China: A Look at Growth, the Environment, Real Estate and Education

Dilip Badlani at Hong Kong's Convention Center

During my recent visit to Hong Kong, the U.S. and European financial crises were front and center in the minds of local management teams.

China has been aiming to wean itself away from being an export-driven economy into more of a consumption-driven economy, but the transition is still in its very early stages.

Despite measures by Chinese policymakers to drive more internal consumption, the share of GDP driven by consumption has actually fallen during the past decade from 46.4% in 2000 to 35.1% in 2010¹. As the share of consumption has fallen, the proportion of GDP attributable to investment has increased, now making up close to 50%.

During the financial crisis in late 2008, China implemented a stimulus plan, which was focused on infrastructure spending. As Chinese consumers retrenched, fearing the worst from the slowdown, investments' share as a percentage of GDP increased.

Americans tend to assume that most of the mass-market consumer goods available on U.S. store shelves are now made in China. This assumption is not unjustified, as the U.S.'s imports from China have increased steadily over the past decade, from $102 billion in 2001 to $365 billion in 2010². The U.S. as a country is China's largest export destination and is its largest trade partner. (The EU countries as a group would be China's largest trade partners.)

However, as China's economy has grown, contrary to common perception, its trade surplus has actually decreased—both as a percentage of GDP as well as in absolute terms. Its trade surplus in 2010 was $183 billion, down from $298 billion in 2008 when it peaked. In order to fulfill its investment spending, China has been importing a significant amount of commodities. As the prices of commodities such as oil have increased, China's trade surplus has been decreasing.

That said, China remains a dominant manufacturer, with exports still representing close to 30% of its GDP, and net exports making up around 5% of GDP. Therefore, people in China are definitely concerned about a demand slowdown in the developed world.

At Royce & Associates, we invest in companies with strong balance sheets, so a slowdown may actually work to the long-term advantage of some of our investments by allowing them to take market share from more leveraged peers that may be constrained and distracted by financing needs. Once a recovery ensues, our investments may be better positioned than they were going into the slowdown.

Environmental Regulations

China is a rapidly evolving country. Given the breakneck pace of GDP growth over the past two decades, there have been concerns about pollution and the environment. As the people of China have seen their wealth increase massively from 1990, they too are demanding more stringent environmental standards from the companies operating in their cities.

On the first morning of my arrival, the front page of The South China Morning Post, which is the dominant English language newspaper in Hong Kong, had a story regarding the closure of a proposed chemical plant in Dalian, China.

Public companies have usually maintained comparatively higher environmental standards; they are usually larger than their private competitors and also come under greater public scrutiny. The larger companies have seen their margins compress due to higher cost burdens.

Ultimately, environmental regulators may fix their spotlight on smaller competitors too, and it is likely many of them will struggle in the face of significantly higher capital and operating costs. It is unlikely that many smaller private companies will be able to keep operating as they have been. This may stimulate consolidation and eliminate some capacity to the benefit of some of our investments in China.

At the same time, the slowdown in the U.S. and European economies over the past few years has eliminated some of the marginal competitors in both regions. Lower demand in conjunction with a tighter credit environment has led to several private businesses being forced to close their doors. Surviving larger businesses are less likely to want to deal with small private operators in China, as they may not meet their demand requirements or be able to provide them with financial statements certifying their financial and operating health.

One of our Hong Kong-listed investments is a China-based textile manufacturer. The company has consistently grown its revenues by aligning itself with larger entities in the developed world as well as maintaining a high quality, low cost operation. While to an outsider, this investment may lack the attractiveness of a China-driven growth story, the financial metrics that it boasts suggest otherwise. Management has consistently grown its top and bottom line while maintaining a clean balance sheet and rewarding shareholders via increased dividends.

Is Real Estate Stable?

Significant attention has been paid to the question of whether Chinese real estate is a massive bubble waiting to pop. Given the rampant price appreciation, it is easy to understand the skepticism over the prices of Chinese property. Earlier this year, the Chinese statistics agency said it will stop publishing the country's much-watched official index of national property prices, scrapping a set of data whose accuracy was widely questioned but that also had become a rallying point for public anger over rapidly rising housing prices³.

There have been several measures put in place by the central and local governments in order to slow down the property market over the past year. These measures are gradually beginning to have an impact as transaction volumes in China are starting to slow. Property prices in China's biggest cities—Beijing, Shanghai and Shenzhen—were flat on a monthly basis in July, the first time this has happened in three years⁵.

We currently don't have any direct investments in Chinese real estate developers. However, we have an investment in a company that could help to meet the high demand caused by urbanization.

Our investment is the largest real estate brokerage firm in China, and though its earnings are likely to fluctuate with the demand for real estate in China, it does not have the associated risk of having to take potential write-downs for land purchased at high prices. Its business has low capital intensity with an ability to flex its cost structure with underlying demand.

Additionally, it has developed the largest real estate information database in China, which will prove invaluable to developers as they become more circumspect in their land purchases. Lastly, the balance sheet of the company is flush with cash, which should enable it to grow its business as smaller competitors exit the market during a slowdown. With the commission rates of its brokers having stabilized, it is in a good position to ride out this rough patch and perhaps take some market share.

Focus on Education

Chinese society places a significant importance on the value of education. In 1998, when then President Jiang Zemin announced plans to bolster higher education, Chinese universities and colleges produced 830,000 graduates a year. In May 2010, that number was more than six million and rising, quite an amazing accomplishment. Demographics show the increase in the ranks of China's 20-to-25-year-olds to 123 million, about 17 million more than there were just four years ago⁶.

Despite the impressive increase in the number of graduates, the PRC Ministry of Education (MOE), plans to increase spending on public education to 4.0% of GDP as the spending per capita on education in China is still low when compared to other countries.

China's per capita public expenditure on education only accounted for 0.8% of per capita GDP, relative to Brazil, which spent 2.3%; the U.S. by contrast spends 6.1%⁸.

One of our investments is a provider of higher education services. As the Chinese increase their spending on education this firm should benefit through price increases for its services as well as an increase in the number of enrollees. This company also provides e-Learning services, which should see an increase in demand as people aim to differentiate themselves when applying for jobs.

China's economy, today, has become the second largest economy on a global basis⁹. It is increasingly integrated to the global economy and therefore a slowdown in the developed markets of the US and Europe will have an impact on its growth rate. However, the underlying trend of increased demand for improved environmental standards as well as for better private education will only continue as they are still in their early stages. At Royce, we will continue investing in companies that will be beneficiaries of these trends.

¹ http://roundtable.newamerica.net/blogposts/2011/putting_china_s_low_household_consumption_in_perspective-
² https://www.uschina.org/statistics/tradetable.html
³ http://online.wsj.com/article/SB10001424052748703373404576147792827651116.html
⁴ http://www.globalpropertyguide.com/Asia/China/Price-History
⁵ http://www.propertywire.com/news/asia/latest-figures-show-property-prices-flattening-out-in-chinese-cities-201108235485.html
⁶ http://www.nytimes.com/2010/12/12/world/asia/12beijing.html
⁷ http://www.chinadaily.com.cn/china/2010-03/01/content_9515384.htm
⁸ http://www.globaltimes.cn/opinion/observer/2010-02/506897.html
⁹ Estimated by IMF staff.