Braking China …

Without Breaking
the World

BlackRock Investment Institute

April 2012
[ 2 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d
What Is Inside
First Words and Summary
China Inc: Bull, Bear and Bottom Line
Introduction: Why China Matters
– A Matter of Timing
Credit: Too Much, Too Quickly 8 Mark McCombe
– The Great Credit Leap Forward
– Bad Debt? Just Roll It Over
– No Banker Will Come Clean This Year
– A Less Offensive Four-Letter Word
Real Estate: Can a Bubble Be Deflated? 13
– Something’s Got to Give
– A Men’s Shirtmaker Diversifies
– A Quiet New Year for Realtors
– Breaking a Vicious Circle
Investment and Consumption:
Looking for Balance
– A Case of Diminishing Returns
– Go Buy a Refrigerator!
– A Blueprint for Rebalancing Success
– Bankers Are Shooting Fish in a Barrel
– Wanted: Carefree Spenders
– In Search of Luxury Goods
Politics: Change Is Hard 23
– The Emperor Is Far Away
– Vested Interests and Paralysis
– 300 Million Publishers
– From Small Piles of Rocks to Oil Shock
– Tit for Tat in Trade Wars
Competiveness: Beyond Cheap Labor
– Of Robots and Old People
Markets: Counting on China 29
– Equities and Corporate Bonds:
A Growing Addiction
– Commodities: An Outsized Influence
– Government Bonds: A Big Overhang
The opinions expressed are as of April 2012, and may change as subsequent conditions vary.
Joel Kim
Head of BlackRock Asia-Pacific
3 Fixed Income
4
6
Chairman, BlackRock Asia-Pacific
Neeraj Seth
Head of Asian Credit, BlackRock
Fundamental Fixed Income Group
Jeff Shen, PhD
Head of Asia-Pacific and Emerging
Market Equity, BlackRock Scientific
17 Active Equity Group
Ewen Cameron Watt
Chief Investment Strategist,
BlackRock Investment Institute
BlackRock’s China Forum
About 50 leading BlackRock portfolio managers and external
experts from around the globe recently exchanged views on China’s
economic trajectory at the BlackRock Investment Institute’s
China Forum. Many went in bullish and came out still bullish—
but with much less complacency and certainty. This publication
summarizes their ideas.
27
The BlackRock Investment Institute leverages the firm’s
expertise across asset classes, client groups and regions.
The Institute’s goal is to produce information that makes
BlackRock’s portfolio managers better investors and helps
deliver positive investment results for clients.
Lee Kempler Executive Director
Ewen Cameron Watt Chief Investment Strategist
Jack Reerink Executive Editor

First Words and Summary
China is at a crossroads. Investment-driven growth has spun
an economic success story without equal since the country
opened for business in 1978. This has come at a cost: Unbridled
credit growth, overbuilding, environmental damage and a widening
divide between the haves and have-nots.
It has become clear China’s old playbook of “invest and grow” no
longer works so well. But a shift to a consumption-driven society
is tough for a command economy and wrought with pitfalls. The
country’s upcoming once-a-decade leadership change brings
both opportunity and uncertainty. The downfall of “princeling”
Bo Xilai, the former charis-matic leader of Chongqing, shows
tumult below the surface. This changing of the guard will
reverberate well beyond its own population, as China has
become the globe’s growth engine.
We are optimistic on China’s economic trajectory in the short term.
A nagging worry: Markets already factor in a “soft landing” this
year, leaving potential downside risk. The leaders walk a tightrope,
and have lowered the official growth target to 7.5% for 2012. We
are concerned about China’s ability to keep up its economic march
in the long run. Challenges are big and solutions are not easy.
This publication discusses key factors driving China’s economy
this year and beyond, signposts for change and implications for
investors. Examining the financial system, the deflating real
estate bubble, the tricky shift to a consumption economy,
politics and competitiveness, our main findings are:
An explosion in credit growth resulting from Beijing’s 2009
} 
stimulus has made the financial sector the economy’s Achilles
heel and its biggest long-term threat. The country can pave
over problems this year, but the bills will come due. China will
have to charge borrowers real money and give savers a real
return to create a healthy financial system in the long run.
} The real estate slump is the biggest threat to economic growth
and confidence this year. The sector is interwoven with the
entire economy and has been a key growth driver. A government-
engineered slowdown has brought down prices to more
affordable levels, but also has created ghost cities. Urbanization
and growing incomes should balance supply and demand
eventually. The question now is: Can Beijing break a vicious
circle of falling prices and sales (when it is ready to do so)?
} China’s economic miracle was built on an undervalued currency,
lots of investment, and subsidized energy and credit for
The opinions expressed are as of April 2012, and may change as subsequent conditions vary.
Blackrock investment institute [3]
manufacturers. Domestic savers financed China Inc.’s master
plan by accepting savings rates below inflation, wage increases
that lagged economic growth and a minimal social safety net.
This is changing, but powerful interests are stacked against
a true shift to a consumption economy: exporters, state
enterprises and local governments.
} China’s new leadership could take the tough measures needed to
engineer a shift—liberalizing interest rates, opening capital
markets, market pricing of resources, and building out social
services. But Beijing is not almighty; local governments tend
to go their own way and a desire for consensus has often resulted
in political paralysis. Risks of a popular revolt or foreign conflicts
are low as the one-party state has kept a tight lid on dissent
and is focused on fulfilling its domestic social contract.
} Real wage growth, rising materials costs and environmental
restrictions are changing the workshop of the world—for the
better. Some labor-intensive industries are moving elsewhere
and automation is increasing. There is room for more productivity
growth even as the easy gains have been harvested. Protection
of intellectual property is still weak and global brands have
yet to emerge, but we believe chances are China will remain
competitive and confound the doomsayers.
So What Do I Do With My Money?TM
} Global consumer companies and high-end machinery
makers are likely to be good long-term bets.
} Energy, precious metals and agricultural commodities
prices should be underpinned by the country’s insatiable
demand, and boost companies in those areas.
} Most Chinese companies are likely to report poor
earnings this year, but valuations look cheap.
} China’s demand for basic materials such as cement
and steel should peak soon, hitting key suppliers and
resource currencies in those markets.
} China’s buying of US Treasuries may slow over time,
but a fire sale does not look to be in the cards.
More investment implications on pages 29 to 31.
[ 4 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

China Inc: Bull, Bear and Bottom Line

Factor Bull Case
A Sickly Financial System It is easy to pave over financial problems in the
short term, Beijing has plenty of firepower for
bailouts. Growth in local government debt has
come to a screeching halt. China has proved
many times it can fix its banks when needed. The
same team that engineered a doubling of annual
credit to 14 trillion RMB during the financial crisis
can pull the strings in a different direction.
Bear Case
Banks’ non-performing loans have fallen by 97%
in the past decade, but this masks a poisonous
reality: Unpaid loans are rolled over. Debts of
state enterprises and, to a lesser extent, of local
governments appear to be ticking time bombs.
Banks are bleeding deposits and luring customers
with asset-backed securities. (Hmmm, what kind
of assets?) Banks are lending to all the wrong
people: lumbering state giants and developers.
Banks are bad at risk management.

A Deflating Urbanization and the desire for upgrades provide
Real Estate Bubble steady demand. Affordability is improving due to
falling prices and rapid real wage growth. Buyers
pay a majority of the purchase in cash, so price
declines will not hurt the financial system. Savers
have few other places to park their cash. A
push on low-end “social” housing will keep
the construction industry busy.
Local governments, banks and companies all bet
prices would keep rising and are overexposed.
Real estate has been the driver of economic
growth. Homes are too expensive for average
earners. Overbuilding has resulted in ghost
cities and a huge inventory of unsold properties.
Beijing may not be able to arrest a vicious
cycle of lower prices and lower sales.

Too Much Investment and
Too Little Consumption
Is there such a thing as too much investment?
Capital stock is not yet excessive by international
standards, and China needs investments in
infrastructure and automation to keep up
productivity growth. Consumption is rising
rapidly, and half of households will soon classify
as “middle income.” Rural wages are growing faster
than urban ones, making for more balanced
development. Building out a social safety net
would unleash a pile of precautionary savings
for illness and old age.
Investment is a case of diminishing returns: It
takes $5 to generate $1 of GDP growth. The model
is based on an undervalued currency, low real
wage growth and financial repression—factors
that policymakers are loath or unable to change.
China’s command economy appears ill-equipped
to stimulate consumption. Much industry would
collapse without below-cost energy and interest
rates. “Vested interests” will work hard to torpedo
a shift to a consumption model. Commodities
demand is at risk. Watch out, Australia.

Political Risk The Communist Party arguably is built for stability:
It knows internal strife can result in Cultural
Revolution-type horrors. Regimes historically
have faced popular revolts only when incomes
reach the world’s median: China has a long way
to go there. Beijing has kept a tight lid on internal
dissent and has not had a major overseas
confrontation in the last 30 years.
All politics are local. It is an uphill battle to
effectively steer the country toward a new course.
China has not done enough to improve the
environment, curb corruption, address the widening
inequality gap and stimulate consumption.
The leadership often is paralyzed because it is
pulled in too many directions. China’s military
build-up could set up the world for a major
confrontation down the road.

Competitiveness China’s value-added exports are increasing and
industries are investing in automation to stay
competitive and improve quality. China is filing
more patents and is now dominating industries
of the future such as solar power. The country
has a first-class infrastructure. The migration of
labor-intensive industries to Vietnam, Cambodia
and elsewhere is a good thing.
Heavy subsidies have thwarted competitiveness
and innovation. Violations of intellectual property
rights still occur. The easy productivity gains
have been harvested, and wage growth is a
problem. China has yet to develop real brands.

