Burton Malkiel on China

Author: Eric Uhlfelder

29 January 2010

Burton Malkiel, professor of economics at Princeton, is the author of the venerable investment tome, A Random Walk Down Wall Street. Malkiel, 77, has served on the US President’s Council of Economic Advisors, was Dean of the Yale School of Management, and is the Chief Investment Officer of AlphaShares.


Why are you bullish on China?

China has been the world’s growth story. Its rate of expansion over the last 20 years has been unprecedented. No country, during its growth phase, has grown at anything like this–not South Korea, not Japan, not the US.

That said, I’m certainly concerned about the smoothness of 9 and 9.5% annual growth rate. Some observers say, for example, there is a disconnect between automobile production and gasoline sales. The former is booming; the latter is not. But then GM tells us that the Far East is the only part of the world in which they are selling cars.

Power generation and GDP growth are also not in sync, though one would think they should be well correlated. And there is competition among local governments to meet imposed growth goals, regardless if they actually do or not.

But it’s the people’s hard-working nature and entrepreneurial skills, unleashed by Dung Xiaoping’s reforms, that’s really compelling. Even if you don’t trust the numbers, if you visit Shanghai once a year, you know darn well that something quite real is happening.

Will this growth rate last?

I think so. So far, all the growth has been in the eastern part of the country. The center and west are still dirt poor. There are over 500 million unemployed or underemployed, educated workers, or potential workers who would like to enjoy the riches and better life that ‘s been created in the east. And you have a government policy that wants to bring that growth to the country’s underdeveloped regions. I am convinced that they will be able to do so.

The key reason comes from Nobel laureate, Sir W. Arthur Lewis. He was one of my teachers in graduate school and helped invent the curriculum of emerging market economics. I remember Arthur telling me that while economists worried about the efficacy of central planning, 5-year plans, and protecting infant industries, he found that emerging markets succeeded for other reasons: You give me a people who revere education, like the Chinese have done since the time of Confucious; you give me a people who are hard working; you give me a people who are entrepreneurial; and as long as you give them the freedom to do their own thing, you will see economic growth.

China went from the collective farms under Mao, that couldn’t feed the people tilling the land, to the reforms of this practical man Xioping who said that “if you produce a little more, you can keep some of the profits.

This has worked extremely well in the east. There is tremendous labor capacity in the center and the west. And the government knows that to build a harmonious society, it needs to support pro-growth policies. I’m convinced it will continue to do so.

Further, China designed a fiscal stimulus package, that relative to GDP, is much larger than the US’ package and is much better designed in its focus on infrastructure spending on highways, railroads and power plants.

The government has a fiscal position that’s also unparalleled in the world. Japan has Debt/GDP exceeding 200%; The European Union and the US are approaching about 100%. But China’s ratio is less than 25%.

China’s got one of the strongest fiscal positions in the world, with $2.3 trillion in reserve.
There will be hiccups along the way, sure. But growth will continue for at least another decade or two. And China will soon pass Japan as the second largest economy in the world. My own guess is that in another 20 years, its economy will be as large as the US’.

What are the biggest risks to investing in China?

Practically speaking, China’s growth has been unbalanced and unsustainable because it’s largely export lead. Leaders admit that can’t continue, if for no other than political reasons. People in the US and the European Community, experiencing high unemployment, are fed up with so many of their goods being manufactured in China.

At the same time, China potentially has the largest consumer market in the world. Currently, consumption is less than 40 percent of GDP in China. That ratio hasn’t changed over the past decade. In the US, that ratio is about 70 percent.

One reason for relatively low consumption is that Chinese traditionally have to save more because there are no safety nets in place for catastrophic events, unemployment insurance, social security, illness, and retirement. The one-child policy makes it very difficult to count on one’s kids to bail you out. The Chinese must save.

I imagine we will see consumption grow to maybe 45 or 50 percent of GDP. That may be propelled by the government’s stimulus program, which includes the genesis of a safety net. This will help free up some savings and direct it toward consumption. With a small debt-to-GDP ratio, China has plenty of room to keep current government spending going.

Politically, I’m not worried about communists and capitalists pulling the country apart. I think the old guard knows that capitalism works. It has produced wealth and growth. I don’t imagine even the most ardent communists are going to destroy it.

I am concerned, however, about the potential divide between the Haves and the Have Nots. People complain about the income distribution in the US, but China’s is far worse, not only between rich and poor but between East and the Center/West. And this has already led to some unrest. Potential instability is a great danger. But that’s why the government is now throwing a lot more money into these poorer regions. While this effort is nascent, the government is starting to develop infrastructure, education, and a social safety net.

