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Greater Good Utilitarian Principles in China and Investing Implications

The Chinese economy will continue to march on at 6% GDP growth per year – so by that logic, should it match or outperform the S&P 500 every year which represents the U.S. with 2% GDP growth (or global GDP growth)? Likewise, will the average Chinese stock move up in tandem with GDP growth?

Chinese equities should do well on the whole, but don’t expect them to race ahead of U.S. and global equities for this reason – China is a socialist country. As such, the gains from capital are more evenly distributed between the bourgeoisie and the proletariat.

As we alluded to in previous articles, the Communist Part of China considers social stability to be paramount – at least until it reaches the standard of living that exists in first world countries in Europe. Investor gains are secondary to initiatives such as poverty alleviation, rising median wages and nationwide standard of living.

At least in my narrow interaction with Chinese nationals, the people who dislike the party the most are the rich. The party is for the people, by the people.

Here are some current examples of how this will play out.

Petrochina Midstream Spin Off

The major Chinese energy conglomerates are integrated. These are Petrochina, Sinopec and CNOOC. This means that they have both exploration and production, midstream (pipelines and infrastructure) and refining and retail. They touch every point on the energy value chain.

Given their scale and dominant market position in China, the midstream assets offer great value as they are able to charge steady tolls in a business known for volatility (from fluctuating oil prices).

However, this outcome is inefficient for society. China is a net energy importer – it requires vast amounts of oil and gas to feed its growing economy, which is a big reason why they are pushing the development of green energy – whether through renewables generating electricity or electric vehicles (Tesla is fast becoming a Chinese stock, and Elon Musk has been caught eating lamb hot pot with Grimes) or the rollout of mass transit and high speed rail. While China has large oil and gas reserves relative to other countries, it is not enough for now.

Controlling most of the infrastructure is great for investors but is not necessarily in the national interest. Pipelines with onerous tolls may discourage hydrocarbon exploration. Also, without having very clear returns that meet investment hurdles (or needing to compete for capital within a larger corporate), large players may be disincentivized to build out new infrastructure.

The Chinese government forced them to consolidate and spin out the midstream pipeline network. Shares of the major Chinese oil SOEs dropped upon announcement.

Quantitative Easing and Low Interest Rates in China

Wall Street pundits have thrown this out there as a talking point repeatedly. China’s slowing growth (soft or hard landing) may lead the government to bring out stimulus measures, which may include lowering interest rates or printing money (quantitative or monetary easing).

We have seen this in most of the Western world, and it has done wonders for asset prices. For example, I am so rich. So is everyone who has had large exposure to the market.

China Daily has reported that there are no plans for easing.

An influx of money into the system causes asset prices to rise in nominal terms. Real estate, stocks and private equity asset values are propped up by cheap money. So those who hold assets will become richer while breaking down the purchasing power of the middle class. This is an unacceptable outcome to the government.

Risk free interest rates are higher in China, which means that the discount rate on equities is also higher.

Long story short, do not expect monetary policy to help the equity story.

Private Entrepreneurship in China and Interest Rate Liberalization

China is listening to the fears of many entrepreneurs that feel like they have been disadvantaged in terms of borrowing and receiving approvals in competition from state owned enterprises.

Chinese state owned bank stocks have also given preference to large state owned corporates in terms of lending as they know that they are safe (or at least in the past likely to be bailed out) versus private firms with more risk, because they were not allowed to adequately price for this risk.

This will change – red tape will be cut and enterprise encouraged.

Chinese banks are poised to catch up to a more liberal interest rate regime as well. Banks in the U.S. have had a hundred years to refine risk management best practices and triangulate on how to price risk or where the true expected discount rate is, Chinese banks do not.

However, given the applications of big data and artificial intelligence in assessing loans, and no one will have more data than China given their 1.4 billion person populace, harnessing technology can get Chinese banks up the learning curve quickly en route to lower non-performing loans and appropriately priced debt.

Unlike the U.S. where large banks would never give their lending data to a competitor, it is foreseeable that the government could mandate the pooling of data in a centralized repository so that the most efficient outcome is achieved for society and the optimal amount of credit is extended.

Chinese Infrastructure Build Out and High Speed Rail

A few years ago, a major broker put out an interesting thought piece on compressed natural gas vehicles in the U.S., possibly replacing some of the existing truck fleet. They sized the market and NPV’d all the benefits, coming to some impressive numbers. This is what equity research folk do all day. Ultimately, it was the pointless piece because they ended up mentioning the key chicken egg NIMBYism problem that all democracies face right now.

No one is going to build the infrastructure without the demand. There is no demand without the infrastructure. And in what is a largely free market for this space as well as the vested interests of various industries, the government would not contemplate spearheading this charge. In fact, that would lead to more questions – which government?

Would one government’s plan encroach on another government’s jurisdiction? Is any elected government capable of having long term vision beyond the current election to plan and execute on a fairly complex scheme? How many contingencies would be needed to account for delays, problems with organized labour and various other interest groups?

For China Inc., projects such as dams, bridges, mass transit initiatives and agriculture are evaluated, tested on a small scale in a guinea pig and then rolled out for an almost factory like production where engineers continually move up the learning curve. In Shanghai, there was a time when a new full metro line was built every year.

Perhaps the best known example of this is China’s world beating high speed passenger rail network. Today, Chinese can get just about anywhere domestically without ever needing to go to an airport – which is no small feat given that China is one of the largest countries in the world by geographic mass.

Since nothing of this size or scale has been accomplished before in any country – and it does not depend on positive externalities (high speed rail makes money, period), the planning required is incredible. The cash flows understandably discounted by an extremely low cost of capital (bank funds but safe and long lived infrastructure), but passenger figures, in transit purchases (food and beverages, gifts) and real estate income (where stations are built, economic activity follows, further raising the rents and underlying property value) have been appropriately forecasted.

How does an investor take advantage of these trends? The Beijing Shanghai route is aiming for an IPO in 2020, which offers a way to play the infrastructure. But looking at the huge economic value that it generates from both the construction and time savings trickling through to the rest of the economy is also a good way to start.

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Matt
ex investment banking associate
https://www.linkedin.com/in/matt-walker-ssh/

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