Shadows - Market Overview

China often operates in the shadows.  This raises questions as to the accuracy of the economic data that is released by their government, the internal actions being taken that are kept secret, and their overall motives.  These shadows of doubt and reduced growth expectations have clouded investor perception and have caused foreign investment to flow out of China.

However, two things are certain.

First, they are trying to transform their economy into one that is “consumer-driven” with increased domestic demand as opposed to their current economy that is driven by exports and investment.  One way they are trying to accomplish this goal is to urbanize their country by pulling an additional 100 million Chinese out of the countryside and into the cities by 2020.

Second, they are beginning to exert their economic and military strength in order to create a “sphere of influence” over the entire Asian region that supercedes any influence currently exerted by Japan, South Korea or the United States.

Even though there are uncertainties lingering in the shadows, here are some other things we know:

The Third Plenum

Few Americans even noticed the Third Plenary Session of the 18th Central Committee of the Chinese Communist Party meeting that was held in November of last year.  And yet, the outcomes of this meeting could dramatically impact the global economy and directly impact our own.

Third Plenum meetings are traditionally held 12 months after a new Party leader is appointed, and are used as a way to spell out long-term strategies in secret and to consolidate power.  Even though statements are released following these meetings, they are generally vague in nature and do not contain any specifics as to the methods of implementation. 

The most notable previous Third Plenum meeting was held in December 1978 under Deng Xiaoping.  Under Deng’s “gaige kaifang”  (reform and opening up), market reforms were put in place that formally ended Mao’s Cultural Revolution and unleashed the power of the profit motive in China.

The current Third Plenum document is also fairly vague, but it does contain some indications of reform that could change the country if they can overcome significant barriers.  Some of the more important reforms in the document include:

  1. A phasing out of China’s one child policy.  Couples will be allowed to have two children if one spouse is an only child.  This would apply to just about anyone of childbearing age since the one child policy has been in place since 1980. While this sounds good, the decisions surrounding the implementation of this reform depend on the provinces, not the central government.  There is also no timetable set for this reform.
  2. Under one category, the Party says it will “give the market the right to set prices and push forward with changes to the pricing of water, natural gas, oil, electricity, transportation and telecommunications.”  In other words, they want to open up these areas to a free-market pricing system.
  3. There are general statements of financial reform to open up other closed sectors to private and foreign competition, free up their financial and currency markets to foreigners, and new regulations to make their banking system more competitive.
  4. A mandate was issued to increase worker wages by a minimum of 13% per year into the foreseeable future.  This is on top of the 500% wage increase already experienced over the past decade.  The logic behind this official proclamation is that it will put more money in worker’s pockets thus increasing consumer demand.
  5. Probably the most important reform introduced is the reduction of stringent limitations on farmers under the “hukou system” that restricts farmer migration and property ownership where farmers still lack clear rights to their land. 

If enacted - which is questionable due to strong local government opposition - this would make it easier for farmers to sell or lease their land, migrate to the cities and qualify for public health and pension services from which they are currently excluded.

One problem with the Third Plenum document is that it does not address political reforms; instead it actually consolidates more power in Beijing. 

It also does not address the very powerful State Owned Enterprises (SOE’s) that exert influence over financial and political matters in the provinces.  The only reference to the SOE’s in the document is that their tax to the central government will be increased to 30% to help pay for an anticipated increase in social welfare programs caused by the overhaul of the hukou system.

And finally, while the Communist Party establishes policy, it is the central and local government agencies that are charged with putting these policies into effect.  This is a tremendous barrier due to personal and political rivalries, close relationships with outside interests, and self-interests that benefit from the status quo.

Consolidation of Power

One take-away from the Third Plenum and the President’s first year-and-a-half in office, is how quickly Xi Jinping has consolidated power into his own hands and his eagerness to use it. 

For example, unlike the two previous presidents Mr. Xi has established complete authority over the military, domestic security, intelligence, foreign policy and economic officials through his security committee. 

He has also initiated an aggressive anticorruption campaign that has nabbed and imprisoned several senior party officials.  This sends a clear message to party leaders that might oppose his reforms.

In addition, he has created a new “leading small group” to push through his reforms.  This is notable since this group bypasses other party groups and is under the direct supervision of the President.