The only likely way to assuage this risk over the near term would be through significant wealth transfers. Will that happen?

No. But the Chinese are developing unemployment insurance and welfare for those that need it. But it’s somewhat countered by the government’s hard approach to individual responsibility and work, even if there isn’t much opportunity. And with its various ethnic groups, there is a cultural source to this tension as well.

How would you react as a player in the Chinese market if the authorities responded violently again to unrest, such as what we saw in Tianamen Square?

That’s a tough question. I’m not sure I can answer it at this moment. We certainly would be upset and shocked if we saw the government resort to another such crackdown. It wouldn’t be unprecedented. But I think that the Chinese are slowly learning that its country’s fortunes are as linked to its people’s well being as it is to its own authority.

Accepting Professor Niall Ferguson’s description of Chimerica, do you surmise there will be fundamental changes in the way in which the US and China deal with one another?

Chimerica is an apt description of the model in which the US consumer borrows and buys and the Chinese produce goods and lend dollars at a fixed exchange rate to support our spending. Premiere Wen has conceded that the yuan can’t remain pegged to the dollar. This is indeed unfair for all other regional trading partners, and for US manufacturing. I believe that the Chinese will ease its currency control as early as this year, pursuing a dirty float against a basket of currencies, where the yuan may appreciate by as much as five percent.

Remember, the Chinese move very slowly, especially when change is not in their interest. But this matter is more a response to US discontent. I don’t expect this to materially affect the structural imbalances of Chimerca. And that’s the real problem.
In fact Chimerica is not sustainable. It made us vulnerable to the crisis we’re in. Chimerica worked only when the US savings rate went to zero and US consumers took on more debt. In 1990, US consumer balance sheet had a debt-to- income ratio of approximately 40 percent; now it’s 120 percent. This has been largely the result of consumer access to cheap money to buy cheap goods.

How do you respond to hedge fund manager James Chanos’ view that China is a bubble ready to burst, which should be shorted?

Look, Chanos is a short seller. I think Tom Friedman responded most aptly to Chanos’ concerns. He said: If you think the big winners of this century will be based on education, hard work, and the worth derived from human capital, don’t be so quick to sell China short.

China is growing very rapidly, and when anything grows fast, bubbles occur. China has had them in the past in real estate. But the country is going through intense urbanization, and I think that real estate bubbles are more likely to be temporary as migration and increasing wealth catches up with where jobs are being created and development.

China has also known banking crises. This has occured when many borrowers and banks are partially state-owned, and officials simply decided to force banks to keep lending to financially broken companies rather than restructure or close them and send thousands of people out of work.

The result: non-performing loans soared. When the banks’ balance sheets got desperate, the government has done what governments do all over the world: they bailed the banks out, without necessarily addressing the underlying problems.

The government can do this because the related costs, relative to GDP, is small. But the Chinese are slowly shutting down the poorest state-owned businesses.

The Chinese stock market is one of the most volatile in the world, making Brazil’s bourse look tame. And it too goes through the same boom and bust cycle. We may be in a bubble now. Will the economy collapse because of this? Absolutely not. It will correct, and then restart because of the strength of the underlying story.

You are a believer in investing in China; do the Chinese permit their nationals to invest outside of the mainland?

There is some investment in Hong Kong by Chinese nationals. But the broad answer to your question is no. There is virtually no foreign equity investments by the local citizenry, save for a few institutional accounts. I think this is unfortunate. It does not foster the openness necessary for healthy, dynamic global markets. It has created discrepancies in the value of the same Chinese stocks that trade in China versus those that trad in Hong Kong and the US. The Chinese fear that substantial investment outflows could make it more difficult for them to maintain the yuan’s link with the dollar. Long term, I don’t see how such restrictions can persist as China continues to grow wealthier.


How does your Chinese AlphaShares deal with the issue of market capitalization?

Our indices are typically float-weighted, which only partially addresses the issue you raise. Companies with government stakes, especially some banks, are problematic. China’s stock market may not be as efficient as ours in determining fair values. But this doesn’t mean that active managers are going to be able to do better than passive indexers. We have the concrete advantage of lower expenses. Typical actively managed China funds have annual expenses of 200 basis points; ours are 70 basis points.

How does your broad-market ETF compare with its main competitor?

