The spectre of a Chinese meltdown has been the hot investment topic of 2016 but is the story a little over-cooked? Nick Dravitzki, Devon Funds Management portfolio manager, reports some cold facts from an icy Middle Kingdom
The daytime temperature in Beijing in January struggles to get into positive figures and as the evening wears on it plunges into the negatives. In recent weeks a thermometer measuring those fluctuations could have been mistaken for the returns of the Chinese share indices.
The worryingly poor performance of stocks and broader concerns about the Chinese economy have dominated news in the first weeks of the new year so it seemed an excellent time to try and get some closer insight.
To that end I spent a week this January in Beijing and Chongqing attending presentations, talking to investors and officials and touring property projects.
There is no doubt that China is front and centre of people’s thoughts. The response of global equity markets to volatility in China has been sharp – year to date the S&P 500 is down 9 per cent, the Nikkei 225 is down nearly 14 per cent and the Australian ASX200 is down 8.1 per cent. The degree of fear and near panic that has characterised commodity and equity markets seems, at least in part, to be premised on concerns that China is heading for a ‘hard landing’ and possibly a financial crisis of the same sort that affected much of Asia in 1998. For that to happen it would mean that the Chinese government had lost the ability to control capital flows and its currency. Large increases in capital outflows and falls in reserves has stimulated these fears.
The good news is that there are strong reasons to think that the Chinese government still has the capability to control the country’s capital account.
Firstly, there is a logical explanation for the capital outflows. Throughout 2013 and 2014 Chinese corporates greatly increased their borrowing of US dollar denominated debt. They did so because interest rates were much lower in the US and they expected the Remnimbi (RMB) to continue to appreciate against the US dollar. When, in August 2015, the Peoples Bank of China moved to depreciate the RMB against the dollar (by setting its valuation benchmark against a broader basket of trading partner currencies) it caused panic amongst these, almost without exception, unhedged borrowers. The corporates were in a position to respond because over 2015 the Chinese on-shore bond market had grown in size and interest rate liberalisation had made domestic borrowing much more attractive. Consequently a large number of the US dollar borrowers refinanced in the domestic market and sold the borrowed RMB to pay back US dollar debt (property developers for example borrowed RMB340b on-shore in 2015, compared to just RMB125b in 2014). It was that selling of RMB to buy dollars to pay back debt that made up the bulk of capital flows in the second half of 2015.
Secondly, there is much anecdotal evidence that taking capital out of China is becoming more difficult. Domestic Chinese wealth managers say it is becoming more difficult to move RMB into offshore assets. Participants in the Chinese bond and currency markets believe that the value gap between the on-shore (CNY) and off-shore (CNH) RMB that has widened recently is a result of a decision in September to close the cross-border channels that used to enable any differential to be arbitraged away. The tightening of flows is not necessarily indicative of economic strength but it does present a compelling argument that the Chinese authorities still have the ability and willingness to manage capital and currency.
Having confidence that China will avoid a full-blown crisis isn’t the same as believing that all is sweetness and light. Since the global financial crisis China has seen a massive build-up in leverage – it has added debt to the equivalent of 60 per cent of GDP in just five years. Unquestionably much of this debt has been into industrial capacity that is not productive. As underlying demand for continued fixed asset investment has slowed and much of that investment has become unprofitable, it has acted as a drag on economic growth and caused rising non-performing loans in the banking system. The authorities have been reluctant to allow the large banks (all state-owned) to cut funding to loss-making (state-owned) industrial enterprises – partly because doing so would entail the banks recognising a significant proportion of loans as bad debts. There is now solid evidence that this is beginning to happen. Many steel mills and coal mines in particular are no longer being extended credit and are being forced to close. Economists closely involved in policy are adamant that the government is committed to reducing excess capacity and reducing debt.
This process is necessary and if further evidence emerges that significant economic restructuring is taking place then it is likely the Chinese equity market will respond very positively. It will however cause significant job losses, which will have an impact on consumer confidence and consumption. Moreover, it is difficult to see demand for commodities, particularly iron ore and copper, rising in an environment where excess industrial capacity is being removed. The Chinese industrial base is enormous – it has 59 per cent of the globe’s cement producing capacity and 10-times the steel making capacity of the United States. Much of that capacity is still being utilised but the production is being exported because domestic demand is falling. As some of that capacity is withdrawn the demand weakness is likely to be felt in the seaborne materials market where the Australian iron ore and coal producers are exposed.
There are many reasons to feel optimistic about China’s economic performance. Even over the near term lower interest rates (which will mainly flow through to households from early 2016) and changes in home ownership rules have seen property sales and prices pick up. Because local governments mainly derive their revenue from land sales tax this recovery will offer a modest fiscal boost. Activity in the service sector is growing strongly – although this is hard to measure several data points emphasise how rapid consumption growth has been: box office receipts have grown around 40 per cent per year for the last three years, air passenger travel has grown 9 per cent p.a. for several years, and rail passenger growth has been at a similar level.
China also has some profound structural advantages. Like the US it has an enormous home market that allows domestic companies to accumulate large capital bases before expanding globally. It is a society that values education and will graduate more than 7 million university students this year. And the collapse in commodities and the price of oil in particular has seen its terms of trades improve dramatically.
Nevertheless, over the next year or two the inevitable decline in fixed asset investment coupled with large scale closures of excess capacity are likely to see economic growth continue to moderate. Those hoping for a growth rebound are almost certainly going to be disappointed.
But the good news is that a slowing growth rate is likely to be the extent of the bad news. With markets currently fearing a much worse scenario, if it is correct that a ‘hard landing’ can be avoided then, as that outcome becomes apparent, investor sentiment and expectations are very likely to improve.