BlackRock Investment InstituteApril 2012

Braking China … Without Breaking the World

[ 2 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

Blackrock’s China Forum

About 50 leading BlackRock portfolio managers and external

experts from around the globe recently exchanged views on China’s

economic trajectory at the BlackRock Investment Institute’s

China Forum. Many went in bullish and came out still bullish—

but with much less complacency and certainty. This publication

summarizes their ideas.

The Blackrock investment institute leverages the firm’s

expertise across asset classes, client groups and regions.

The Institute’s goal is to produce information that makes

BlackRock’s portfolio managers better investors and helps

deliver positive investment results for clients.

Lee Kempler Executive Director

Ewen Cameron Watt Chief Investment Strategist

Jack Reerink Executive Editor

What is insideFirst Words and Summary 3China inc: Bull, Bear and Bottom line 4introduction: Why China Matters 6 – A Matter of Timing

Credit: too Much, too Quickly 8 – The Great Credit Leap Forward – Bad Debt? Just Roll It Over – No Banker Will Come Clean This Year – A Less Offensive Four-Letter Word

real estate: Can a Bubble Be deflated? 13 – Something’s Got to Give – A Men’s Shirtmaker Diversifies – A Quiet New Year for Realtors – Breaking a Vicious Circle

investment and Consumption: looking for Balance 17 – A Case of Diminishing Returns – Go Buy a Refrigerator! – A Blueprint for Rebalancing Success – Bankers Are Shooting Fish in a Barrel – Wanted: Carefree Spenders – In Search of Luxury Goods

Politics: Change is hard 23 – The Emperor Is Far Away – Vested Interests and Paralysis – 300 Million Publishers – From Small Piles of Rocks to Oil Shock – Tit for Tat in Trade Wars

Competiveness: Beyond Cheap labor 27 – Of Robots and Old People

Markets: Counting on China 29 – Equities and Corporate Bonds: A Growing Addiction – Commodities: An Outsized Influence – Government Bonds: A Big Overhang

The opinions expressed are as of April 2012, and may change as subsequent conditions vary.

Joel Kim

Head of BlackRock Asia-Pacific

Fixed Income

Mark McCombe Chairman, BlackRock Asia-Pacific

Neeraj Seth Head of Asian Credit, BlackRock

Fundamental Fixed Income Group

Jeff Shen, PhD

Head of Asia-Pacific and Emerging

Market Equity, BlackRock Scientific

Active Equity Group

Ewen Cameron Watt Chief Investment Strategist,

BlackRock Investment Institute

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 3 ]

First Words and Summary

China is at a crossroads. Investment-driven growth has spun

an economic success story without equal since the country

opened for business in 1978. This has come at a cost: Unbridled

credit growth, overbuilding, environmental damage and a widening

divide between the haves and have-nots.

It has become clear China’s old playbook of “invest and grow” no

longer works so well. But a shift to a consumption-driven society

is tough for a command economy and wrought with pitfalls. The

country’s upcoming once-a-decade leadership change brings

both opportunity and uncertainty. The downfall of “princeling”

Bo Xilai, the former charis-matic leader of Chongqing, shows

tumult below the surface. This changing of the guard will

reverberate well beyond its own population, as China has

become the globe’s growth engine.

We are optimistic on China’s economic trajectory in the short term.

A nagging worry: Markets already factor in a “soft landing” this

year, leaving potential downside risk. The leaders walk a tightrope,

and have lowered the official growth target to 7.5% for 2012. We

are concerned about China’s ability to keep up its economic march

in the long run. Challenges are big and solutions are not easy.

This publication discusses key factors driving China’s economy

this year and beyond, signposts for change and implications for

investors. Examining the financial system, the deflating real

estate bubble, the tricky shift to a consumption economy,

politics and competitiveness, our main findings are:

}An explosion in credit growth resulting from Beijing’s 2009

stimulus has made the financial sector the economy’s Achilles

heel and its biggest long-term threat. The country can pave

over problems this year, but the bills will come due. China will

have to charge borrowers real money and give savers a real

return to create a healthy financial system in the long run.

} The real estate slump is the biggest threat to economic growth

and confidence this year. The sector is interwoven with the

entire economy and has been a key growth driver. A government-

engineered slowdown has brought down prices to more

affordable levels, but also has created ghost cities. Urbanization

and growing incomes should balance supply and demand

eventually. The question now is: Can Beijing break a vicious

circle of falling prices and sales (when it is ready to do so)?

} China’s economic miracle was built on an undervalued currency,

lots of investment, and subsidized energy and credit for

manufacturers. Domestic savers financed China Inc.’s master

plan by accepting savings rates below inflation, wage increases

that lagged economic growth and a minimal social safety net.

This is changing, but powerful interests are stacked against

a true shift to a consumption economy: exporters, state

enterprises and local governments.

} China’s new leadership could take the tough measures needed to

engineer a shift—liberalizing interest rates, opening capital

markets, market pricing of resources, and building out social

services. But Beijing is not almighty; local governments tend

to go their own way and a desire for consensus has often resulted

in political paralysis. Risks of a popular revolt or foreign conflicts

are low as the one-party state has kept a tight lid on dissent

and is focused on fulfilling its domestic social contract.

} Real wage growth, rising materials costs and environmental

restrictions are changing the workshop of the world—for the

better. Some labor-intensive industries are moving elsewhere

and automation is increasing. There is room for more productivity

growth even as the easy gains have been harvested. Protection

of intellectual property is still weak and global brands have

yet to emerge, but we believe chances are China will remain

competitive and confound the doomsayers.

So What do i do With My Money?tM

} global consumer companies and high-end machinery

makers are likely to be good long-term bets.

} energy, precious metals and agricultural commodities

prices should be underpinned by the country’s insatiable

demand, and boost companies in those areas.

} Most Chinese companies are likely to report poor

earnings this year, but valuations look cheap.

} China’s demand for basic materials such as cement

and steel should peak soon, hitting key suppliers and

resource currencies in those markets.

} China’s buying of uS treasuries may slow over time,

but a fire sale does not look to be in the cards.

More investment implications on pages 29 to 31.

The opinions expressed are as of April 2012, and may change as subsequent conditions vary.

Factor Bull Case Bear Case Bottom line Signposts (What to look for)

A Sickly Financial System 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.

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.

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.

} 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

A Deflating Real Estate Bubble

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.

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.

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.

} 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

Too Much Investment and Too Little Consumption

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.

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.

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.

} 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

Political Risk 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.

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.

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.

} 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

Competitiveness 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.

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.

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

} 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

[ 4 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

China Inc: Bull, Bear and Bottom Line

Factor Bull Case Bear Case Bottom line Signposts (What to look for)

A Sickly Financial System 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.

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.

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.

} 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

A Deflating Real Estate Bubble

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.

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.

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.

} 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

Too Much Investment and Too Little Consumption

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.

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.

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.

} 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

Political Risk 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.

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.

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.

} 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

Competitiveness 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.

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.

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

} 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

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 5 ]

China Inc: Bull, Bear and Bottom Line

Bull Bear

Bull Bear

Bull Bear

Bull Bear

Bull Bear

100

80

60

40

20

0

250%

200

150

100

50

0

-50

-100

2008 2009 2010 2011 2012

YoY %Monthly Machinery Sales

UN

ITS

(TH

OU

SAN

DS) Y-O

-Y GR

OW

TH (%

)

2,000

1,500

1,000

500

0

150%

120

90

60

30

0

-30

-60

2002 2004 2006 20102008 2012

YoY %Monthly Auto Sales

UN

ITS

(TH

OU

SAN

DS) Y-O

-Y GR

OW

TH (%

)

China 40%

Rest of Asia 24%

Other Emerging Markets 17%

US 17%

Other Developed Markets 2%

[ 6 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

A Heavy BurdenChina’s Share of expected 2012 global economic growth

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.

See the chart below. Resource-hungry China has an outsized

influence on most commodities markets, and is the largest

foreign holder of US Treasuries.

GDP per capita jumped more than 20-fold to $4,400 in the 30-year

period ended 2010. Ports, bridges, airports, expressways and

entire cities have been built in record time. China is now the largest

market in the world for cars, computers, mobile phones—the

list is endless. Wine sales have more than tripled in just five years.

Source: Deutsche Bank (January 2012). Note: Assumes global economic growth of 3.2% in 2012.

The big questions are how the current government will navigate

the domestic real estate slump and the global economic slowdown,

and whether the future leaders will be able to solve a ticking

bad debt time bomb and deliver on promises to rebalance the

economy toward consumption and sustainable growth.

Add in challenges of maintaining a “harmonious society” in a

place with rapidly growing expectations, corruption, a long history

of regionalism and world-beating income inequality, and you have

a troublesome brew. This is before you even consider artificial

pricing of money and a financial system that subsidizes borrowers

at the expense of lenders. Or ponder environmental despoilment,

deteriorating demographics, water shortages and a growing

addiction to imported energy. It is a wonder the place works

so well—or at all. There is enough fodder for a fierce debate

between panda haters and panda huggers. Now read on…

a Matter of timing

Real reforms to rebalance China’s economy are on hold this

year because of the once-a-decade leadership change. An

imminent collapse is unlikely, we think. The current leadership

will not go out with a bang, but certainly does not want a train

wreck during the final stages of stewardship.

Business cycles exist in China as elsewhere —but we expect a

soft landing in 2012.

Flattening OutSales of heavy Machinery and autos

Sources: Bank of America Merrill Lynch, China Construction Machinery Institute and China Association of Automobile Manufacturers. Notes: Machinery sales data through January 2012. Auto sales data through February 2012.

Introduction: Why China Matters

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 7 ]

In this interim period, it is important to read the economic tea

leaves. Real estate prices, sales and construction are important

ones. Politically sensitive food inflation is another one, as are

manufacturing gauges such as the various purchasing manager

indexes (PMIs).

At the start of 2012, the data were both conflicting and skewed

by the effects of the early lunar New Year holiday. Real estate and

key consumption indicators pointed down, while other gauges

pointed up.

For example, sales of heavy machinery used in construction,

such as excavators, crashed. Auto sales flattened, pointing to

a general slowing in the wider economy. See the charts on the

previous page.

