China: The Greatest Game

Philip Blix, Kato Capital Management (philip@katocapital.com) July, 2009

Background: China has been one of the greatest success stories of the last 30 years. The country has
grown tremendously and wealth has increased materially. This growth has been built on the back of a
massive investment program and a currency regime that has allowed China to become the world’s
manufacturing hub.

Thesis: 50% of China’s GDP is made up of capital investment (“capital formation” or FAI). That strategy
was effective when the economy and the exports were growing, however, as exports wind down and
growth slows as a greater service economy takes hold, so should investment, thereby creating the
possibility for negative GDP growth. However, the Chinese government is determined to maintain
growth and output and so we find ourselves at a point when factories, houses and investments are
being built at a pace that far exceed expected demand. As we move into 2010, the markets believe that
this spending will increase and create even more overcapacity. Rolling that assumption forward, it
becomes apparent that over time, the only way to maintain growth in the Chinese economy is to
continuously increase fixed asset investment, FAI. This is unsustainable and a Ponzi scheme of the first
order.

Timing: The timing to take advantage of the trade is right now. Basically, in August or September it will
become apparent that there are only two courses of action (1) a decrease in bank lending forcing 2010
expectations of FAI to fall OR (2) an increase in deficit funded government spending of epic proportions
which will lead to (hyper)inflation. Either should have a negative effect on the stock market.

Is there a way out? Yes. The Chinese consumer can step up and start consuming. Is that possible? No.

Why now? Many people have noticed these issues in the past. I believe this is a good time to revisit the
idea because:

• Bank loans accelerated during 4Q2008/2Q2009 to such a degree that it will be very difficult to
repeat a further growth spurt from the current level and it will be more difficult to see increased
fixed asset growth as loans start to taper off in July/August of 2009
o The current level of FAI can no longer be supported by any rational business judgment
and is adding capacity to industries where there is overcapacity and building buildings
that nobody will possibly fill--driving deflation despite 25% Y/Y M2 growth
• The market has recovered around 1/2 of its decline from its 2007 peak which is a typical reversal
point based on Elliot Wave type analysis. Valuations are also high relative to past periods and on
an absolute basis. The Chinese market is now valued at 22x P/E and represents 50% of GDP – a
level twice that of the S&P vs. the U.S. GDP
• The external macro environment continues to be negative
• Consumers are neither ready nor able to offset the decline in FAI
• A reversal in GDP would be a surprise of the first order but is a logical extension of a fall in bank
lending
• A failure to reign in credit expansion could easily become hyper-inflationary as M2 growth is in
the 25% y/y area and the propagation mechanisms in China (relative to the US) are much more
efficient
Components of the Thesis:

GDP Growth:

Over the last decade China has produced stellar growth. The main component of the growth has been
acceleration in FAI. Looking at the data, it is clear that in order to maintain GDP growth with FAI an ever
increasing proportion of GDP (and GDP growth), growth will require ever increasing amounts of FAI. FAI
is used to build long-life assets which will support the Chinese consumer over many years – hence at
some point this will need to taper off as enough plants have been built to meet the burgeoning demand.
Depending on the pace of deceleration, slowing FAI can very quickly turn China’s GDP growth negative.

GDP Development (Nominal RMB Billions)

40,000
Trade Balance
35,000
Investments
30,000 Consumption
s)
n
io
lli 25,000
B
B 20,000
M
(R
P 15,000
D
G
10,000

5,000

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E

Source: Citigroup

It is clear from the yearly changes that the Chinese consumer has so far failed to offset decline in FAI
through increased consumption and that as the economy grows and the FAI grows, the required “step”
change for consumers will grow increasingly wide. This is why the economy will run into a wall – I think
it’s today, but maybe it’ll hold for a little longer. This increasing requirement to maintain investments is
the key of the argument why this cannot last – for example, think about what would happen in 2014 at
current rates of growth?