Bottom Line
We expect a soft landing in 2012. Longer term,
the financial system represents the biggest risk
to the economy, we believe. The sheer magnitude
and pace of credit growth does not pass our
smell test.
Bull Bear
Real estate is the No. 1 threat to China’s growth
this year because the sector is so interwoven with
the rest of the economy. Supply and demand
should balance out in the long run. The lack of
leverage is a big positive.
Bull Bear
A pullback in consumption in the wake of falling
real estate prices and slowing export growth is
a major risk this year. Longer term, a big worry
is that a rush to rebalance could lead to an
economic implosion.
Bull Bear
A one-party system is geared to retain its
hegemony and ensure stability. The upcoming
once-a-decade leadership change is hairy. Bo
Xilai’s downfall is the tip of the iceberg, and one
that is freezing policy for now.
Bull Bear
Loss of competitiveness is the lowest risk to the
economy this year and beyond. China already is
moving up the value chain.
Bull Bear
Blackrock investment institute [5]
Signposts (What to Look for)
} Reserve ratio changes
} Deposit outflows and sales of wealth management products
} Bank cash flows and operating cash levels
} Credit growth and non-performing loan trends
} Corporate bond issuance and trading
} Gradual moves toward market-driven deposit and lending rates
} Demand for gold and other “hard” assets
} Inventories, sales volumes and price trends
} Ratio of new construction vs. sold floor space
} Debt and stock prices of major developers and consolidation in the sector
} Policy actions such as property taxes or, conversely, more curbs
} Sales of construction machinery and durable household goods
} Sales and volumes in secondary and tertiary cities
} Granting migrant workers urban residency permits so they can own homes
} Monthly retail, auto and luxury sales
} Consumption share of GDP and GDP growth, and real wage growth
} Raw materials imports, energy subsidies and commodities prices
} Import/export trends (beyond one-month aberrations such as this February)
} Loosening the currency peg and opening capital markets
} Privatizing state enterprises and liberalizing interest rates
} New sources of local government financing
} Macau gambling revenues and capital flows
} Political unrest beyond local flare-ups
} Food price inflation, unemployment and rising inequality
} Efforts to curb corruption, protect the environment and ensure food safety
} High-profile casualties of the upcoming leadership change such as Bo Xilai
} Restrictions on social networks such as Weibo
} Confrontations in the East China Sea with other Asian countries or the US
} Increased secessionist and religious militancy
} Productivity and real wage growth
} High-end machinery orders
} R&D spending and patent applications
} Trends in returns of Chinese who have studied abroad
} Emergence of domestic and global Chinese brands
} Protectionist actions by China’s trade partners
[ 6 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

Introduction: Why China Matters

China matters—a lot. The country has rapidly become the second-
largest economy in the world. It will likely contribute two-fifths
to global growth this year, twice as much as the United States.
See the chart below. Resource-hungry China has an outsized
influence on most commodities markets, and is the largest
foreign holder of US Treasuries.
GDP per capita jumped more than 20-fold to $4,400 in the 30-year
period ended 2010. Ports, bridges, airports, expressways and
entire cities have been built in record time. China is now the largest
market in the world for cars, computers, mobile phones—the
list is endless. Wine sales have more than tripled in just five years.
A Heavy Burden
China’s Share of Expected 2012 Global Economic Growth
China 40%
Rest of Asia 24%
Other Emerging Markets 17%
US 17%
Other Developed Markets 2%
Source: Deutsche Bank (January 2012).
Note: Assumes global economic growth of 3.2% in 2012.
The big questions are how the current government will navigate
the domestic real estate slump and the global economic slowdown,
and whether the future leaders will be able to solve a ticking
bad debt time bomb and deliver on promises to rebalance the
economy toward consumption and sustainable growth.
Add in challenges of maintaining a “harmonious society” in a
place with rapidly growing expectations, corruption, a long history
of regionalism and world-beating income inequality, and you have
a troublesome brew. This is before you even consider artificial
pricing of money and a financial system that subsidizes borrowers
at the expense of lenders. Or ponder environmental despoilment,
deteriorating demographics, water shortages and a growing
addiction to imported energy. It is a wonder the place works
so well—or at all. There is enough fodder for a fierce debate
between panda haters and panda huggers. Now read on…
A Matter of Timing
Real reforms to rebalance China’s economy are on hold this
year because of the once-a-decade leadership change. An
imminent collapse is unlikely, we think. The current leadership
will not go out with a bang, but certainly does not want a train
wreck during the final stages of stewardship.
Business cycles exist in China as elsewhere —but we expect a
soft landing in 2012.

Flattening Out
Sales of Heavy Machinery and Autos

100 250% 2,000 150%

200 120
80
UNITS (THOUSANDS)

UNITS (THOUSANDS)

1,500
Y-O-Y GROWTH (%)

Y-O-Y GROWTH (%)

150 90
60 100 60
1,000
40 50 30
0 500 0
20
-50 -30
0 -100 0 -60
2008 2009 2010 2011 2012 2002 2004 2006 2008 2010 2012
Monthly Machinery Sales YoY % Monthly Auto Sales YoY %

Sources: Bank of America Merrill Lynch, China Construction Machinery Institute and China Association of Automobile Manufacturers.
Notes: Machinery sales data through January 2012. Auto sales data through February 2012.
 Blackrock investment institute [7]

In this interim period, it is important to read the economic tea Like some corporate chieftains, China likes to manage
leaves. Real estate prices, sales and construction are important expectations by under-promising and over-delivering.
ones. Politically sensitive food inflation is another one, as are
manufacturing gauges such as the various purchasing manager Premier Wen Jiabao set a 7.5% annual growth target for 2012

indexes (PMIs). in March—the lowest rate in almost a decade. Most China

At the start of 2012, the data were both conflicting and skewed
by the effects of the early lunar New Year holiday. Real estate and
key consumption indicators pointed down, while other gauges
pointed up.
For example, sales of heavy machinery used in construction,
such as excavators, crashed. Auto sales flattened, pointing to
a general slowing in the wider economy. See the charts on the
previous page.
By contrast, transport volumes are strong. And a gauge of small
business activity has been ticking up. See the chart below. This
is important because small businesses employ 60% of China’s
workers and make up 90% of companies.
The rebound could indicate the government’s easing policy
on liquidity has started to work. Bank credit enabled large
companies to pay their supplier bills. Secondly, it could mean
the bottom has not fallen out of exports because many small
companies are exporters.
watchers, however, believe the country will want to achieve at
least 8.5% a year. Official targets exist to be beaten. Like some
corporate chieftains, China likes to manage expectations by
under-promising and over-delivering.
It is realistic to expect China to move toward economic growth
of 6%-7% a year this decade versus the 10%-plus clip in the old
days, we believe. Five reasons:
} The political leadership appears to understand the
drawbacks of too much credit.
} Slow growth in the debt-ridden developed world likely means
slack demand for exports.
} The real estate boom has ended because tightening
measures have taken hold.
} Infrastructure spending is slowing as policy shifts from
favoring bridges for the masses to pills for the people.
} Savings rates—the fuel of deposit and loan growth—are
likely to remain flat or drop from mind-blowingly high levels.

Beijing is expected to arrest this year’s slowdown in growth

A Ray of Light with all sorts of administrative and fiscal measures, while at the
China’s Small Business PMI, 2011-2012 same time trying to keep a lid on inflation and prevent more bad
debts that eventually could overwhelm the banking system.
60
58 Most people, perhaps too many, believe Beijing will walk this
56 tightrope. At US investor gatherings in late February, one Wall
SMALL BUSINESS PMI

54 Street firm’s China strategist polled the audiences and found

52 just one bear among roughly 1,000 people. This lonely creature
50
contrasted with a host of cubs the previous year.
48
46 Beyond 2012, the picture becomes very different. It is now clear
44 China’s 2009 stimulus was too much, in too short a time. Beijing
42 overestimated the US recession’s fallout. The result is a pile of
40 debt—which looks ready to fall over in the next few years (or
Jan ’11 Mar ’11 May ’11 Jul ’11 Sep ’11 Nov ’11 Feb’ 12 stay shaky forever).

Source: China Federation of Logistics and Procurement.

Note: Data through February 2012.
Most people, perhaps too many, believe Beijing will
walk this tightrope.
[ 8 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

Credit: Too Much, Too Quickly

For a poster child of “financial repression,” pick any of China’s What changed in 2004? China had started to rack up huge account
one-billion-plus consumers. They have been bankrolling the surpluses because of bumper exports and an underappreciated
country’s infrastructure boom and manufacturing machine— RMB currency. The surplus hit an unprecedented 10% of GDP at
and have lost money in real terms in the process. (A cynic would its peak in 2007. The central bank started to offset, or sterilize,
say the West now is importing this made-in-China concept.) the flood of foreign currency by selling bills at very low rates.
Consumers who park their savings at banks have received For bankers, these were “bills you can’t refuse.”
negative returns after factoring in inflation, an average loss
To keep the banks profitable, authorities set deposit rates low.
of 0.54% a year since 2004. See the chart below.
Low deposit rates and high reserve ratios also would put a brake
on inflows of “hot money” speculating on appreciation of the
Don’t Take It to the Bank! RMB. The result: an effective tax on consumers who kept their
Real Return on Household One-Year Deposits, 1997-2011 savings at banks.

8% Financial repression worked well because consumption took

7
a back seat in China’s investment-driven master plan. More on
6
China’s hard-pressed consumer and unprecedented investment
REAL INTEREST RATE (%)

5 Average Interest
4 Rate = 3.04%
boom later. In this chapter, we review the credit boom these
3
2 savings helped create.
1
0
-1
The Great Credit Leap Forward
-2 Average Interest
Rate = -0.54% Armed with a reliable supply of cheap deposits, banks went on
-3
-4 a lending binge. The biggest beneficiaries were state-owned
-5 enterprises (SOEs) and local governments.
’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11
The first group revved up exports and capital expenditures even
Source: Peterson Institute for International Economics. more, supported by cheap credit and subsidized energy costs.
Note: Data through December 2011. It was a lifeline to many enterprises that had no business
staying in business.

Debts Have a Way of Piling Up—Even in China

Credit Growth in Billions of RMB and as a Percentage of GDP, 1993-2011

15,000 50%
CREDIT GROWTH (RMB BILLIONS)

CREDIT GROWTH TO GDP (%)

12,000 40

9,000 30

6,000 20
% GDP
3,000 10

0 0
’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11
New RMB Loans New Foreign Currency Loans New Entrusted Loans New Trust Loans New Bank Acceptances
Corporate Bonds New Stock Issued by Non-Financial Enterprises Insurance Claims Paid Insurance Company Real Estate Other

Sources: Carl Walter, Su Ning, China Bank Statistics and People’s Bank of China.
 Blackrock investment institute [9]

The second group financed infrastructure works, office towers, It is unlikely China will let the market collapse.
conference centers and an array of faux landmarks, from Nobody wants to see a local government default
Chengdu’s Dorchester-inspired British town to Venetian canals or a big state firm go belly up.
and a replica of St Mark’s bell tower at the New South China Mall in
A bank CEO in a coastal city may say his operation is lending 100%
Dongguan. This helped inflate an emerging real estate bubble.
of deposits, no problem. He gets away with it because his bank
Credit grew and grew ... until a great leap forward in 2009. Worried is part of a national network that (still) has enough deposits in the
the world financial crisis and subsequent US recession would interior to make up for shortfalls on the coast. The government
hit China hard, Beijing engineered a huge monetary stimulus. may abolish this cap because it has many other ways to control
Credit doubled to a clip of at least 14 trillion RMB a year. See loan growth, notably its stranglehold on interbank market.
the chart on previous page.
Everything appears just hunky-dory for China’s banks: Non-
Credit grew at an compounded annual growth rate of 36% in the performing loans (NPLs) fell by 97% over the past decade and
period 2004 to 2010. As a result, the total value of bank loans now average just 1% of the loan book. See the chart below.
and bonds quickly exceeded GDP. See the chart below.