By contrast, transport volumes are strong. And a gauge of small

business activity has been ticking up. See the chart below. This

is important because small businesses employ 60% of China’s

workers and make up 90% of companies.

The rebound could indicate the government’s easing policy

on liquidity has started to work. Bank credit enabled large

companies to pay their supplier bills. Secondly, it could mean

the bottom has not fallen out of exports because many small

companies are exporters.

60

58

56

54

50

52

48

46

44

42

40

Jan ’11 Mar ’11 May ’11 Jul ’11 Sep ’11 Nov ’11 Feb’ 12

SMA

LL B

USI

NES

S PM

I

A Ray of LightChina’s Small Business PMi, 2011-2012

Source: China Federation of Logistics and Procurement. Note: Data through February 2012.

Premier Wen Jiabao set a 7.5% annual growth target for 2012

in March—the lowest rate in almost a decade. Most China

watchers, however, believe the country will want to achieve at

least 8.5% a year. Official targets exist to be beaten. Like some

corporate chieftains, China likes to manage expectations by

under-promising and over-delivering.

It is realistic to expect China to move toward economic growth

of 6%-7% a year this decade versus the 10%-plus clip in the old

days, we believe. Five reasons:

} The political leadership appears to understand the

drawbacks of too much credit.

} Slow growth in the debt-ridden developed world likely means

slack demand for exports.

} The real estate boom has ended because tightening

measures have taken hold.

} Infrastructure spending is slowing as policy shifts from

favoring bridges for the masses to pills for the people.

} Savings rates—the fuel of deposit and loan growth—are

likely to remain flat or drop from mind-blowingly high levels.

Beijing is expected to arrest this year’s slowdown in growth

with all sorts of administrative and fiscal measures, while at the

same time trying to keep a lid on inflation and prevent more bad

debts that eventually could overwhelm the banking system.

Most people, perhaps too many, believe Beijing will walk this

tightrope. At US investor gatherings in late February, one Wall

Street firm’s China strategist polled the audiences and found

just one bear among roughly 1,000 people. This lonely creature

contrasted with a host of cubs the previous year.

Beyond 2012, the picture becomes very different. It is now clear

China’s 2009 stimulus was too much, in too short a time. Beijing

overestimated the US recession’s fallout. The result is a pile of

debt—which looks ready to fall over in the next few years (or

stay shaky forever).

Like some corporate chieftains, China likes to manage expectations by under-promising and over-delivering.

Most people, perhaps too many, believe Beijing will walk this tightrope.

[ 8 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

15,000

12,000

9,000

6,000

3,000

0

50%

40

30

20

10

0

’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 ’09’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’11

OtherInsurance Company Real EstateInsurance Claims PaidNew Stock Issued by Non-Financial Enterprises

CRED

IT G

RO

WTH

(RM

B B

ILLI

ON

S) CRED

IT GR

OW

TH TO

GD

P (%)

New Trust LoansNew RMB Loans New Entrusted LoansNew Foreign Currency Loans New Bank Acceptances

Corporate Bonds

% GDP

Debts Have a Way of Piling Up—Even in ChinaCredit growth in Billions of rMB and as a Percentage of gdP, 1993-2011

Sources: Carl Walter, Su Ning, China Bank Statistics and People’s Bank of China.

What changed in 2004? China had started to rack up huge account

surpluses because of bumper exports and an underappreciated

RMB currency. The surplus hit an unprecedented 10% of GDP at

its peak in 2007. The central bank started to offset, or sterilize,

the flood of foreign currency by selling bills at very low rates.

For bankers, these were “bills you can’t refuse.”

To keep the banks profitable, authorities set deposit rates low.

Low deposit rates and high reserve ratios also would put a brake

on inflows of “hot money” speculating on appreciation of the

RMB. The result: an effective tax on consumers who kept their

savings at banks.

Financial repression worked well because consumption took

a back seat in China’s investment-driven master plan. More on

China’s hard-pressed consumer and unprecedented investment

boom later. In this chapter, we review the credit boom these

savings helped create.

the great Credit leap Forward

Armed with a reliable supply of cheap deposits, banks went on

a lending binge. The biggest beneficiaries were state-owned

enterprises (SOEs) and local governments.

The first group revved up exports and capital expenditures even

more, supported by cheap credit and subsidized energy costs.

It was a lifeline to many enterprises that had no business

staying in business.

Credit: Too Much, Too Quickly

For a poster child of “financial repression,” pick any of China’s

one-billion-plus consumers. They have been bankrolling the

country’s infrastructure boom and manufacturing machine—

and have lost money in real terms in the process. (A cynic would

say the West now is importing this made-in-China concept.)

Consumers who park their savings at banks have received

negative returns after factoring in inflation, an average loss

of 0.54% a year since 2004. See the chart below.

8%765

34

210

-1-2-3-4-5

’97 ’99 ’01 ’03 ’05 ’09’07 ’11

REA

L IN

TER

EST

RAT

E (%

)

Average Interest Rate = 3.04%

Average Interest Rate = -0.54%

Don’t Take It to the Bank! real return on household one-Year deposits, 1997-2011

Source: Peterson Institute for International Economics. Note: Data through December 2011.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 9 ]

60,000

40,000

50,000

30,000

20,000

10,000

0

140%

120

100

80

60

20

40

0

’96 ’00 ’04 ’08’98 ’02 ’06 ’10

Bank Loans Bonds

LOA

NS

AN

D B

ON

DS

(RM

B B

ILLI

ON

S) LOA

NS A

ND

BO

ND

S TO G

DP (%

)

Loans and Bonds/GDPLoans/GDP

A Likely Sad Endingoutstanding loans and Bonds, 1996-2010

Sources: Carl Walter, People’s Bank of China and Wind Information.

The second group financed infrastructure works, office towers,

conference centers and an array of faux landmarks, from

Chengdu’s Dorchester-inspired British town to Venetian canals

and a replica of St Mark’s bell tower at the New South China Mall in

Dongguan. This helped inflate an emerging real estate bubble.

Credit grew and grew ... until a great leap forward in 2009. Worried

the world financial crisis and subsequent US recession would

hit China hard, Beijing engineered a huge monetary stimulus.

Credit doubled to a clip of at least 14 trillion RMB a year. See

the chart on previous page.

Credit grew at an compounded annual growth rate of 36% in the

period 2004 to 2010. As a result, the total value of bank loans

and bonds quickly exceeded GDP. See the chart below.

35%

25

30

15

20

10

5

0

’98 ’99

NO

N-P

ERFO

RM

ING

LO

AN

S (%

)

’00 ’04 ’08’02 ’06 ’10’01 ’05 ’09’03 ’07 ’11

Too Good to Be Truenon-Performing loan ratios of Major Banks, 1998-2011

Sources: UBS, People’s Bank of China, China Banking Regulatory Commission and CEIC. Note: Data before 2002 only cover the Big-4 state-owned banks.

This is where the problem lies: Take a machine that runs along

at a steady pace, suddenly inject adrenaline and order: “Go

lend.” The sheer magnitude and pace of this unbridled credit

growth does not pass our smell test. It suggests to experienced

investors there has to be trouble somewhere, sometime.

Bad debt? Just roll it over

China has plenty of rules to keep credit growth in check. But

they are loosely enforced. For example, Chinese banks are

supposed to lend up to 75% of deposits. But banks need to show

a 75% loan-to-deposit ratio only at the month’s end—giving

them about 30 days each month when they can lend more.

A bank CEO in a coastal city may say his operation is lending 100%

of deposits, no problem. He gets away with it because his bank

is part of a national network that (still) has enough deposits in the

interior to make up for shortfalls on the coast. The government

may abolish this cap because it has many other ways to control

loan growth, notably its stranglehold on interbank market.

Everything appears just hunky-dory for China’s banks: Non-

performing loans (NPLs) fell by 97% over the past decade and

now average just 1% of the loan book. See the chart below.

This is dangerous, especially because both local authorities

and SOEs are already deep in debt. It is unlikely China will let the

market collapse, though: Nobody wants to see a local government

default or a big state firm go belly up. There is nothing subtle

about the government guarantees of these entities.

High-profile bankruptcies just do not fit into China Inc.’s master

plan of economic growth and employment. And banks are very much

part of the plan. Banks are, after all, an extension of the fiscal

policy. This is also the reason they trade at such low valuations.

It is unlikely China will let the market collapse. Nobody wants to see a local government default or a big state firm go belly up.

Take a machine that runs along at a steady pace, suddenly inject adrenaline and order: “Go lend.”

[ 10 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

no Banker Will Come Clean this Year

The practice of rolling over loans works—as long as banks have

enough deposits to play with. It is like a bath filling up faster

than it empties out.

But companies and consumers—faced with cash flow needs

and fed up with negative real returns—are starting to vote with

their feet and are pulling deposits. Banks, especially in coastal

areas, are trying to fight these outflows by offering asset-backed

securities that carry higher interest rates. About 10% of deposits

has flowed into these “wealth management” products. See the

chart below.

have deteriorated across the industry in the past three years,

with many second-tier banks already facing shortfalls, according

to ratings agency Fitch Ratings.

Do not expect any banks to come clean this year. Bank chieftains

angling for government positions in the leadership change will

want their records to remain squeaky clean.

Put yourself in the position of a bank CEO. You have been presiding

over five years—20 quarters—of profit increases. Now you are

gunning for that position in the State Council. Are you going to

bring down your profits this year by increasing provisions? Just

to be prudent? Chances are you will not. You leave it for the next

guy to deal with.

To be sure, there are plenty of deposits. They are just not for

lending. One example: To recycle the inflows of foreign exchange

and prevent the RMB from appreciating, the central bank obliges

banks to hold vast quantities of reserve bonds yielding only 1.5%.

This deflates the money multiplier and kicks sand into the engine

of a credit-led economy.