GDP Y/Y Change in RMB by Component

Consumption Trade
Year GDP & Government Investments Balance
2001 1,022 525 467 20
2002 1,138 574 650 143
2003 1,605 554 1,019 (88)
2004 2,388 880 1,300 208
2005 2,841 1,157 1,222 463
2006 3,296 1,271 1,417 830
2007 4,144 1,809 1,519 595
2008 4,377 2,145 2,452 87
2009E 2,332 1,143 1,687 (804)
2010E 3,632 1,413 2,404 (185)
Fixed Asset Investment and GDP Reversal

A reversal of FAI could very quickly move GDP from positive territory to negative. At the extreme, this
could lead to a 30% quarter-on-quarter decline. However, that kind of move is probably too dramatic.
For example, if you let FAI decline by 20%, GDP would decline by 10%.

Illustrative GDP Decline based on rapid FAI reversal

GDP C I G X-M Q/Q Y/Y

Q1 2009 5,745 2,155 2,340 750 500

Q2 2009 8,995 2,230 5,500 765 500
Q3 2009 9,289 2,308 5,700 780 500 3.3%
Q4 2009 9,685 2,389 6,000 796 500 4.3%
Q1 2010 5,785 2,473 2,000 812 500 -40.3% 0.7%
Q2 2010 7,888 2,559 4,000 828 500 36.4% -12.3%
Q3 2010 7,994 2,649 4,000 845 500 1.3% -13.9%
Q4 2010 8,103 2,742 4,000 862 500 1.4% -16.3%

In the following analysis, I assume that ALL of the investment in smelters and cyclicals is either
stockpiling or used to fill working capital shortfalls (as a result of the export declines). This FAI demand
could reverse quickly so it is not entirely unlikely to see a 10-20% drop in FAI in the third and fourth
quarter of this year.

FAI Based on Data through May from China Statistics Bureau

2009/5 2008/5 2007/5 2006/5
Mining and Washing of Coal 72.9 52.7 35.8 31.6
Extraction of Petroleum and Natural Gas 69.7 63.2 54.0 43.8
Mining and Processing of Ferrous Metal Ores 22.4 14.9 9.6 9.4
Mining and Processing of Non-Ferrous Metal Ores 19.0 16.0 10.7 6.8
Mining and Processing of Nonmetal Ores 15.1 9.1 10.7 5.0
Mining of Other Ores 0.4 0.2 0.3 0.2
Processing, Coking, Processing of Nuclear Fuel 52.3 52.8 31.7 26.0
Manufacture of Chemical Material and Chemical Products 171.6 131.9 94.2 74.0
Smelting and Pressing of Ferrous Metals 96.8 96.6 79.9 76.1
Smelting and Pressing of Non-Ferrous Metals 63.8 49.8 35.8 26.3
Manufacture of Metal Products 85.9 61.8 46.0 29.5
Production and Supply of Electric and Heat Power 297.7 247.1 236.8 212.8
Real Estate 1,211.9 1,075.4 802.8 619.1
Total "Speculative" and non-productive assets 2,179.4 1,871.5 1,448.3 1,160.5

Working Capital coverage

Processing of Timber, Manufacture of Wood, Bamboo, Rattan, Palm, and Straw Products 24.0 - -
Manufacture of Paper and Paper Products 36.7 - -
Manufacture of Chemical Fibre 8.5 - -
Manufacture of Rubber 19.7 - -
Manufacture of Plastics 40.7 - -
Manufacture of Non-Metallic Mineral Products 168.7 - -
Manufacture of Electrical Machinery and Equipment 104.2 - -
Manufacture of Communication Equipment, Computers and Other Electronic Equipment 71.1 - -
Total "Working Capital" 473.6 - - -

Total "Non-productive Fixed Asset Investment" 2,652.9 1,871.5 1,448.3 1,160.5

Remaining Fixed Asset Investment 2,699.1 2,154.9 1,756.2 1,383.8
Last Year Fixed Asset Investment 4,026.4 3,204.5 2,544.3 1,971.9