As a result of these actions, Xi Jinping has undoubtedly become the most powerful president in China since Deng Xiaoping.

In essence, Mr. Xi is embracing Mao-era rhetoric and tactics to seize power and enact his reforms.  For instance, he has taken a vow to “utilize and standardize Internet supervision”, which is really just a deceptive way of saying censorship. 

This is followed up with top court promises of jail-time if “defamatory rumors” are posted online and read by more than 5000 people.  In this case defamatory rumors simply mean any criticism of the state.

Mr. Xi is also following Maoist principles by strictly enforcing ideological orthodoxy of the Communist Party.  For example, he has brought back the Maoist notion of a “mass line” by requiring officials to “listen to the people, introspect, and cleanse themselves of any deviation from party doctrine.”

How has President Xi Jinping acquired so much power in such a short time when his predecessors could not?  In the first place, his predecessors were pure technocrats.  Mr. Xi on the other hand, grew up in a world of wealth and political connections due to his father Xi Zhongxun who fought alongside Mao. 

According to official reports, Mao saved the elder Xi from execution, and he repaid the favor by sheltering Mao and his troops at the end of the Long March retreat from the Nationalist forces of Chiang Kai-shek.  This gave the elder Xi great power and influence in the new regime once the Communists seized power.

As a result of his upbringing and background, Xi Jinping is determined to demonstrate his ties to the founding generation with the intent of returning China to a purer past.

The deep irony is that while the world applauds Mr. Xi’s reforms by opening up China’s economy and eliminating the one child policy, in the shadows he is returning the power structure of China back to its Communist roots.

Economic Growth

China is not hitting its 2014 growth target of 7.5% with trade, factory output and productivity, and retail sales all falling below expectations. 

These factors are coupled with a continued out-flow of foreign investment, over-capacity in some industries, excessive debt in both the private and local government sectors, and a currency that has fallen about 3% against the U.S. dollar so far this year.

In order to provide a cushion against the negative impact of these conditions, the Peoples Bank of China slightly reversed course in the spring and initiated a mini-stimulus program to improve banking system liquidity.

This is where the central bank and central government are walking something of a tightrope.  On the one hand if they move too fast to address the debt problem and enact reforms, then they risk dramatically slower growth, financial panic, higher unemployment and public unrest. 

Higher unemployment and public unrest are the two things Beijing fears most.

On the other hand if they move too slow then their debt bubble, which is at its peak, could have a final burst up and then a full-blown bust down that would throw the economy into a tailspin.

For now it seems they are willing to accept even slower growth below their target of 7.5% so long as unemployment does not become a problem. 

Then again, their mandated 13% per year wage increase is not helping the situation since factories are looking for ways to control wage costs through automation or by relocating their facilities to a lower wage environment outside of China.

Shadow Banks and Debt

China’s debt has been growing faster than the economy for the past several years. 

Much of this debt has been accumulated by local governments who borrowed heavily and then spent lavishly on infrastructure and pet projects that may or may not have been warranted.   This includes everything from multi-lane highways with no traffic to swank government buildings. 

This has given rise to a common joke in China that the new government buildings in their town have more rooms than employees.

Adding to the debt situation are the highly leveraged developers that continued to build aggressively even though their commercial and housing properties stood empty.

And finally, there are the households that got caught up in the housing boom by buying two or three or even seven or eight apartment units that stood empty.  Even though these units were unoccupied, their investment logic is easy to see since the appraised value of these units doubled or even tripled during the boom years that stretched into 2013. 

It is the shadow banks that have provided much of the fuel that has sustained this debt binge.

Shadow banks, which are commonly known as trusts in China, are simply non-bank institutions that make loans and come under less regulatory scrutiny than traditional banks.  

China’s trust companies take money from investors - both foreign and domestic - and make loans, invest in stocks and invest in just about anything from junk bonds to wine.  In China they have played a vital role in the debt bubble by providing tens upon tens of billions of dollars to local governments, developers, mining companies and anyone hard pressed to tap credit.

Of course qualifying lending requirements on trust loans are usually very lax with above market interest rates as high as 40%.

Besides the obvious problems surrounding the aforementioned terms, another problem stems from the higher terms and tighter credit from traditional banks.  This situation has caused an explosion in loans from shadow banks over the past couple of years, with China’s trust companies providing 10 times as much new funding to the property sector in the last three months of 2013 as they did a year earlier.