8,000

4,000

2,000

1,000

7,000

6,000

5,000

3,000

0

2007 2009 20112008 2010

Asset-Backed Bills Asset-Backed Loans

Index-Linked Asset-Backed Other

ASSE

T-B

ACK

ED S

ECU

RIT

IES

(RM

B M

ILLI

ON

S)

Looks Familiar?investment in asset-Backed Securities Quadrupled, 2007-2011

Sources: Carl Walter, Wind Information and Fitch Ratings. Note: Data through June 30, 2011.

Deposits from corporations under cash flow pressure (and with the

ability to export capital by padding overseas invoices) dwindled to

near zero in the first nine months of 2011, compared with growth of

3.7 trillion RMB in 2010. In the third quarter alone, corporate

deposits of an estimated 1 trillion RMB vanished into thin air.

Combined with the strangle of rising reserve ratios, growth in

the M1 money supply has dwindled to a clip of 3%-4%.

Moreover, deposit outflows have triggered a slow-motion cash

crunch. Smaller banks in particular are vulnerable, partly because

their loans are coming due earlier. Operating cash reserves

In all, the Triple R (Required Reserve Ratio) and other measures

tie up some 10 trillion RMB of deposits. This has given the central

bank the means to provide stimulus when the economy needs

it. Every cut in the Triple R pumps some 380 billion RMB into the

system (provided the cuts are not offset by capital outflows).

This doesn’t mean SOEs and other politically connected players

have a tough time getting credit. Not at all. They are issuing bonds

like there is no tomorrow—forced down banks’ throats at slightly

higher rates than one-year deposit rates. The result is a huge debt

capital market where very few trades take place. Why? If a bank

sells these bonds, it is almost guaranteed to take a loss because

nobody wants them at the price the bank paid for them. Bottom

line: The corporate bond market is bank lending in disguise.

The bulls believe China has proved again and again it can fix

these problems. The basic argument goes like this: Chinese banks

go bust every decade, but the country has just found a much

better way to deal with it than the West. Conclusion: Any

weakness in the financial system will be dealt with quietly.

Deposit outflows have triggered a slow-motion cash crunch.

Bank chieftains angling for government positions in the leadership change will want their records to remain squeaky clean.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 11 ]

Acronym to Watch: LGFV Structure and Mechanics of local government Financing vehicles (lgFvs)

Sources: Deutsche Bank and China Statistical Yearbook 2010.

a less offensive Four-letter Word

Local governments cannot borrow unless they have specific

approval from the State Council, the country’s highest executive

administrative body chaired by the premier. This doesn’t happen

very often. It is not meant to happen often. Think of it as a

company requiring CEO sign-off for all travel and entertainment.

T&E costs will go down very quickly.

Where there is a will, there is a way, though—especially in

China. Local authorities have set up special entities to pay for

infrastructure and other projects. This is perfectly legal. The

chart above shows the mechanics of these so-called local

government financing vehicles (LGFVs).

LGFVs have taken out trillions of RMB in loans backed by land

sales. China bears have long argued this represents a ticking

How LGFVs Come To Be Typical LGFV Structure

Incorporated 6,500-8,200 LGFVs

Central Government

23 Provinces 5 Autonomous Regions

4 Municipalities (Beijing, Shanghai, Chongqing, Tianjin)

2 Special Administrative Regions

333 Prefectures

2,858 Counties

40,858 Townships

Bank

Local Government

LGFV

Activities (Infrastructure, Utilities,

Transportation, Land Development)

Repayment

Cash Loan

Ownership of Local Enterprises, Land and Tax Subsidies

Equity/Loan Injection

Cash InvestmentsProfit

Others are optimistic. LGFV net debt barely increased in 2011

because regulators discouraged banks from making new loans,

according to research firm CLSA. This compared with a 19% rise

in LGFV net debt in 2010 and a 62% stimulus-fueled jump in 2009.

CLSA says. Local governments can pocket an increasingly smaller

share of land sales because of higher spending on compensation

and relocation. As a result, local revenues from land fees

equaled just 9% of total national spending on infrastructure

in 2011, CLSA notes.

In any case, all local debt is an explicit liability of the central

government—which saw a 30% jump in tax revenues in 2011.

Beijing can pay a lot of bills.

The bulls believe China has proved again and again it can fix these problems.

Where there is a will, there is a way—especially in China.

time bomb, especially at a time a main source of local

government revenues—land sales—has dried up amid

falling real estate prices.

[ 12 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

3,000

1,000

2,500

2,000

1,500

0

Pot

enti

al N

PLs

Loca

l Gov

t. B

ond

Ass

et S

ales

Loca

l Gov

t. R

even

ues

Cen

tral

Gov

t. S

uppo

rt

Ove

r-P

rovi

sion

for

NP

Ls

Rec

over

ies

on P

roje

cts

Wri

te-O

ffs

RM

B B

ILLI

ON

S

2,550 600

600

600

260

120245

125

Get Out of Debt Tomorrowa Possible Solution for Bad lgFv debts

Source: Deutsche Bank estimates. Notes: Assumes 30% of LGFV loans default. Assumes local governments sell 10% of assets and divert 2% of revenue.

3,500

2,500

3,000

1,500

2,000

1,000

500

0

35%

25

30

15

20

10

5

0TO

TAL

DEB

T (R

MB

BIL

LIO

NS)

PERCEN

T DU

E (%)

24.5%

17.2%

11.4%

30.2%

9.3%

7.5%

2011 2012 2013 2014 2015 2016 andBeyond

Over the Refinancing HumpMaturities of local government debt

Sources: Deutsche Bank and National Audit Office. Note: Data as of year-end 2010.

Even if 30% of all LGFV loans default, the problem is manageable,

according to Deutsche Bank. Local government bond issues,

asset sales and diverting 2% of government revenues would

solve most of the problem in its view. See the chart above.

In addition, most LGFV debt is spread out after scaling a renewal

hump last year, with almost a third due only after 2016. See

the chart above.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 13 ]

Rapid urbanization drove China’s housing boom for much of the

2000s—and is likely to do so in the future. China is expected to

have almost one billion urbanites by 2025. It already has 214

metropolitan areas with more than one million people, four

times as many as the United States. See the chart above.

Many Chinese already owned their homes, but often these were

shacks or rural dwellings. There was definitely a need to upgrade,

and many households did just that.

Then savers desperate for yield and “hard assets” started to

snap up apartments. Where else could they go? Banks offered

negative real interest rates. The stock market was perceived as

a big high-roller table at best. And offshore markets were—and

are—pretty much shut.

100%

80

60

20

40

0

1950 1978 2005 2025

SHA

RE

OF

POPU

LATI

ON

(%)

UrbanRural

Shanghai

Xi’an

Harbin

Beijing

Guangzhou

Shenyang

Tianjian

WuhanChengdu

Chongqing

Nanjing

Hangzhou

490mln

790mln

745mln

467mln

62mln

172mln

562mln

960mln

552mln

962mln

1,307mln

1,427mln

The City Beckonsurbanization and Migration

Sources: ISI Group, CEIC and National Bureau of Statistics. Note: Numbers in millions of people.

Something’s got to give

Some 40%-45% of all residential properties sold in early 2009

were for investment purposes, according to think tank Peterson

Institute. Other speculative bubbles built in jade, art and gold

prices, but there was nothing like real estate. Beijing inadvertently

made it the preferred asset class, egged on by powerful

interests that cashed in on this state-sponsored freebie.

Real Estate: Can a Bubble Be Deflated?

22 Cities > 5 Million = 180 Million

71 Cities 2-5 Million = 216 Million

121 Cities 1-2 Million = 175 Million

214 Cities = 571 Million

Other speculative bubbles built in jade, art and gold prices, but there was nothing like real estate.

[ 14 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

12,000

10,000

8,000

6,000

2,000

4,000

0

2007 20092008 20112010 2012

RM

B P

ER S

QU

AR

E M

ETER

150%

120

90

30

60

0

-30

-60

-90

2010 2011 2012

Y-O

-Y S

ALE

S VO

LUM

E G

RO

WTH

(%)

Weekly Sales Prices Volume Growth

That Sinking Feelingreal estate Prices and Sales volumes in Major Cities

Sources: Deutsche Bank and Soufun. Notes: Price and sales volume trends in 39 major cities. Volumes represent year-over-year growth in four-week periods. Data through March 2012.

Local governments did their part to support the boom by providing

infrastructure and sponsoring grandiose projects. They bought

farmland at artificially low prices and sold it for a profit to

developers. Over time, local governments became addicted to

these land sales as a source of revenues. And the practice to

appropriate land became the root cause of periodic local

outbreaks of social unrest.

Real estate has been a great wealth creator, for companies, local

governments and individuals alike. The top source of wealth

among China’s richest 1,000 people is real estate, according to the

latest ranking by Hurun Report Magazine (which was appropriately

sponsored by the Hainan Clearwater Bay luxury development).

No wonder those feasting want the banquet to continue.

Sales volumes and prices fell after government measures to

dampen speculation and prevent prices from spiraling beyond

the reach of the emerging middle class. There are some tentative

signs of bottoming (see the charts below), especially in second-

and third-tier cities where people buying homes for themselves

are a more important source of demand than investors.

a Men’s Shirtmaker diversifies

The real estate market is the biggest risk to China’s economic

growth this year. The tipping point will likely come in the second

quarter, when downside risks to the entire economy will start to

outweigh inflation and affordability considerations. Or will they?

Our assumption is Beijing wants to take real estate prices down

25%-30% from their highs. With a 10% fall already, there is a painful

additional 15%-20% to go. This is dangerous. The biggest risk

is stagflation—when activity drops off a cliff while prices stay high.

In that case, the government may stick to its tightening policy.

How big is the real estate sector? It makes up 20% of fixed

investments, translating into a 10% share of GDP. But the sector

looms much larger in reality. We suspect land is collateral for

more than half of loans. Real estate is interwoven with the

entire economy. In other words: The risk to housing in China is

not so much its imminent collapse, but how ubiquitous other

segments of the economy are exposed to it.

Bubbles involving real estate are quite common. This seemed to

have all the signs, including the endemic involvement of local

governments and the corporate sector. It is clear the boom

cannot last. (Nor does Beijing want it to last.) Consider:

} China’s residential housing construction equaled almost 10%

of GDP in 2011, compared with 6% for the US economy during

the height of the boom in 2005.

