Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
Over the past few years we have come across a considerable amount of research pointing out the risk of an imminent financial crisis in China. Predictions have ranged from “the economy could just stop”, “the currency is in danger of collapsing” to the “housing market is not sustainable”. The purveyors of these views have ranged from well-known independent research houses and a number of high profile hedge fund managers to the occasional brave Chinese bank sell side analyst warning of disaster.
No doubt at some point these predictions have a high chance of occurring. The key is “at some point”. In the early 2000’s it was the sustainability of China’s high rate of gross fixed capital formation that scared many economists. Despite these fears it is now at an absolute level of 7x the level of 2002!!!! No doubt many would have been tempted to short this figure if there was a suitable tradable index.
So why have so many of the predictions proven wrong, or at least premature? From our experience investing in the emerging market asset class over the past twenty years the key is the savings rate.
China’s Gross Savings Rate (Gross national income less consumption plus transfers) including both individuals, the corporate sector and government was close to 49% in 2013. In contrast the U.S. rate was only 18%. A high rate of savings has allowed the government to “overinvest”, particularly in infrastructure. It has also enabled the banking sector to be recapitalised without having to resort to a large currency devaluation in order to attract foreign savings.
Real interest rates in China have remained low, and even negative for a number of periods over the past twenty five years. As a result the private sector has in effect subsidised investment by the State. For this reason it should not come as a surprise that many Chinese households prefer to “save” by investing in real estate, where they believe their investment will be protected from inflation.
On the opposite end of the spectrum lies Brazil with a savings rate lower than that of the US. Without the benefit of having the world’s reserve currency, Brazil has found itself repeatedly hostage to global financial conditions. Any rapid expansions in the economy have inevitably been followed by busts as external capital came and went. As a result the country has to offer some of the highest real rates of interest of any major economy in order to attract savings. The result is subpar economic growth due to a perennial underinvestment in the economy.
What will change the situation for China and Brazil? In Brazil’s case it is reforming the absurdity of a system that allows the average public sector worker to retire at the age of 54. This is a blatant middle class entitlement that ultimately impoverishes the country. Even the prospect that things could change with the departure of the previous President has resulted in the more than doubling of the Brazil’s stock market in dollar terms over the past twenty months.
In China’s case it the lack of a social safety net, combined with the historic one child policy, which has frightened individuals to save for retirement and unforeseen expenses. The high price of property in many tier one and two cities has also reinforced the need to save in order to afford a down payment. As stated earlier, property ownership is viewed as a savings vehicle by many Chinese.
For these reasons it is difficult to see an immediate catalyst that will result in a decline in China’s saving rate. Of course it will eventually happen, maybe due to an aging population or an improvement in the country’s social safety net. China would like the renminbi to join the U.S. dollar as one of the world’s reserve currencies before this happens, something which has allowed the U.S. to avoid the negative implications of its low savings rate.
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