Keynes’ advocacy of fiscal stimulus to revive an economy from recession is well documented. For obvious reasons it has also been fiercely debated over the past two years, so it is somewhat ironic communist China could stake a claim to being the most Keynesian state in the global economy.
The Chinese Government’s fiscal stimulus of its economy caused both GDP, and the money supply, to boom throughout 2009. By Q3, domestic demand was rising by 7.3%, something that any western government would be delighted with for a year, never mind in just a quarter. The effects have been dramatic, Chinese stockpiling of commodities has pushed up prices, while the stimulus to international monetary growth has boosted the values of risk assets, such as equities.
Domestically, the Chinese output gap has probably disappeared and been replaced by a surplus (ie domestic demand is now almost certainly running higher than the economy’s ability to satisfy it, which is inflationary). The Chinese Government clearly recognises this which is why, apart from perhaps Australia, it is one of the first major economies to start reversing its fiscal and monetary stimulus. This did not go unnoticed in the markets which, having risen strongly through the latter part of 2009, reversed some of their profits as investors got cold feet about the effect falling liquidity would have on global share prices.
Do not be fooled
All this talk of Keynesian theory in the application and removal of government fiscal stimulus could fool you into thinking China is fast becoming a typical free market democracy. And this view is likely to be reinforced by talk of China overtaking Germany as the world’s biggest exporter and Japan as the world’s second biggest economy. Do not be fooled. China is not a free market, and it certainly is not democratic.
A league of their own
The Economist Democracy Index 2008 provides a league table in which it gives scores for 167 countries. There are five categories and the maximum score for each category is 10. These include electoral process and pluralism, functioning of government, political participation, political culture, and civil liberties.
The average is taken as the overall score, where Sweden is ranked first with an average of 9.88, and North Korea last (167th) with an average of 0.86. China is ranked well down the league at 136th, marginally ahead of Afghanistan and behind Angola (131st), which is hardly a shining example of democracy in action!
In comparison to other Bric economies, India is 35th with a score of 7.8, Brazil 41st with a score of 7.38 and Russia 107th with a score of 4.48.
For recent anecdotal evidence of China’s appalling record of civil liberties, look no further than the Google incident when the internet service provider realised the intrusion of the Chinese Government into Google’s accounts was compromising the security of some of its Chinese customers.
Free markets
Turning now to free markets, China is not one of these either. The People’s Bank of China implements policy at the behest of the communist leadership and this is designed, primarily, to avoid unrest among the peasant population, which is the majority of the Chinese people. To achieve their ends, the Government often uses blunt tools, such as setting minimum borrowing requirements for its business communities with the result that loans are simply recycled through several parties until the money finds its way back to the originator. This may, indirectly, boost money supply a little during a recession, but it is hardly beneficial to the cause of improving economic efficiency.
The share market is not much better either. The Chinese categorise equities between class A and B shares. The former is available to domestic buyers (and a few privileged overseas institutions) whilst the latter are available to foreigners. Needless to say, class B shares tend to be less attractive than class A stock.
One way around this, when you are looking at Chinese exposure, is to use “H” shares that are traded in Hong Kong. These can provide indirect and/or direct exposure to businesses that operate in, or benefit from, the Chinese economy, so you are buying into the long term Chinese story of a growing economy with improved productivity.
Hong Kong
Although Hong Kong is now ultimately owned by China, it has retained the qualities it has long demonstrated as an effective financial market, that is good regulation, transparency, supportive contract law and liquidity (and despite initial fears, the Chinese were never going to destroy their Hong Kong asset by diluting its attractiveness as a financial market). Apart from trading individual shares, Hong Kong offers the facility to trade liquid indices that give exposure to China. We use the Hang Seng China Enterprise Index for our core exposure and we have never encountered any difficulties trading this.
A lot of what I have said in this article may seem negative. This is not intentional, I just wanted to highlight the contrast between China and what we have come to regard as the “normal” democratic free market economies we have grown accustomed to in the west.
Each year we carry out a detailed regression analysis which looks at all the emerging economies of the world and ranks them according to their potential GDP per head (having regard to their infrastructure, resources, legal system, political system, business community, etc). On the basis we regard any emerging market that exhibits a GDP per head that is higher than its potential (eg Nigeria, which apart from strong oil revenue has little else going for the economy) as uninvestable, and an emerging market that has potential GDP per head as much higher than current GDP per head as very investable, China falls into the latter category and ranks highly on our list of emerging markets that are attractive for the future.
The rate of new capital required to stimulate domestic economic growth in the west is increasing, ie capital is becoming more expensive and that does not bode well for future returns. But in emerging markets, capital can generate significant profits and this is why the sector has shown such good returns, relative to developed markets, in recent years.
Despite what I have said about China’s shortcomings as a democratic free market economy, it offers a lot of potential as an emerging region. And it is very difficult to leave it out of any portfolio that is internationally diversified with the objective of seeking above average returns.
Gary Reynolds, director and CIO, Courtiers