The largest ETF is the FTSE/Xinhua China 25-stock index [FXI], with annual expenses 73 basis points. Ours range between 65 and 70 basis points. Our broad-market index has more stocks [150 stocks], and is more broadly diversified. One-third of our All-Market portfolio [YAO] is financial services, 17.67% is energy, 10.95% is information technology, and 10.38% is industrials. FXI is nearly half financial services; 21% energy; 3.05% information technology, and 7.30% industrial materials.

YAO has 6.40% exposure in Consumer Discretionary, where FXI has none. However, FXI has a heavy exposure to 16.34% versus about half that in YAO. Data is of 31 December 2009.

A key difference between the two funds is that FXI is restricted to Hong Kong-traded stocks, where YAO also buys US-traded stocks that are not available in Hong Kong. This means we have exposure to all the most important companies. Take the Internet giant Baidu.com. Because foreigners can only buy the ADRs that sell in the US, we have it in our portfolio; FXI does not.

Are they better ways for foreign investors to invest in China than through an equity index?

It’s very hard to do. We are looking at developing a government bond product. But there are restrictions on doing that.

Where does the corporate bond market stand in China?

The yuan-denominated corporate bond market is the third largest in the world, following the US dollar and euro market. While most issuers are state-linked, more than 100 companies have bonds outstanding that trade primarily in China’s Interbank market. Some are also listed on the Shenzhen and Shanghai exchanges. But trading is relatively thin, given that most buyers hold these securities until maturity.

There are also Chinese corporate bonds trading in Hong Kong and Singapore. These are typically denominated in Hong Kong or U.S. dollars.

Will Hong Kong’s firm peg to the dollar stand?

That’s an interesting question. I do think that will change when the yuan’s link is altered. But the fate of the HK dollar is less certain.

How many funds do you surmise Alpha Shares will end up with?

We plan to expand the number of our specific industry funds. But we are currently running some other funds privately. They include an enhanced-index fund–the Red Dragon Fund. In it, we tile our weighting towards smaller, value stocks which we believe will generate greater returns.

We have a China-linked portfolio, which invests in countries and markets that are directly benefiting from China’s growth. These include Australian resource plays BHP Biliton, and Rio Tinto, Brazil’s energy giant Petrobras, and US fast-food giant YUM brands. This fund is actively managed because an index of such companies doesn’t formerly exist.

And we are managing a buy-write strategy through our Green Dragon Fund. Because China is so volatile, one can get very large option premiums. A buy-write strategy is based on going long the index–including the FTSE Xinhua Index–and write options against it to pick up premia. At some point we may take all three of these public.

How do you square this decisively active management approach with your long-held belief in passive investing?

There are inherent inefficiencies in the way the Chinese market functions and is tracked. Simply put, I believe unprecedented growth, trifurcated shares [Mainland, Hong Kong, and foreign classes], and volatility present special opportunities, which can’t be captured through traditional indices.

Could you describe your ideal asset allocation for a family man in his mid-40s?

First and foremost, I believe in diversification and rebalancing annually to take profits and reinvest them in securities that have underperformed.

I would suggest 20 percent in safe bonds–US Treasurys, Agency, AAA-rated Corporates, and certain foreign country sovereigns–80 percent in equity.

In selecting both equities and even bonds, a key is to avoid a home-country bias. This is a significant, well-documented handicap. I would want half my equity exposure in foreign stocks, with half of this position in emerging markets, including China, Brazil, and India.

This is not your traditional asset allocation because I believe significant future growth will be in emerging, not developed, markets. They also provide significant exposure to commodities. Take Brazil. Its economy is extremely rich in natural resources, with the largest oil find in the Americas having been found recently off its coast. Brazil could also become the breadbasket for the entire world, greatly assisting China, which is perennially short of water.

The other half of the equity portfolio should probably be in MSCI EAFE. But I have no problem if people want to bulk up on specific country exposure within this context, such as Australia, whose representation in EAFE is relatively modest, under 10 percent.

Australia’s commodities make it among the most desirable developed markets, supported by refined corporate governance and laws. Higher interest rates and sound government finances make Australia’s sovereigns attractive as well. I would double up on my Australian exposure.

So it seems you believe one can enhance the returns of broad market index funds?

My portfolio strategy remains passive, I’m not picking stocks. But I’m adjusting for economic realities. And we see the need for such investment modification in China where a low free float [on which most indices are based] undercounts China by at least a factor of four. A purchasing power-adjusted GDP weighting, which adjusts for the yuan’s significant undervaluation, suggests investor equity exposure of between 6 and 12 percent.

Why did you shift your thinking that broader exposure to the likes of the Wilshire 5000 is superior to the S&P 500?