Decrease in Productive Fixed Asset Investment -33.0% NM NM NM

Change in Productive Fixed Asset Investment 25.3% 22.7% 26.9% NA

Proportion "Speculative" 100% 75% 50% 25%

Adjusted Series 2,652.9 2,622.8 2,480.3 2,254.2
"Adjusted Productive Investment" 1.2% 5.7% 10.0% 14.3%
Components of Fixed Asset Investment

FAI can be grouped into real estate investment, government investment/spending and industrial
construction/other. There are significant lags as well as policy initiatives which impact GDP development
as well. However, over time it will be hard for a privatized property market as well as a publicly owned
industrial base not to adjust their spending based on external factors rather than government strategy.

Over the next 12 months, the majority of FAI spending is expected to come from property development
and private enterprises as they ramp up spending on new plants.

Both of these premises appear to be wrong-headed:

1. Private enterprises, while needing to complete plants started in 2008, have not started
significant projects so far in 2009 (and don’t have cash flow for building). Based on the above
analysis, private enterprise spending may even start to decline (which would be rational given
the overcapacity)
2. Unemployment is rising as utilization falls – why would private enterprise start more projects in
such an environment?
3. There has been a rush to acquire land for property development– however, land is only
that – it is a sunk cost until a project of some type has been built. We can observe that the
construction index is significantly down
4. Loans to fund construction through April did not grow in parity with overall loan growth

Near-term Fixed Asset Investment Analysis

H1 2009 H2 2009 H1 2010 H2 2010

Property Investment 1.6 2.4 2.0 2.8

Government Investment 2.0 3.2 2.2 3.3
Industry and Other 3.8 5.9 6.6 7.1
Total FAI 7.4 11.5 10.8 13.2
Source: Deutsche Bank
The cadence of approved projects and bank lending suggests that (1) projects peaked in the 4Q 2008, (2)
lending peaked in 4Q 2008/1Q 2009 and (3) project starts are peaking in 2Q 2009.

Project Approval Cadence Bank Lending

Project Starts Construction Indicators

Despite a decline in starts, prices for real estate are not increasing in real terms.

Prices and Sales Volume for Residential Real Estate

Source: JP Morgan
Construction companies did not participate in taking out new loans through April, but may have seen a
slight increase in June.

Construction Indicators

Source: JP Morgan

Construction Workload Index

Source: UBS

Floor Space Completed

Source: UBS
The Chinese Consumer:

It is clear that the consumer will have to pick up a very, very large piece of the decline in FAI in order to
maintain GDP growth in the future. This level of spending increase equates to a tripling of the growth in
consumer spending over the next three years while assuming even a relatively slow ramp-down of FAI.
This is obviously a positive for the stock market. However, it may not be possible. The below chart
illustrates this point—consumer spending increasing as markedly as required to maintain growth is
unrealistic at best.

GDP Growth by Component

Per Capita
Consumption Trade Change in
Year GDP & Government Investments Balance Population GDP/Capita Consump. Consum.
2001 1,022 525 467 20 988 11,026 6,726 531
2002 1,138 574 650 143 1,019 11,812 7,087 563
2003 1,605 554 1,019 (88) 1,050 12,986 7,402 527
2004 2,388 880 1,300 208 1,083 14,802 7,993 813
2005 2,841 1,157 1,222 463 1,116 16,903 8,789 1,036
2006 3,296 1,271 1,417 830 1,151 19,259 9,630 1,104
2007 4,144 1,809 1,519 595 1,186 22,174 10,865 1,525
2008 4,377 2,145 2,452 87 1,223 25,087 12,293 1,753
2009E 2,266 1,110 1,656 (807) 1,261 26,132 12,805 881
2010E 3,457 1,330 2,318 (191) 1,300 28,007 13,443 1,023
2011E 4,005 4,751 (502) (244) 1,326 30,478 16,763 3,583
2012E 4,446 4,239 73 133 1,353 33,167 19,569 3,134
2013E 4,935 4,405 381 148 1,380 36,094 22,378 3,193

Based on my analysis, the Chinese consumer accounts for 55% of GDP--a level that compares quite
favorably to the debt-laden US consumer who currently accounts for 70% of GDP or so.

