Brandywine Global Investment Management, LLC Topical Insight | January 19, 2012

China at a Crossroads Exploring the Path to Sustainable Growth

“TO GO BEYOND IS AS WRONG AS TO FALL SHORT.” — CONFUCIUS China has reached an important point on the path to its modernization and industrial development. Gains in gross domestic product (GDP) and incomes over the past 25 years have been spectacular but progress also has created dramatic structural economic imbalances, an extreme mal-distribution of income, a real-estate bubble, environmental degradation and widespread corruption. Many investors believe that an economic bust is imminent. Our view is that China needs more reform and liberalization without which it could fall into a period of chronic stagflation. The current administration has reacted to the problems of development by retreating and unwinding previous reforms. We doubt this strategy will work in the long run because it would intensify and prolong the current distortions. However, a new administration takes charge over the course of the next year. China’s future very much depends on whether this new regime embraces liberalization and reform anew or settles for the status quo.

THE EVOLUTION OF CHINA’S CURRENT GROWTH MODEL China embarked on its first reforms in agriculture during the era of Deng Xiao Ping (1978-1993). Deng started to de-collectivize agriculture and established the Household-Responsibility System, which permitted farmers to profit from the sale of any produce in excess of their quota. Similarly, a dual price system was introduced in the industrial sectors in which state-owned enterprises Francis A. Scotland (SOE) were allowed to sell any production above the plan quota at market prices. The country was Director of Global Macro Research opened to foreign investment for the first time with a series of special economic zones that were • Joined the Firm in 2006, and has 33 relatively free of tax, government regulations and interventions. During 1984 to 1993, controls on years of investment experience private businesses and government intervention continued to decrease and state enterprises were privatized on a small scale. Tracy Chen, CFA, CAIA* Sr Research Analyst - Portfolio Manager, The reform process accelerated after Deng’s death in 1997 under the leadership of Jiang Zemin Mortgage-Backed Securities and Zhu Rongji. They quickened the pace of privatizations in the SOE sector, dismantled much of • Joined the Firm in 2008, and has 14 the Mao-era social welfare system, privatized public housing, joined the World Trade Organization years of investment experience (WTO), and stimulated infrastructure development. The results have been powerful: since the late 1990’s, China’s GDP has approximately quadrupled. From 1979 to 2010, the economy has grown at a compounded average real rate of 9.9%. The domestic private sector first exceeded 50% of GDP in 2005 and has continued to increase its share of the economy. Since China joined the WTO, international trade as a percentage of GDP has increased from less than 10% to 64% as of 2010. The administration of Hu Jintao and Wen Jiabao took office in 2005. This regime’s focus has been the emergence of a growing number of imbalances and problems linked to the speed of growth in the economy. Their solution: to reverse course on economic liberalization. Subsidies and controls

For Institutional Investors Only China at a Crossroads | p2 Brandywine Global Investment Management, LLC Topical Insight | January 19, 2012

were boosted in the healthcare sector, privatization was halted and the state sector’s importance in the economy has increased. The Hu government has also encouraged a policy of easy money. Low interest rates relative to China’s economic growth have provided a massive subsidy to corporate profits and helped stimulate asset bubbles and inflation. In addition, the economic stimulus which followed the global financial crisis of 2008 was enormous and helped swell China’s monetary stock (the M2 aggregate). The level of M2 has doubled over the past four years and is 180% of GDP, leaving it a third larger than its U.S. counterpart ($12 trillion versus $9 trillion in the U.S.) even though China’s economy is half the size of the American economy.

UNDERSTANDING THE DRIVERS BEHIND ECONOMIC GROWTH Two essential characteristics tend to explain both China’s economic success and many of its imbalances.

• The first driver is the ideological pursuit of growth. Feeding off of Deng’s manifesto “to be rich is glorious,” growth has been the guiding principle behind China’s development model. It is important to appreciate the full meaning of this growth goal in the context of China’s centrally planned legacy. Reform was viewed as a means to achieving an end as opposed to embracing the idea that laissez-faire capitalism was in the long-term interests of the country. The communist party has institutionalized the goal of growth at all levels of the political system through its control of SOEs, state-owned financial institutions, as well as currency and financial policies of the government. As a result, China’s various layers of government behave more like growth-maximizing corporations instead of political institutions. Achieving strong economic growth is incentivized across all levels of Chinese governments making it a key aspect of building a political career. Consequently, local and provincial government officials act more like corporate chief executive officers as they pursue measures to boost growth rather than political officials responsible for the public good.

