Managing The Dragon’s 2013 China Predictions

Greater China. Note the oval Tarim Basin, the ...

Greater China. Note the oval Tarim Basin, the dryer area separating Inner and Outer Mongolia and the projection of steppe into Manchuria (Photo credit: Wikipedia)

In December, I had an opportunity to speak about China to audiences in such diverse cities as New York, Philadelphia, Anchorage, Cincinnati, Pittsburgh and Reno. The audiences represented a wide range of occupations—from hedge fund and investment managers to ordinary investors, business men and women, students and government officials. As a result, I received a pretty good sampling of the latest “view from the States” as far as China is concerned, providing useful background for this year’s predictions.

As might be expected, questions about China’s leadership transition, the state of China’s economy and the prospects for the shares of Chinese companies traded in China and elsewhere were raised at every stop. I feel compelled, therefore, to include my views on those issues in my predictions for the upcoming year. Unlike in past years, not many had questions about the exchange rate between the renminbi and the U.S. While the exchange rate issue does not appear to be front and center — at least for now — there are other important developments on the currency front which I do address.

Prediction #1: China’s new leadership will accomplish a smooth transition of power in their first year of governing and will largely continue on the same path as their predecessors.

Throughout much of last year, the Bo Xilai affair dominated the headlines and tended to cast a pall over the leadership transition that occurred in October. The actions of Bo, his wife and the Communist Party seemed to suggest that there were deep divisions within the Party and that the leadership transition would be anything but peaceful.

While only true insiders can categorically say whether such divisions are present, the transition has been uneventful thus far, and all signs point to the fact that Xi Jinping and Li Keqiang will largely continue down the same path as their predecessors. Both were understudies to the outgoing leaders — Xi to Hu Jintao and Li to Wen Jiabao — and both were selected for their new positions by their mentors. Xi Jinping, as Hu Jintao’s number two, and Li Keqiang, as deputy to Wen Jiabao, have already played a large role in setting policy over recent years.

Stephen S. Roach, a member of the faculty at Yale University, former Chairman of Morgan Stanley Asia, the author of The Next Asia, and a well-regarded expert on China, is very positive on the new leaders. According to Roach:

Xi Jinping and Li Keqiang – the top two officials in China’s new governing council (the Standing Committee of the Politburo) – are both well educated, well-traveled, and sophisticated thinkers who bring a wealth of experience to the many challenges that China faces. As so-called Fifth Generation leaders, they continue the steady progress in competence that has marked each of China’s leadership transitions since the emergence of Deng Xiaoping in the late 1970s.

From all appearances, China seems to be in good hands.

Prediction #2: China’s Gross Domestic Product (GDP) will grow faster than it did in 2012, ending several years of a declining growth rate.

“Will the decline in China’s growth rate continue in 2013?” was one of the most frequently asked questions on my travels through the United States.
After increasing from 9.1 percent in the post crisis year of 2009 to 10.4 percent in 2010, China’s GDP growth rate declined to 9.3 percent in 2011 and will most likely fall to somewhere between 7.7 percent and 8.0 percent in 2012. China’s GDP growth rate has slowed in each of the past seven quarters, reaching a low of 7.4 percent in the third quarter of last year. The National Bureau of Statistics (NBS) will announce the growth rate for the fourth quarter and the year on January 18, so we will see if this downward trend reversed itself in the past three months.

A consensus seems to be building, though, that China’s economy bottomed in the third quarter. Lu Zhongyuan, deputy director of the Development Research Center under the State Council, or China’s Cabinet, said recently that China’s economy has bottomed since June, buoyed by the country’s “economic restructuring, innovation incentives and the market’s self-stabilizing forces.” Lu went on to say that this momentum will continue to drive up growth in the year ahead and that there is no doubt that China’s economy will grow by more than 8 percent in 2013.

Likewise, the World Bank recently predicted that China’s economy will grow by 8.4 percent, and Andy Rothman, China Macro Strategist for CLSA, believes that 8 plus percent growth is on the horizon for the coming year. Add to that the fact that the new leadership will be determined to get off to a good start economically, and my prediction that China’s GDP growth rate in 2013 will exceed 8 percent appears relatively safe.

Prediction #3: The Shanghai Stock Exchange Composite Index (SSE) will register a double-digit increase in 2013, rewarding investors for their patience.

The third time is a charm. After being flat out wrong in 2011 when I predicted a 25 percent increase in the SSE, and only partially right in 2012 when I again predicted a similar increase, I predict that the SSE will continue its December momentum and register a double-digit increase in the New Year.