A Likely Sad Ending Too Good to Be True

Outstanding Loans and Bonds, 1996-2010 Non-Performing Loan Ratios of Major Banks, 1998-2011

60,000 140% 35%

LOANS AND BONDS (RMB BILLIONS)

LOANS AND BONDS TO GDP (%)

50,000 120 30
NON-PERFORMING LOANS (%)

100
40,000 25
80
30,000 20
60
20,000 15
40
10,000 20 10

0 0 5
’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10
0
Bank Loans Bonds
’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11
Loans/GDP Loans and Bonds/GDP
Sources: UBS, People’s Bank of China, China Banking Regulatory Commission and CEIC.
Sources: Carl Walter, People’s Bank of China and Wind Information. Note: Data before 2002 only cover the Big-4 state-owned banks.

This is where the problem lies: Take a machine that runs along
This is dangerous, especially because both local authorities
at a steady pace, suddenly inject adrenaline and order: “Go
and SOEs are already deep in debt. It is unlikely China will let the
lend.” The sheer magnitude and pace of this unbridled credit
market collapse, though: Nobody wants to see a local government
growth does not pass our smell test. It suggests to experienced
default or a big state firm go belly up. There is nothing subtle
investors there has to be trouble somewhere, sometime.
about the government guarantees of these entities.

Bad Debt? Just Roll It Over High-profile bankruptcies just do not fit into China Inc.’s master
China has plenty of rules to keep credit growth in check. But plan of economic growth and employment. And banks are very much
they are loosely enforced. For example, Chinese banks are part of the plan. Banks are, after all, an extension of the fiscal
supposed to lend up to 75% of deposits. But banks need to show policy. This is also the reason they trade at such low valuations.
a 75% loan-to-deposit ratio only at the month’s end—giving
them about 30 days each month when they can lend more.
Take a machine that runs along at a steady pace,
suddenly inject adrenaline and order: “Go lend.”
[ 10 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d
No Banker Will Come Clean This Year
The practice of rolling over loans works—as long as banks have
enough deposits to play with. It is like a bath filling up faster
than it empties out.
But companies and consumers—faced with cash flow needs
and fed up with negative real returns—are starting to vote with
their feet and are pulling deposits. Banks, especially in coastal
areas, are trying to fight these outflows by offering asset-backed
securities that carry higher interest rates. About 10% of deposits
has flowed into these “wealth management” products. See the
chart below.
Looks Familiar?
Investment in Asset-Backed Securities Quadrupled, 2007-2011
8,000
ASSET-BACKED SECURITIES (RMB MILLIONS)
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
2007 2008 2009
Index-Linked
Asset-Backed Bills
Sources: Carl Walter, Wind Information and Fitch Ratings.
Note: Data through June 30, 2011.
Deposits from corporations under cash flow pressure (and with the
ability to export capital by padding overseas invoices) dwindled to
near zero in the first nine months of 2011, compared with growth of
3.7 trillion RMB in 2010. In the third quarter alone, corporate
deposits of an estimated 1 trillion RMB vanished into thin air.
Combined with the strangle of rising reserve ratios, growth in
the M1 money supply has dwindled to a clip of 3%-4%.
Moreover, deposit outflows have triggered a slow-motion cash
crunch. Smaller banks in particular are vulnerable, partly because
their loans are coming due earlier. Operating cash reserves
have deteriorated across the industry in the past three years,
with many second-tier banks already facing shortfalls, according
to ratings agency Fitch Ratings.
Do not expect any banks to come clean this year. Bank chieftains
angling for government positions in the leadership change will
want their records to remain squeaky clean.
Put yourself in the position of a bank CEO. You have been presiding
over five years—20 quarters—of profit increases. Now you are
gunning for that position in the State Council. Are you going to
bring down your profits this year by increasing provisions? Just
to be prudent? Chances are you will not. You leave it for the next
guy to deal with.
To be sure, there are plenty of deposits. They are just not for
lending. One example: To recycle the inflows of foreign exchange
and prevent the RMB from appreciating, the central bank obliges
banks to hold vast quantities of reserve bonds yielding only 1.5%.
This deflates the money multiplier and kicks sand into the engine
of a credit-led economy.
Bank chieftains angling for government positions
in the leadership change will want their records to
remain squeaky clean.
In all, the Triple R (Required Reserve Ratio) and other measures
tie up some 10 trillion RMB of deposits. This has given the central
bank the means to provide stimulus when the economy needs
it. Every cut in the Triple R pumps some 380 billion RMB into the
2010 2011
system (provided the cuts are not offset by capital outflows).
Asset-Backed Other
Asset-Backed Loans This doesn’t mean SOEs and other politically connected players
have a tough time getting credit. Not at all. They are issuing bonds
like there is no tomorrow—forced down banks’ throats at slightly
higher rates than one-year deposit rates. The result is a huge debt
capital market where very few trades take place. Why? If a bank
sells these bonds, it is almost guaranteed to take a loss because
nobody wants them at the price the bank paid for them. Bottom
line: The corporate bond market is bank lending in disguise.
The bulls believe China has proved again and again it can fix
these problems. The basic argument goes like this: Chinese banks
go bust every decade, but the country has just found a much
better way to deal with it than the West. Conclusion: Any
weakness in the financial system will be dealt with quietly.
Deposit outflows have triggered a slow-motion
cash crunch.
 Blackrock investment institute [ 11 ]

Acronym to Watch: LGFV

Structure and Mechanics of Local Government Financing Vehicles (LGFVs)

How LGFVs Come To Be Typical LGFV Structure

Central Government Local Government

Equity/Loan Ownership of Local Enterprises,

23 Provinces Injection Land and Tax Subsidies
5 Autonomous Regions
4 Municipalities
(Beijing, Shanghai,
Chongqing, Tianjin) Repayment
2 Special LGFV Bank
Administrative Regions Cash Loan
Incorporated
6,500-8,200 LGFVs

Profit Cash Investments

333 Prefectures

2,858 Counties Activities

(Infrastructure, Utilities,
Transportation, Land
Development)
40,858 Townships

Sources: Deutsche Bank and China Statistical Yearbook 2010.

A Less Offensive Four-Letter Word
Local governments cannot borrow unless they have specific
approval from the State Council, the country’s highest executive
administrative body chaired by the premier. This doesn’t happen
very often. It is not meant to happen often. Think of it as a
company requiring CEO sign-off for all travel and entertainment.
T&E costs will go down very quickly.
Where there is a will, there is a way, though—especially in
China. Local authorities have set up special entities to pay for
infrastructure and other projects. This is perfectly legal. The
chart above shows the mechanics of these so-called local
government financing vehicles (LGFVs).
The bulls believe China has proved again and again
it can fix these problems.
time bomb, especially at a time a main source of local
government revenues—land sales—has dried up amid
falling real estate prices.
Where there is a will, there is a way—especially
in China.
Others are optimistic. LGFV net debt barely increased in 2011
because regulators discouraged banks from making new loans,
according to research firm CLSA. This compared with a 19% rise
in LGFV net debt in 2010 and a 62% stimulus-fueled jump in 2009.
CLSA says. Local governments can pocket an increasingly smaller
share of land sales because of higher spending on compensation
and relocation. As a result, local revenues from land fees
equaled just 9% of total national spending on infrastructure
in 2011, CLSA notes.

In any case, all local debt is an explicit liability of the central

LGFVs have taken out trillions of RMB in loans backed by land
government—which saw a 30% jump in tax revenues in 2011.
sales. China bears have long argued this represents a ticking
Beijing can pay a lot of bills.
[ 12 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

Get Out of Debt Tomorrow Over the Refinancing Hump

A Possible Solution for Bad LGFV Debts Maturities of Local Government Debt

3,000 3,500 35%

30.2%
2,550 600
2,500 3,000 30
600 24.5%
RMB BILLIONS

2,000

TOTAL DEBT (RMB BILLIONS)

2,500 25
600
1,500

PERCENT DUE (%)

2,000 17.2% 20
260
1,000 120
245
1,500 15
125
0 11.4%
9.3%
Local Govt. Revenues
Asset Sales

Recoveries on Projects
Potential NPLs

Local Govt. Bond

Central Govt. Support

Over-Provision for NPLs

Write-Offs
1,000 7.5% 10

500 5

0 0
2011 2012 2013 2014 2015 2016 and
Beyond
Source: Deutsche Bank estimates.
Notes: Assumes 30% of LGFV loans default. Assumes local governments sell 10% of assets Sources: Deutsche Bank and National Audit Office.
and divert 2% of revenue. Note: Data as of year-end 2010.

Even if 30% of all LGFV loans default, the problem is manageable, In addition, most LGFV debt is spread out after scaling a renewal
according to Deutsche Bank. Local government bond issues, hump last year, with almost a third due only after 2016. See
asset sales and diverting 2% of government revenues would the chart above.
solve most of the problem in its view. See the chart above.
 Blackrock investment institute [ 13 ]

Real Estate: Can a Bubble Be Deflated?

The City Beckons
Urbanization and Migration

22 Cities > 5 Million = 180 Million

71 Cities 2-5 Million = 216 Million 552 962 1,307 1,427
121 Cities 1-2 Million = 175 Million mln mln mln mln
100%
214 Cities = 571 Million Harbin

467
Shenyang 80 mln

Beijing 745

SHARE OF POPULATION (%)

mln
Tianjian
60 790
490 mln
Xi’an mln

Nanjing
40
Shanghai 960
mln
Chengdu Wuhan
Hangzhou 562
20
mln
Chongqing
172
62 mln
Guangzhou 0 mln

1950 1978 2005 2025

Rural Urban

Sources: ISI Group, CEIC and National Bureau of Statistics.

Note: Numbers in millions of people.