• The second driver of China’s transformation has been the asymmetric/incomplete nature of its liberalization programs. Product markets have been almost completely liberalized while many factor markets have not. Many factor costs have been kept artificially suppressed in order to boost output, take advantage of export markets, be competitive and increase profits. Output and GDP have exploded higher but so have imbalances and income inequality. Related to this is the ongoing lack of property rights. The paradox of China’s success is that the combination of growth at any price and its twin-speed liberalization program—one for product markets, another for factor markets—is also the underlying root cause of many of China’s biggest imbalances and problems: 1. Degradation of the environment and pollution may be the most obvious example. Treating the environment as a free good has kept the cost of production low and boosted China’s ability to compete in the global market. The consequence, however, has been incredible pollution to a level that is impacting the health of the population. Last year, China’s top web portal for health information reported that 247 “cancer villages” may be spread throughout 27 provinces. Heavy-metal contamination in water and soil has led to high instances of occupational diseases and death in China, prompting use of the term China’s “bloody GDP.” Food safety is a related concern. Some food companies use illegal means and substances to hold down product prices in order to maintain consumer loyalty at a time when savings and wages are being eaten away by rising costs. 2. Lack of regulation and safety oversight has helped lower China’s production costs and subsidized output but at the expense, in many instances, of faulty construction. The recent accident on China’s showpiece high-speed train service has brought this issue to the forefront. 3. China’s real-estate bubble is a direct result of its growth model. Since 2002, government policies on restricting urban land supply have caused serious shortages in most major urban centers. This trend has accelerated since 2004 and in combination with easy money is the main reason for the high level of real-estate prices in the country. Property prices are currently as high as 20 times average household incomes in large cities like Beijing and Shanghai. The artificial restriction on land supply has been a hotbed for speculation, monopolizing and corruption. High home prices limit consumption and household expenditure. The reason for the government’s insistence on restrictive supply is power—it channels significant resources to local governments through the property market. High property prices have bolstered local governments’ economic clout but dimmed the ability of China’s emerging middle class to expand. 4. The ultimate factor of production, the cost of money, is regulated and set by the central bank well below levels that subsidize profits. The government controls both the level of interest rates and the currency exchange rate. Credit is rationed through a quota system enforced by the China at a Crossroads | p3 Brandywine Global Investment Management, LLC Topical Insight | January 19, 2012

