Catella scopes Chinese growth

Frédéric Cho is often described as perhaps Sweden's foremost expert on China and the Chinese economy. He has also lived for long periods in the country, which he first visited in 1980 with his parents. Two years later he was back, at Beijing University, to learn Chinese.

"Then I returned to China for my first job, with Astra, which together with some other Swedish pharmaceutical companies was setting up Sweden's first joint venture in China. It was a drug factory in a town outside Shanghai," says Frédéric Cho in a podcast arranged by Catella Fonder.

After a time in the pharmaceutical industry he was recruited to Handelsbanken, and so began a long career focused on China. Frédéric Cho has lived 18 years in China, including 15 years on the mainland, one and a half years in Hong Kong and the same amount of time in Taiwan. When he has not been working in China, he has been working with China, from a Swedish horizon. His employers have included Crédit Agricole, SEB and Skandia.

A comparison between today's China and how the country looked ten years ago shows that industry then accounted for a much larger share of GDP, and the service sector for a comparatively smaller share. Now the service sector accounts for more than 50 percent of GDP, so a dramatic change has indeed taken place.

This change does not mean that China has shut down its industrial production. The problem is that the country may be a little too good at producing and manufacturing too much, thus creating overcapacity. Meanwhile, China has over the past 30 years lifted more than 400 million people out of poverty – it has not brought them riches, but it has given them a growing disposable income. In 2015, this was almost USD 10,000 per capita, which means people can afford to start consuming.

The high productivity, however, has paradoxically made the country less powerful in some industries, according to Frédéric Cho.

"China has made itself less competitive in sectors such as simple, inexpensive light industrial products. Costs have risen. Minimum wages have been raised in each province every year for the past ten years, which has made it too expensive to manufacture certain products. So even Chinese companies are outsourcing production from China: to Indochina, Sri Lanka, India and so on," he says.

Meanwhile, as China has become more expensive, places like Mexico and Eastern Europe have come to appear more obvious areas for investment; Mexico for North Americans and Eastern Europe for Western European companies. China cannot be everything to everyone, and has to focus.

As regards domestic demand, this is largely driven by entertainment. Online sales of fashion apparel and tourism are sectors that are growing exponentially, according to Frédéric Cho.

"We can see this just walking down Biblioteksgatan in Stockholm, where there are more Chinese tourists, and these are no paupers. This year it is estimated that 120 million Chinese tourists will travel abroad, which is an annual increase of 10 percent," he says.

Cinemas in China are filled with Chinese people who want to see Hollywood movies, and another consumer product, of course, is cars. Although not all types of car fare well amongst the tough Chinese competition. A model that generally does well in the country is the SUV, which experienced 45 percent sales growth in 2015 alone.

As disposable incomes rise, the Chinese are also becoming more concerned about their own well-being. This factor is expected to drive growth in health care and pharmaceuticals. And, not least, care for the elderly – in China today, 12-13 percent of the population is over 65, but in ten years 20 percent are likely to be over 65. The need to expand elderly care is thus enormous.

"There has been strong interest from China to learn from the Swedish experience of elderly care, so there may be opportunities for service providers from Sweden. Or by providing equipment," says Frédéric Cho.

One problem an aging population brings with it, of course, is the need for pensions. Although Chinese people are often diligent savers, there is an overall shortage of money in the public pension pot. According to Frédéric Cho, the central government has become more concerned about filling the pot for future needs, which means it has forced state-owned companies to pay more to the government in the form of dividends. In addition, tax revenues are being raised overall, which is possible since large parts of the economy could be described as under-taxed.

China's growth has fallen from double digits to a level just below 7 percent. The country's government has recently given up on the ambitions of previous years to hold back, and has instead made an effort to get the wheels moving. There have been a large number of interest rate cuts, and more are likely, says Frédéric Cho, who also points out that bank reserve requirements have been lowered.

"Two or three weeks ago, the Chinese Communist Party held its annual spring meeting. I often liken this to the annual general meeting of a limited company, where ministers present their plans. They will focus on what they call supply-side economics, meaning easier conditions for businesses. Lowering establishment costs, reducing administration and bureaucracy. The question is when this will have full impact," says Frédéric Cho.

One sector where Sweden, through SSAB, has experienced the tough competition from China is the steel industry. This sector has a gigantic surplus in China, with production last year that was twice as high as domestic demand. The solution of sending the surplus to export has not fallen on good ground – a dumped global market price creates irritation.

Overcapacity is largely due, in turn, to faltering construction in many areas. Real estate is one of the really big sectors, and the overcapacity is very substantial.

"This is greatly due to incentives and the command culture of the Communist Party, with local party officials being judged on how much they can build. It was sub-optimisation, with everyone wanting to build a lot," says Frédéric Cho.

The problems are exacerbated by local party representatives not remaining in the same place, since they expect to be rotated; after three to five years they are reposted. The result is similar to the mortgage salesmen in the United States a decade ago. They would do anything to get an upfront fee and, once they had stitched together the deal, they moved on, while their successors were left with the surplus.

According to Frédéric Cho, however, there is a realisation that the country cannot continue to flood the rest of the world with deflationary tendencies. It casts doubt on China's role as a reliable trading partner, and this is a concern that the country actually takes seriously.