Rapid urbanization drove China’s housing boom for much of the Something’s Got to Give
2000s—and is likely to do so in the future. China is expected to
Some 40%-45% of all residential properties sold in early 2009
have almost one billion urbanites by 2025. It already has 214
were for investment purposes, according to think tank Peterson
metropolitan areas with more than one million people, four
Institute. Other speculative bubbles built in jade, art and gold
times as many as the United States. See the chart above.
prices, but there was nothing like real estate. Beijing inadvertently
Many Chinese already owned their homes, but often these were made it the preferred asset class, egged on by powerful
shacks or rural dwellings. There was definitely a need to upgrade, interests that cashed in on this state-sponsored freebie.
and many households did just that.
Other speculative bubbles built in jade, art and gold
Then savers desperate for yield and “hard assets” started to prices, but there was nothing like real estate.
snap up apartments. Where else could they go? Banks offered
negative real interest rates. The stock market was perceived as
a big high-roller table at best. And offshore markets were—and
are—pretty much shut.
[ 14 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

Local governments did their part to support the boom by providing
infrastructure and sponsoring grandiose projects. They bought
farmland at artificially low prices and sold it for a profit to
developers. Over time, local governments became addicted to
these land sales as a source of revenues. And the practice to
appropriate land became the root cause of periodic local
outbreaks of social unrest.
Real estate has been a great wealth creator, for companies, local
governments and individuals alike. The top source of wealth
among China’s richest 1,000 people is real estate, according to the
latest ranking by Hurun Report Magazine (which was appropriately
sponsored by the Hainan Clearwater Bay luxury development).
No wonder those feasting want the banquet to continue.
Sales volumes and prices fell after government
measures to dampen speculation and prevent
prices from spiraling upward.
Bubbles involving real estate are quite common. This seemed to
have all the signs, including the endemic involvement of local
governments and the corporate sector. It is clear the boom
cannot last. (Nor does Beijing want it to last.) Consider:
The risk to housing in China is not so much its
imminent collapse, but how ubiquitous other
segments of the economy are exposed to it.
Sales volumes and prices fell after government measures to
dampen speculation and prevent prices from spiraling beyond
the reach of the emerging middle class. There are some tentative
signs of bottoming (see the charts below), especially in second-
and third-tier cities where people buying homes for themselves
are a more important source of demand than investors.
A Men’s Shirtmaker Diversifies
The real estate market is the biggest risk to China’s economic
growth this year. The tipping point will likely come in the second
quarter, when downside risks to the entire economy will start to
outweigh inflation and affordability considerations. Or will they?
Our assumption is Beijing wants to take real estate prices down
25%-30% from their highs. With a 10% fall already, there is a painful
additional 15%-20% to go. This is dangerous. The biggest risk
is stagflation—when activity drops off a cliff while prices stay high.
In that case, the government may stick to its tightening policy.

} China’s residential housing construction equaled almost 10% How big is the real estate sector? It makes up 20% of fixed

of GDP in 2011, compared with 6% for the US economy during investments, translating into a 10% share of GDP. But the sector

the height of the boom in 2005.
} Real estate accounted for 40% of urban household wealth
in 2010, double the proportion in 1997, according to Peterson
Institute. It is hard to imagine it doubling again in the next decade.
looms much larger in reality. We suspect land is collateral for
more than half of loans. Real estate is interwoven with the
entire economy. In other words: The risk to housing in China is
not so much its imminent collapse, but how ubiquitous other
segments of the economy are exposed to it.

That Sinking Feeling

Real Estate Prices and Sales Volumes in Major Cities

12,000 150%

120
Y-O-Y SALES VOLUME GROWTH (%)

10,000
RMB PER SQUARE METER

90
8,000
60

6,000 30

0
4,000
-30
2,000
-60

0 -90
2007 2008 2009 2010 2011 2012 2010 2011 2012
Weekly Sales Prices Volume Growth

Sources: Deutsche Bank and Soufun.

Notes: Price and sales volume trends in 39 major cities. Volumes represent year-over-year growth in four-week periods. Data through March 2012.
 Blackrock investment institute [ 15 ]

Clearing Out Inventory Can We Finally Afford It?

Months to Clear Real Estate Inventory at Current Sales Rates Housing Prices as a Factor of Annual Household Incomes

40 12

35
11

FACTOR OF HOUSEHOLD INCOME

30
MONTHS TO CLEAR INVENTORY

10
25

20 9

15 8

10
7
5

6
0
2007 2008 2009 2010 2011 2012
2008 2009 2010 2011 2012 Housing Affordability
Inventory +1 Standard Deviation -1 Standard Deviation

Source: Deutsche Bank. Source: Deutsche Bank.

Note: Weekly data through March 18, 2012. Note: Estimated data through end 2012.

One example: The CEO of a men’s shirtmaker says he expects
100 billion RMB in revenue in three years, with the core shirt
business making up just 1%. It is tough to make money in the
apparel business, so the CEO is building a 400-meter office
tower—the highest in his city—and outlet malls.
This particular CEO is not alone. He illustrates how real estate
runs through the entire economy. It is not about a few developers
going bust. It is about local governments. It is about the entire
corporate sector. It is hard to see a happy ending here. We
struggle to find a precedent in history where the bursting
of a property bubble did not lead to financial distress.
A Quiet New Year for Realtors
A slowdown or, worse, a crash in the real estate market
also would hurt consumer spending. If the US experience
is any guidance, ever-increasing real estate prices can drive
consumption. Take them away, and consumption plummets.
Some money is already fleeing the country. China had capital
outflows in the fourth quarter of 2011—the first time since the
Asia crisis in the late 1990s. Speculative inflows betting on an
RMB revaluation dried up as it became clear China’s economy
was slowing. This put the spotlight on the wealthy taking money
abroad.
Anecdotal evidence abounds: Coffers with cash in Macau and
Hong Kong. Record real estate prices in Vancouver. Australian
mines and vineyards snapped up by Chinese buyers.
Once people start believing prices will keep falling, they stop
buying. Just 19% of people expected housing prices would go
up in the first half of 2012, down from around 45% in 2009,
according to a December People’s Bank of China quarterly
survey. The same survey showed 21% expected prices to
fall and 46% anticipated a flat market.
Things looked pretty grim in the first quarter. For example, not
one transaction closed in Beijing, a city of 20 million, during
the entire Chinese Year of the Dragon celebrations, according
to JPMorgan. Overall, transactions have plummeted and
inventory has risen to 15 months worth of sales. See the
chart above on the left.
The inventory may be understated as the gap between floor space
under construction and the amount sold is huge: 1.9 billion vs.
1.1 billion square meters in 2011. The gap is slowly closing, but
there is a big overhang. And new construction usually lags six
months behind trends in real estate sales.
Once people start believing prices will keep falling,
they stop buying.
[ 16 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d
Commercial real estate is hit hardest, especially in second-tier
cities. Chongqing, for example, will have nearly 800,000 square
meters of new commercial space in 2012, whereas the annual
take-up has been just 150,000 square meters.
The government has started to offer incentives for first-time
home buyers, including lower mortgage rates combined with
“guidance” to banks to lend to this group. It could ax deed taxes
and even cut mortgage down payments—although it would not
resort to the latter measure lightly.
Breaking a Vicious Circle
Some fear it is already too late to re-engineer a real estate
turnaround—even in a command economy such as China’s.
These bears predict a vicious circle of lower real estate prices
and lower activity.
On the positive side, China has had much shorter real estate
cycles than the West. Policy measures reversed a downturn
at the end of 2008 in six months, for example. In the current
climate, affordability is improving fast. If prices were to fall 20%
from their peak and real wages were to grow 13%, affordability
would improve by one third in one year. In the US market, this
would take about a decade. See the chart on the previous page.
One way to boost the housing market—and consumption—is
reforming or doing away with the hukou system that bars migrant
workers without proper urban registration from essential services
such as schooling and healthcare. As much as 15% of the
The question we ask ourselves is: Suppose the
government took its foot off the brake; could it
reignite demand in housing?
population, or 200 million people, live in cities but do not
have a proper registration.
Another avenue is the push toward low-end “social housing.” This
will not do much for prices of high-end private homes, but it does
serve the dual purpose of creating affordable housing for the
masses and keeping the construction industry going. Expect
social housing construction to almost double to more than seven
million units this year, according to Bank of America Merrill Lynch.
The market is starting to believe the magic of policy. Bonds and
shares of Hong Kong-listed developers rose sharply at the start
of the year. One company even raised new equity. The triumph
of hope over experience? Only time will tell.
It is clear the government is not ready yet to reverse its housing
policy. Premier Wen Jiabao in early March emphasized house
prices were still too high and that relaxing existing curbs could
cause “chaos.” This dampened investor hopes for a policy reversal
and caused stocks to post their biggest daily loss in months.
The questions we ask ourselves are: Suppose the government
took its foot off the brake; could it reignite demand in housing?
And suppose the paralysis in policymaking lasts long enough
to destroy confidence in real estate as an inflation hedge?
 Blackrock investment institute [ 17 ]

Investment and Consumption:

Looking for Balance
China is about investments. Ports, multi-lane highways, dams, The country is becoming less efficient in turning
bridges, high-speed trains, nuclear reactors, office towers, entire credit growth into economic growth. It needs ever
cities pop up seemingly overnight. The world’s workshop has more gasoline in the tank to make the car go down
the highway at the same speed.
renewed its plumbing, has redone its floor plan and is better
connected with customers around the world than ever before.
You might ask: Is there such a thing as too much investment?
The result is an export juggernaut with productivity growth
(Especially if you live in a place in desperate need of an
more than three times that of competitors.
infrastructure upgrade—and many of us do.) The answer is: Yes.
China is not unique in following an investment model. Germany
It has taken China $5 of investment to generate $1 of GDP growth
did it in the 1930s; the USSR in the 1950s and 1960s; Brazil in
since 2001, 40% more than Japan or South Korea in their take-
the 1960s; and Japan in the 1970s and 1980s. Most of these
off periods, according to the International Monetary Fund. The
efforts produced short booms but ended on ugly notes: war,
country is becoming less efficient in turning credit growth into
debt drama and stagnation.
economic growth. It needs ever more gasoline in the tank to
make the car go down the highway at the same speed.
A Case of Diminishing Returns
We believe this is unsustainable—and a real worry. This is even
Like Japan and others, China enabled investment through
truer if you accept some analyst views that China’s subsidies
repression of consumption in three main ways:
and production input advantages represent more than half of
} An undervalued currency essentially taxed imports the return on invested capital.
} Increases in real wages lagged GDP growth
Demand for raw materials, especially cement and steel, may
} Deposit rates were artificially low peak earlier than many expect. See the table below. China is
now using 590 kilos of cement for every $1,000 of capital
What is extraordinary is investments are still increasing their
formation, compared with 155 kilos in South Korea and just
share of China’s economy. In most places, consumption kicks in
29 for the United States, according to Deutsche Bank.
and investment tapers off because of diminishing returns. Not
so in China. See the chart below.
Topping Out
Expected Peak Demand for Selected Raw Materials
Investment: Too Much of a Good Thing?
Investment Share of GDP, 1997-2010 Material Cement Steel Copper

50% 2010 Chinese consumption

1,396 448 4.8
(in kilos per capita)
Accumulated Chinese
13,939 3,348 37
INVESTMENTS TO GDP (%)

Average = 44.1% consumption to 2010

45
Accumulated consumption peak
23,382 9,449 147
in Japan and United States
40
Projected peak consumption year 2015 2017 2025
Average = 37.1%
Projected peak year consumption 1,633 657 10.8
35 Projected increase from current
17% 47% 125%
levels to peak year (%)

30 Source: Deutsche Bank.

Note: All data in kilos per capita except where noted.
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10

Sources: Peterson Institute for International Economics and National Bureau of Statistics.
[ 18 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

Building, Building … Building

Spending on Infrastructure in Billions of RMB, 2005-2010

Total
High- Highways & Urban Water Spending
Conventional Speed Express- Transit & Waterways Pipelines & Electricity, Conserva- Environ- (RMB
Year Rails Rails ways Subways Airports & Ports Storage Gas & Water tion ment Billions)
2005 93 17 548 53 21 69 39 725 82 33 1,680
2006 110 64 623 80 31 87 51 820 95 42 2,004
2007 98 98 649 107 46 89 79 907 109 60 2,242
2008 130 231 688 127 57 99 112 1,048 142 73 2,707
2009 246 377 967 203 59 106 177 1,348 216 120 3,820
2010 294 442 1,148 236 65 117 224 1,454 275 153 4,407
Total
878 1,212 4,075 754 258 497 643 5,577 837 449 15,180
(2006-2010)
Growth Rate
26% 92% 16% 35% 25% 11% 42% 15% 27% 36% 21%
(2006-2010)

Sources: ISI Group and CEIC.