} Real estate accounted for 40% of urban household wealth

in 2010, double the proportion in 1997, according to Peterson

Institute. It is hard to imagine it doubling again in the next decade.

Sales volumes and prices fell after government measures to dampen speculation and prevent prices from spiraling upward.

The risk to housing in China is not so much its imminent collapse, but how ubiquitous other segments of the economy are exposed to it.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 15 ]

40

30

35

20

25

15

10

5

0

2008 2009 2010 2011 2012

MO

NTH

S TO

CLE

AR

INVE

NTO

RY

Inventory

Clearing Out InventoryMonths to Clear real estate inventory at Current Sales rates

Source: Deutsche Bank. Note: Weekly data through March 18, 2012.

One example: The CEO of a men’s shirtmaker says he expects

100 billion RMB in revenue in three years, with the core shirt

business making up just 1%. It is tough to make money in the

apparel business, so the CEO is building a 400-meter office

tower—the highest in his city—and outlet malls.

This particular CEO is not alone. He illustrates how real estate

runs through the entire economy. It is not about a few developers

going bust. It is about local governments. It is about the entire

corporate sector. It is hard to see a happy ending here. We

struggle to find a precedent in history where the bursting

of a property bubble did not lead to financial distress.

a Quiet new Year for realtors

A slowdown or, worse, a crash in the real estate market

also would hurt consumer spending. If the US experience

is any guidance, ever-increasing real estate prices can drive

consumption. Take them away, and consumption plummets.

Some money is already fleeing the country. China had capital

outflows in the fourth quarter of 2011—the first time since the

Asia crisis in the late 1990s. Speculative inflows betting on an

RMB revaluation dried up as it became clear China’s economy

was slowing. This put the spotlight on the wealthy taking money

abroad.

12

11

10

9

7

8

6

2007 2008 2009 2010 2011 2012FA

CTO

R O

F H

OU

SEH

OLD

INCO

ME

Housing Affordability-1 Standard Deviation+1 Standard Deviation

Can We Finally Afford It? housing Prices as a Factor of annual household incomes

Source: Deutsche Bank. Note: Estimated data through end 2012.

Anecdotal evidence abounds: Coffers with cash in Macau and

Hong Kong. Record real estate prices in Vancouver. Australian

mines and vineyards snapped up by Chinese buyers.

Once people start believing prices will keep falling, they stop

buying. Just 19% of people expected housing prices would go

up in the first half of 2012, down from around 45% in 2009,

according to a December People’s Bank of China quarterly

survey. The same survey showed 21% expected prices to

fall and 46% anticipated a flat market.

Things looked pretty grim in the first quarter. For example, not

one transaction closed in Beijing, a city of 20 million, during

the entire Chinese Year of the Dragon celebrations, according

to JPMorgan. Overall, transactions have plummeted and

inventory has risen to 15 months worth of sales. See the

chart above on the left.

The inventory may be understated as the gap between floor space

under construction and the amount sold is huge: 1.9 billion vs.

1.1 billion square meters in 2011. The gap is slowly closing, but

there is a big overhang. And new construction usually lags six

months behind trends in real estate sales.

Once people start believing prices will keep falling, they stop buying.

[ 16 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

Commercial real estate is hit hardest, especially in second-tier

cities. Chongqing, for example, will have nearly 800,000 square

meters of new commercial space in 2012, whereas the annual

take-up has been just 150,000 square meters.

The government has started to offer incentives for first-time

home buyers, including lower mortgage rates combined with

“guidance” to banks to lend to this group. It could ax deed taxes

and even cut mortgage down payments—although it would not

resort to the latter measure lightly.

Breaking a vicious Circle

Some fear it is already too late to re-engineer a real estate

turnaround—even in a command economy such as China’s.

These bears predict a vicious circle of lower real estate prices

and lower activity.

On the positive side, China has had much shorter real estate

cycles than the West. Policy measures reversed a downturn

at the end of 2008 in six months, for example. In the current

climate, affordability is improving fast. If prices were to fall 20%

from their peak and real wages were to grow 13%, affordability

would improve by one third in one year. In the US market, this

would take about a decade. See the chart on the previous page.

One way to boost the housing market—and consumption—is

reforming or doing away with the hukou system that bars migrant

workers without proper urban registration from essential services

such as schooling and healthcare. As much as 15% of the

population, or 200 million people, live in cities but do not

have a proper registration.

Another avenue is the push toward low-end “social housing.” This

will not do much for prices of high-end private homes, but it does

serve the dual purpose of creating affordable housing for the

masses and keeping the construction industry going. Expect

social housing construction to almost double to more than seven

million units this year, according to Bank of America Merrill Lynch.

The market is starting to believe the magic of policy. Bonds and

shares of Hong Kong-listed developers rose sharply at the start

of the year. One company even raised new equity. The triumph

of hope over experience? Only time will tell.

It is clear the government is not ready yet to reverse its housing

policy. Premier Wen Jiabao in early March emphasized house

prices were still too high and that relaxing existing curbs could

cause “chaos.” This dampened investor hopes for a policy reversal

and caused stocks to post their biggest daily loss in months.

The questions we ask ourselves are: Suppose the government

took its foot off the brake; could it reignite demand in housing?

And suppose the paralysis in policymaking lasts long enough

to destroy confidence in real estate as an inflation hedge?

The question we ask ourselves is: Suppose the government took its foot off the brake; could it reignite demand in housing?

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 17 ]

China is about investments. Ports, multi-lane highways, dams,

bridges, high-speed trains, nuclear reactors, office towers, entire

cities pop up seemingly overnight. The world’s workshop has

renewed its plumbing, has redone its floor plan and is better

connected with customers around the world than ever before.

The result is an export juggernaut with productivity growth

more than three times that of competitors.

China is not unique in following an investment model. Germany

did it in the 1930s; the USSR in the 1950s and 1960s; Brazil in

the 1960s; and Japan in the 1970s and 1980s. Most of these

efforts produced short booms but ended on ugly notes: war,

debt drama and stagnation.

a Case of diminishing returns

Like Japan and others, China enabled investment through

repression of consumption in three main ways:

} An undervalued currency essentially taxed imports

} Increases in real wages lagged GDP growth

} Deposit rates were artificially low

What is extraordinary is investments are still increasing their

share of China’s economy. In most places, consumption kicks in

and investment tapers off because of diminishing returns. Not

so in China. See the chart below.

50%

40

30

45

35

’97 ’99 ’01 ’03 ’05 ’09’07’98 ’00 ’02 ’04 ’06 ’10’08

INVE

STM

ENTS

TO

GD

P (%

)

Average = 44.1%

Average = 37.1%

Investment: Too Much of a Good Thing?investment Share of gdP, 1997-2010

Sources: Peterson Institute for International Economics and National Bureau of Statistics.

You might ask: Is there such a thing as too much investment?

(Especially if you live in a place in desperate need of an

infrastructure upgrade—and many of us do.) The answer is: Yes.

It has taken China $5 of investment to generate $1 of GDP growth

since 2001, 40% more than Japan or South Korea in their take-

off periods, according to the International Monetary Fund. The

country is becoming less efficient in turning credit growth into

economic growth. It needs ever more gasoline in the tank to

make the car go down the highway at the same speed.

We believe this is unsustainable—and a real worry. This is even

truer if you accept some analyst views that China’s subsidies

and production input advantages represent more than half of

the return on invested capital.

Demand for raw materials, especially cement and steel, may

peak earlier than many expect. See the table below. China is

now using 590 kilos of cement for every $1,000 of capital

formation, compared with 155 kilos in South Korea and just

29 for the United States, according to Deutsche Bank.

Material Cement Steel Copper

2010 Chinese consumption (in kilos per capita) 1,396 448 4.8

Accumulated Chinese consumption to 2010 13,939 3,348 37

Accumulated consumption peak in Japan and United States 23,382 9,449 147

Projected peak consumption year 2015 2017 2025

Projected peak year consumption 1,633 657 10.8

Projected increase from current levels to peak year (%) 17% 47% 125%

Topping Outexpected Peak demand for Selected raw Materials

Source: Deutsche Bank. Note: All data in kilos per capita except where noted.

Investment and Consumption: Looking for Balance

The country is becoming less efficient in turning credit growth into economic growth. It needs ever more gasoline in the tank to make the car go down the highway at the same speed.

[ 18 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

Building, Building … BuildingSpending on infrastructure in Billions of rMB, 2005-2010

Sources: ISI Group and CEIC. Notes: Conventional rails exclude rolling stocks & locomotives. High-speed rails include new capital construction. Airports exclude aircraft and other special vehicles. Growth rates are compounded.

In addition, China’s capital stock—the country’s highways, ports,

rail tracks, airports and factories—is still far below that of the

United States, Japan and South Korea on a per capita basis.

Even as a percentage of the relatively small economy, capital

stock has not been excessive. See the charts below.

350%

300

250

200

325

275

225

’78 ’82 ’86 ’90 ’94 ’98 ’02 ’06 ’10

CAPI

TAL

STO

CK T

O G

DP

(%)

$150,000

120,000

90,000

30,000

60,000

0

1995 2000 2005 2010

CA

PITA

L ST

OCK

PER

CA

PITA

($)

South KoreaUSChina South KoreaJapanUSChina

… And Building MoreChina’s Capital Stock to gdP and Per Capita

Sources: HSBC, CEIC, Bureau of Economic Analysis and Japan’s Cabinet Office. Note: Per capita figures in constant 2005 US dollars.

YearConventional

rails

high-Speed rails

highways & express-

ways

urban transit & Subways airports

Waterways & Ports

Pipelines & Storage

electricity, gas & Water

Water Conserva-

tionenviron-

ment

total Spending

(rMB Billions)

2005 93 17 548 53 21 69 39 725 82 33 1,680

2006 110 64 623 80 31 87 51 820 95 42 2,004

2007 98 98 649 107 46 89 79 907 109 60 2,242

2008 130 231 688 127 57 99 112 1,048 142 73 2,707

2009 246 377 967 203 59 106 177 1,348 216 120 3,820

2010 294 442 1,148 236 65 117 224 1,454 275 153 4,407

Total (2006-2010) 878 1,212 4,075 754 258 497 643 5,577 837 449 15,180

Growth Rate (2006-2010) 26% 92% 16% 35% 25% 11% 42% 15% 27% 36% 21%

To be sure, investment in infrastructure is still needed to secure

energy, conserve water and connect China’s interior to the coast

and the world. In the past decade, about 50% of investments

have gone into transport. Expect less spending on transport in

the future, especially on high-speed trains after recent mishaps,

and more on nuclear power and water conservation. See the

table above for past spending trends.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 19 ]

go Buy a refrigerator!