"Unlike Russia, China is aware of its international reputation. It wants to have trade relations with all countries in the world, and realises that if it dumps too much it will fall out with the US and Western Europe," says Frédéric Cho.

However, the problems are entirely manageable, according to the China expert. It all depends on political will. For example, the country has said it will cut steel production by 100-150 million tonnes, which means that up to a million steelworkers will be made redundant. A fund of 100 billion renminbi is being created to address the social impact.

China could do even more, if we compare how the country handled its last acid test in the 1990s. Over a period of ten years it laid off 4 to 5 million state workers each year – totalling 40-50 million. Despite this, China maintained growth and moved the right way structurally. Frédéric Cho wishes that more of the old boldness remained.

"Now there is perhaps neither the same will nor the same boldness in the new generation of leaders. It's more of a psychological inhibition. In the 1990s, the state sector accounted for a much larger share of the total economy than today, so the real economic effects of taking more drastic action would be smaller now," he says.

The regime in China has many ambitions, and one of these is to turn the country's renminbi into a real global currency. It has succeeded – at least partially.

On November 30, 2015 the International Monetary Fund's board decided to adopt the Chinese renminbi as the fifth reserve currency in its currency basket, alongside the dollar, euro, yen and pound, and with a weighting of around 10 percent.

Meanwhile, the Communist Party's need to keep control has meant that the currency has in practice not become much more convertible since then, as they have restricted currency inflows and outflows. In the autumn it became apparent that there was an increased outflow of currency from China – the country's foreign exchange reserves decreased over six months by USD 700-800 million, according to Frédéric Cho.

Another discussion concerns the Chinese stock exchanges. In June 2015, MSCI decided not to include the Chinese stock markets in its MSCI Emerging Markets index. The extent to which the Communist Party can refrain from intervening, in either the currency market or the stock market, is an important issue for long-term confidence.

China's currency is regarded by many as overvalued, but a sudden and sharp devaluation is not likely, believes Frédéric Cho.

"As long as China has a surplus in its current account and balance of payments, the currency ought to strengthen. If there are any corrections, I think it will be a maximum of a few percent. It has been around 6.45-6.50 against the dollar, and they have not been active in any currency war," he says.

In part of the Chinese economy, exporting industry, there is some upset over the loss of competitiveness and a desire for the currency to fall by perhaps 20-25 percent. Since this would generally impede the structural change the country needs, it is unlikely to happen.

"The majority of top decision-makers in China think the country should not compete on price, but on quality. And with quality, the currency should be of secondary importance," says Frédéric Cho.

Outside observers that find it difficult to evaluate China like to talk about the risk of bubbles in the Chinese economy. And of course there are bubbles in some areas. Property in the most expensive cities like Beijing, Shanghai and Shenzhen is being driven by very strong demand, coupled with limited options for Chinese people who want to invest money.

In Shenzhen, property prices rose 50 percent in the twelve months from February 2015 to February of this year.

"The overall problem remains that there are too few investment options for Chinese people. The stock market rose because it was thought the property market had hit a ceiling. More and more capital moved over, and pushed up the stock market. Now that the stock market has fallen, capital is seeking its way back to the property sector, and perhaps abroad," says Frédéric Cho.

The property rush will not necessarily generate a serious banking crisis. Although the biggest Chinese banks hold large bad debt due to excessive borrowing, overcapacity and other factors, the country at least has experience in dealing with such situations. Some of this experience has also been taken from Sweden.

"In the 1990s it drew lessons from Sweden and the US; the four largest state banks in China created their own Securum-like bad banks. At that time they did not dare to liquidate assets at market prices, but instead at book value. This time they may not be able to afford to put things off, and may have to deal with them. I expect selective elimination, with the biggest banks being too big to fail, while small and medium sized banks are absorbed by the larger ones, or allowed to go bankrupt as a warning," says Frédéric Cho.

China's future will be largely determined by what the country's young population wants. We know that they long for movies, fashion and cars. That they will need health and social care is also clear.

"China has monitored what it believes to be Sweden's enormous capacity for innovation. How can it be that Spotify, Skype and others come from Sweden? There is also growing interest among Swedish and Chinese gaming companies," says Frédéric Cho, adding that everything related to the purification of air and water is extremely interesting in a country that is increasingly tormented by pollution.

The country has not been capitalist for very long, but long enough to create some "super entrepreneurs". Internet celebrities like Alibaba's founder Jack Ma, or property magnate Wang Jianlin, who has invested in everything from US cinemas to football team Atlético Madrid. These entrepreneurs already have China in their hands, and their attention is therefore directed towards the outside world. China has in recent years become one of the world's largest exporters of capital, according to Frédéric Cho, and Chinese investment abroad will be seen more and more.

The Chinese mainland stock markets, Shanghai and Shenzhen, have made a slight recovery after the wobbles of the second half of 2015. For outside investors, the question now is whether it is time to invest, or whether it would be better to wait. Frédéric Cho votes for the latter option.

"I still think we can hold off when it comes to the domestic stock exchanges in Shanghai and Shenzhen, due to political uncertainty and intervention. However, the Hong Kong stock exchange is investable, and has many of the lower valued Chinese companies."