government instead of the price mechanism. As a result, imbalances abound across the financial system, beginning with the largest reserve accumulation of any country in the world. The subsidized cost of credit has encouraged massive demand for credit. China’s non-financial sector indebtedness to financial institutions was 72.7 trillion yuan in April, or 182% of 2010 GDP. The ratings agency Fitch estimates 25% of the banking system’s assets are off balance sheets. The nation’s gray market for financing could account for another 25%. Thus, it’s fair to say that debts of the non-financial sector—private and public—exceed 200% of GDP; that level of indebtedness is unprecedented for a country like China with a per-capita income of about US$4,400 as of the end of 2010. 5. Inflation is higher than the statistics suggest. The GDP deflator puts inflation almost twice as high as what the Consumer Price Index implies. Moreover, the recent attack on inflation has relied on credit rationing. Banks have been lending to underperforming SOEs simply because they are owned by the government. Fewer private companies can get credit from banks, forcing them to turn to the gray market for financing at rates that are sometimes above 20%. Hence the private sector is bearing a disproportionate share of the tightening sequence. Many will not survive if these rates continue. This situation is ironic because Chinese monetary policy remains behind the curve in many respects. Chronic inflation coupled with negative real interest rates results in an allocation of capital to inefficient users. In this case, the low-productivity SOEs are sustained while the high-productivity private sector slows. The result is financial discrimination that runs the risk of stagflation. 6. The extreme focus on investment has created chronic overcapacity and underlying weak profitability, absent the salve of easy money. China has one of the most advanced infrastructures in the world with investment as a share of GDP at 45%, up from 38% in 2003. Beginning in 2008, China’s local government financing platform (LGFP) loans exploded to around 10 trillion yuan. The infrastructure financing splurge helped China stave off the global financial crisis, but left unanswered how many of the projects would turn into non-performing loan assets. One case in point is the LGFP Yunnan Highway Development Investment Limited. In April, the corporation informed its creditor banks that, effective immediately, it would repay interest but not principal. The company had nearly 100 billion yuan in loans from a dozen banks including China Construction Bank, China Development Bank, and the Industrial and Commercial Bank of China. The Yunnan Highway investment dates back to 2006, when it began to undertake the construction, operation, financing, management and development of highways in China’s southwest Yunnan Province. During the 11th Five-Year Plan from 2006 to 2010, the highway and road network doubled in length to 206,700 kilometers through Yunnan—making it the third-longest stretch of highway in the country. The accelerated build-up peaked in 2009 and 2010, when investment alone reached 80 billion yuan. Toll collections, however, have failed to keep pace with the highway’s costs. China’s highway network is already comparable in length to that of the U.S.’, but passenger traffic is much less. Aside from China’s urbanized zones in the Yangtze and Pearl River deltas, its vast network of expressways in the rest of the country is otherwise close to empty. In Yunnan, where the population density is low and economic development lags behind that of eastern regions, the problem is even more pronounced. With insufficient traffic flows and toll revenues, Yunnan Highway is now wrestling with the question of whether it can repay the principal and interest on its loans. 7. China’s labor market faces a surplus in the college graduate segment. The unemployment rate for this population segment has been in the range of 10% to 15% over the past two to three years versus an urban average of 4.1%. In contrast, there is a reported shortage of low-paying industrial workers. Various media reports estimate the undersupply of low-skilled labor at around a million people in Guangzhou and neighboring cities—the centers of China’s export boom. Numerous assembly lines and construction sites are sitting idle while anxious employers have raised salaries by more than 30% but still can’t attract enough applicants. One factor is that many of the outstanding job vacancies reflect a lack of skilled workers as segments of China’s export industry crawl up the value chain. Another factor driving an undersupply of low-skilled workers is that growing farm income reduces interest in low-paying, physically demanding industrial work. Additionally, the current labor shortage in affluent coastal regions is partly due to the construction boom and fast economic growth in inland cities. Many migrant workers prefer these places because salaries are, in some cases, almost on par with Shanghai’s and it’s simply closer to home. As well, the young generation of the rural population seems to have taken on a different world view than their parents. The increase in overall affluence reduces the pressure on younger people to support their families. All of this gives some indication of what is likely to be a massive labor shortage issue in China over coming decades as it attempts to continue modernizing while facing an aging population. Premier Wen has called the economy “uncoordinated, imbalanced, inefficient, and unsustainable.” Despite this recognition there has been no material structural change or progressive reform in the last eight years. China’s 12th Five-Year Plan clearly focuses on the transition of the economic growth model from investment- and export-driven to consumption-driven—but so did the 11th Five-Year Plan with no results. China at a Crossroads | p4 Brandywine Global Investment Management, LLC Topical Insight | January 19, 2012

Instead, the current administration has reverted to its central planning roots in an attempt to curtail the symptoms of its development problems. The government has increased subsidies and control over the healthcare sector, halted privatization, increased the bias toward the state sector’s importance in the economy while monetary policy is still not ahead of the curve. Rather than liberalize the supply of land, the government has banned the purchase of second homes in major cities, limited real-estate lending, and, in some cities, banned outright price increases. Chinese policymakers boosted minimum wages, heralding the move as a means to redress the rising cost of living for those workers earning only minimum wage. The reaction speaks volumes about the mindset of current policy thinking.

