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Bull, Bear and Bottom Line

China matters—a lot. The country has rapidly become the second largest economy in the world. It will likely contribute two-fifths to global growth this year, twice as much as the United States. Resource-hungry China has an outsized influence on most commodities markets, and is the largest foreign holder of US Treasuries.

There are five critical factors that will determine if the market will reflect a Bull, Bear or Neutral position and the signposts to look for in each scenario. Click on the tabs below to learn more.

 

Bull Case

It is easy to pave over financial problems in the short term, Beijing has plenty of firepower for bailouts. Growth in local government debt has come to a screeching halt. China has proved many times it can fix its banks when needed. The same team that engineered a doubling of annual credit to 14 trillion RMB during the financial crisis can pull the strings in a different direction.


Bear Case

Banks' non-performing loans have fallen by 97% in the past decade, but this masks a poisonous reality: Unpaid loans are rolled over. Debts of state enterprises and, to a lesser extent, of local governments appear to be ticking time bombs. Banks are bleeding deposits and luring customers with asset-backed securities. (Hmmm, what kind of assets?) Banks are lending to all the wrong people: lumbering state giants and developers. Banks are bad at risk management.


Bottom Line

Business cycles exist in China as elsewhere-but we expect a soft landing in 2012. Longer term, the financial system represents the biggest risk to the economy, we believe. The sheer magnitude and pace of credit growth does not pass our smell test.


Signposts (What to Look for)
  • Reserve ratio changes
  • Deposit outflows and sales of wealth management products
  • Bank cash flows and operating cash levels
  • Credit growth and non-performing loan trends
  • Corporate bond issuance and trading
  • Gradual moves toward market-driven deposit and lending rates
  • Demand for gold and other "hard" assets

Bull Case

Urbanization and the desire for upgrades provide steady demand. Affordability is improving due to falling prices and rapid real wage growth. Buyers pay a majority of the purchase in cash, so price declines will not hurt the financial system. Savers have few other places to park their cash. A push on low-end "social" housing will keep the construction industry busy.


Bear Case

Local governments, banks and companies all bet prices would keep rising and are overexposed. Real estate has been the driver of economic growth. Homes are too expensive for average earners. Overbuilding has resulted in ghost cities and a huge inventory of unsold properties. Beijing may not be able to arrest a vicious cycle of lower prices and lower sales.


Bottom Line

Real estate is the No. 1 threat to China's growth this year because the sector is so interwoven with the rest of the economy. Supply and demand should balance out in the long run. The lack of leverage is a big positive.


Signposts (What to Look for)

  • Inventories, sales volumes and price trends
  • Ratio of new construction vs. sold floor space
  • Debt and stock prices of major developers and consolidation in the sector
  • Policy actions such as property taxes or, conversely, more curbs
  • Sales of construction machinery and durable household goods
  • Sales and volumes in secondary and tertiary cities
  • Granting migrant workers urban residency permits so they can own homes

 

Bull Case

Is there such a thing as too much investment? Capital stock is not yet excessive by international standards, and China needs investments in infrastructure and automation to keep up productivity growth. Consumption is rising rapidly, and half of households will soon classify as "middle income." Rural wages are growing faster than urban ones, making for more balanced development. Building out a social safety net would unleash a pile of precautionary savings for illness and old age.


Bear Case

Investment is a case of diminishing returns: It takes $5 to generate $1 of GDP growth. The model is based on an undervalued currency, low real wage growth and financial repression—factors that policymakers are loath or unable to change. China's command economy appears ill-equipped to stimulate consumption. Much industry would collapse without below-cost energy and interest rates. "Vested interests" will work hard to torpedo a shift to a consumption model. Commodities demand is at risk. Watch out, Australia.


Bottom Line

A pullback in consumption in the wake of falling real estate prices and slowing export growth is a major risk this year. Longer term, a big worry is that a rush to rebalance could lead to an economic implosion.


Signposts (What to Look for)

  • Monthly retail, auto and luxury sales
  • Consumption share of GDP and GDP growth, and real wage growth
  • Raw materials imports, energy subsidies and commodities prices
  • Import/export trends (beyond one-month aberrations such as this February)
  • Loosening the currency peg and opening capital markets
  • Privatizing state enterprises and liberalizing interest rates
  • New sources of local government financing
  • Macau gambling revenues and capital flows

Bull Case

The Communist Party arguably is built for stability: It knows internal strife can result in Cultural Revolution-type horrors. Regimes historically have faced popular revolts only when incomes reach the world's median: China has a long way to go there. Beijing has kept a tight lid on internal dissent and has not had a major overseas confrontation in the last 30 years.


Bear Case

All politics are local. It is an uphill battle to effectively steer the country toward a new course. China has not done enough to improve the environment, curb corruption, address the widening inequality gap and stimulate consumption. The leadership often is paralyzed because it is pulled in too many directions. China's military build-up could set up the world for a major confrontation down the road. Beijing is not almighty: Local governments tend to go their own way and a desire for consensus has often resulted in political paralysis.


Bottom Line

A one-party system is geared to retain its hegemony and ensure stability. The upcoming once-a-decade leadership change is hairy. Bo Xilai's downfall is the tip of the iceberg, and one that is freezing policy for now.


Signposts (What to Look for)

  • Political unrest beyond local flare-ups
  • Food price inflation, unemployment and rising inequality
  • Efforts to curb corruption, protect the environment and ensure food safety
  • High-profile casualties of the upcoming leadership change such as Bo Xilai
  • Restrictions on social networks such as Weibo
  • Confrontations in the East China Sea with other Asian countries or the US
  • Increased secessionist and religious militancy

 

Bull Case

China's value-added exports are increasing and industries are investing in automation to stay competitive and improve quality. China is filing more patents and is now dominating industries of the future such as solar power. The country has a first-class infrastructure. The migration of labor-intensive industries to Vietnam, Cambodia and elsewhere is a good thing.


Bear Case

Heavy subsidies have thwarted competitiveness and innovation. Violations of intellectual property rights still occur. The easy productivity gains have been harvested, and wage growth is a problem. China has yet to develop real brands.


Bottom Line

Loss of competitiveness is the lowest risk to the economy this year and beyond. China already is moving up the value chain.


Signposts (What to Look for)

  • Productivity and real wage growth
  • High-end machinery orders
  • R&D spending and patent applications
  • Trends in returns of Chinese who have studied abroad
  • Emergence of domestic and global Chinese brands
  • Protectionist actions by China's trade partners