The mirror image of the investment boom is subdued consumption.

Consumption has grown—we have all heard about the excesses—

but not as fast as GDP. As a result, it made up barely a third of

the economy in 2010.

To many economists, this number is surreal—it is something

you just never see. The contribution of consumption to GDP

growth also remains extraordinarily low. See the chart below.

15%

3

-3

12

9

6

0

-6

’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12

ExportsConsumption Investment

CON

TRIB

UTI

ON

TO

GD

P G

RO

WTH

(%)

Consumption Growth Is Surreal—In Its Modesty Composition of gdP growth, 1996-2012

Sources: CLSA and CEIC. Note: 2012 data is estimated.

Highly unusual? Yes. Damaging? Probably. The internal imbalances

are reflected externally, with China’s trade surplus and foreign

currency pile ever increasing. Leaving prescriptions for debtor

nations such as the United States aside, everybody agrees

China has to rebalance its economy toward consumption.

Can a command economy successfully make such a shift?

It is tough.

A command economy is very good at investing. The order “build

a highway” comes down, and it gets done. It is much harder to

say “go buy a refrigerator,” and get much traction.

Any moves toward a consumption society are likely to be gradual

and slow. This is a good thing. Suddenly taking away industrial

subsidies such as below-cost loans and electricity, for example,

would create a train wreck. Similar to how a July 2011 deadly

accident near Wenzhou upended China’s ambitious plans for

a high-speed rail network, a big economic downturn could

set back the clock on any moves made to favor consumers

over manufacturers.

a Blueprint for rebalancing Success

rebalancing the economy is a multi-year project. nobody

wants to upset the delicate equilibrium holding China’s

economy together now.

the ingredients of rebalancing are well known:

}Liberalizing interest rates: given the economy’s torrid

growth, interest rates should be in the double-digit range

to allocate capital efficiently and offer savers real rewards.

the trick is to go slowly: local governments and state enter-

prises would go bankrupt if rates became real overnight.

}Exchange rate flexibility and opening of capital accounts: another multi-year project, but one that

is very necessary to address global imbalances.

}Privatizing state-owned companies: Would cut bad

debts and reduce reliance on exports. assets

could go into the underfunded social security fund.

}Building out a social safety net: Would help turn at

least some precautionary savings into consumption.

}New sources of local financing: Would lessen the

reliance on land sales. a possibility is recurring real

estate taxes pioneered by Shanghai and Chongqing.

}Market pricing of resources: electricity prices are

artificially low to protect manufacturing, which

uses the brunt of electric power.

expectations for reform are massive, but do not hold your

breath this year. the once-a-decade leadership change is

putting the big decisions on hold. it is more about what

Beijing won’t do than what it can do for now.

the February 2012 “China 2030” World Bank report hits many

of the right buttons. Many recommendations have been on

the agenda for years, but nothing has happened. the main

reasons are twofold: Powerful forces, including local

governments, exporters and banks, support the

investment model. and a consensus-driven

leadership tries to placate too many interests.

Similarly, a rush to rebalance could trigger a spike in inflation

around the world. For years, China “exported” deflation by

providing consumers elsewhere with goodies that became cheaper

and better over time. The secret sauce consisted of low wages,

a low exchange rate and investment-driven jumps in productivity,

such as better and cheaper transport. Change the sauce’s

ingredients, and the world is looking at a very different dish.

[ 20 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

Bankers are Shooting Fish in a Barrel

In our view, rebalancing the economy should start with a gradual

interest rate liberalization. The 11th and 12th five-year plans

(2006-2015) stressed this … but nothing has happened. One

way to make progress would be to slowly expand the band of

deposit rates. Banks would not like it, but they are in much

better shape than a decade ago.

Fat lending spreads helped banks ring up a combined profit of

1 trillion RMB in 2011—which is close to half of all private sector

profits. They are shooting fish in a barrel! This has created tensions

between bankers and the “real economy.” Banks make money

hand over fist while small businesses are cut off from credit

and consumers lose money on deposits.

This situation has raised the possibility of an asymmetrical rate

cut: reducing the lending rate while leaving deposit rates alone.

Until recently, the government’s sole focus was to keep a lid on

food price inflation triggered by surging pork prices. The CPI—

short for Consumer Pork Index in China—hit 6% last year but

has receded since. The government’s 2012 inflation target of 4%

on March 5 beat expectations, leaving more room for fiscal and

monetary stimulus.

In other areas, China is slowly making progress. For example,

Beijing has deliberately been punching (small) holes in its Great

Wall of capital controls. All companies authorized for foreign trade

can now settle payments in RMB; qualified foreign investors

can invest in Chinese securities; and central banks from Japan

to Nigeria are adding RMB and Chinese bonds to their reserves.

Wanted: Carefree Spenders

We have talked a lot about under-consumption in relative

terms. As a part of a fast-growing economic pie, its size is

miniscule. In absolute terms, it is breathtaking.

The growth in the number of China’s wealthy— and their spending

power—is huge. Half of China’s households will have income of

100,000 RMB or more a year—close to Mississippi’s GDP per

capita—by 2015, up from less than 15% in 2010, according to

Deutsche Bank. See the chart on the left.

This is a huge middle income class with money to spend.

Supposedly, the most popular phrase in China is: “New

Louis Vuitton opening soon.” There may be some truth to this.

15%

3

12

9

6

0

’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11

Urban Rural

Y-O

-Y IN

COM

E G

RO

WTH

RAT

E (%

)

A Sweeter Home on the Farm income growth in rural vs. urban growth areas, 1997-2011

Sources: CLSA and CEIC. Note: Income growth rates in real terms. Rural is growth in net income. Urban is growth in disposable income.

400,000

200,000

0

300,000

100,000

150,000

250,000

350,000

50,000

0% 20 40 60 80 100

AN

NU

AL

HO

USE

HO

LD IN

COM

E (R

MB

)

POPULATION (%)

2015 (Forecast)20102005

Total income of households in top

bracket by 2015

Total income of households in top

bracket in 2005

Total income of households in top

bracket in 2010

Middle Kingdom of Middle Incomehouseholds With annual income over 100,000 rMB, 2005-2015

Source: Deutsche Bank. Note: Income figures are nominal.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 21 ]

Incomes are now growing faster in rural areas, reversing a long

trend of faster rising urban wages. See the chart on the previous

page. This caused many coastal employers this year to anxiously

await the return of migrant workers from visiting family over the

New Year holiday. Some never did. Nearby family, low costs of

living and now faster wage growth are big attractions of the

interior. This trend bodes well for a more geographically

balanced economy.

45%

35

25

40

30

’97 ’99 ’01 ’03 ’05 ’07’98 ’00 ’02 ’04 ’06 ’08

SAVI

NG

S TO

DIS

POSA

BLE

INCO

ME

(%)

Average = 36.4%

Average = 29.4%

Spending Is Not a National Duty Yethousehold Savings to disposable income, 1997-2008

Source: Peterson Institute for International Economics.

A Country of Old People Population by age Bracket, 1995-2050

Source: World Bank. Note: Population figures in millions of people.

Income is one thing. Getting people to spend is another. China

has become a lot richer, but savings have gone up even more.

See the chart on the left.

Financial repression is one reason for the high savings rates, as

we have seen. In addition, people set aside buckets of money to

pay for retirement and illnesses. The lower the interest rate on

deposits, the greater the amount of savings needed to create a self-

directed social safety net. Building out social security programs

would reduce the need for these precautionary savings.

There are plenty of other reasons to establish provisions for the

elderly. China is graying—fast. The country will have 300 million

people aged 65 and over by 2050. See the table below.

120

110

100

90

’95 ’11

MO

NTH

LY C

ON

SUM

ER C

ON

FID

ENCE

40%

30

10

20

0

’94 ’96 ’98 ’00 ’06 ’08 ’10’02 ’04’97 ’99 ’07 ’09’01 ’03 ’05 ’12

MO

NTH

LY Y

-O-Y

RET

AIL

SA

LES

GR

OW

TH (%

)

Sagging Confidence = Sagging SalesConsumer Confidence index and retail Sales growth

Sources: ISI Group and National Bureau of Statistics. Notes: Retail sales consist of all purchases by individuals, organizations and government. Consumer confidence data through January 2012. Retail sales growth through December 2012.

Population 0-14 years 15-64 years 65+ years

1995 1,211 327 808 76

2000 1,260 328 845 87

2010 1,353 293 956 104

2020 1,449 287 989 173

2030 1,481 278 989 214

2040 1,489 287 950 252

2050 1,473 211 962 300

[ 22 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

in Search of luxury goods

It is clear the real estate downturn has spread throughout the

economy. Consumer confidence plummeted in late 2011, triggering

a decline in the growth of retail sales. See the charts on the

previous page.

Remember the economic bar is high in China. Sales are still

rising at a rate retailers in the developed world would kill for.

Overall retail sales increased almost 15% in the first two

months of this year, although this was less than forecast

and less than the previous clip of 18%.

One way to jumpstart consumption is to cut duties. China has

relatively high duties, especially on luxury goods. See the table

on the right.

Luxury—At a Pricetax rates on luxury goods in Selected Countries

Sources: Deutche Bank and Central University of Finance and Economics. Note: Tax rates include import consumption tax, VAT/GST and import tariffs.

Chinese tourists mob upscale department stores around the

world because prices are cheaper overseas (and you have a better

chance of buying the real thing). Some 70 million mainland Chinese

traveled outside the country in 2011, spending about $70 billion,

according to the China Outbound Tourism Research Institute.