If the Chinese economy was to rebalance and capital spending make up 15% of GDP versus the current
50%, the consumer would have to become ~70% of the economy and require an entirely new
infrastructure in terms of consumer lending and credit policy similar to the U.S. (e.g. subprime, credit
cards etc). In addition, because the Chinese government subsidizes certain products through fixed price
(e.g. fuel, food) the 55% including the government deficits today could be adjusted higher. This 55% also
excludes many basic items which Western consumers spend money on such as healthcare and
education. This will take a lot of time and the perception that the Chinese customer has a large portion
of “untapped” spending power appears to be less clear than normally assumed.

Even the savings rate argument appears flawed as the level of savings by Chinese retail depositors is
only $2,500 per capita--well short of the U.S. where liquid net household wealth is significant.

Chinese Consumption
Current GDP 32,952
Less: Investments at Current Rate (15,158)
Less : Government (4,200)
Private Consumption 13,594

Implied Sustainable GDP 24,717

Normalizing for 25% Investment
and 20% Government
Current Consumption as a % of Sustainable GDP 55.0%

Increases Required in Private Consumption 14,726

Implied Total Consumption as a % of GDP 71.8%
Overcapacity within Industry and Property Markets

The below is not a definitive study but points to some clear imbalances.

Housing Market

• It is estimated that approximately 10% of property transactions are speculative and the living
area per capita is very comparable to western standards. These facts suggest that the housing
market is either overbuilt, or very fully built.

Living Space Per Capita

• The average house price in China appears to be stretched – assuming you adjust GDP for fixed
assets (which cannot be used to pay rent). Basically, the below suggests that house prices
equate to between 6-10x GDP/capita. The equivalent metric in the U.S. is around 5x.

Living Space Per Capita

Av. Living Av. Price/
Price/m2 $ / sqft Area Price Adj. GDP

Shanghai 11,000 144 330,000 48,316 10

Beijing 5,900 77 177,000 25,915 6

Chongquing 3,000 39 81,000 11,859 7

General Industrial

Based on actual output it appears that the production index has gone from approximately 16-18 in
2006/2007 to approximately 8-10 today. However, even though this is an almost 40% decline, Chinese
industry has been aggressively expanding and utilization therefore (assuming some internal
consumption growth) is more likely to be in the 50-60% range than the 80% needed in general to
achieve mid-cycle profitability.

Chinese Manufacturing Output

Source: UBS

Based on specific sector studies it is clear that there is more overcapacity in some of the basic industry
sectors (as per Deutsche Bank).

Overcapacity in Basic Industries

Another indicator of real industrial demand is truck demand, down around 20% compared to 2009. This
is one of the few vehicle categories which has not been influenced by government policy. .

Heavy Truck Demand

Transportation of industrial goods is similarly down pointing to even greater under-utilization within
general industry.

China Composite Freight Index

Sovereign Leverage

There is a myth circulating that China is not levered. This appears to be fundamentally incorrect. Adding
up the leverage at the bank level and debt issued by the central government, it is clear that there is
significant leverage on the economy--the below table would suggest the level is somewhere between
2.5x-4x. This compares to the 3.5x leverage on the U.S. which has most of the world up in arms. A
historic sustainable range is around 1.2x – 1.8x. The other part of argument goes that only external debt
is important – however, it appears that history does not bear this out (see Rogoff and Reinhart, 2008).
That said, I’m not suggesting China default – only that it will realize its own constraints and therefore not
be able to stimulate as aggressively as it is perceived to be able to. This analysis also hints at the idea
that Chinese businesses have been increasing debt and “eating” losses while underbidding their
Western counterparts while enjoying continuous support from a friendly banking system -- a scenario
which has been suggested by Western business leaders for some time.

