On Dec. 4, 2007, on a FORBES investor cruise, I suggested selling Chinese stocks. Since then the Shanghai Composite Index has fallen 37% (33% in U.S. dollar terms). If you missed that boat, don't think FORBES reserves all its wisdom for people on cruises; the magazine's Beijing correspondent had, a week earlier, published a story that asked, "How do you say 'irrational exuberance' in Chinese?"
And don't think it's too late to respond to our advice. If you still own Chinese shares, sell. If you are daring, short-sell an exchange-traded fund of Chinese shares.
China is very vulnerable in the unfolding global recession. The downturn that started in the U.S. late last year with the subprime mess and quickly spread to overleveraged Wall Street now has American home prices sliding toward my long-held forecast of 25% off their peak. That will eliminate the home equity of most people with a mortgage, and with it the fuel for consumer spending. Europe and Japan are also headed for recession, as their exports to the U.S. drop, their own housing bubbles collapse and their consumers retrench. Despite what many have hoped, emerging economies do remain coupled to the U.S., as it buys most of their exports, directly or indirectly.
China's exports account for 38% of its gross domestic product, versus 12% for America's. In the first quarter Chinese exports of U.S.-bound products were up 5.4% from 2007. Not too long ago 30% growth was the norm. Without export growth and the foreign investment it brings, China's economy is in trouble. You need to make at least $5,000 a year there to have meaningful discretionary spending power. Some 110 million Chinese do, but they account for only 8% of the population. In the U.S. it takes at least $26,000, and 80% qualify.
The Chinese save 30% of their income, which puts them just about 30 percentage points ahead of Americans. Consumer spending is only 36% of GDP, against 71% in America. Where do they put all those savings? Not in the state banks, with their regulated deposit rate of 4.1%, which is less than half the current rate of inflation. Real estate isn't attractive; the government has been moving to cut off housing speculation for several years now. Chinese aren't allowed to invest abroad. So stocks have gotten the play. Despite the recent downturn, the Shanghai Composite Index was up 435% from the beginning of 2006 to the peak last October.
Slower export growth and higher materials costs are already depressing profit margins. In the first two months of this year profits grew 16.5% from a year earlier, down from 36.7% growth from 2006 to 2007. At the same time, the government has moved to quash booming capital spending and inflation. Bank reserve requirements have been raised 13 times since early 2007, and further tightening is likely as the state tries to curb lending and slow the growth of the M2 money supply, which was up 16.3% in March from a year earlier.
Capacity utilization is tight, but it takes a lot of steel and cement to build more steel and cement plants. When the bubble breaks, the use of these materials in new factories will collapse suddenly. In the first two months of 2008 real urban fixed investment, the benchmark measure of capital spending, rose 18% from a year earlier; annual growth ranged between 23% and 25% over most of 2007.
As loans dry up, heavily leveraged real estate developers are finding themselves strapped for cash and unable to build on the land they've acquired, so real estate prices are starting to fall. Furthermore, heavy construction spending for the Beijing Olympic Games is winding down. To be sure, with $1.68 trillion in reserves and a budget surplus, the government can stimulate the economy by spending on social services and on infrastructure. But reversing gears takes time.
Meanwhile, the government is trying to beat down inflation. February's food costs were up 23% from a year earlier. Recall that the 1989 Tiananmen Square uprising was caused partly by inflation fears. The coming hard landing could similarly provoke social unrest. Economic growth could drop from its recent annual rate of 11% to a recessionary 5% or 6%. What's more, further declines in Chinese stocks will rile the 100 million Chinese who have invested in equities with the government's encouragement, and since most public companies are state-owned, those investors may blame the state for their price collapses.
China forbids short-selling. But many companies are dual-listed in Hong Kong, and those H-shares can be shorted. So can exchange-traded funds that own Chinese shares and trade in the U.S., and there are at least four of them.