Duty cuts on luxury goods would serve to boost consumption,

give domestic retailers a shot in the arm and reduce the trade

surplus. It is a bit of a political football, though, as duty cuts are

seen as only benefiting the very wealthy.

China uS hong kong Singapore

Coach Handbag 27% 8% 0% 7%

Porsche 911 82% 11% 90% 134%

Rolex Watch 47% 15% 0% 7%

Lancôme Perfume 57% 8% 0% 7%

The economic bar is high in China. Sales are still rising at a rate retailers in the developed world would kill for.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 23 ]

An Almighty Party China’s Political and leadership Power Structure

Source: ISI Group.

China is in the midst of a once-a-decade leadership change.

The change starts at the top, where seven of nine members of

the all-powerful Standing Committee of the Politburo are slated

to change in October or November this year. The newcomers will

likely include political scientists and economists, making it a more

diverse crowd than the engineering-dominated current group.

A system of patronage causes the changes to trickle down,

not just to ministries, provinces, mega cities and the armed forces,

but to the humblest townships and courts. In a country where

policy and government influence every walk of life, the

leadership handover is the topic du jour. This explains why

municipal politics such as the events in Chongqing discussed

earlier can take on national and international significance.

The leadership change is a complex game of musical chairs

that is likely to last well into 2013. The clear aim is to have the

process take place with caution and consensus building rather

than prolonged and public tree shaking. That said the markets

will watch closely to see if this morphs into policy delays and

subsequent changes in investment risk.

Politics: Change Is Hard

Communist Party of China

Politiburo

Armed Forces Courts & ProsecutorsMinistries &

AgenciesProvinces & Townships

National People’s Congress

State CouncilMilitary Affairs

Commission

Discipline Committee Party Elders

Influence Control

The leadership change is a complex game of musical chairs that is likely to last well into 2013.

[ 24 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

vested interests and Paralysis

If all politics are local, it makes sense central government initiatives

take time to gain traction and in some cases never do. Local

officials will take their concerns to Beijing, adding to a cacophony

of voices proclaiming what needs to be done. The result can be

political paralysis—especially if the leadership’s penchant is to

seek consensus rather than to rock the boat.

Some measures are opposed by the same groups across the

nation. The drive to rebalance the economy, for example, is

opposed by “vested interests,” industries and people who have

the most to lose. The investment model is supported by exporters,

heavy manufacturing, banks and many local government

chieftains. The powerful People’s Liberation Army has commercial

interests, too. All this makes change a poor second choice, and

is one reason reform happens slowly.

Beijing always overdelivers on five-year plan goals that relate to

investments. And why not? Investment is easy to command and

there are no budget constraints. It is a different story when it

comes to objectives that cannot be achieved by investing alone:

things like tackling corruption, increasing consumption and

improving the environment. This is where Beijing barely passes

or is at risk of getting a failing grade.

300 Million Publishers

Internal conflicts are unlikely to spin out of control. Beijing has

kept a tight lid on religious, ethnic and secessionist sentiments.

And protests typically only turn into social unrest when a

country’s income hits the world’s median level—which

will take at least another decade for China.

At the same time, corruption, illegal land appropriations and

growing inequality are flash points for popular anger. The surplus of

young males resulting from the one-child policy can aggravate

these simmering tensions, especially if unemployment were

to mount. The latter would be a breach of the country’s social

contract: employment and rising wages in return for obedience.

The recent stand-off at the fishing village of Wukan illustrates

the point—and is the tip of the iceberg. It is difficult to see an

Arab Spring-type scenario for China, though, especially if

Beijing plays it smartly and tackles corruption.

The web allows activists unprecedented means to broadcast their

messages. SINA’s Weibo (or microblog), a cross between Facebook

and Twitter, has 300 million members. This means China has

300 million publishers. The government works very hard to control

the web, but is likely fighting a losing battle in the long run.

The party, which claims some 80 million members, controls

every level of society, including the People’s Liberation Army

and the State Council, which oversees ministries and provinces.

It was split by internal strife in the 1970s with the Cultural

Revolution as a disastrous result. These days, it appears it

is built for stability. At least, most investors like to believe so.

the emperor is Far away

Is the political leadership all-knowing? Far from it. For one,

the country is too big and too diverse. There is an old saying in

China that roughly translates as: “The mountains are high and

the emperor is far away.”

The country has a long history of provincialism, and the central

government has always looked to tighten its grip on the regions.

Nobody ever really knows the whole picture in China. This is

why the national statistics bureau uses satellite pictures: It

is to understand land use and double-check data from local

governments. Another example: Some people believe GDP is

underestimated by 30% due to a huge black market, whereas

others contend it is overestimated by 30% because investments

have generated a pile of non-performing loans.

There is actually an upside to this opaqueness: Policymakers

have more time to adjust to whatever picture emerges. This is

partly why China’s political system has had resiliency.

Keep in mind regional differences: Every province, city and

township is competing for resources in the top-down economy—or

trying to stave off changes that may upset its business model.

The government in Guangdong, for example, is deeply uninterested

in incentives to develop the inland provinces if it comes at the

expense of Guangdong.

And every cadre owes his or her position to the ability to pursue

a growth agenda. China may not be a formal democracy, but the

Communist Party has a clear social contract with the population to

deliver growth—and a deep institutional memory of what happens

when this is broken, as in the Tiananmen Square protests of 1989.

Do not underestimate local officials. They often are smart and

well-informed—and in a position to move the needle. The vice

mayor is a must-see stop for investors visiting one of China’s

200 lesser-known cities with more than one million inhabitants.

Nobody ever really knows the whole picture in China.

China may not be a formal democracy, but the Communist Party has a clear social contract with the population to deliver growth.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 25 ]

From Small Piles of rocks to oil Shock

The risks of external conflicts appear small at this time, we

believe. The re-election of President Ma Ying-jeou in Taiwan

in early 2012 lessened the risk of a Cross-Straits flare-up and

will likely strengthen ties between the “renegade province”

and the mainland.

Ma’s re-election also adds fuel to China’s project to develop

a Greater China economic zone, taking in not just Taiwan and

South Korea, but an entire “String of Pearls” of ports across the

Indian Ocean. This would link China to growing interests in Africa

that are a crucial part of the incoming tide of natural resources.

Stand-offs between China and Japan, Vietnam and South Korea

over small islands in the East China Sea are likely to remain

just that: flare-ups over small piles of rock that mostly involve

fishing boat captains.

In the immediate term, two risks loom large: First and most

important is a potential oil price shock. Sustained high oil

prices would kill global growth and simultaneously drive up

China’s production costs and energy subsidies. A trigger could

be an Israeli attack on Iran’s nuclear installations. Or it could be

something we have not yet thought about.

tit for tat in trade Wars

The second risk is trade wars brought about by new protectionist

and populist politics in the run-up to elections in key countries.

French President Nicolas Sarkozy, for one, has dusted off

a “Buy European” slogan (which really means: Buy French)

as the election campaign heats up.

China’s exports have been slowing in the wake of the European

debt crisis. The country’s biggest trading partners are the

European Union, United States, Japan and Hong Kong, with

the latter mostly a half-way station for goods on their way

to US and European markets. See the table on the next page.

Expect trade brawls to flare up more often, and China to stand

alone more often. The rare earths dispute is a good example. It

pitted China against the United States, European Union and Japan

all at once. This tells us three things: 1) China’s trade adversaries

are finding the political will to act together. 2) China cannot

have a trade war with all three simultaneously, so it must start

to provide concessions while trying to save face (not easy).

3) The World Trade Organization and other global bodies meant

to resolve trade disputes remain a sideshow: Governments

engage in hand-to-hand combat while regulators look on.

Tit-for-tat strategies will cause casualties. Case in point: China

recently struck back at Europe by suspending a large Airbus

order (supposedly because of emissions standards). In such

an environment, the risk of policy miscalculations driven by

domestic needs is high. And some companies will end up as

collateral damage.

The rest of Asia is viewing China’s military built-up warily, however.

China’s military budget is expected to double to $238 billion a year

by 2015, according to HIS Jane’s Defense weekly. This is still

less than half the (shrinking) US defense budget, but China’s

increasing military prowess is causing anxiety among its neighbors.

In addition, US President Barack Obama recently turned his focus

to the Pacific, potentially setting the superpowers up for conflict.

The longer-term risks are “competing adversarial power blocks”

in the region, warns one of the architects of the opening of China,

Henry Kissinger, in a 2012 article in Foreign Affairs. This need

not be—if both countries set aside rivalries and make genuine

efforts at cooperation, Kissinger believes.

Another long-term risk is conflict with India over water. Both

countries derive much of their fresh water from the Himalayas.

Expect trade brawls to flare up more often, and China to stand alone more often.

[ 26 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

A Global Trade WebChina’s trade Partners in 2010

Sources: ISI Group; CEIC; General Administration of Customs. Notes: Figures in millions of US dollars. Percentages are the share of China’s total.