Notes: Conventional rails exclude rolling stocks & locomotives. High-speed rails include new capital construction. Airports exclude aircraft and other special vehicles. Growth rates are compounded.

To be sure, investment in infrastructure is still needed to secure
energy, conserve water and connect China’s interior to the coast
and the world. In the past decade, about 50% of investments
have gone into transport. Expect less spending on transport in
the future, especially on high-speed trains after recent mishaps,
and more on nuclear power and water conservation. See the
table above for past spending trends.
In addition, China’s capital stock—the country’s highways, ports,
rail tracks, airports and factories—is still far below that of the
United States, Japan and South Korea on a per capita basis.
Even as a percentage of the relatively small economy, capital
stock has not been excessive. See the charts below.

… And Building More

China’s Capital Stock to GDP and Per Capita

350% $150,000

325
120,000
CAPITAL STOCK PER CAPITA ($)
CAPITAL STOCK TO GDP (%)

300
90,000

275

60,000
250

30,000
225

200 0
’78 ’82 ’86 ’90 ’94 ’98 ’02 ’06 ’10 1995 2000 2005 2010
China US South Korea China US Japan South Korea

Sources: HSBC, CEIC, Bureau of Economic Analysis and Japan’s Cabinet Office.
Note: Per capita figures in constant 2005 US dollars.

Go Buy a Refrigerator!
The mirror image of the investment boom is subdued consumption.
Consumption has grown—we have all heard about the excesses—
but not as fast as GDP. As a result, it made up barely a third of
the economy in 2010.
To many economists, this number is surreal—it is something
you just never see. The contribution of consumption to GDP
growth also remains extraordinarily low. See the chart below.
Consumption Growth Is Surreal—In Its Modesty
Composition of GDP Growth, 1996-2012
15%
CONTRIBUTION TO GDP GROWTH (%)
12
9 Privatizing state-owned companies: Would cut bad
6 debts and reduce reliance on exports. Assets
3
0
-3
-6
’96 ’98 ’00 ’02
Consumption
Sources: CLSA and CEIC.
Note: 2012 data is estimated.
Highly unusual? Yes. Damaging? Probably. The internal imbalances
are reflected externally, with China’s trade surplus and foreign
currency pile ever increasing. Leaving prescriptions for debtor
nations such as the United States aside, everybody agrees
China has to rebalance its economy toward consumption.
Can a command economy successfully make such a shift?
It is tough.
A command economy is very good at investing. The order “build
a highway” comes down, and it gets done. It is much harder to
say “go buy a refrigerator,” and get much traction.
Any moves toward a consumption society are likely to be gradual
and slow. This is a good thing. Suddenly taking away industrial
subsidies such as below-cost loans and electricity, for example,
would create a train wreck. Similar to how a July 2011 deadly
accident near Wenzhou upended China’s ambitious plans for
a high-speed rail network, a big economic downturn could
set back the clock on any moves made to favor consumers
over manufacturers.
Blackrock investment institute [ 19 ]
A Blueprint for Rebalancing Success
Rebalancing the economy is a multi-year project. Nobody
wants to upset the delicate equilibrium holding China’s
economy together now.
The ingredients of rebalancing are well known:
Liberalizing interest rates: Given the economy’s torrid
} 
growth, interest rates should be in the double-digit range
to allocate capital efficiently and offer savers real rewards.
The trick is to go slowly: Local governments and state enter-
prises would go bankrupt if rates became real overnight.
E xchange rate flexibility and opening of capital
} 
accounts: Another multi-year project, but one that
is very necessary to address global imbalances.
} 
could go into the underfunded social security fund.
Building out a social safety net: Would help turn at
} 
least some precautionary savings into consumption.
New sources of local financing: Would lessen the
} 
reliance on land sales. A possibility is recurring real
’04 ’06 ’08 ’10 ’12 estate taxes pioneered by Shanghai and Chongqing.
Investment Exports
Market pricing of resources: Electricity prices are
} 
artificially low to protect manufacturing, which
uses the brunt of electric power.
Expectations for reform are massive, but do not hold your
breath this year. The once-a-decade leadership change is
putting the big decisions on hold. It is more about what
Beijing won’t do than what it can do for now.
The February 2012 “China 2030” World Bank report hits many
of the right buttons. Many recommendations have been on
the agenda for years, but nothing has happened. The main
reasons are twofold: Powerful forces, including local
governments, exporters and banks, support the
investment model. And a consensus-driven
leadership tries to placate too many interests.
Similarly, a rush to rebalance could trigger a spike in inflation
around the world. For years, China “exported” deflation by
providing consumers elsewhere with goodies that became cheaper
and better over time. The secret sauce consisted of low wages,
a low exchange rate and investment-driven jumps in productivity,
such as better and cheaper transport. Change the sauce’s
ingredients, and the world is looking at a very different dish.
[ 20 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

Bankers Are Shooting Fish in a Barrel
In our view, rebalancing the economy should start with a gradual
interest rate liberalization. The 11th and 12th five-year plans
(2006-2015) stressed this … but nothing has happened. One
way to make progress would be to slowly expand the band of
deposit rates. Banks would not like it, but they are in much
better shape than a decade ago.
Fat lending spreads helped banks ring up a combined profit of
1 trillion RMB in 2011—which is close to half of all private sector
profits. They are shooting fish in a barrel! This has created tensions
between bankers and the “real economy.” Banks make money
hand over fist while small businesses are cut off from credit
and consumers lose money on deposits.
This situation has raised the possibility of an asymmetrical rate
cut: reducing the lending rate while leaving deposit rates alone.
Until recently, the government’s sole focus was to keep a lid on
Middle Kingdom of Middle Income
Households With Annual Income Over 100,000 RMB, 2005-2015
400,000
food price inflation triggered by surging pork prices. The CPI—
short for Consumer Pork Index in China—hit 6% last year but
has receded since. The government’s 2012 inflation target of 4%
on March 5 beat expectations, leaving more room for fiscal and
monetary stimulus.
In other areas, China is slowly making progress. For example,
Beijing has deliberately been punching (small) holes in its Great
Wall of capital controls. All companies authorized for foreign trade
can now settle payments in RMB; qualified foreign investors
can invest in Chinese securities; and central banks from Japan
to Nigeria are adding RMB and Chinese bonds to their reserves.
Wanted: Carefree Spenders
We have talked a lot about under-consumption in relative
terms. As a part of a fast-growing economic pie, its size is
miniscule. In absolute terms, it is breathtaking.
The growth in the number of China’s wealthy— and their spending
power—is huge. Half of China’s households will have income of
100,000 RMB or more a year—close to Mississippi’s GDP per
capita—by 2015, up from less than 15% in 2010, according to
Deutsche Bank. See the chart on the left.

Total income of This is a huge middle income class with money to spend.
households in top
350,000 bracket in 2005
Supposedly, the most popular phrase in China is: “New
Louis Vuitton opening soon.” There may be some truth to this.

300,000 Total income of

households in top
ANNUAL HOUSEHOLD INCOME (RMB)

bracket in 2010 A Sweeter Home on the Farm

250,000 Income Growth in Rural vs. Urban Growth Areas, 1997-2011

15%
200,000
Y-O-Y INCOME GROWTH RATE (%)

12

150,000
Total income of 9
households in top
bracket by 2015
100,000 6

50,000 3

0
0
’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11
0% 20 40 60 80 100
POPULATION (%) Urban Rural

2005 2010 2015 (Forecast)

Sources: CLSA and CEIC.
Note: Income growth rates in real terms. Rural is growth in net income. Urban is growth in
Source: Deutsche Bank. disposable income.
Note: Income figures are nominal.
 Blackrock investment institute [ 21 ]

Incomes are now growing faster in rural areas, reversing a long
trend of faster rising urban wages. See the chart on the previous
page. This caused many coastal employers this year to anxiously
await the return of migrant workers from visiting family over the
New Year holiday. Some never did. Nearby family, low costs of
living and now faster wage growth are big attractions of the
interior. This trend bodes well for a more geographically
balanced economy.
Spending Is Not a National Duty Yet
Household Savings to Disposable Income, 1997-2008
45%
SAVINGS TO DISPOSABLE INCOME (%)
Income is one thing. Getting people to spend is another. China
has become a lot richer, but savings have gone up even more.
See the chart on the left.
Financial repression is one reason for the high savings rates, as
we have seen. In addition, people set aside buckets of money to
pay for retirement and illnesses. The lower the interest rate on
deposits, the greater the amount of savings needed to create a self-
directed social safety net. Building out social security programs
would reduce the need for these precautionary savings.
There are plenty of other reasons to establish provisions for the
elderly. China is graying—fast. The country will have 300 million
people aged 65 and over by 2050. See the table below.

40
A Country of Old People
Population by Age Bracket, 1995-2050

Average = 36.4%
Population 0-14 years 15-64 years 65+ years
35 1995 1,211 327 808 76
2000 1,260 328 845 87
Average = 29.4% 2010 1,353 293 956 104
30
2020 1,449 287 989 173
2030 1,481 278 989 214
2040 1,489 287 950 252
25
2050 1,473 211 962 300
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08
Source: World Bank.
Source: Peterson Institute for International Economics. Note: Population figures in millions of people.

Sagging Confidence = Sagging Sales

Consumer Confidence Index and Retail Sales Growth

120 40%
MONTHLY Y-O-Y RETAIL SALES GROWTH (%)
MONTHLY CONSUMER CONFIDENCE

30
110

20

100
10

90 0
’95 ’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12

Sources: ISI Group and National Bureau of Statistics.

Notes: Retail sales consist of all purchases by individuals, organizations and government. Consumer confidence data through January 2012. Retail sales growth through December 2012.
[ 22 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

In Search of Luxury Goods

Luxury—At a Price
It is clear the real estate downturn has spread throughout the Tax Rates on Luxury Goods in Selected Countries
economy. Consumer confidence plummeted in late 2011, triggering
China US Hong Kong Singapore
a decline in the growth of retail sales. See the charts on the
Coach Handbag 27% 8% 0% 7%
previous page.
Porsche 911 82% 11% 90% 134%
Remember the economic bar is high in China. Sales are still Rolex Watch 47% 15% 0% 7%
rising at a rate retailers in the developed world would kill for. Lancôme Perfume 57% 8% 0% 7%
Overall retail sales increased almost 15% in the first two Sources: Deutche Bank and Central University of Finance and Economics.
months of this year, although this was less than forecast Note: Tax rates include import consumption tax, VAT/GST and import tariffs.

and less than the previous clip of 18%.