PROSPECT FOR MORE REFORM The Chinese Communist Party will change its leadership next year followed by another change in government in early 2013. It remains to be seen if the new incoming administration will turn out to be more like the old-style central planning technocrats that Hu/Wen represent, or more radical in their pursuit of continued liberalization. Economic development in many Latin American economies has been unable to advance from the initial take- off phase, owing to reactionary policy measures brought on by concerns over income inequality. For China’s economy to avoid this outcome, it needs to embrace reform on a number of fronts: 1. The government needs to liberalize the financial sector and allow the price of credit to be an accurate reflection of demand and supply. The government is moving in this direction but too slowly. Plans to make the renminbi convertible have been in place for some time but keep being deferred. Artificially low interest rates distort activity but SOEs like them because their credit allocations are cheap and allow them to stay in business. 2. Liberalization of land supply and farmers’ property rights is another area where reforms are needed. High real-estate prices can be resolved by deregulating the supply of land for new construction. Resistance to this reform is obvious due to state-owned financial institutions’ high exposure to property prices. Nonetheless, China has the resources to rebuild bank capital as these asset prices realign. Equally important, further liberalization needs to take place in the farm sector. The Household-Responsibility System never gave ownership of the land to farmers. Instead, they only earn income off a portion of the land that has been allocated to them by the government. Consequently, farmers are left with an incentive to exploit the land rather than invest and develop it. Moreover, the size of the land parcels was in proportion to family size and from time to time reallocated. As a result, the economies of scale of production seen in the West are not achievable in China because of its underlying ownership structure. Ultimately, the government must withdraw from the economic process, not the reverse, as has been the case under the current administration.

CONCLUSIONS The current status quo growth model in China will lead to stagflation, greater income inequality and economic disappointment. In the worst-case scenario of no progress on the reform front, China could end up spending the next 10 years plugging the holes of its current development model with capital accumulated over the course of the last 25 years. Alternatively, re-engagement of the liberalization process and an extension of the progress made under the Deng and Jiang/Zhu regimes would boost productivity and ease many of the imbalances currently undermining the sustainability of China’s growth miracle. The implications for the global economy could be significant. Deregulation of land supply would allow ordinary Chinese to purchase a home along with related household durables. The net impact would be the emergence of a more consumption-based economy, which would be extremely positive for a global economy lacking aggregate demand. The beginning of a reduction in China’s household savings rate would have implications for its balance of payments as well as capital available to the rest of the world. Predictions of an economic bust are based largely on the excesses built up mainly in the real-estate sector. Distortions are real and prices are high relative to almost any common valuation metric. Moreover, recent reports suggest that real-estate activity has fallen off and prices are beginning to roll over. The authorities are happy to see some of the froth come out of this sector but their willingness to tolerate much growth pain will be limited. China at a Crossroads | p5 Brandywine Global Investment Management, LLC Topical Insight | January 19, 2012

In the short-term, the authorities probably have the ability to overcome any setbacks caused by housing. Despite high home prices, the Chinese household is unlevered. According to HSBC research, mortgage loans are less than 15% of total bank loans and only 6% of urban households in China have mortgages. The credit excess is in the SOEs and the related uncertainty is the scale and impact of non-peforming loans on the banking system. The government already has stepped in to shore up bank capital via investments through the country’s sovereign wealth fund and is beginning to micro-manage access to capital in other industrial sectors of the economy. In the end, stress in the SOEs will inevitably lead to a transfer payment from the central government, minimizing the hit to the economy. The biggest impact on the global economy from these measures may be to take some of the edge off the boom in the commodity complex as infrastructure and capital spending begin to soften. Whether this becomes a stop-gap measure, or a consolidation before another round of liberalization depends on the new leadership coming to power over the course of the next year.

All economic data is sourced from Thomson Reuters Datastream, additional data sourced from China Daily and HSBC. The views expressed represent the opinions of Brandywine Global Investment Management, LLC or any of its affiliates (“Brandywine Global”) and are not intended as a forecast or guarantee of future results. In rendering portfolio management services, Brandywine Global Investment Management, LLC may use the portfolio management services, research and other resources of its affiliates. This information should not be considered a solicitation or an offer to provide any Brandywine Global service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. There may be additional risks associated with international investments such as market/currency fluctuations, investment risks, and other risks involving foreign economic, political, monetary, taxation, auditing and/ or legal factors. These risks are magnified in emerging markets. International investing may not be suitable for everyone. Fixed income securities involve interest rate, credit, inflation and reinvestment risk; and possible loss of principal. This material may not be reproduced or used in any form or medium without express written permission.