Holding the faith (Archived)
Global market uncertainty is prompting China to find new ways of boosting domestic growth. But, despite the many challenges facing the Chinese government, its economic plans remain broadly on track and ongoing reforms could deliver significant long-term gains, says Amy Leung, a member of Newton’s Asian equity team.
Since the late 1990s the China story has been one of rapid development, social change and economic growth. From 1993 to 2007 alone China averaged growth of 10.5% a year.1Throughout the 1990s/2000s the world’s second largest economy became the manufacturing engine room of the world and one of its largest importers and exporters.
However in the past two years weakening global economic recovery, falling industrial output and a rising dependence on credit have all contributed to lower Chinese economic growth. This in turn has fuelled concerns the Chinese economy could be heading for a major correction and raised questions over whether its current economic issues represent a short-term blip or a longer term problem.
At Newton we acknowledge China faces a variety of tough challenges and that its fundamentals remain very weak. However, we do believe the Chinese government, led by president Xi Jinping, is highly intelligent and capable and is riding a steep learning curve while governing and implementing reforms for its 1.3 billion population. From a structural perspective we remain positive on the long-term outlook for China. From an investment perspective, however, we expect more attractive entry points to emerge as the market reprices the risks currently embedded in the market, particularly in the Chinese banking sector.
China faces some challenging structural issues as it transitions from a manufacturing-driven to a more consumer-led market economy. Most recently the exponential growth of its debt - now more than 240% of GDP2 - has become a genuine cause for investor concern. High debt ratios partly stem from a proliferation of corporate loans funding unproductive projects, some of which are not generating sufficient cash flows to service their debts.
An ongoing property sector boom in China has also seen supply dramatically outstrip demand - driving a sharp fall in real estate prices in the smaller so-called tier 3 and 4 Chinese cities in particular.3
Despite some recent moves to develop municipal bond markets in China4, we continue to see local government debt ratios as one of the most worrying aspects of the Chinese economy. In the past, a proliferation of local government borrowing from financial intermediaries led to distortions in the system and higher credit costs for many other participants in the market. However, we believe the Chinese government is aware of this problem and is seeking to address it, though this will take time to resolve.
Ultimately, we would like to see a clearer delineation of proper fiscal debt versus non-fiscal debt in China and the removal of implicit government guarantees from non-fiscal debt so the market can price these accordingly. This should help clarify non-performing loan risk and also reduce ‘moral hazard’.
On the debt front, however, we are not entirely bearish. Unlike some markets, China’s investment driven leverage is almost entirely domestically financed, savings rates are high and various government controls and financial ‘buffers’5 exist which should help China to offer its economy at least some protection in any worst case scenario.
China is currently using various measures to push its credit risk further into the future and its monetary policy continues to show an easing bias. Targeted easing was a theme last year, with the government variously providing affordable financing for small and medium sized companies and for the farming and social housing sectors. The danger is that some of the monetary tools China is using are beginning to lose their effectiveness.
Beyond the debt challenge, wage inflation is also a major issue, with China facing a growing contraction in its ageing working population. The rapid and growing urbanisation of China in recent decades has also created problems. Since 1978, over 270 million workers have moved from rural China into cities6 to get better paid jobs in factories. Those who move from rural areas do not currently enjoy equal status to existing urban citizens and are not entitled to a full set of social benefits, giving rise to growing workforce dissatisfaction and disharmony.
Fortunately the Chinese government has made tackling this a priority through its hukou reform programme. Again, change will take time but we believe the country is at last heading in the right direction on this.
The reform of state-owned enterprises is also on the agenda with the state-owned Assets Supervision and Administration Commission of the State Council finally moving beyond the talking stage to implement real change. According to some 2015 media reports7 the Chinese government plans major changes to the executive management of its giant state oil and gas companies in order to improve their performance. The government has also launched a powerful anti-corruption campaign designed to clean up graft and improve transparency within the wider public sector.
While many assume China is a closed economy the country has in fact done much to liberalise its capital market in recent years. The internationalisation of the renminbi currency continues apace and the Qualified Foreign Institutional Investor and Qualified Domestic Institutional Investor have opened significant gateways for foreign investors – albeit through tightly supervised quotas.
On the investment market front, the Shanghai Stock Exchange (SSE) was the best performing major global stock market last year, rising more than 50%.8 In 2014, China also opened the new Hong Kong-Shanghai Stock Connect trading scheme to broaden investor access to the Chinese market. The new scheme, dubbed the ‘through-train’, has already attracted significant retail inflows and enhanced foreign access to China’s Shanghai A-share market and has also enabled some mainland Chinese investors to access Hong Kong’s H-share market.
Against a buoyant, if somewhat volatile market backdrop, the Chinese government recently announced measures to ease restrictions on the foreign ownership and trading of mutual funds9 and index provider MSCI aims to add some Chinese American depositary receipts to its standard indices later this year, further broadening investor access.10
While China is still predominantly a command-driven industrialised economy its leaders are helping to steer the country towards a more globally oriented, consumer-led market model. The record breaking US$25 bn initial public offering of Chinese e-commerce giant Alibaba11 Group last year suggests its future may ultimately lie in service sectors such as e-commerce.
No one expects the transition towards a more fundamentally balanced economy will take place seamlessly overnight. But, as investors look towards 2016, the Chinese government’s gradual approach looks set to deliver positive long term economic change. While recent growth levels may have slowed in China - leaving it temporarily out of step with other recovering economies such as the US - there is some strong evidence to suggest it is ultimately moving in the right direction.
1. When giants slow down. The Economist. 27.07.13
2. The great hole of China. The Economist. 18.10.14.
3. IMF Says China Should Aim Lower As Housing Prices Triple-Dip. Forbes. 08.03.14.
4. Wanted: Global Buyers for China’s $258 Billion Muni Bond Flood. BloombergBusiness.
5. The great hole of China. The Economist. 18.10.14.
6. China’s migrant miracle grinds to a halt as rural labour supply runs dry. FT. 05.05.15.
7. China’s Leadership Shuffle at Big Oil Clears Path for Reform. Bloomberg. 03.05.15.
8. Bull run in Chinese shares is just the 'beginning'. BBC. 13.01.15.
9. CSRC to ease controls on foreign ownership. FT. 20.07.14.
10. Newton Investment Management, MSCI, CLSA 30.03.2015.
11. Alibaba IPO ranks as world's biggest after additional shares sold. Reuters. 22.09.14.