One way to jumpstart consumption is to cut duties. China has Chinese tourists mob upscale department stores around the

relatively high duties, especially on luxury goods. See the table world because prices are cheaper overseas (and you have a better

on the right. chance of buying the real thing). Some 70 million mainland Chinese
traveled outside the country in 2011, spending about $70 billion,
The economic bar is high in China. Sales are still according to the China Outbound Tourism Research Institute.
rising at a rate retailers in the developed world
Duty cuts on luxury goods would serve to boost consumption,
would kill for.
give domestic retailers a shot in the arm and reduce the trade
surplus. It is a bit of a political football, though, as duty cuts are
seen as only benefiting the very wealthy.
 Blackrock investment institute [ 23 ]

Politics: Change Is Hard

China is in the midst of a once-a-decade leadership change. The leadership change is a complex game of
The change starts at the top, where seven of nine members of musical chairs that is likely to last well into 2013.
the all-powerful Standing Committee of the Politburo are slated
municipal politics such as the events in Chongqing discussed
to change in October or November this year. The newcomers will
earlier can take on national and international significance.
likely include political scientists and economists, making it a more
diverse crowd than the engineering-dominated current group. The leadership change is a complex game of musical chairs
that is likely to last well into 2013. The clear aim is to have the
A system of patronage causes the changes to trickle down,
process take place with caution and consensus building rather
not just to ministries, provinces, mega cities and the armed forces,
than prolonged and public tree shaking. That said the markets
but to the humblest townships and courts. In a country where
will watch closely to see if this morphs into policy delays and
policy and government influence every walk of life, the
subsequent changes in investment risk.
leadership handover is the topic du jour. This explains why

An Almighty Party
China’s Political and Leadership Power Structure

Communist Party of China

Discipline Committee Politiburo Party Elders

Military Affairs National People’s

State Council
Commission Congress

Ministries & Provinces &

Armed Forces Courts & Prosecutors
Agencies Townships

Influence Control

Source: ISI Group.

[ 24 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d
Nobody ever really knows the whole picture in China.
The party, which claims some 80 million members, controls
every level of society, including the People’s Liberation Army
and the State Council, which oversees ministries and provinces.
It was split by internal strife in the 1970s with the Cultural
Revolution as a disastrous result. These days, it appears it
is built for stability. At least, most investors like to believe so.
The Emperor Is Far Away
Is the political leadership all-knowing? Far from it. For one,
the country is too big and too diverse. There is an old saying in
China that roughly translates as: “The mountains are high and
the emperor is far away.”
The country has a long history of provincialism, and the central
government has always looked to tighten its grip on the regions.
Nobody ever really knows the whole picture in China. This is
why the national statistics bureau uses satellite pictures: It
is to understand land use and double-check data from local
governments. Another example: Some people believe GDP is
underestimated by 30% due to a huge black market, whereas
others contend it is overestimated by 30% because investments
have generated a pile of non-performing loans.
There is actually an upside to this opaqueness: Policymakers
have more time to adjust to whatever picture emerges. This is
partly why China’s political system has had resiliency.
Keep in mind regional differences: Every province, city and
township is competing for resources in the top-down economy—or
trying to stave off changes that may upset its business model.
The government in Guangdong, for example, is deeply uninterested
in incentives to develop the inland provinces if it comes at the
expense of Guangdong.
And every cadre owes his or her position to the ability to pursue
a growth agenda. China may not be a formal democracy, but the
Communist Party has a clear social contract with the population to
deliver growth—and a deep institutional memory of what happens
when this is broken, as in the Tiananmen Square protests of 1989.
Do not underestimate local officials. They often are smart and
well-informed—and in a position to move the needle. The vice
mayor is a must-see stop for investors visiting one of China’s
200 lesser-known cities with more than one million inhabitants.
China may not be a formal democracy, but the
Communist Party has a clear social contract
with the population to deliver growth.
Vested Interests and Paralysis
If all politics are local, it makes sense central government initiatives
take time to gain traction and in some cases never do. Local
officials will take their concerns to Beijing, adding to a cacophony
of voices proclaiming what needs to be done. The result can be
political paralysis—especially if the leadership’s penchant is to
seek consensus rather than to rock the boat.
Some measures are opposed by the same groups across the
nation. The drive to rebalance the economy, for example, is
opposed by “vested interests,” industries and people who have
the most to lose. The investment model is supported by exporters,
heavy manufacturing, banks and many local government
chieftains. The powerful People’s Liberation Army has commercial
interests, too. All this makes change a poor second choice, and
is one reason reform happens slowly.
Beijing always overdelivers on five-year plan goals that relate to
investments. And why not? Investment is easy to command and
there are no budget constraints. It is a different story when it
comes to objectives that cannot be achieved by investing alone:
things like tackling corruption, increasing consumption and
improving the environment. This is where Beijing barely passes
or is at risk of getting a failing grade.
300 Million Publishers
Internal conflicts are unlikely to spin out of control. Beijing has
kept a tight lid on religious, ethnic and secessionist sentiments.
And protests typically only turn into social unrest when a
country’s income hits the world’s median level—which
will take at least another decade for China.
At the same time, corruption, illegal land appropriations and
growing inequality are flash points for popular anger. The surplus of
young males resulting from the one-child policy can aggravate
these simmering tensions, especially if unemployment were
to mount. The latter would be a breach of the country’s social
contract: employment and rising wages in return for obedience.
The recent stand-off at the fishing village of Wukan illustrates
the point—and is the tip of the iceberg. It is difficult to see an
Arab Spring-type scenario for China, though, especially if
Beijing plays it smartly and tackles corruption.
The web allows activists unprecedented means to broadcast their
messages. SINA’s Weibo (or microblog), a cross between Facebook
and Twitter, has 300 million members. This means China has
300 million publishers. The government works very hard to control
the web, but is likely fighting a losing battle in the long run.

From Small Piles of Rocks to Oil Shock
The risks of external conflicts appear small at this time, we
believe. The re-election of President Ma Ying-jeou in Taiwan
in early 2012 lessened the risk of a Cross-Straits flare-up and
will likely strengthen ties between the “renegade province”
and the mainland.
Ma’s re-election also adds fuel to China’s project to develop
a Greater China economic zone, taking in not just Taiwan and
South Korea, but an entire “String of Pearls” of ports across the
Indian Ocean. This would link China to growing interests in Africa
that are a crucial part of the incoming tide of natural resources.
Stand-offs between China and Japan, Vietnam and South Korea
over small islands in the East China Sea are likely to remain
just that: flare-ups over small piles of rock that mostly involve
fishing boat captains.
Expect trade brawls to flare up more often, and
China to stand alone more often.
The rest of Asia is viewing China’s military built-up warily, however.
China’s military budget is expected to double to $238 billion a year
by 2015, according to HIS Jane’s Defense weekly. This is still
less than half the (shrinking) US defense budget, but China’s
increasing military prowess is causing anxiety among its neighbors.
In addition, US President Barack Obama recently turned his focus
to the Pacific, potentially setting the superpowers up for conflict.
The longer-term risks are “competing adversarial power blocks”
in the region, warns one of the architects of the opening of China,
Henry Kissinger, in a 2012 article in Foreign Affairs. This need
not be—if both countries set aside rivalries and make genuine
efforts at cooperation, Kissinger believes.
Another long-term risk is conflict with India over water. Both
countries derive much of their fresh water from the Himalayas.
Blackrock investment institute [ 25 ]
In the immediate term, two risks loom large: First and most
important is a potential oil price shock. Sustained high oil
prices would kill global growth and simultaneously drive up
China’s production costs and energy subsidies. A trigger could
be an Israeli attack on Iran’s nuclear installations. Or it could be
something we have not yet thought about.
Tit for Tat in Trade Wars
The second risk is trade wars brought about by new protectionist
and populist politics in the run-up to elections in key countries.
French President Nicolas Sarkozy, for one, has dusted off
a “Buy European” slogan (which really means: Buy French)
as the election campaign heats up.
China’s exports have been slowing in the wake of the European
debt crisis. The country’s biggest trading partners are the
European Union, United States, Japan and Hong Kong, with
the latter mostly a half-way station for goods on their way
to US and European markets. See the table on the next page.
Expect trade brawls to flare up more often, and China to stand
alone more often. The rare earths dispute is a good example. It
pitted China against the United States, European Union and Japan
all at once. This tells us three things: 1) China’s trade adversaries
are finding the political will to act together. 2) China cannot
have a trade war with all three simultaneously, so it must start
to provide concessions while trying to save face (not easy).
3) The World Trade Organization and other global bodies meant
to resolve trade disputes remain a sideshow: Governments
engage in hand-to-hand combat while regulators look on.
Tit-for-tat strategies will cause casualties. Case in point: China
recently struck back at Europe by suspending a large Airbus
order (supposedly because of emissions standards). In such
an environment, the risk of policy miscalculations driven by
domestic needs is high. And some companies will end up as
collateral damage.
[ 26 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

A Global Trade Web

China’s Trade Partners in 2010

China's Trade With the Eurozone

Rank Exports To Imports From Total Trade Balance With

1 Germany $68,088 4.3% Germany $74,391 5.3% Germany $142,480 4.8% Netherlands $43,239 23.4%

2 Netherlands $49,717 3.1% France $17,107 1.2% Netherlands $56,196 1.9% Italy $17,137 9.3%

3 Italy $31,143 2.0% Italy $14,006 1.0% Italy $45,149 1.5% Spain $11,950 6.5%

4 France $27,659 1.8% Belgium $7,828 0.6% France $44,766 1.5% France $10,552 5.7%

5 Spain $18,177 1.2% Netherlands $6,479 0.5% Spain $24,403 0.8% Belgium $6,478 3.5%

6 Belgium $14,306 0.9% Spain $6,227 0.4% Belgium $22,134 0.7% Greece $3,569 1.9%

7 Finland $5,507 0.3% Austria $4,237 0.3% Finland $9,541 0.3% Portugal $1,760 1.0%

8 Greece $3,959 0.3% Finland $4,034 0.3% Austria $6,091 0.2% Finland $1,473 0.8%

9 Portugal $2,514 0.2% Ireland $3,409 0.2% Ireland $5,402 0.2% Cyprus $1,331 0.7%

10 Ireland $1,993 0.1% Slovakia $1,790 0.1% Greece $4,350 0.1% Malta $1,274 0.7%

11 Slovakia $1,959 0.1% Portugal $754 0.1% Slovakia $3,749 0.1% Slovenia $1,209 0.7%

12 Austria $1,854 0.1% Malta $569 0.0% Portugal $3,268 0.1% Luxembourg $730 0.4%

13 Malta $1,843 0.1% Greece $390 0.0% Malta $2,413 0.1% Estonia $500 0.3%

14 Slovenia $1,385 0.1% Luxembourg $258 0.0% Slovenia $1,562 0.1% Slovakia $168 0.1%

15 Cyprus $1,348 0.1% Slovenia $177 0.0% Cyprus $1,366 0.0% Ireland ($1,417) -0.8%

16 Luxembourg $988 0.1% Estonia $177 0.0% Luxembourg $1,246 0.0% Austria ($2,383) -1.3%

17 Estonia $677 0.0% Cyprus $17 0.0% Estonia $854 0.0% Germany ($6,303) -3.4%

Eurozone $233,118 14.8% Eurozone $141,851 10.2% Eurozone $374,969 12.6% Eurozone $91,267 49.5%