China's trade With the eurozone

rank exports to imports From total trade Balance With

1 Germany $68,088 4.3% Germany $74,391 5.3% Germany $142,480 4.8% Netherlands $43,239 23.4%

2 Netherlands $49,717 3.1% France $17,107 1.2% Netherlands $56,196 1.9% Italy $17,137 9.3%

3 Italy $31,143 2.0% Italy $14,006 1.0% Italy $45,149 1.5% Spain $11,950 6.5%

4 France $27,659 1.8% Belgium $7,828 0.6% France $44,766 1.5% France $10,552 5.7%

5 Spain $18,177 1.2% Netherlands $6,479 0.5% Spain $24,403 0.8% Belgium $6,478 3.5%

6 Belgium $14,306 0.9% Spain $6,227 0.4% Belgium $22,134 0.7% Greece $3,569 1.9%

7 Finland $5,507 0.3% Austria $4,237 0.3% Finland $9,541 0.3% Portugal $1,760 1.0%

8 Greece $3,959 0.3% Finland $4,034 0.3% Austria $6,091 0.2% Finland $1,473 0.8%

9 Portugal $2,514 0.2% Ireland $3,409 0.2% Ireland $5,402 0.2% Cyprus $1,331 0.7%

10 Ireland $1,993 0.1% Slovakia $1,790 0.1% Greece $4,350 0.1% Malta $1,274 0.7%

11 Slovakia $1,959 0.1% Portugal $754 0.1% Slovakia $3,749 0.1% Slovenia $1,209 0.7%

12 Austria $1,854 0.1% Malta $569 0.0% Portugal $3,268 0.1% Luxembourg $730 0.4%

13 Malta $1,843 0.1% Greece $390 0.0% Malta $2,413 0.1% Estonia $500 0.3%

14 Slovenia $1,385 0.1% Luxembourg $258 0.0% Slovenia $1,562 0.1% Slovakia $168 0.1%

15 Cyprus $1,348 0.1% Slovenia $177 0.0% Cyprus $1,366 0.0% Ireland ($1,417) -0.8%

16 Luxembourg $988 0.1% Estonia $177 0.0% Luxembourg $1,246 0.0% Austria ($2,383) -1.3%

17 Estonia $677 0.0% Cyprus $17 0.0% Estonia $854 0.0% Germany ($6,303) -3.4%

Eurozone $233,118 14.8% Eurozone $141,851 10.2% Eurozone $374,969 12.6% Eurozone $91,267 49.5%

EU $311,342 19.7% EU $168,484 12.1% EU $479,826 16.1% EU $142,858 77.4%

China's trade outside the eurozone

rank exports to imports From total trade Balance With

1 US $283,375 18.0% Japan $176,785 12.7% US $385,435 13.0% HKG $206,109 111.7%

2 HKG $218,380 13.8% Korea $138,423 9.9% Japan $297,941 10.0% US $181,314 98.3%

3 Japan $121,156 7.7% Taiwan $115,649 8.3% HKG $230,650 7.8% UK $27,481 14.9%

4 Korea $68,818 4.4% US $102,060 7.3% Korea $207,241 7.0% India $20,053 10.9%

5 India $40,920 2.6 % Australia $60,340 4.3% Taiwan $145,341 4.9% UAE $16,863 9.1%

6 UK $38,790 2.5% Malaysia $50,396 3.6% Australia $87,575 2.9% Malaysia ($26,577) (14.4%)

7 SGP $32,374 2.1% Brazil $38,038 2.7% Malaysia $74,216 2.5% Australia ($33,106) (17.9%)

8 Taiwan $29,693 1.9% Thailand $33,201 2.4% Brazil $62,504 2.1% Japan ($55,629) (30.1%)

9 Russia $29,615 1.9% Saudi Arabia $32,862 2.4% India $61,787 2.1% Korea ($69,605) (37.7%)

10 Australia $27,234 1.7% Russia $25,814 1.9% SGP $57,053 1.9% Taiwan ($85,956) (46.6%)

Total $890,355 56.4% Total $773,569 55.5% Total $1,609,744 54.2%

China $1,578,447 100.0% China $1,393,909 100.0% China $2,972,356 100.0% China $184,538

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 27 ]

A visitor to the port city of Ningbo soon after Chinese New

Year was struck by how little traffic this large port city had.

Employers were anxious to see if migrant workers would return

from visiting their families in the interior. The city’s mayor had

called an emergency meeting with local business leaders

because exports had plunged in January. This illustrated the

plight of China’s coastal region.

Wage growth is currently outpacing productivity. This is good

for consumption, but hurts China’s competitiveness in labor-

intensive industries. Many of the latter, including garment

makers, have already moved to cheaper countries such as

Vietnam and Cambodia.

This is a good thing for China. The country wants to move up

the value chain, and this is one way to achieve it. It is starting

to work, evidenced by the share of processed exports slowly

diminishing. These are exports of basic products using mostly

(imported) raw materials or simple assemblage where China

adds little value. See the chart below.

of robots and old People

The easy productivity gains have been harvested, but there is

room for more. The work of Tsinghua University professor Gavriel

Salvendy, for example, shows it is easy to rack up double-digit

productivity increases by introducing basic management

techniques to minimize waste and stop staff churn.

New highways and rail tracks have opened up the country’s

interior. Companies have moved inland to take advantage of lower

wage and real estate costs. Apple supplier Foxconn, which employs

more than one million in China, has already made a big push

into Chengdu from its “Foxconn City” base in Shenzhen. It is

going one step further: Chairman Terry Gou plans to put to work

one million robots in the next three years, up from 10,000 in 2011.

Vietnam, Indonesia and Bangladesh are just not in the same

league. These are smaller economies without the enterprise,

scale and infrastructure of China. With productivity growth

running at a much higher clip than that of the developed world,

China is not about to lose world trade share.

Also remember there is no average in China: Income levels and

minimum wages vary greatly by city and province. See the table

on the next page. This means relocating to the interior can lead

to easy productivity gains.

Productivity will need to keep growing to make up for the effects of

a graying population: The number of people older than 65 will

surpass the group of people younger than 19 by 2030. Bottom

line: China’s demographic dividend—a huge working population

supporting a relatively small number of dependents—is

disappearing fast. See the charts on the next page.

The real estate boom has arguably thwarted innovation because

the government, businesses and consumers alike focused

on making quick profits. On the other hand, China surpassed

Japan and the United States in patent filings in 2011, according

to Thomson Reuters research.

In all, chances are China will overcome competitive pressures. It

may even emerge stronger. Competitiveness is very much part of

the China story—and likely more sustained than doubters opine.

Competitiveness: Beyond Cheap Labor

70%

35

65

60

40

50

45

55

30

’00 ’06 ’07 ’08 ’09 ’10’01 ’02 ’03 ’04 ’05 ’11

Value-Added Exports Processed Exports

EXPO

RTS

(%)

Up the Value Chainvalue-added exports vs. Processed exports, 2000-2011

Source: Deutsche Bank.

Vietnam, Indonesia and Bangladesh are just not in the same league.

[ 28 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

There Is No Average in ChinaMinimum Wages by Province in rMB per Month

Sources: ISI Group, Ministry of Human Resources and Social Security, and National Bureau of Statistics. Notes: All wages in urban areas. Annual disposable income is per capita. Urban populations are in millions as of 2009. * Excluding Shenzhen.

100%

60

0

80

40

20

1950 1970 1990 2010 2030 2050 1950 1970 1990 2010 2030 2050

YOU

NG

AN

D O

LD T

OW

OR

KIN

G P

OPU

LATI

ON

(%) 100%

60

0

80

40

20YOU

NG

AN

D O

LD T

OW

OR

KIN

G P

OPU

LATI

ON

(%)

65 Years or Older0-19 Years Old 65 Years or Older0-19 Years Old

JAPAN CHINA

Going the Way of Japan Young (0-19) and old (over 65) to Working age Population, 1950-2050

Sources: ISI Group and United Nations.

Province

Monthly Minimum Wages urban

Population

% of total

annual disposable

income

ratio of national average2005 2006 2007 2008 2009 2010 2011 2012

Shanghai 690 750 840 960 960 1,120 1,280 1,450 17 2.7 31,838 1.67Beijing 580 640 730 800 800 960 1,160 1,260 15 2.4 29,073 1.52Zhejiang 490 645 750 960 960 1,100 1,310 30 4.8 27,359 1.43Tianjin 570 660 670 820 820 920 1,160 10 1.5 24,293 1.27Guangdong* 352 604 780 860 860 1,030 1,300 61 9.8 23,898 1.25

Shenzhen 635 755 755 950 950 1,100 1,320 1,500Jiangsu 400 630 750 850 850 960 1,140 43 6.9 22,944 1.20Fujian 320 542 650 750 750 900 1,100 19 3.0 21,781 1.14Shandong 350 490 610 760 760 920 1,100 46 7.4 19,946 1.04Liaoning 350 497 590 700 700 900 1,100 26 4.2 17,713 0.93Inner Mongolia 380 485 560 680 680 900 1,050 13 2.1 17,698 0.93Chongqing 330 500 580 680 680 680 870 15 2.4 17,532 0.92Guangxi 320 417 500 670 670 820 820 19 3.1 17,064 0.89Hunan 350 475 600 665 665 850 1,020 28 4.4 16,566 0.87Hebei 420 510 580 750 750 900 1,100 30 4.9 16,263 0.85Yunnan 350 480 540 680 680 830 830 16 2.5 16,065 0.84Hubei 280 364 460 700 700 900 1,100 26 4.2 16,058 0.84Henan 320 400 480 650 650 800 1,080 36 5.8 15,930 0.83Anhui 290 443 520 560 560 720 1,010 26 4.1 15,788 0.83Shaanxi 400 480 540 600 600 760 860 16 2.6 15,695 0.82Shanxi 400 490 550 720 720 850 980 16 2.5 15,648 0.82Hainan 350 497 580 630 630 830 830 4 0.7 15,581 0.82Jiangxi 270 315 360 580 580 720 720 870 19 3.1 15,481 0.81Sichuan 280 485 580 650 650 850 850 1,050 32 5.1 15,461 0.81Jilin 300 460 510 650 650 820 1,000 15 2.3 15,411 0.81Ningxia 320 417 450 560 560 710 900 3 0.5 15,344 0.80Tibet 445 470 495 730 730 950 950 1 0.1 14,980 0.78Guizhou 320 500 550 650 650 830 930 11 1.8 14,143 0.74Heilongjiang 235 476 620 680 680 880 880 21 3.4 13,857 0.73Qinghai 330 450 460 580 580 750 750 2 0.4 13,855 0.73Xinjiang 300 536 670 800 800 960 1,160 9 1.4 13,644 0.71Gansu 300 378 430 620 620 760 760 9 1.4 13,189 0.69National Average 376 507 586 715 715 874 1,013YoY Growth 39% 16% 24% 0% 23% 16%

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 29 ]

Specialized machinery makers should do well as China moves

up the value chain. The country is starting to become very

competitive in capital goods with big improvements in quality.

Giants such as GE, Siemens and Caterpillar are worried about

China stealing their secret sauce, but should be okay for now as

they are capturing share in a booming market.

At the same time, disasters such as the high-speed rail crash

and mining accidents have dented China’s ambitions in some

areas. And hazardous industries with heavy capital equipment

needs and high potential for disasters (the oil and gas industry,

for example) are becoming less likely to take risks on China’s

quality control.

