China appears to have a huge "grey" economy, meaning that it is fueled by grey or unreported income. On July 19th, China's most famous researcher on grey income, Dr. Wang Xiaolu, stipulated that actual urban household income may be 100 percent higher than the official data reported by the government. He also concluded that China’s per capita disposable income in 2008 should have been 67 percent higher than the official data.
Dr. Wang goes on to say that China’s national housing affordability ratio (the ratio of average home prices to average income) should have been about 2.8x in 2008, and is about 3.5x currently, which are lower than in many developed countries. His research concludes that the income gap between the top 10 percent and bottom 10 percent of the population was 26x; considerably higher than the government’s estimate of 9x.
In our opinion, this goes a long way to explain why the wealthy continue to buy real estate, and how they can afford the high prices. It also explains why the government is so intent to spend national resources to build low income housing and to stop the speculation in high priced status properties so the wealth gap does not continue to escalate. China’s leaders consider, among other things, the Confucian ideal of moderation and a cohesive society in their planning. Clearly, huge income and wealth disparities undermine these Confucian ideals.
CHINA TO IMPLEMENT CREDIT DEFAULT SWAPS IN THE SECOND HALF OF 2010; THIS WILL CHANGE THE WAY THEY MANAGE THEIR ECONOMY
China’s National Association of Financial Market Institutional Investors (NAFMII) recently announced their plan to launch a market for credit default swaps. In China, these will be known as credit risk mitigation (CRM) contracts. The NAFMII report said Chinese credit derivatives must follow the principles of simplicity and transparency and cater to the ‘real’ economy.
Economical management is paramount in China. For years, the central government has allowed local governments to create economic growth through activities such as selling real estate to developers who in turn create housing and large commercial developments. The ultimate effect of this has been more employment and more demand for raw materials. Now, the Central Government is reigning in local government flexibility, and is going to manage the money supply by growing it and shrinking it in a manner similar to the U.S. Federal Reserve. Furthermore, they will expand a bond market for Chinese government bonds and begin to use bond issuance as a method to control the money supply in China.
CHINA PLANS TO CHANGE THEIR ECONOMIC MODEL TO AVOID TOO MUCH SPENDING AND RISK-TAKING BY LOCAL GOVERNMENTS IN THE FUTURE
China has taken on a new policy approach translated by some as ‘loose fiscal policy and tight monetary policy’. Loose fiscal policy refers to the bevy of tax incentive and other fiscal measures to stimulate spending by government and private developers on affordable public housing and other public works.
Tight monetary policy means government will continue to reign in loan growth, especially to Local Government Funding Vehicles. Total loans in the economy are expected to decline over the remainder of 2010 and in future years. The commencement of a government bond market in coming months will create another policy tool for government planners.
FACTS ABOUT CHINA’S LOCAL GOVERNMENT FUNDING VEHICLES [LGFV]
Many rumors are swirling around about these vehicles, most of which are inaccurate. They argue for the potential of a meltdown in Chinese economic activity. We disagree with most of these confused analyses.
On July 20, 2010, China’s CBRC (China Banking Regulatory Commission) published information about outstanding bank loans including the loans to the local government funding vehicles. Total loans outstanding to these vehicles were about 1 trillion U.S. dollars on June 30, 2010. The report states that 27 percent were fully viable, 50 percent need to be serviced by secondary sources (legal guarantors or secondary cash flows), and 23 percent could pose a risk of default if cash flows do not improve or new guarantors are not found. Let us focus upon the 23 percent with potential problems, which is about $230 billion U.S. dollars.
Of these loans, we assume that about 2/3 will benefit from rising land prices or cash flows from completed projects already under construction. We estimate that about $75 billion U.S. dollars in bad loans will need to be written off or re-capitalized. Assuming all of the questionable loans go bad (a very unlikely occurrence in our view) write offs would total $230 billion.
On a national level, China has about $1.4 trillion in cash reserves available. In addition, the formation of a bond market, stock sales and cash held by provincial and local governments can also be used to restructure the bad debts. Bad debts are likely to be anywhere from $75 billion to $230 billion in the worst case scenario. While this is serious, such figures are not unmanageable given the size of their reserves.
INDIA’S GDP GROWTH IS APPROACHING A VERY IMPRESSIVE 10 PERCENT
India will continue to grow rapidly. We expect India’s high inflation (and rising interest rates) which have frightened many investors, will moderate after September when a successful monsoon season finishes with good rainfall, moderating food prices.
GOLD PRICES
We believe that all of the serious economic and political problems that have argued for a strong gold price continue to support rising demand for gold over the long-term. India, Russia, China, and Persian Gulf countries are all accumulating gold. A few weak, fiscally unsound institutions have been selling some of their gold to raise cash. Demand has far outstripped supply over the last eight years and we have repeatedly seen that using periods of price decline to add to long term positions in gold is wise.
Gold recently approached $1,140 an ounce, which many technical analysts believe is a good buy point. We suggest that gold taking partial profits in holdings on rallies and taking a larger percentage of your profits at $1650 per ounce.
We have been buyers during every prolonged period of gold weakness for years, and we continue to be buyers of gold during the current bout of weakness. A word to the wise is sufficient.
U.S. MARKET VOLATILITY
Markets have been volatile and we believe that they will remain volatile until the U.S. Securities and Exchange Commission begins to rein in the activities of the high frequency trading community. These fast traders create unstable markets, increase volatility, and are scaring individual investors away from the markets. When their actions are moderated, market movements will be more driven by fundamentals, and the individual investor will return, making the U.S. stock and bond market much healthier.
SUMMARY
We believe that higher volatility warrants high cash balances as volatility leads to market dislocations and good buying opportunities.
In our opinion, gold is approaching attractive prices for additions to portfolios. We also find some high-yielding oil related shares to be attractive on price declines. Longer term, China, India, Malaysia, Thailand, Singapore, and Brazil continue to be attractive destinations for investment capital.
