%, or US$248 billion, during this period.
The massive export increase has led to a rapid increase in deposits in China’s banking system. This has funded China’s massive infrastructure program first and a massive property boom in the past two years. In turn, these sectors have been powering China’s imports of equipment and commodities. China’s growth dynamic goes from exports, to savings, to investment and, finally, to imports.
There are two angles to China’s economic cycle. First, the US Fed policy determines China’s export growth rate. China’s exports averaged a 16.8% annual growth rate in the past 10 years and 15.2% in the preceding 10 years. However, the growth rate could fluctuate sharply around the trend. China’s exports grew by 22.4% last year and 32.7% this year. When the Fed starts to tighten, which we expect to happen in the second half of 2004, China’s exports are likely to slow. We expect China’s exports to grow at the trend rate next year. The risk, however, is to the downside, as China has built up such a high base in the past two years.
The other angle to China’s cycle is its credit creation that translates export revenue into investment, which causes imports of equipment and commodities. The optimal credit policy is to make it countercyclical to the export cycle. With a tightly controlled capital account, China could do that, as it successfully did in 1998 and 2000. However, China made its credit policy pro-cyclical in 1993 and again in this cycle. This led to exceptionally strong growth in China.
When China’s economy experiences an upsurge in both exports and credit, its economy becomes exceptionally strong. Its cyclical industries grow twice as fast as normal, as we are witnessing now. The exceptional strength leads to market euphoria, as we observe currently in Hong Kong. Because the market mistakes the cycle-peak growth rate as sustainable, it grossly overprices stocks.
How does the party end? Rate hikes by the Fed are the normal party crasher. I believe this factor is the most likely candidate in this cycle. However, it wasn’t so in the last two cycles. The Asian Financial Crisis ended the mania in 1997. The Nasdaq crash ended the one in 2000. There are always exceptions.
China’s credit tightening, for example, could go a long way to cool the mania. The evidence is mounting that the credit tightening is working. Financial institutions increased loans by Rmb100 billion in November after a Rmb62 billion increase in October. This compares with an increase of Rmb310 billion/month in the first half and Rmb230 billion/month in the third quarter.
Of course, there is a lag between credit and demand. How long a lag is determined by how much borrowed monies have not been spent. My own guesstimate is that the lag is one quarter, i.e., we should see the signs of slowdown in 1Q04. These signs would include (1) declining steel pricing, (2) a softening electricity growth rate, and (3) sharply slower housing starts.
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