Eu $311,342 19.7% Eu $168,484 12.1% Eu $479,826 16.1% Eu $142,858 77.4%

China's Trade Outside the Eurozone

Rank Exports To Imports From Total Trade Balance With

1 US $283,375 18.0% Japan $176,785 12.7% US $385,435 13.0% Hkg $206,109 111.7%

2 Hkg $218,380 13.8% Korea $138,423 9.9% Japan $297,941 10.0% US $181,314 98.3%

3 Japan $121,156 7.7% Taiwan $115,649 8.3% Hkg $230,650 7.8% UK $27,481 14.9%

4 Korea $68,818 4.4% US $102,060 7.3% Korea $207,241 7.0% India $20,053 10.9%

5 India $40,920 2.6 % Australia $60,340 4.3% Taiwan $145,341 4.9% Uae $16,863 9.1%

6 UK $38,790 2.5% Malaysia $50,396 3.6% Australia $87,575 2.9% Malaysia ($26,577) (14.4%)

7 Sgp $32,374 2.1% Brazil $38,038 2.7% Malaysia $74,216 2.5% Australia ($33,106) (17.9%)

8 Taiwan $29,693 1.9% Thailand $33,201 2.4% Brazil $62,504 2.1% Japan ($55,629) (30.1%)

9 Russia $29,615 1.9% Saudi Arabia $32,862 2.4% India $61,787 2.1% Korea ($69,605) (37.7%)

10 Australia $27,234 1.7% Russia $25,814 1.9% Sgp $57,053 1.9% Taiwan ($85,956) (46.6%)

Total $890,355 56.4% Total $773,569 55.5% Total $1,609,744 54.2%

China $1,578,447 100.0% China $1,393,909 100.0% China $2,972,356 100.0% China $184,538

Sources: ISI Group; CEIC; General Administration of Customs.

Notes: Figures in millions of US dollars. Percentages are the share of China’s total.
 Blackrock investment institute [ 27 ]

Competitiveness: Beyond Cheap Labor

A visitor to the port city of Ningbo soon after Chinese New Of Robots and Old People
Year was struck by how little traffic this large port city had.
The easy productivity gains have been harvested, but there is
Employers were anxious to see if migrant workers would return
room for more. The work of Tsinghua University professor Gavriel
from visiting their families in the interior. The city’s mayor had
Salvendy, for example, shows it is easy to rack up double-digit
called an emergency meeting with local business leaders
productivity increases by introducing basic management
because exports had plunged in January. This illustrated the
techniques to minimize waste and stop staff churn.
plight of China’s coastal region.
New highways and rail tracks have opened up the country’s
Wage growth is currently outpacing productivity. This is good
interior. Companies have moved inland to take advantage of lower
for consumption, but hurts China’s competitiveness in labor-
wage and real estate costs. Apple supplier Foxconn, which employs
intensive industries. Many of the latter, including garment
more than one million in China, has already made a big push
makers, have already moved to cheaper countries such as
into Chengdu from its “Foxconn City” base in Shenzhen. It is
Vietnam and Cambodia.
going one step further: Chairman Terry Gou plans to put to work
This is a good thing for China. The country wants to move up one million robots in the next three years, up from 10,000 in 2011.
the value chain, and this is one way to achieve it. It is starting
Vietnam, Indonesia and Bangladesh are just not in the same
to work, evidenced by the share of processed exports slowly
league. These are smaller economies without the enterprise,
diminishing. These are exports of basic products using mostly
scale and infrastructure of China. With productivity growth
(imported) raw materials or simple assemblage where China
running at a much higher clip than that of the developed world,
adds little value. See the chart below.
China is not about to lose world trade share.

Also remember there is no average in China: Income levels and

Up the Value Chain
minimum wages vary greatly by city and province. See the table
Value-Added Exports vs. Processed Exports, 2000-2011
on the next page. This means relocating to the interior can lead
70% to easy productivity gains.

65 Productivity will need to keep growing to make up for the effects of

a graying population: The number of people older than 65 will
60
surpass the group of people younger than 19 by 2030. Bottom
EXPORTS (%)

55 line: China’s demographic dividend—a huge working population

supporting a relatively small number of dependents—is
50
disappearing fast. See the charts on the next page.
45
The real estate boom has arguably thwarted innovation because
40 the government, businesses and consumers alike focused
35 on making quick profits. On the other hand, China surpassed
Japan and the United States in patent filings in 2011, according
30
to Thomson Reuters research.
’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11
In all, chances are China will overcome competitive pressures. It
Value-Added Exports Processed Exports
may even emerge stronger. Competitiveness is very much part of
Source: Deutsche Bank. the China story—and likely more sustained than doubters opine.

Vietnam, Indonesia and Bangladesh are just not in

the same league.
[ 28 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

There Is No Average in China

Minimum Wages by Province in RMB per Month

Monthly Minimum Wages Annual Ratio of

Urban % of Disposable National
Province 2005 2006 2007 2008 2009 2010 2011 2012 Population Total Income Average
Shanghai 690 750 840 960 960 1,120 1,280 1,450 17 2.7 31,838 1.67
Beijing 580 640 730 800 800 960 1,160 1,260 15 2.4 29,073 1.52
Zhejiang 490 645 750 960 960 1,100 1,310 30 4.8 27,359 1.43
Tianjin 570 660 670 820 820 920 1,160 10 1.5 24,293 1.27
Guangdong* 352 604 780 860 860 1,030 1,300 61 9.8 23,898 1.25
Shenzhen 635 755 755 950 950 1,100 1,320 1,500
Jiangsu 400 630 750 850 850 960 1,140 43 6.9 22,944 1.20
Fujian 320 542 650 750 750 900 1,100 19 3.0 21,781 1.14
Shandong 350 490 610 760 760 920 1,100 46 7.4 19,946 1.04
Liaoning 350 497 590 700 700 900 1,100 26 4.2 17,713 0.93
Inner Mongolia 380 485 560 680 680 900 1,050 13 2.1 17,698 0.93
Chongqing 330 500 580 680 680 680 870 15 2.4 17,532 0.92
Guangxi 320 417 500 670 670 820 820 19 3.1 17,064 0.89
Hunan 350 475 600 665 665 850 1,020 28 4.4 16,566 0.87
Hebei 420 510 580 750 750 900 1,100 30 4.9 16,263 0.85
Yunnan 350 480 540 680 680 830 830 16 2.5 16,065 0.84
Hubei 280 364 460 700 700 900 1,100 26 4.2 16,058 0.84
Henan 320 400 480 650 650 800 1,080 36 5.8 15,930 0.83
Anhui 290 443 520 560 560 720 1,010 26 4.1 15,788 0.83
Shaanxi 400 480 540 600 600 760 860 16 2.6 15,695 0.82
Shanxi 400 490 550 720 720 850 980 16 2.5 15,648 0.82
Hainan 350 497 580 630 630 830 830 4 0.7 15,581 0.82
Jiangxi 270 315 360 580 580 720 720 870 19 3.1 15,481 0.81
Sichuan 280 485 580 650 650 850 850 1,050 32 5.1 15,461 0.81
Jilin 300 460 510 650 650 820 1,000 15 2.3 15,411 0.81
Ningxia 320 417 450 560 560 710 900 3 0.5 15,344 0.80
Tibet 445 470 495 730 730 950 950 1 0.1 14,980 0.78
Guizhou 320 500 550 650 650 830 930 11 1.8 14,143 0.74
Heilongjiang 235 476 620 680 680 880 880 21 3.4 13,857 0.73
Qinghai 330 450 460 580 580 750 750 2 0.4 13,855 0.73
Xinjiang 300 536 670 800 800 960 1,160 9 1.4 13,644 0.71
Gansu 300 378 430 620 620 760 760 9 1.4 13,189 0.69
National Average 376 507 586 715 715 874 1,013
YoY Growth 39% 16% 24% 0% 23% 16%

Sources: ISI Group, Ministry of Human Resources and Social Security, and National Bureau of Statistics.
Notes: All wages in urban areas. Annual disposable income is per capita. Urban populations are in millions as of 2009. * Excluding Shenzhen.

Going the Way of Japan

Young (0-19) and Old (over 65) to Working Age Population, 1950-2050

JAPAN CHINA

100% 100%
WORKING POPULATION (%)

WORKING POPULATION (%)

YOUNG AND OLD TO

YOUNG AND OLD TO

80 80

60 60

40 40

20 20

0 0
1950 1970 1990 2010 2030 2050 1950 1970 1990 2010 2030 2050
0-19 Years Old 65 Years or Older 0-19 Years Old 65 Years or Older

Sources: ISI Group and United Nations.

 Blackrock investment institute [ 29 ]

Markets: Counting on China

Equities and Corporate Bonds: Specialized machinery makers should do well as China moves

A Growing Addiction up the value chain. The country is starting to become very
competitive in capital goods with big improvements in quality.
Makers of luxury goods around the world have become dependent
Giants such as GE, Siemens and Caterpillar are worried about
on China’s ravenous appetite for their goodies. See the table
China stealing their secret sauce, but should be okay for now as
below. Don’t expect this to change in the near term. In the long
they are capturing share in a booming market.
run, we believe, it is crucial for China to take steps to encourage
consumption to keep up the torrid growth rates. At the same time, disasters such as the high-speed rail crash
and mining accidents have dented China’s ambitions in some
The luxury goods boom goes beyond exports to Greater
areas. And hazardous industries with heavy capital equipment
China. A jump in Chinese travel and the hiring of Mandarin-
needs and high potential for disasters (the oil and gas industry,
and Cantonese-speaking staff is keeping department stores
for example) are becoming less likely to take risks on China’s
busy from Tokyo to New York.
quality control.
Basic materials companies are likely to suffer as China hits the
China Inc. can quickly wipe out whole sectors by mass producing
ceiling for cement and steel consumption. The country is still
high-quality goods. Case in point is the solar industry. European,
far from reaching peak demand in other commodities, including
US and Indian companies cried foul over unfair subsidies for
oil and copper as well as agricultural products such as corn and
Chinese makers, but the coup still happened. This doesn’t
potash used in fertilizer. This has a big impact on UK, Australian
mean emerging Chinese players in these industries are good
and Canadian equities because of the heavy weighting of mining
investments. Just check the implosion of stock prices of (loss-
companies in those markets. Shale and other new sources of
making) Chinese solar makers.
energy have become a focus given China’s supply vulnerability.

