TAKE NOTE COVER STORY

Changes in China

China's shift toward an economic model emphasizing domestic consumption over government stimulus will have repercussions throughout the global economy.
The resulting changes present investors with opportunities and risks.

China's leadership is seeking to engineer a transition from an export-driven economy to one reliant on domestic consumers. Key to this transition is an enormous and expanding middle class, which is on track to double its share to nearly half of the Chinese population in less than a decade.

The transition will require fundamental economic and political reforms. It's also unfolding at a time when the Chinese economy is slowing—in part because of excessive debt accumulated during recent stimulus efforts. "This transition presents very different challenges for China," explains Anh Lu, portfolio manager of the T. Rowe Price New Asia Fund (PRASX), "not because the politics have changed, but because the economy has changed, the world has changed, and the working environment in China has changed."

LIFTING THE MIDDLE CLASS
Despite its growing clout, China's middle class is not yet ready to drive the country's economy in the absence of state-sponsored stimulus programs. This segment currently accounts for less than 20% of China's total population,1 insufficient to generate the levels of demand common in most developed economies. Moreover, China is a nation of savers, with an average urban household savings rate of more than 30% of disposable income, according to the International Monetary Fund.2 With a weak social safety net, Chinese workers are unwilling to consume to the same extent as Americans or Europeans.

China's middle class currently accounts for less than 20% of its total population

China's middle class currently accounts for less than 20% of its total population and may double to 43% by 2020. But this nation of savers will need incentives to save less and spend more.

China's most recent Five Year Plan—a high-level economic blueprint covering the period from 2011 through 2015—aims to bolster the middle class and increase its ability to reap the benefits of economic growth. The plan targets a minimum wage growth of at least 13% per year, and includes cleaning up the environment and reducing corruption among its goals. Steadily increasing wages is a necessary step toward stronger domestic consumption and higher living standards. But rapid wage growth can also lead to inflation, negating many of its benefits. "Wage inflation clearly increases the cost of production in China and will have some detrimental impact on China's competitiveness," Lu says. "However, wage inflation has tended to far outstrip overall inflation."

The latest Five Year Plan states the necessity of improving public welfare and social justice, including specific goals at both the regional and community level. A nationwide social insurance program would help reduce the dependence on personal savings and free up more money for consumption. "The government is aware of these issues and is slowly putting in reforms," explains Ernest Yeung, who manages the Asian emerging markets portion of the small-cap T. Rowe Price International Discovery Fund (PRIDX). "Once they solve these problems, I believe households will spend more."

GROWING DEBT RAISES WORRIES
Boosting consumption is a major challenge, but it is not the only obstacle policymakers face as they attempt to overhaul the country's economic drivers. A $600 billion stimulus program announced in late 2008 triggered massive spending and lending, much of which drove real estate purchases. As a result, land prices have run up in many Chinese cities and have raised concerns about a housing bubble, which, if it were to collapse, would weigh heavily on the economy.

Most worrisome is China's rising indebtedness. Infrastructure projects started in the wake of the stimulus have saddled local banks and governments with loans, some of which are likely to go unpaid. The country's total debt-to-GDP (gross domestic product) ratio has soared in recent years to just over 200%, according to Lu, who notes that other emerging markets have encountered problems at that level. A surge in lending by lightly regulated trust companies and underground banks—otherwise known as "shadow lending"—has spurred worries that a credit bubble is forming in China, with the potential for severe damage to the economy.

Due Diligence in China
How T. Rowe Price managers deal with the impact of corruption on their investments.

The Chinese government has recently embarked on a highly publicized campaign to fight graft and encourage transparency. Anh Lu, portfolio manager of the T. Rowe Price New Asia Fund (PRASX), describes how she factors corruption and similar considerations into her thinking when making investments for the fund. "In emerging markets, the law doesn't tend to be the problem," she says. "It's the ability to enforce it."

Disclosure laws for Chinese companies mirror those in Hong Kong, where many of the same companies are listed. But enforcement of those laws has been sporadic in the past, as it has been in other emerging markets such as Russia, South Korea, and India. Lu and her team perform background checks on the executives at each company under consideration for investment, including investigations into any other businesses in which its executives may be involved. All numbers are verified against regional and industry norms. For instance, Lu might evaluate a listed $1,000 expense for a new car purchase. "People at the company may be trying to inflate their costs as a way to pull money out of the business," she says. "It's our job to find out if they should have paid $800 or even $2,000."

Lu notes that the government's efforts to stem corruption should improve over time. "They will set examples to scare people enough that they will slow down the corruption practices," she says.

Additionally, because political factors often determine lending decisions, many local bank loans ended up financing unprofitable ventures. The misallocation of capital led to widespread reports of empty cities, idle power plants and other pockets of excess capacity across China's interior.

Should the economy slow too much or too quickly, borrowers might be unable to pay off their loans. That could lead to defaults and a potential financial crisis. "Some of the debts are interlinked, with one party guaranteeing the debt for another company," says Yeung. "If China's slowdown persists, it could jeopardize the system, in particular the financial companies that did the lending and the construction-related companies with the highest debt burdens."

1The Brookings Institution, Homi Kharas, 2012.
2International Monetary Fund, Sino-Spending, September 2012.

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