"Notice that the stiffest tree is most easily cracked, while the bamboo or willow survives by bending with the wind." - Bruce Lee Recently I traveled to China with a group of institutional investors and visited Beijing, Shanghai, Shenzhen and Hong Kong. Along the way we met with almost 20 Chinese companies, as well as government officials, entrepreneurs, venture capitalists, foreign business leaders in China, and the manager of our PNC office in Shanghai. This month's outlook reflects some of the major points gleaned from the meetings and our view of the implications for investors. China is now the second-largest economy in the world at approximately 8% of global GDP. This trails only the United States, which accounts for about 25% of global GDP. China's GDP has grown at a low double-digit year-over-year rate in the first two quarters of 2010 and is certainly viewed as a key driver of the global economic recovery. For these reasons any concerns about the durability of the Chinese growth story typically result in ripples of fear through the financial markets. While China has been an amazing growth story, it is worth considering and examining some of the possible risks in its system. A few risks that seem to be evident are:
residential real estate;
local government borrowing and the Chinese banking system; and
policy tail risk.
Our view is that despite some risks there remains a strong tailwind from the Chinese industrial revolution, so current conditions support continued economic growth. We believe Chinese economic growth will likely slow as the year progresses but still remain in the high single-digit range. In other words, we expect the Chinese economy to continue to support the global economic recovery. There remain risks -- policy error tail risks to combine them under one heading -- which we will continue to monitor. Alluding to our Bruce Lee quote, it remains to be seen over the long-term if the Chinese economy will become too rigid and crack under the accumulated weight of any errors or grow by bending and adapting to the challenges. In addition to the previous macroeconomic thoughts, our research in China led us to two very specific implications for those interested in investment within China.
Many Chinese companies' earnings could be overstated due to government support.
Rapid Chinese GDP growth is no guarantee of rapid stock price appreciation.
There is little doubt that government support makes profits subject to arbitrary alteration of government policy and removing these subsidies would reduce profits. In addition many of these subsidies are opaque and make it difficult to estimate the true (excluding government subsidy) earnings of the companies.