more opportunity than its banking sectors
By Jerry Zhang, Ph.D., CFA—Portfolio Manager
Emerging Markets Equity Fund
Given the relative strength of China's export-oriented economy, investors have generally not given the same attention to potential credit problems among Chinese banks as to those among European and U.S. banks. However, we have long believed that China's banks have low-quality balance sheets and face some of the same problems with questionable real estate loans as its developed market counterparts. By contrast, we see far more opportunity in China’s nascent-but-developing consumer market.
We believe that Chinese banks have substantially overinvested in the real estate market, whether through property or land development loans. According to Citigroup Inc., investment in residential property accounted for 6.1% of China’s gross domestic product (GDP) in 2010—approximately the same level that U.S. real estate investment reached in 2005—prior to the subprime crisis. As in the U.S., real estate overinvestment has migrated throughout the economy, leading to increased demand for building-related industries such as steel and cement. We estimate that property construction-related activities account for 40% of China's GDP and that all investment-related activities, including capital expenditures, account for as much as 60% of China’s GDP.
The negative effects of real estate overinvestment have been compounded by the government's attempts to use bank lending to stimulate the economy. Banks partially or wholly owned by the national or local governments account for the majority of China's banking system. Even banks with no government ownership are under government control, because government officials set maximum deposit and lending rates. In late 2008, the government announced a stimulus plan that relied heavily upon increased lending, most of which went into fixed assets such as bridges, parks, toll roads, and other labor-intensive projects. Unfortunately, many of these projects have greater political—rather than financial—appeal and don't produce the necessary cash flow to pay back the loans.
We believe that China's developing consumer market holds far more promise than its banking sector. Currently, Chinese consumers are more willing to save than spend. A 2010 report by the Economist Intelligence Unit showed that in large cities such as Shanghai and Beijing, 67% of survey respondents reported saving 25% or more of their household income and 33% said they saved 35% or more. Reported saving rates were even higher in smaller cities. However, retail spending has risen, especially in luxurydriven markets such as Hong Kong, and the government has introduced national holidays as a means of encouraging internal tourism. Moreover, the government’s most recent five-year plan targeted increased domestic consumption as one of its goals, so we expect the trend toward greater consumption to continue.
As a result of the real estate bubble and large amounts of politically oriented lending, we believe that many Chinese banks have low-quality credit fundamentals. We further believe that better opportunities exist in companies tied to China's developing consumer market. Companies that would benefit from increased spending include consumer discretionary and consumer staples firms, as well as any company positioned to take advantage of growing wealth in rural areas. In our view, investors can find the best opportunities to add value in China within its consumer sectors and by underweighting their exposure to the country’s banking sector.