Since its high water mark in late 2007 when the SSE reached 6036, China’s stock market has been plagued by concerns as to how China would be impacted by the global economic crisis, the property bubble and the credit tightening that followed, the weak economic prospects for the United States and Europe, China’s two largest trading partners, and lately, uncertainty about the leadership transition. The SSE declined by 11 percent in 2010, 22 percent in 2011, and was down another 10 percent for the first 11 months of 2012, making it one of the worst performing stock markets in the world for most of the year. The SSE then came alive in December and gained almost 16 percent during the month to finish 2012 at 2269, up 4 percent.

While not all of the concerns regarding China’s economic and political situation have eased, many of them have, so stock market sentiment should be much more favorable in 2013. A continuation of the momentum established in December, and a double-digit increase in the SSE in 2013 seems to be in the cards. A more positive sentiment with regard to China will also have a favorable impact on the shares of Chinese companies that are traded in Hong Kong, the United States and other overseas markets.

Prediction #4: China will continue to slow its purchases of U.S. Treasury securities.

From the end of 2003 to the end of 2010, China’s holdings of U.S. Treasury securities grew from $159 billion to $1.166 billion as China’s currency reserves increased and the U.S. debt doubled from approximately $7.0 trillion to $14.0 trillion. In other words, purchases of U.S. Treasury securities by China accounted for just over 14 percent of the new debt issued by the U.S. government during that period.

Since then, however, the pattern has been much different. Over the past two years, China’s holdings of U.S. debt have been flat to declining, despite the fact that the U.S. government debt has increased to $16.4 trillion. In essence, China has not financed any new bond issuances by the United States since the end of 2010. As noted by Thomas Donlan in the December 8, 2012, issue of Barron’s: “Between September 2011 and September 2012, China reduced its holdings of U.S. Treasury debt 9 percent, from $1,270 billion to $1,155 billion…”

While the policymakers in Washington may not understand economics and the basic laws of the capital markets, the legions of U.S. trained economists that advise the Chinese government understand full well that when you have more supply of something than demand, prices will fall. While the additional supply of Treasury notes and bonds is currently being taken up by the Federal Reserve, and to a small extent by Japan and other countries, they know that this cannot last and that the value of China’s holdings will ultimately decline.

Like any prudent investor, China has been diversifying its holdings away from an asset class where prices are likely to fall. While China is unlikely to “shoot itself in the foot” by dumping its holdings of Treasuries, as many fear, it has not taken up any new supply for several years now.

Look for this pattern to continue in 2013 as China continues to wean itself from the U.S. dollar and to diversify its holdings to include a larger basket of currencies, as well as hard assets in Europe, the United States, South America and Africa. China is currently the second largest holder of U.S. Treasuries, but Japan has been increasing its purchases and is just $26.8 billion behind. Many analysts expect Japan to take over the number-one spot sometime in 2013, a distinction that China will be only too happy to relinquish.

Prediction #5: China will continue its efforts to internationalize the yuan in 2013.

While full convertibility of the yuan is still several years away, China has been quietly building demand for its currency outside China and internationalizing its role in the global economy.
China began this process in November 2010 when the Russian Prime Minister Vladimir Putin and Chinese Premier Wen Jiabao announced that Russia and China had decided to use their own national currencies for bilateral trade, instead of the U.S. dollar. The yuan started trading against the ruble in the Chinese bank market in Shanghai immediately, and in December 2010, began trading on the Moscow Interbank Currency Exchange, marking the first time that the yuan has traded outside of China and Hong Kong.

A year later, China agreed to a deal with Hong Kong that will give the territory more access to the Chinese currency, enabling Hong Kong to access 400 billion yuan ($63 billion) from the Chinese central bank, and at the end of 2011, the Japanese government announced that Japan and China will promote direct trading of the yen and yuan without using dollars.

A string of trade/currency deals followed in 2012. In March, China struck a deal with Australia that allows for an exchange of local currencies between the central banks of the two countries. In June, a similar deal was struck with Brazil, and in August, German Chancellor Angela Merkel and Chinese Premier Wen Jiabao announced in a joint statement from Beijing that the two countries plan to conduct an increasing amount of their trade in euros and yuan. In addition to deals with its largest trading partners, China also concluded similar arrangements with the United Arab Emirates (UAE) and Turkey in 2012.

Look for more of the same in 2013.

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