China Inc. can quickly wipe out whole sectors by mass producing

high-quality goods. Case in point is the solar industry. European,

US and Indian companies cried foul over unfair subsidies for

Chinese makers, but the coup still happened. This doesn’t

mean emerging Chinese players in these industries are good

investments. Just check the implosion of stock prices of (loss-

making) Chinese solar makers.

Markets: Counting on China

equities and Corporate Bonds: a growing addiction

Makers of luxury goods around the world have become dependent

on China’s ravenous appetite for their goodies. See the table

below. Don’t expect this to change in the near term. In the long

run, we believe, it is crucial for China to take steps to encourage

consumption to keep up the torrid growth rates.

The luxury goods boom goes beyond exports to Greater

China. A jump in Chinese travel and the hiring of Mandarin-

and Cantonese-speaking staff is keeping department stores

busy from Tokyo to New York.

Basic materials companies are likely to suffer as China hits the

ceiling for cement and steel consumption. The country is still

far from reaching peak demand in other commodities, including

oil and copper as well as agricultural products such as corn and

potash used in fertilizer. This has a big impact on UK, Australian

and Canadian equities because of the heavy weighting of mining

companies in those markets. Shale and other new sources of

energy have become a focus given China’s supply vulnerability.

Investors and other stakeholders have taken note. For

example, the Reserve Bank of Australia studies China given its

importance to the large farm-cum-mine surrounded by beach

known as Australia. The European Central Bank studies China

because it needs growth. We all are China watchers.

Mainland China greater China

Burberry 5% 8-10%Coach 3% 6%Hermès 15% 23%LVMH 7-8% 12%Luxottica 3% 5%Prada Group 15% 21%Richemont 33% 40%Safilo 1% 3%Salvatore Ferragamo 17% 27%Swatch 15% 22%Tiffany 10% 18%Tod’s 5% 12%Yoox 2% 2%

My Best Customer Is ChinaPercentage of China Sales of Selected luxury Companies in 2011

Source: Deutsche Bank. Note: Estimated fiscal 2012 sales for Coach, Burberry and Tiffany.

Medical device and agricultural equipment makers are likely

beneficiaries from a population that is getting richer and living

longer—but not necessarily healthier. Spending on these

sectors, as well as on water conservation, should grow at twice

the rate or more of China’s overall budget spending, we believe.

China’s cement makers, aluminum smelters and building

materials companies saw business implode only in the fourth

quarter. Full-year 2011 results mask this implosion, and more

pain is likely to come in 2012. Even successful women’s shoemaker

Belle International reported a slowdown in same-store sales

to the high single digits. The only companies that report sales

growth in the 20% range are mass consumer plays such as

Yum!, the owner of the KFC fast food restaurants. China’s

banks remain cheap for (good) reasons described earlier.

China’s companies will likely see profits hit this year, we believe.

SOEs already reported an 11% drop in profit in the first two

months of the year. That said, Chinese equities look cheap by

historical valuations. It is reasonable to expect gains of 25%

or more this year after a horrible 2011.

China Inc. can quickly wipe out whole sectors by mass producing high-quality goods.

[ 30 ] B r a k i n g C h i n a … W i t h o u t B r e a k i n g t h e W o r l d

CementPigs

Iron OreSteelLead

CopperZinc

AluminumNickel

Platinum

China’s PopulationCorn

Palladium

CoalSoybeans

Autos

WheatChina’s GDP in PPP

OilSugar

Uranium

60

COM

MO

DIT

IES

CON

SUM

PTIO

N (%

)

50403020100%

Hunger for CommoditiesChina’s Share of global Commodities Consumption in 2010

Source: Deutsche Bank.

Commodities: an outsized influence

China has an outsized influence on commodities markets.

The country has one fifth of the world’s population and

accounts for 11% of world GDP. Yet it accounts for about half

the world’s cement and iron ore consumption. See the chart above.

We expect the iron ore boom to fizzle out as China nears peak

consumption in steel and cement. The country’s demand for

copper, which has many uses beyond construction, should

hold up better, we believe.

Energy demand should also hold steady, we believe. Oil demand

typically runs at 0.6 times GDP growth. So even with the economy

slowing down to 7% a year, oil demand increases by 4% a year.

China’s import dependence is rising at an annual clip of 500,000

barrels a day (b/d), from an import bill of 5 million b/d in 2009,

according to research firm ISI Group.

China is already the world’s biggest energy consumer, with a

20% share in 2010, up from a tenth in 2000, according to BP. It

still relies on coal for the brunt of its energy supply. See the chart

above right. Expect a shift to natural gas and nuclear energy

(Japan’s Fukushima accident in 2011 only temporarily halted

construction). This bodes well for uranium prices in the long run.

The story is different for alternative energy. Chinese manufacturers

have brought down prices for wind and solar energy to levels

80%

20

60

40

0

Nuclear Hydro Nat. Gas Oil Coal

China World ex-China

ENER

GY

USA

GE

(%)

1%7% 7% 7% 4%

30%

18%

37%

70%

20%

Addicted to Coal—For NowChina’s energy Supply Sources Compared With the World’s

Sources: ISI Group and BP World Energy Outlook. Note: Data as of 2010.

where these energy sources can start to compete with oil, gas

and coal. A shift to a consumption-driven economy could imperil

this. Similarly, a credit contraction or financial bust would likely

result in the drying up of Chinese project financing that has

supported the global market.

The country’s commodities appetite goes beyond the obvious.

China has become the second-largest importer of gold, after

India. It now makes up around one fifth of world gold demand

for jewelry, according to ISI Group. Gold is seen as a hedge

against inflation. Policy also may drive demand for precious

metals such as platinum and palladium, which are used in car

catalytic converters.

government Bonds: a Big overhang

China is the single largest holder of publicly traded US Treasuries,

excluding the US Federal Reserve. It has a $1.3 trillion share, or

one-sixth of the total. It has slowed buying but is still a major

player (the Fed trumps it). The reasons: China wants to keep

its own currency in check, doesn’t have many alternatives for

parking the flood of export-generated dollars and would hate to

see the value of its existing holdings implode. See the chart on

the next page on the left

China, which has additional US assets in its foreign reserve kit,

has been diversifying into the euro, yen and other currencies as

well as gold. It is transferring funds to sovereign wealth fund

China Investment Corp, which in turn is spreading its bets across

the globe and across asset classes. Talk of investment in Europe

to mitigate the debt crisis is likely real.

Expect the iron ore boom to fizzle out as China nears peak consumption in steel and cement.

B l a C k r o C k i n v e S t M e n t i n S t i t u t e [ 31 ]

$3,500

1,500

2,000

2,500

3,000

1,000

500

0

50%

40

30

20

10

0

2001 2003 2005 20092007 2011

US Treasuries to FX Reserves (%)China’s Total FX ReservesChina’s US Treasury Holdings

CHIN

A’S

FX R

ESER

VES

IN B

ILLI

ON

S ($

)

SHA

RE O

F RESER

VES (%)

A Case of Too Many Greenbacks China’s uS treasury holdings and FX reserves, 2001-2011

Sources: US Department of Treasury and BlackRock. Note: Data as of June 30 of each year. 2011 data based on preliminary survey data.

80%

60

20

40

0

$400

300

200

100

0

2002 2004 2006 2008 2011

China Buying ($ Billions) China Buying of Publicly Available Net Issuance (%)

China Buying of Net Issuance (%)

SHA

RE

OF

TREA

SUR

Y B

UYI

NG

(%)

PUR

CHA

SES IN B

ILLION

S ($)

A US Bond Market ForceChina’s Buying of newly issued uS treasuries, 2002-2011

Sources: US Department of Treasury and BlackRock. Notes: Data as of June 30 of each year. Publicly available Treasuries are those not purchased by the US Federal Reserve. 2011 data based on preliminary survey data.

China’s buying of US Treasuries illustrates the power the country

holds over the US bond market. The US Federal Reserve crowded

out all other buyers in the year ended June 20, 2011, so China’s

share was just 18%. Excluding Fed purchases, however, China

had a 73% share. See the chart below on the right.

A shift to a consumption economy would mean less Chinese

buying of US Treasuries—as opposed to absolute reductions.

Assuming the US government is not closing the budget gap any

time soon, conventional wisdom says fewer Chinese purchases

would drive up yields and pummel bond prices. Fewer buyers

equals lower prices.

Conventional wisdom is always dangerous, so here is an opposite

view: Rates actually could go down in a sort of flight-to-safety

bond rally. Why? If foreign buying dries up, simple math says

private savings will have to pick up the slack (assuming the US

government doesn’t cut the deficit markedly).

To do this, investors would have to sell risk assets. This would

hammer equities, high-yield bonds, commodities and emerging

market assets, in turn triggering a dash for safety.

As China opens to the world, more of its debt may become available

for international trading. This may coincide with a bailout of its

financial system and a jump in its debt-to-GDP ratio.

This appears a likely scenario—and does not bode well for China’s

ranking in the BlackRock Sovereign Risk Index. The country

advanced three spots in the fourth quarter to rank 15th—ahead

of the UK and France.

Commodity currencies such as the Australian and Canadian dollars

could take a hit as China reaches peak consumption in key

industries such as steel. The currencies are a good signpost for

whether China’s economy is perking up in the short term and

shifting toward consumption in the long run.

Exporters and countries closely linked to the booming resources

trade, such as Australia and Chile, could suffer. The Aussie

dollar and bond market are just as much China plays as LVMH

and Daimler. More insulated economies such as Brazil could

power along, driven by domestic consumption.

Asian investors appear more upbeat than those in the developed

world. For US and European investors, things are about as bleak

as they have been in decades. Asians, on the other hand, have

overcome three economic crises in recent memory: the 1998-

1999 Asia crisis, the 2003 SARS crisis and the 2008-2009 world

financial crisis. Plus, the sheer scale of consumption and

wealth is breathtaking when you are on the spot.

A shift to a consumption economy would mean less Chinese buying of US Treasuries—as opposed to absolute reductions.

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