Five reasons China is not a bubble

This post is a guest contribution by Romeo Dator, co-manager of the China Region Fund (USCOX) of US Global Investors.

A year ago, nobody thought China could manage 8 percent GDP growth in 2009. With year-to-date growth coming in at 7.7 percent through the first three quarters and getting stronger, China is poised to break that 8 percent mark rather easily.

The success of the stimulus and the lofty economic numbers China has managed to produce amidst a global crisis has led many to claim China is the next great bubble.

We see five reasons China is not a bubble and believe that its prospects remain strong for at least the next 20 years.

1) Consumption continues to be strong
China is transitioning to a consumption-based workforce. Retail sales rose 16.2 percent in nominal terms during October and have been accelerating. The retail sales figure isn’t a perfect proxy, but it is the best available indicator of overall consumption because it does include sales to consumers and not just purchases made by the government.

We also saw strong growth in industrial production (IP) and power generation both were up more than 16 percent on a year-over-year basis in October. Housing starts were up more than 50 percent (yoy) for the second straight month.

2) Structural changes to domestic economy
We’re seeing a transition to a service-related economy. The service industry is the fastest-growing sector (roughly 20 percent faster than construction) and now accounts for one-third of China’s workforce.

In general, the size of the service sector is directly correlated to the amount of goods and services an economy consumes. This is why the government has spent such a large amount of the stimulus on areas that benefit the domestic market - that’s where it thinks the economy is headed.

3) Stimulus exit strategy in place
China’s stimulus exit strategy is simple - create a strong economic base that the private sector can launch from. After private investment surpassed that of state-owned enterprises in September, the two flip-flopped during October.

Given the environment, month-to-month fluctuations like this are to be expected since private investment is dependent on how willing Chinese citizens are to put their own money at risk. Even though Beijing is determined to wean China’s economy off of government stimulus, the government will not hesitate to ramp up activity should the private investors become risk-averse.

4) Government controls on flow of money
After lending more money over the first five months of 2009 than all of 2008, we’ve seen loan numbers come down. There’s a longstanding pattern of new loans slowing down during the second part of the year as banks have historically rushed to meet government-mandated loan quotas.

The magnitude of this year’s slowdown - trillions of yuan - is evidence of Beijing’s dedication to prevent a bubble from forming. Once the figures grew too large, the government moved quickly to hit the brakes.

While US regulators have many holes to plug in order to keep the economy afloat, the limited number of investment options available to Chinese citizens - basically stocks, bank savings and property - makes it easier for the government to institute controls.

This is what happened in 2007 when the government forced a slowdown in the housing market before it overheated. After its economy grew 12.6 percent in the second quarter of 2007, China took more aggressive actions to cool its economic growth. The government raised lending rates and also raised reserve requirements to shrink the pool of money available for lending.

5) China’s long-term goals match up with short-term goals
In the US, the Federal Reserve and policymakers are faced with conflicting goals. They need people to spend in order to get the economy rolling again, but their end game is to have the American people spend less and save more.

It’s the opposite for China.

The problem in China is excess savings and not enough spending. The short-term and long-term challenges are the same - to get people to spend more.

Recent signals that China will begin letting the yuan appreciate against the US dollar are not new. For several years, Beijing has stated a gradual appreciation of the yuan will benefit the economy, and CLSA expects Beijing to resume a 5 to 7 percent annualized appreciation process about midway through 2010.

Rapid economic growth may be common in emerging economies, but there’s only one China. Already the world’s third-largest economy on a nominal GDP basis and second-largest based on purchasing power parity, the Chinese aren’t making a break from the back of the pack - they’re leading it.

Domestic consumption, the rise of the service sector and increased private investment won’t make China immune to economic bubbles, but these strengths will provide some protection from external forces.

Source:  Romeo Dator, US Global Investors - Weekly Investor Alert, November 13, 2009.

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