Conclusion: We like countries that have proactively prepared themselves to grow organically in light of a slowdown in global trade. China is one of those economies.
Position: Long the Chinese yuan via the etf CYB. Short the U.S. dollar via the etf UUP. Short 1-3 year U.S. Treasuries via the etf SHY.
As we pointed out a few months back, China’s organic growth story will matter more to investors when consensus finally comprehends the downside risk associated with the U.S.’s 12-18 month forward economic outlook – which we are starting to see signs of, but not nearly in the area code of bearish enough. As easy money brought on by REFLATION, accelerating trade, and industrial production slows globally, organic growth stories will move to the forefront of investment opportunities. Those economies that have proactively prepared themselves to grow organically will see their equity markets and currencies strengthen in 2H10 and 2011, and beyond. China (along with Singapore, Indonesia, Thailand, and Brazil) is one of our favorite economies in which to play this theme.
For the 12th consecutive month in July, Foreign Direct Investment (FDI) in China increased on a Y/Y basis. Though down sequentially from June’s near peak inflows, the upward trend continues – on a YTD basis, FDI accelerated in the seven months through July, up 20.7% vs. +19.6% from January through June. China, the world’s second largest recipient of foreign investment behind the U.S. ($95 billion vs. $130 billion in 2009), continues to take share amid the current global search for yield. What is important here is not just the nominal uptrend, but rather the tonal shift from investors. For years, foreign companies poured capital into China to take advantage of cheap labor to sell cheap products to American and Western European consumers. Now with both of those markets poised to slow for the foreseeable future, investor attention has turned towards China as a place where yield-seeking can and likely will be met with ample growth opportunities. Globally, companies ranging from Volkswagen AG to Tesco to Merck & Co. are increasing investments in China to take advantage of a growing Chinese consumer base.
This year, China has increased minimum wages in as many as 21 provinces and municipalities as part of a longer term trend to wean the country off of exports and real estate investment as the main drivers of growth. To be clear, however, the path towards rebalancing China’s GDP composition towards a more sustainable model is a long road that will not be trekked as quickly as things will unravel in the U.S. and W. Europe – there will be bumps along the way as a result of slowing consumer demand from those markets. With that said, however, China has made some serious headway and those gains are set to accelerate given the administration’s resolve to make its economy more defensive.
Currently, roughly 40% of China’s labor market is agricultural, which implies 40% of workers are living on subsistence incomes that do not support a meaningful increase in consumption in the near term. Moreover, the fall in agricultural employment has been modest according to the OECD, with a trend decline of less than 1.5% per year. This suggests it would take another decade at the current pace for China’s share of agricultural labor to fall to 25% – the level at which Japan’s wages of those that move from rural to urban settings began to rise substantially (OECD). As we say at Hedgeye, however, everything in macro happens on the margin. And, on the margin, the Chinese consumer’s purchasing power is growing. Moreover, further marginal shifts in China’s employment composition will continue to supply upward pressure on the price of agricultural commodities (corn, sugar, soybeans, etc.), as China produces less produce for itself.
As previously noted, the improvement is not likely to come without a bump in the road here and there. Looking back over the last 4-5 years, we’ve seen that employment growth has been largest in the coastal regions – where factories and exporters dominate the labor market. That region is also home to the greatest percentage of migrant workers, as the restrictive hukou rules are less enforced there vs. larger cities like Shanghai and Beijing. As expected, a negative shift in the external demand curve greatly disadvantages this region over any other, as evidenced in the relatively large slowdown in employment from 3Q08 to 1Q09 (see chart below). To combat future slow-downs in external demand and the negative implications that would have on migrant workers, the government is expanding its program in which unemployed migrant workers, college graduates, and laid-off workers receive subsidies to undergo vocational training. Net-net, although a slowdown in the U.S. and Western Europe economies is negative for Chinese employment in the intermediate term, China is taking steps to reduce this risk over the longer term.
What would likely allow China to expedite this risk management and beef up its consumer base more quickly is any incremental increase in policy shifts towards urbanization, which is limited by the restrictive hukou system. Further loosening of these rules will allow China to urbanize even quicker than the rapid pace at which it is currently. From 2000-2008, China’s urbanization increased to 46% from 32%. Contrast that with a similar increase in the U.S., which happended over a 25-year period from 1 (OECD). The 60% mark was not eclipsed in the U.S. for another 35 years, whereas in China, that level could be reached in less than a decade at the current rate. All told, policies directed at improving urbanization in conjunction with changing the employment composition towards a more urban profile will allow wages in China to accelerate meaningfully over the long term. We will continue to monitor the Chinese government’s sentiment towards these policies as indicators of acceleration in the growth of the Chinese consumer.
Interestingly, policy shifts bring me to our next topic – investment recommendations. In conjunction with today’s release of China’s foreign direct investment data, the People’s Bank of China announced that it will let overseas financial institutions invest their yuan holdings in the Chinese interbank market bond market. The pilot program will start with foreign central banks, clearing banks for cross-border settlement in Hong Kong and Macau, and other international lenders involved in trade settlement. By implementing this program, China sets out to accomplish two things: 1) to accelerate capital flows from abroad by opening up its domestic securities market and 2) to make its currency more attractive to foreign central banks by broadening its use globally. Traditionally, trade has been the main way for foreign holders of yuan to return money to China. By opening up its $2.1 trillion interbank market, China is now creating new avenues for foreign investors to invest in China.
Make no mistake, in ten years we’ll likely look back at today’s policy announcement as one major catalyst for the yuan gaining major share as a percentage of global FX reserves. Furthermore, we continue to have conviction that the yuan’s gain will be at the U.S. dollar’s expense and we have expressed this conviction in our Virtual Portfolio via long CYB and short UUP. Acknowledging the deep simplicity that is the chaos theory model by which we research, it’s really not a shock that this policy announcement came just one day after the world learns that China reduced its FX exposure to dollar denominated U.S. Treasuries by the most ever.