Research in asset pricing has shown that smaller company stocks tend to outperform larger stocks. This is probably due to the fact that smaller companies have more growth potential than larger-cap stocks. If you look at the Ibbotson numbers since 1926 through the present, stocks as a whole have generated annualized returns of 9.5%. Small-company stocks have generated a rate of return of over 10%. So you want exposure to some of the smaller stocks as well, which you get in a broader index. But you must be mindful of liquidity issues involving stocks that may be too small.

With Alpha Shares currently offering 4 Chinese industry funds and 3 broader market funds, how would you advise an investor to blend them?

I would just buy the All-Company index [YAO]. But our Small-Cap Index fund [HAO] has the most trading activity because these companies are virtually all privately owned, with no government ownership stake, offering a pure private play on China. One could use our technology and forthcoming consumer shares to tweak exposure.

Do you know the long and short interest in your Chinese indices?

We have found the small-cap shares are the most popular funds with clear long interest. The real estate fund [TAO] has probably been shorted of late due to skepticism about overdevelopment and a property bubble.

Are you concerned about a spread risk between your fund’s prices and their NAVs?

Investors can trade in and out of the funds and their underlying securities. This ensures that their spreads remain modest. But because the Chinese market isn’t as efficient as ours, and given the time difference between operational hours, significant spreads have appeared.

The All-Cap Fund [YAO] has seen premium and discounts of less than 3%, with the average spread being a slight premium of 29 basis points. As you move into more riskier shares, the spread has widened, with premium and discount of the Real Estate Fund [TAO] running around 9%. But its average spread is a modest 7 basis point premium. The Small-Cap index has seen its premium reach nearly 14% and fund shares trading at a discount that has exceeded 11%. But on average, the spread remains a manageable 80 basis points.

Who do you find are buying these shares?

It’s been largely individuals, but we are finding that some institutions are buying. These include Polaris Asset Management in Taiwan, Migdal Asset Management in Israel, FUH-HWA in Taiwan.

Have their been foreign investor interest in your products? Are there equivalent foreign ETFs that are available in other markets?

There are several ETFs based on the FTSE Xinhua 25 in Asia and Europe that would be somewhat similar to our YAO All Cap ETF. We feel the YAO has a much better underlying index that the FTSE 25. But our sector indices, including the China Real Estate Index ETF [TAO] and our China Small-Cap Index ETF [HAO], are unique.


What are thoughts about how Obama has been handling the crisis?

I think Obama was pretty much forced to the follow the lead of the Bush administration. I didn’t like the way the latter put money into the banks. I think it was far too generous, and I think the government made a bad deal.

When Warren Buffet put money into Goldman Sachs, he got a 10% coupon on preferreds and scads of equity. When the government put money into Citi and Bank of America, we got a 5% coupon and less equity. If the government made a much tougher deal at the outset, I’d be feeling a bit better about the banks new-found riches.

I’d also would have liked to have seen haircuts on some of AIG’s credit default swaps. Why should the CDS people get 100 cents on the dollar? And why should the bondholders have gotten off with 100 cents on the dollar? I think it would’ve been much better if some of the financial pain had been spread around, because you want a system where the private market absorbs the risk. But now the market thinks there is little risk because it knows the government will bail such firms out.

Where are we in the financial crisis?

We have probably passed the worst. The real economy is improving. I think it’s going to continue to improve. The Federal Reserve will be very slow in unwinding its balance sheet, as it should. I’m glad Ben Bernanke was reappointed because I think what he and the central bankers all over the world have done the right thing.

But looking forward, I think of what the British like to say: we will be muddling through. I don’t expect the system to crumble, as many feared just a year ago. I think we are going to see regulators being extra careful in requiring banks to maintain more and more capital. It’s like, “God, make me virtuous, but not quite yet.”

Look, we haven’t solved the real problems that caused the crisis, and we still have a hulluva lot of risk. There are a lot of economists, like Joseph Steiglitz and Nouriel Roubini, who believe we should’ve let the banks go bankrupt and wiped out shareholders. We didn’t do that.

Would that have fixed some of the structural problems? I don’t know.
Our policies have allowed banks to remain under capitalized and overleveraged, while we are requiring them to earn their way out of government obligations. Yet, at the same, time, we are considering moves that may undercut their earnings power. That’s a bit confusing.

I’m skeptical about the Volker policy towards the banks, which is seeking to restrict investment risks of banks that enjoy the government backstop of deposit insurance and access to cheap borrowing. There is a logic to what he has proposed. You don’t want banks to take on huge risks when they have government backing, which essentially means that profits are privatized while risks are socialized.

