Consumer Credit in China

The Roaring 20's - Bank Reform, Consumerism and Inflation

Originally published in the May 2007 issue

China used to be a communist country with a command economy. In those days, the state's role in marshalling resources meant that personal consumption expenditure, even by the end of the 1980s, was just 52 percent of Gross Domestic Product (GDP). Today it is less than 40 percent of GDP. Two decades of unparalleled growth and development and personal consumption expenditure is low even by command economy standards. This perverse development is due solely to the fact that China's command economy banking system has been functioning as normal throughout this true 'great leap forward.' Things have changed. Private capital is now flushing the Chinese commercial banking system and the command economy banking system is withering on the vine. Now the banking system can do in China what it does in the rest of the world- take money from older generations of people who save and lend it to the younger generations who buy. This transformation of the Chinese banking system is less than two years old and it could be a key driver for global financial markets for decades.

The widespread growth of the hedge fund industry has been in an unparalleled era when the savings of one of the world's poorest countries supported the consumption of one of the world's richest. This under-consumption by China has been a key factor in depressing US Dollar (USD) interest rates and reducing inflation. Depressing the world's de facto benchmark interest rate and enhancing deflationary forces has produced positives for almost every global financial market. Japan has been the exception – where domestic policy errors combined with the disinflationary impact from China turned benign disinflation into the nightmare of deflation.

Even this has produced considerable opportunities for investors as a capped Yen/USD rate and low interest have provided cheap leverage for investors. So how does the world change in an environment where the fresh private bank capital in the Chinese banking system is targeted at growing loans to Chinese consumers rather than to Chinese state owned industries?

We are at the birth of consumer credit in China, which is not dissimilar to the birth which occurred in the United States in 1919 with the creation of the General Motors Acceptance Corporation (GMAC). The creation of GMAC and the spread of consumer credit beyond the poorer sections of society spurred the creation of thousands of consumer credit companies.

The US economy's first taste of widely available consumer credit was at the heart of the economic and stock market boom which followed in the 1920s. The birth of consumer credit in the United States produced a structural alteration in the US economy, which saw declining savings rates and a greater percentage of personal consumption expenditure targeted on consumer durables. This was a permanent structural shift and is what we could expect in China, meaning that there will be times in China when demand outstrips supply and when China is exporting inflation and not disinflation to the world. There also will be times when China runs a current account deficit and imports, rather than exports, capital.

Implications of reform

The reform of the Chinese banking system threatens to reverse the benign impact China has had on global financial markets for almost two decades. We can now expect to move to a period when China is not depressing US interest rates and bringing disinflation to the world. This would be a normal cyclical phenomenon and replace the structural disinflation which has come from combining economic growth and a command economy banking system. If you started managing funds after 1980, you were educated about financial market relationships in a period of disinflation. What will you do when this inflationary structural change in China is combined with ECB action to dim the rise of the Euro against the USD? Will it be clear then that the downward pressure of the USD may not result in a collapse of it but rather easing monetary policy outside the United States and rising inflation? How many investors fully understand how these relationships between financial markets change in periods of rising inflation? For equity investors in particular, how do you decide which global stock markets benefit in a period of rising inflation?

There is limited room to discuss the huge global ramifications from the return of inflation in one article however, there are some important dynamics which will change how you run your portfolio. Inflation is bad for equities and bad consequences for equities become particularly apparent as inflation rises through 4 percent.

The evidence for that proposition comes from a study of the return data for 16 equity markets over the course of the 20th century (see Practical History of Financial Markets: Edinburgh Business School). A study of the US market suggests that inflation has been the key catalyst to reduce very high valuations. One should expect the shock of inflation and the harsh measures needed to contain it to reduce equity valuations. The cyclically adjusted PE (calculated using 10-year rolling inflation adjusted EPS data) for the S&P Composite index should decline to around 10 times from the current level of almost 30 times (see Anatomy of The Bear: Lessons From Wall Streets Four Great Bottoms: R. Napier, CLSA Books, December 2005).

Good news for Japan

The key equity markets that should benefit from a rise of inflation are those that have been depressed to cheap levels by deflation. Japan stands out in this regard and, as we have seen in US history, the end of deflation will bring forward postponed consumption and a shift away from domestic bonds and into domestic equities. Perhaps more surprisingly, a rise of inflation could be very positive in jurisdictions where the authorities are powerless to adjust their monetary policy to combat inflation.

A good example of such a jurisdiction is Hong Kong, where the strictures of the currency board system can result in inflation rising with much more limited rises, or even declines, in interest rates. In such a jurisdiction, the decline in real rates of interest results in a shift of domestic savings from deposits into equities and property. The 'normal' negative relationship between equity valuations and inflation are suspended in such an environment because a policy response to inflation is suspended. There are a range of these peculiar monetary situations across the emerging markets which may offer similar opportunities.

The good news is that it will be a considerable period before the changing inflationary dynamic upsets the profitable mathematics of the Yen carry trade. A time will come to pass when the oil of higher inflation has produced an entrenched domestic demand recovery in Japan. At this stage, the Japanese authorities will be prepared to accept the risks to the export sector that a higher Yen predicts, threatening large losses to those borrowing Yen to invest in non-Yen assets. However this entrenched domestic recovery is many months and probably years in the future, and in the meantime there are plenty of inflation plays, most obviously gold, for Yen leveraged investors to profit from.

The Chinese banking system is changing and in the process unleashing consumerism in what is probably the world's third largest economy. It is usually hyperbole to say the world will never be the same again. However it was true to make this statement at the birth of consumer credit in the United States in 1919 and it is just as true to make such a statement today.

Dust down the history books and try to learn what happens in financial markets when inflation is on the rise. If you do not understand the new dynamic then you might be about to learn some very expensive lessons.

Russell Napier is a consultant with CLSA and author of Anatomy of The Bear: Lessons From Wall Street's Four Great Bottoms