MIKE WILSON (MW): Where is China in its transition from a more investment driven economy to one that is more consumption driven, and what are the big misunderstandings there?

ANDY ROTHMAN (AR): China has significant obstacles ahead, but I think a lot of people misunderstand how much progress is already being made.

The old model of relying on investment isn't sustainable—no one in China would argue that. For nine consecutive years, investment growth averaged about 25% a year as China was effectively building the entire public infrastructure that took the US 100+ years to build. Since 2011, that growth rate has been decelerating but, at the same time, China has had the best consumer story on the planet.

The consumption share of GDP is relatively low compared to developed countries, but it's growing at a faster rate than pretty much anywhere else. Inflation adjusted retail sales growth is running about 10% compared to about 2% in the US—not because the Chinese are maxing out their credit cards but because income growth is running at 8%. Household consumption will continue to be a smaller part of the economy than investment but it's going to drive growth.

MW: Where could the deceleration lead? And what would constitute a soft landing?

AR: I think we're in the middle of the soft landing now, coming off three decades of 10% average annual GDP growth. Last year, GDP growth was just over 7%; this year I think it will be just under 7%. I'm bullish about China's economic prospects, within the context of expecting that every year, on average, all the major economic indicators, including GDP growth, are going to be a bit slower.

Part of this is the base effect—the economy has just gotten so big—and part of it is the change in demographics. A significant portion of the 10% growth came from the fact that the workforce was expanding every year; now it’s shrinking a bit. Also, China is less dependent on heavy industry and more on consumption, where it's harder to drive productivity gains.

But slower is not bad. For example, GDP growth is multiplied against the base. So, last year, 7.4% growth was significantly slower than the 10% a decade earlier, but the base to which that 7.4% was applied was 300% bigger. This meant that the incremental expansion of China’s economy was 100% bigger at the slower growth rate. It's a better opportunity for people selling goods and services to Chinese people, and for investors.

MW: Do you believe the data are relatively trustworthy?

AR: I'm sticking with “trust, but verify.” I think the Chinese government is manipulating the economic data much less than in the early ‘80s. Plus, we have more nongovernmental ways of checking it. A lot of private companies are doing business there now—small privately owned companies unconnected to the government—and when I ask them about wages, accounts receivable or orders, they have no incentive to lie. We're also allowed to do survey work on the ground. Do I know for sure that GDP growth was 7.4% last year as opposed to 7.1? No, but we don't invest in GDP growth rates.

MW: What’s your take on these “ghost cities” and the debt that’s been built up? How does the leverage that was employed to grow compare to other countries at the same level of development?

AR: The ghost city story is a good example of how we can misread—by taking our framework for evaluating a sector and applying it to China. First, when we talk about new-home purchases in China, they're almost all apartments, not single-family homes.

The Chinese also saw what we did ahead of the global financial crisis and decided not to repeat those mistakes. In 2006, the median cash down payment in the US for a new home buyer was 2% of the purchase price. In China, the minimum cash down payment is 30% of the purchase price, with 15% of buyers paying all cash. So debt levels among Chinese homeowners are pretty much the opposite of what they were in the US. There is a debt issue in real estate, but it's among the developers, not the homeowners.

Second, most Chinese buy a home well before the apartment building is completed, knowing they're not going to move in for some time, often several years. They're going to wait for the local government to build subways, light rails, schools, hospitals, sports facilities. If you visit a place before those things are finished, it does look ghostly, but go back a couple years later, and with a few exceptions, they are filled up—with people who paid a lot of cash.

If you look at debt to GDP, China is probably about 20th in the world, and the growth rate has been fast and concerning. But the majority of debt is held by the government or government-controlled companies. Privately owned companies have actually been deleveraging.

Unlike in the US, the medicine to fix the debt problem in China is not going to be broad deleveraging, which strangled credit access for the small and midsize companies that drive the US economy. It's going to be another round of reform of state-owned enterprises, and it shouldn't affect the private companies that account for 80% of employment—and all the new job and wealth creation. Fixing the debt problem may lead to more volatility and steadily slower growth, but I don't see a crisis or a hard landing.

MW: Why did the Chinese equity market suddenly perk up last year?

AR: The domestic equity market, the A share market, is highly driven by Chinese retail investors; foreign participation is about 3% of market cap. It's difficult to know what's going on in the mind of a small-scale retail investor in China.

For six years, up to about a year ago, China had the best macroeconomic performance in the world and some of the worst equity performance. Now we've got a bit of a catch-up, plus a response to the government preparing to embark on a significant easing program. The market did run up, and as of early July it was down more than 25% from its early June peak.

The main market misconception is valuations. There’s talk about bubbles, and many stocks have ridiculous valuations, but, looking at the broad A-share market— which has about 2,800 companies and is held mainly by domestic retail investors— it's expensive. The median forward P/E is about 54, but few US clients will have exposure to that market. Most clients, when they have China exposure, will be in the Hong Kong market, where the median forward P/E is 14.

MW: Has institutional or foreign interest in China accelerated over the last six months?

AR: I think interest continues to rise. More investors and business people are recognizing that China plays an important role in the global economy, accounting for 12.3% of global GDP. The challenge is that more people are opining on China, and many have spent little or no time there, don't understand it very well and get seduced by things like the ghost-city story.

MW: How would you rate the current administration's four to five years of structural-reform goals? Where are they in that continuum?

AR: In the longer-term context, when I started working in China 30 years ago, there were no private companies. Today small, private firms account for 80% of employment in China—all the new job creation and most of the industrial sales and investment.

For the past two years, the current administration has been focused on moving the financial sector to serve the private companies generating all the jobs. The financial sector is one place where the government still retains control; they haven't backed away like they have in most other parts of the economy.

The state-controlled banking system is now directing most of its credit to the nonstate sector, or private companies and households—a huge change that many haven't noticed. We've seen improvements in control over interest rates, and some backsliding as well more recently, where the government is trying to intervene in the equity market. But I don't think that represents a significant obstacle to more reform.

MW: Do you think the potential for geopolitical risks has lessened?

AR: I believe the risks have gone down. I think the current administration made a deliberate decision to end a few decades of China's approach to foreign policy— basically keep its head down overseas, focus on domestic economic development and don't annoy the neighbors.

The new philosophy, however, is, "The time is right. We are now either a global superpower or on that track, and it's time to behave like one and promote our objectives more aggressively." Unfortunately, this has made everybody in the region afraid of China. I think the government is still feeling its way here and has recognized it went too far. We’re seeing fewer reports of incidents in the South China Sea near Vietnam, for example, and the East China Sea toward Japan.

From an investor's perspective, I think the risks are small.

MW: How do you view the actions of the US and Japan toward China in the last year or so?

AR: I think the US and Japan are both still trying to come to terms with the fact that China is a much bigger player. I think we all have an opportunity to guide China in the right direction. There is no reversing the fact that China's getting bigger and more powerful, and that process is likely to continue. We need to continue to bring them into the global structure to engage with us in a positive way, and not try and contain or hold them down.

I still think Japan is doing itself a big disservice by not acknowledging and accounting for its mistakes during World War II. That has affected Japan’s relationships with a lot of its neighbors, not just China.

MW: How would you advise investors, from a broad perspective, over the next 12 to 24 months?

AR: China is a big part of the global economy, driving a larger share of global growth than the US, Europe and Japan combined. Investors need to understand what's happening there. For more experienced investors who want a stake in that, it may no longer be enough to play the China growth story, the consumer story, through multinationals because Chinese brands are stealing market share from them at a good clip. They may want to look for more direct exposure. 

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