This isn’t a complete return to Glass-Steagall. But it’s going in that direction. Volker probably prefers that–where you have very narrowly-defined banks, and where insured banks don’t do hedge funds, private equity, and other such ventures.

But it is very difficult to define proprietary trading. For instance, if customers show demand for my Chinese ETFs, is it wrong for banks to make a market in the underlying shares? How do you really separate proprietary trading that’s legitimate from that which is not legitimate?

And I don’t think the break from Glass-Steagall was the root cause of the crisis. Look at Lehman Brothers and Bear Stearns. These were dedicated investment banks. Look at Fannie Mae and Freddie Mac. These were government-sponsored enterprises. I think what these examples clearly show is that we need to enforce strict capital requirements, we must limit leverage, and we must insist that there is adequate liability and asset matching to help ensure sufficient liquidity at all times. Setting hard standards for just these three issues would go a long way to preventing the kind of crisis we’ve just experienced.

One answer could be to consider enacting such changes to the banking system after they earn their way out.

You could do that. But you run the risk of another crisis hitting as they are trying to earn their way out, especially given that our economic future is far from transparent since we haven’t solved many of the underlying problems that caused the crisis.

We have not come to grips with the Too Big Too Fail problem. And if firms like Goldman Sachs decide to revert to their former status–largely out of regulatory reach and government aid–what happens if they again run into trouble? Does the government bail them out anyway to avoid the potential catastrophic impact of its collapse?

What are thoughts on high-frequency trading?

There are a lot of villains in the world. But I don’t think high-frequency traders are one of them. I don’t think they make the market more volatile. To the contrary, I think they make it more efficient. Consider our ETFs. When there is a discrepancy between our NAV and market values, high-frequency traders are the ones who identify the gap and swoop down and close it. You want those guys in there, and I think they’ve gotten a bad rap.

What do you think of the proposed tax on security transactions?

There are a lot of people, including my colleague Paul Krugman, who thinks such a tax will make the markets less volatile by discouraging high-frequency trading, which would eat away at their small profit margins. But I think such a tax will have the opposite effect, making the market less liquid and efficient.

What’s wrong with tapping the securities markets to help reduce our huge deficit?

I believe the effect would reduce the amount of trading, and result in raising far fewer dollars than one would have thought. You generally want to tax people in a way where there is the least distortion to the economic system. And you generally don’t accomplish that by targeting taxes narrowly on one thing or another. That’s why I’m not thrilled with the proposed new taxes on banks.

How then do we close the budget deficit and reduce our national debt?

Much our budgetary problems can only be addressed by changing the growth rate in discretionary spending and entitlement programs. But we need the political will to fix the things that can be easily be fixed.

Take social security. There are three levers you could pull which would help fix the entire problem. One of them is raising the income limit of $90,000 or $100,000 that’s subject to the social security tax. We could raise it to $120,000 without changing marginal tax rates.

Secondly, we could increase retirement ages. What we know is that most people who keep on working are healthier, happier, more involved with life, and there is no reason why we should encourage people to retire early. I’m in my 70s, still working, very glad that I am. I’m in much better shape because of that. We could start this process by increasing the retirement age by just one month a year. This can make a huge difference.

Thirdly, we could index initial benefits to prices rather than wages, which would help change the spending trajectory of this entitlement program.

Social security is technically an easy problem to solve. But politically, it involves the same challenges we face in dealing with most other budgetary related issues.

Are you against raising taxes?

We will undoubtedly have some taxes raised. But we must be very careful by how much we do so. The private economy that’s going to generate growth to improve living standards shouldn’t be harnessed with a tax burden that’s so high that it kills incentives.

What’s your investment outlook over the next year?

I have no idea. Nobody can time the market. Studies of behavioral finance repeatedly show that people who try to invariably do the wrong thing: buying at the tops and selling at the bottoms. I believe in dollar-cost averaging. I believe in rebalancing annually. I have no idea what the market is going to do over the short run. I’m a long-term optimist, who believes in the growth of our western-style economies. I believe in equities.

Outlook for the US dollar?

Economist and currency traders do a terrible job forecasting exchange rates. I’m only going to make one comment on currencies: the Chinese yuan will appreciate over the next year or two against the dollar.

FXI=FTSE/Xinhua 25;
GXC= S&P China Index
FCHI=iShares FTSE China Hong Kong listed Index
PGJ = PowerShares Golden Dragon Halter
HAO=AlphaShares China Small-Cap
TAO=AS China Real Estate
YAO=AlphaShares China All-Cap

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