Debt at Default

(Rogoff and Reinhart, 2008)

Chinese Leverage
Bank Gov't
Assets Statistics
Total YE 2009 Loans 54,884 41,300 Total Assets of Largets Banks plus Loans made in 2009
Government Debt 12,274 12,274 Assuming 40% of GDP (incl. Muni debt)
Government 2009 Deficit 1,384 1,384 Government Deficit 2009
Total YE 2009 Debt 68,542 54,958 Total Debt ( = assets of banking system and government debt)
GDP 30,686 30,686 2008 GDP
Debt / GDP 2.2x 1.3x Current Leverage
GDP Less Investment 17,184 17,184 GDP = C + I + G + (X-M) … so remove I… you end up with less GDP
Debt / GDP Less Investment 4.0x 2.4x
Assuming Consumers Lever Up 152,193 138,609 Adds FAI through 2013 and increase in Consumption

Pro Forma Debt / Sustained GDP 3.9x 3.5x

Sovereign Wealth Fund, Money Supply and Foreign Exchange

Based on China’s own 2008 statistical yearbook, the foreign exchange holdings of the country are
represented as an asset on the balance sheet of the banking system – an asset which is largely balanced
by a similar amount of industrial deposits. I’m not sufficiently knowledgeable about China bank matters
to understand the whole picture but it appears to me that a portion of the deposits which the banks
hold are actually part of the sterilization process for the USD/RMB peg. As a consequence of these F/X-
related deposits, the oft-quoted statistics of (i) the Chinese savings rate and (ii) the solvency of banks
based on deposits are therefore called into question.

Chinese Bank Deposits

The 55% consumption to adjusted GDP in combination with increases in consumer spending over the
last few years could help explain why Chinese retail savings deposits are dipping -- which runs counter to
the idea of large household savings which are just waiting to be deployed to offset declining FAI.

Chinese Retail Bank Deposits

 Flow of Funds from Sterilization

It is unclear to me exactly how the sterilization works – but suffice to say that if the national statistics
are right and the funds flow as I’ve surmised, then China is essentially running a giant hedge fund with
treasuries on one side and deposits from companies on the other. The downside to this strategy would
be that if the US were to rapidly debase its currency, the assets of the hedge fund would rapidly decline
and increase the debt burden on China. It’s not something China can’t make up by printing additional
money as printing is inflationary.

-
Similarities with Japan in the 1980s

There are some similarities to Japan where, clearly, a real estate bubble created the conditions for a
debt deflation. It appears to me that China is not there – however there are several charts pointing to
certain similarities:

Foreign Exchange and Lending

Lending Ratios in Japan

Lending Ratios in Japan

Source: JP Morgan and UBS

Valuation Considerations

Chinese stocks are valued above U.S. markets and represent a value of 0.7x GDP – which rises to 1.5x if
the FAI is excluded. On a book basis Chinese stocks appear to trade at 2.0x; however, assuming large
parts of the books are tied up in PP&E that will never be used and bank loans that are likely to go bad
the “go forward” book value is significantly less and the value correlates more closely to what the
value/GDP ratios suggest (e.g. 4x or so).

H-share Price / Book

Source: Citi

Value / GDP – Comparison to USA

$ trillion U.S. China

GDP 14.0 4.5

Stocks 7.0 3.0

Stocks / GDP 0.5x 0.7x

Why now?

1. Valuations are becoming stretched. According to Bloomberg the Shanghai index is trading at 22x
P/E
2. Project approvals peaked in 4Q2008, lending peaked in 1Q2009 and project starts are peaking
right now which will result in a reversal in GDP growth which will need to be made up by
consumption in Q3/Q4. The ability of the consumer to make up the shortfall will then be
realized. As markets further look to 2010 I think they will come to realize that the FAI
component will decline and that will trigger a realization that the “game is up”.
3. Technicals of equity markets are more or less fully overbought and sentiment/belief in China is
almost universal. RSI and MACD indicators are at overbought levels.

Elliot Wave Analysis of Shanghai

 Trend Indicators – RSI

Trend Indicators – MACD