Formal banks also own trust companies as “off balance sheet” entities.  This is scary in that it is reminiscent of U.S. banks, such as Citibank, who owned off balance sheet entities known as SIV’s - or Structured Investment Vehicles - in 2007 and 08 that took on excessive risks that led to their downfall and helped fuel our own debt crisis.

Eventually, the China debt situation will lead to loan defaults.  The potential problem is that many of the trusts that hold this paper do not have sufficient capital available to absorb these losses should they occur, which could further lead to a credit crunch and crisis. 

The bottom line is that if, and we repeat if, a debt crisis does occur in China then it will begin in the shadows of the lending institutions known as trusts.

Real Estate Market

Housing sales in China are falling.  This slump began early last year and it is not showing any signs of reversal.

To be more specific, housing sales were growing at the astonishing pace of 90% year-over-year in January 2013.  This rate of sales growth fell steadily throughout 2013-14 to such an extent that today’s year-over-year growth rate now stands at–10%.  

So far this drop in the growth of housing sales has not had a significant impact on housing prices…yet. 

The latest government data showed average new home prices in 70 cities fell 0.15% month-on-month in May.  While this sounds insignificant, it represents the first monthly fall in housing prices in years. 

Land sales are also plunging, falling a full 45% year-over-year from last May.  This is significant since May is the hottest month of the year for land sales.

To this author, this means they are probably sitting at the top of their housing cycle, similar to where we were in the fall of 2006.  However, the outcome of the unwinding of their housing bubble will probably be less dramatic than our own since it does not involve highly leveraged securitized mortgage products.

This top-of the-market conclusion is backed up by comments in May from Pan Shiyi, the president of Soho China, a large Chinese developer who likened the country’s real estate market to the Titanic with the comment: “It will soon hit an iceberg.”  

This fall in housing and land sales is affecting other parts of the economy, including the demand for lumber, wallboard, appliances and roofing materials.  There are also indications it is affecting construction worker employment and wages.

Sea Provocations

China has spent more than a decade building up its military and its diplomatic clout as part of their long-range objective of creating a “sphere of influence” over the entire Asian region. 

Part of this build-up - along with increased air and satellite capabilities - has involved the purchase of a refurbished aircraft carrier, the Liaoning, from Russia.  They have two more carriers on order making their intent apparent in that they want to expand the reach of their military capabilities within the South Pacific and beyond.

They are already starting to flex their muscle, alarming not just Japan and Vietnam over disputed islands, but other neighbors who are alarmed at China’s aggressive approach to maritime disputes.  The rising tensions between the U.S. and China triggered by this approach only add to the anxiety felt by these nations.

So what can we learn from all of this?  Even though there is an obvious downside risk if China’s economy falls harder than expected, an upside from current reforms also exists.

China wants to transform itself, not only from an “export-driven” economy toward a “consumer- driven” economy; but it wants a pure metamorphosis toward a service-oriented society.  The U.S. can fill the void since we have the largest and most competitive services sector in the world.  As a services-hungry China looks forward, they will look toward the U.S. and the developed world to satisfy that hunger.

As previously noted, China also wants to be recognized as a regional and world power.  However their specific long-term goals outside of an Asian “sphere of influence” remain in the shadows.

Then again, one thing we can conclude from China’s recent territorial disputes is that this is just the beginning of things to come, as their political and economic ambitions grow bolder over time.

From a stock market perspective, China should not have an adverse affect upon our market so long as their GDP growth remains above 7.0%, their housing/debt situation unwinds in a slow and orderly fashion and no unforeseen events occur.

In summary, even though current market complacency concerns us, we remain in a secular bull market that will experience future disruptions and corrections.  While we will continue our close monitoring of economic, monetary and financial conditions, we will be focused on any early signs of upward pressure on inflation or short-term interest rates.

- David B. Prilliman


Professional Investment Counsel, Inc.  Principals: Gary M. Borsch ( and David B. Prilliman (

© Copyright 2014, David B. Prilliman.  All rights reserved.  All opinions and estimates included in this report constitute our judgment as of this date and are subject to change without notice.  Although the information in this report has been obtained from sources we believe reliable, they are not necessarily complete and cannot be guaranteed.  This report is for information purposes only.