Investors and other stakeholders have taken note. For China Inc. can quickly wipe out whole sectors by
mass producing high-quality goods.
example, the Reserve Bank of Australia studies China given its
importance to the large farm-cum-mine surrounded by beach Medical device and agricultural equipment makers are likely
known as Australia. The European Central Bank studies China beneficiaries from a population that is getting richer and living
because it needs growth. We all are China watchers. longer—but not necessarily healthier. Spending on these
sectors, as well as on water conservation, should grow at twice
My Best Customer Is China the rate or more of China’s overall budget spending, we believe.
Percentage of China Sales of Selected Luxury Companies in 2011
China’s cement makers, aluminum smelters and building
Mainland China Greater China materials companies saw business implode only in the fourth
Burberry 5% 8-10% quarter. Full-year 2011 results mask this implosion, and more
Coach 3% 6% pain is likely to come in 2012. Even successful women’s shoemaker
Hermès 15% 23% Belle International reported a slowdown in same-store sales
LVMH 7-8% 12%
to the high single digits. The only companies that report sales
Luxottica 3% 5%
Prada Group 15% 21% growth in the 20% range are mass consumer plays such as
Richemont 33% 40% Yum!, the owner of the KFC fast food restaurants. China’s
Safilo 1% 3% banks remain cheap for (good) reasons described earlier.
Salvatore Ferragamo 17% 27%
Swatch 15% 22% China’s companies will likely see profits hit this year, we believe.
Tiffany 10% 18% SOEs already reported an 11% drop in profit in the first two
Tod’s 5% 12% months of the year. That said, Chinese equities look cheap by
Yoox 2% 2%
historical valuations. It is reasonable to expect gains of 25%
Source: Deutsche Bank. or more this year after a horrible 2011.
Note: Estimated fiscal 2012 sales for Coach, Burberry and Tiffany.
[ 30 ] B r a k i n g C h IN a … W i t h o u t B r e a k i n g t h e W o r l d

Hunger for Commodities Addicted to Coal—For Now

China’s Share of Global Commodities Consumption in 2010 China’s Energy Supply Sources Compared With the World’s

Cement 80%
Pigs 70%
Iron Ore
COMMODITIES CONSUMPTION (%)

Steel
Lead 60

ENERGY USAGE (%)

Copper
Zinc
Aluminum
Nickel 40
Platinum 37%
Coal 30%
Soybeans
Autos 20%
China’s Population 20 18%
Corn
Palladium 7% 7% 7%
Wheat 4%
0 1%
China’s GDP in PPP
Oil
Sugar Nuclear Hydro Nat. Gas Oil Coal
Uranium
China World ex-China
0% 10 20 30 40 50 60

Sources: ISI Group and BP World Energy Outlook.

Source: Deutsche Bank. Note: Data as of 2010.

Commodities: An Outsized Influence
China has an outsized influence on commodities markets.
The country has one fifth of the world’s population and
accounts for 11% of world GDP. Yet it accounts for about half
the world’s cement and iron ore consumption. See the chart above.
We expect the iron ore boom to fizzle out as China nears peak
consumption in steel and cement. The country’s demand for
copper, which has many uses beyond construction, should
hold up better, we believe.
Energy demand should also hold steady, we believe. Oil demand
typically runs at 0.6 times GDP growth. So even with the economy
slowing down to 7% a year, oil demand increases by 4% a year.
China’s import dependence is rising at an annual clip of 500,000
barrels a day (b/d), from an import bill of 5 million b/d in 2009,
according to research firm ISI Group.
China is already the world’s biggest energy consumer, with a
20% share in 2010, up from a tenth in 2000, according to BP. It
still relies on coal for the brunt of its energy supply. See the chart
above right. Expect a shift to natural gas and nuclear energy
(Japan’s Fukushima accident in 2011 only temporarily halted
construction). This bodes well for uranium prices in the long run.
where these energy sources can start to compete with oil, gas
and coal. A shift to a consumption-driven economy could imperil
this. Similarly, a credit contraction or financial bust would likely
result in the drying up of Chinese project financing that has
supported the global market.
The country’s commodities appetite goes beyond the obvious.
China has become the second-largest importer of gold, after
India. It now makes up around one fifth of world gold demand
for jewelry, according to ISI Group. Gold is seen as a hedge
against inflation. Policy also may drive demand for precious
metals such as platinum and palladium, which are used in car
catalytic converters.
Government Bonds: A Big Overhang
China is the single largest holder of publicly traded US Treasuries,
excluding the US Federal Reserve. It has a $1.3 trillion share, or
one-sixth of the total. It has slowed buying but is still a major
player (the Fed trumps it). The reasons: China wants to keep
its own currency in check, doesn’t have many alternatives for
parking the flood of export-generated dollars and would hate to
see the value of its existing holdings implode. See the chart on
the next page on the left

The story is different for alternative energy. Chinese manufacturers
have brought down prices for wind and solar energy to levels
Expect the iron ore boom to fizzle out as China
nears peak consumption in steel and cement.
China, which has additional US assets in its foreign reserve kit,
has been diversifying into the euro, yen and other currencies as
well as gold. It is transferring funds to sovereign wealth fund
China Investment Corp, which in turn is spreading its bets across
the globe and across asset classes. Talk of investment in Europe
to mitigate the debt crisis is likely real.
 Blackrock investment institute [ 31 ]

China’s buying of US Treasuries illustrates the power the country A shift to a consumption economy would mean less
holds over the US bond market. The US Federal Reserve crowded Chinese buying of US Treasuries—as opposed to
out all other buyers in the year ended June 20, 2011, so China’s absolute reductions.
share was just 18%. Excluding Fed purchases, however, China
This appears a likely scenario—and does not bode well for China’s
had a 73% share. See the chart below on the right.
ranking in the BlackRock Sovereign Risk Index. The country
A shift to a consumption economy would mean less Chinese advanced three spots in the fourth quarter to rank 15th—ahead
buying of US Treasuries—as opposed to absolute reductions. of the UK and France.
Assuming the US government is not closing the budget gap any
Commodity currencies such as the Australian and Canadian dollars
time soon, conventional wisdom says fewer Chinese purchases
could take a hit as China reaches peak consumption in key
would drive up yields and pummel bond prices. Fewer buyers
industries such as steel. The currencies are a good signpost for
equals lower prices.
whether China’s economy is perking up in the short term and
Conventional wisdom is always dangerous, so here is an opposite shifting toward consumption in the long run.
view: Rates actually could go down in a sort of flight-to-safety
Exporters and countries closely linked to the booming resources
bond rally. Why? If foreign buying dries up, simple math says
trade, such as Australia and Chile, could suffer. The Aussie
private savings will have to pick up the slack (assuming the US
dollar and bond market are just as much China plays as LVMH
government doesn’t cut the deficit markedly).
and Daimler. More insulated economies such as Brazil could
To do this, investors would have to sell risk assets. This would power along, driven by domestic consumption.
hammer equities, high-yield bonds, commodities and emerging
Asian investors appear more upbeat than those in the developed
market assets, in turn triggering a dash for safety.
world. For US and European investors, things are about as bleak
As China opens to the world, more of its debt may become available as they have been in decades. Asians, on the other hand, have
for international trading. This may coincide with a bailout of its overcome three economic crises in recent memory: the 1998-
financial system and a jump in its debt-to-GDP ratio. 1999 Asia crisis, the 2003 SARS crisis and the 2008-2009 world
financial crisis. Plus, the sheer scale of consumption and
wealth is breathtaking when you are on the spot.
A Case of Too Many Greenbacks
China’s US Treasury Holdings and FX Reserves, 2001-2011

$3,500 50%
A US Bond Market Force
China’s Buying of Newly Issued US Treasuries, 2002-2011

3,000 80% $400

CHINA’S FX RESERVES IN BILLIONS ($)

40
SHARE OF TREASURY BUYING (%)

2,500

PURCHASES IN BILLIONS ($)

SHARE OF RESERVES (%)

60 300
30
2,000

40 200
1,500
20

1,000 20 100

10
500
0 0
2002 2004 2006 2008 2011
0 0
China Buying of Net Issuance (%)
2001 2003 2005 2007 2009 2011
China Buying of Publicly Available Net Issuance (%)
China’s US Treasury Holdings China’s Total FX Reserves China Buying ($ Billions)
US Treasuries to FX Reserves (%)
Sources: US Department of Treasury and BlackRock.
Sources: US Department of Treasury and BlackRock. Notes: Data as of June 30 of each year. Publicly available Treasuries are those not purchased
Note: Data as of June 30 of each year. 2011 data based on preliminary survey data. by the US Federal Reserve. 2011 data based on preliminary survey data.
This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research
or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
The opinions expressed are as of April 2012 and may change as subsequent conditions vary. The information and opinions contained in
this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive
and are not guaranteed as to accuracy.
This paper may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other
things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this
paper is at the sole discretion of the reader.
This material is being distributed/issued in Australia and New Zealand by BlackRock Financial Management, Inc. (“BFM”), which is a
United States domiciled entity. In Australia, BFM is exempted under Australian CO 03/1100 from the requirement to hold an Australian
Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian
laws. In Canada, this material is intended for permitted clients only. BFM believes that the information in this document is correct at
the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and
omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. In Hong
Kong, this document is issued by BlackRock (Hong Kong) Limited and has not been reviewed by the Securities and Futures Commission
of Hong Kong. In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). In Japan not for use with
individual investors. In Latin America this material is intended for Institutional and Professional Clients only. This material is solely for
educational purposes and does not constitute investment advice, or an offer or a solicitation to sell or a solicitation of an offer to buy
any shares of any fund (nor shall any such shares be offered or sold to any person) in any jurisdiction within Latin America in which an
offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred
to in this material, it is possible that they have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico and
Peru and Uruguay or any other securities regulator in any Latin American country and no such securities regulators have confirmed the
accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America.
The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding
their tax situation. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically,
when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer
of the bond will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign
currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or
other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

FOR MORE INFORMATION: www.blackrock.com

©2012 BlackRock, Inc. All Rights Reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES and SO WHAT DO I DO WITH MY MONEY
are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks
are those of their respective owners.
Not FDIC Insured • May Lose Value • No Bank Guarantee
Lit. No. BII-CHINA-0312R AC6125-0412