Asia Insight

September 2008

Changing Aspirations

Robert J. Horrocks, PhD
Director of Research
Matthews International Capital Management, LLC

The U.S. and China dominate current economic discussions. Taken to represent “The West” and “Asia,” they form the twin pillars of the global economy and yet they have different personalities: one a free-spirited, entrepreneurial, risk-taking experimentalist; the other, a more cautious, methodical and clinical character. The latter, China, will not abandon her more methodical approach, but sometimes looks at her twin with admiration for its success; sometimes with distaste at her twin’s incautious approach and overbearing attitude. Today, China, still crawling out of the U.S.’s shadow, finds herself caught up in the deflationary aftermath of the U.S. banks’ incautious lending.

China’s long march toward a strong, self-assured economy began in the early 1980s: reforming agricultural landholdings, freeing prices, welcoming foreign trade and liberating itself from the wrongheaded desire to pursue self-sufficiency. Much of this has been achieved by emulating her twin; globalization has brought the two into a much closer and more dependent relationship than in the past. The U.S. consumer has liberally consumed a steady flow of cheap Chinese goods; China has looked to the U.S. as a dynamic economy in which to invest her savings. Until now, the U.S. has consumed with abandon; China has invested with caution. Nevertheless, as China becomes more confident and self-assured it will adopt a more risk-taking attitude, consuming more at home and investing more entrepreneurially both at home and abroad. As China does so, it will raise the rest of Asia along with it.

It is untrue that any sort of linkage between the two economies must mean that Asia is doomed to the same fate as the U.S., unless the two can “decouple.” It is more instructive to examine how the relationship between the two countries might evolve over time. Countries do not have a fixed character—rather, as their institutions evolve and populations change, so do the habits of their citizens and corporations. This evolution is in part directed by their governments and in part set in motion by the changing aspirations of their populations.

The U.S. has clearly been guilty of hubris in the past decade. The productivity revolution of the computer was overhyped and far more kind to the skilled worker than the average U.S. worker. Expectations of all citizens have adjusted slowly, leaving many over-indebted, overfed and living in a fast-depreciating house. The U.S. faces a future of slower rates of productivity growth and years of paying down debt. China, and much of the rest of Asia, has clearly been guilty of the opposite crime. Scarred by a politically unstable history and a financial crisis—and, in some cases, hampered by the insecurities of moving from a planned to a market economy—Asia has been oversaving and underconsuming. Until recently, personal credit was unknown in China and rare in much of Asia. Debt, if taken on at all, was done informally through groups of friends, colleagues or neighbors. Asian governments are tackling this problem with policies to boost wages, strengthen the domestic banking systems and develop the institutions to support a mass consumption society. Asia has the ability to spend and enjoy some of the finer things in life. The U.S. has the ability to provide Asia with goods and services. Neither economy will be helped by decoupling. Who knows? In 20 years time, we may be talking about a U.S. with a current account surplus of 10%, financing the home ownership aspirations of a new generation of professional Chinese.

This is exactly how the world should work. There should be little controversy over the idea of capital flowing to where its return is highest. The only obstacle to our acceptance of this far future is the familiar fact of how things have been in the recent past. And yet, however slow the pace of change has been in Asia, it has been happening, slowly but deliberately, right before our eyes.

The world travel industry has its eyes already focused on the 200 million Chinese that it currently estimates are financially able to travel overseas and the 40 million who already do. Mainland passports were ubiquitous at San Francisco’s airport recently, and a premium brands outlet shopping mall I visited well north of the city gave its welcome announcement to shoppers first in English, then in Mandarin. Shopping tourism, it would seem, is already starting. How long before the producers in China, currently building up inventory that they can’t sell in the U.S.’s weak market, simply turn their efforts to supply the domestic Chinese market?

Taking the long-term view, we would expect the consumer sector in Asia to grow faster than GDP. In addition, banks will have an important role to play in supplying consumer credit—one that will revolutionize and radically improve their businesses. The U.S.’s role as a supplier of risk capital is not going to change immediately, but the Chinese government is tiring of buying U.S. treasuries and is building a more entrepreneurial financial system to supply credit to domestic households and businesses. Chinese banks are also starting to expand overseas. These reforms will increase the efficiency of capital allocation and structurally lower capital costs. Health care will be a key focus of Asian governments as they seek to encourage consumption by building welfare states to relieve the precautionary saving that comes from the lack of health care coverage.

Worries about Earnings Growth and Inflation

In the face of such transformation, it seems churlish to focus on short-term earnings, which have little predictive power for the markets over the short term. However, investors are concerned. Growth is slowing: India’s 2008 growth is likely to fall below 8%; South Korea to 4.5%; and even China has recorded growth of only 10% in the second quarter. Current corporate earnings are running at 3% growth; future forecasts at 10 to 12% growth. This is almost certainly too high—margins squeezed by raw material costs, rising wages and capital depreciation should bring earnings growth down to the 0 to 5% range. Yet, this offers no hint that the markets will move strongly in one direction or another.

Worrying about inflation in the current economic climate also seems unproductive. Doubly so in the case of Asia, where valuations are often higher during inflationary periods. Indeed, the economic climate is deflationary in the U.S. The classic forecast for an over-indebted economy such as the U.S. is: distress selling and shrinking deposits as businesses and households pay off bank loans; slowing velocity of circulation; deflation; and a fall in businesses’ net worth and profits. Bankruptcies and unemployment further compound the problem and raise the real rate of interest. However, for this to badly impact Asia, we require not only a passive Federal Reserve, but suicidal Asian Central Banks, too. The Federal Reserve, however, has been willing to “take actions extended to the very edge of its lawful and implied power.” Even if the slowing U.S. economy sucks away global liquidity, it does not mean it will dry up completely because Chinese authorities have the wherewithal to step in and pursue their own looser monetary policy. An inflationary Asia, relative to the U.S., is precisely the rationale for Asian outperformance.

Valuations

Recent falls in the market have come mostly from a contraction in valuations, suggesting that they are already factoring in a far more negative view than analysts have.

In my view, the “decoupling” term has done a disservice to the entire economic debate. It has given the impression that economies must sever their links, and has denied the possibility that countries might simply transform their relationships whilst remaining close. The failure then of the world to decouple has lead to an overemphasis on the short-term decline in earnings and the worry that Asia will follow the U.S. into recession. Valuations in Asia have collapsed from the overexcited levels of late last year to far more sober levels that capture little of the exciting prospects for Asian growth. As such, they provide a long-term investor with a decent margin of safety. Framing the argument properly, I believe, helps to see the opportunities more clearly.

Robert J. Horrocks, PhD
Director of Research
Matthews International Capital Management, LLC

August 30, 2008

The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.