China. What gives?

The Shanghai stock exchange is down almost 15% this year, shortly after much-touted measures of opening-up to foreign investors.  The Chinese yuan has depreciated. Trade tensions following the announcement of tariffs by the Trump administration continue to escalate.  These developments have taken a toll on other emerging markets, making emerging market equities one of the worst performing asset classes this year. 

This invariably raises a host of perennial questions regarding China’s economy. Has credit grown to a level that is weighing down corporate profitability and growth?  Can the government successfully engineer a transition from high growth to “quality” growth?  Is consumption growth picking up, reducing the reliance of the economy on investment growth?  Have reforms to reduce overcapacities gone far enough to restore financial health to firms? 

The short answer to all of these questions is “maybe”. The more complete answer is that progress has been very spotty.  While the government has been able to reduce risks in some areas, they have increased risks elsewhere.  China’s economy is not imploding, but it is naïve to think that all is well. It’s not.

What deleveraging?

The key risk facing China is credit growth. Total debt is now about 300% of GDP, making it one of the most leveraged economies in the world.  Credit growth was particularly sharp following the 2008 crisis, when the government used it as a tool to support economic growth through a substantial investment program.  Reducing leverage without triggering a sharp deceleration in growth is the government’s main challenge. 

How can deleveraging be achieved while maintaining growth?  China undertook financial sector reforms to reduce off balance sheet credit creation by institutions.  In sectors such as coal and steel, where overcapacities were substantial, financially weak firms that survived on credit were shut down. 

These measures did indeed slow down credit growth, but it remains faster than GDP growth. Corporate debt as a share of GDP stabilised, but growth in household and government debt has not decelerated. This is due to rapid increases in mortgage and consumer lending, as well as off-budget investment by the public sector.  As a result, the debt service capacity of households is deteriorating.

Consumption growth is modest

With an increasing debt burden of households, it is not surprising that consumption growth has failed to accelerate as expected. The contribution of consumption to GDP growth declined last year, and while it has picked up in the first half of 2018, it remains to be seen if it is sustainable. The reason China exceeded growth expectations last year is an unexpected tailwind in the form of export growth.

Alternative facts?

A startling feature of a recent IMF report is the stark difference in perception of reality between Chinese and IMF officials.  IMF officials calculate the total public sector deficit in a way that shows a larger deficit that officials are willing to accept. They also differ on monetary policy.  IMF calculations show that monetary policy is too loose (a fact evidenced by the continued growth in credit). China believes it’s tight (and has recently loosed reserve requirements to support growth).  An analysis of China’s economy would be easier if data were reliable. They’re not.

From Trade War to Currency War?

The yuan has depreciated almost 10% against the dollar since April. This can’t simply be explained by the strength of the dollar. The CNY depreciated against the Euro and Yen as well.  It can be argued that weakening the currency is a legitimate policy move for a central bank that perceives its monetary policy as being too tight. But it’s hard not to wonder if, and to what extent, the depreciation is designed to ameliorate the impact of the trade war. 

We do not think that China is prepared to unleash a full currency war for two reasons. First, it should be concerned about spooking domestic investors and reigniting capital flight.  Second, China has no interest in mutating the bilateral dispute with the US into a multilateral trade war that involves Europe, Japan and other emerging markets.

A high-risk juncture…

China is at its highest risk juncture since the global financial crisis.  The much-vaunted reforms have had uneven results. Debt levels did not stabilise, and the trade war with the US will inflict damage on the profitability of healthy, competitive industries in both economies.  However, none of this means that a crisis is inevitable in the near term.

…with modest rewards for investors

Equity market valuations in China have become significantly more attractive as the market corrected. The same is true of other emerging markets to whom China is an important trading partner.  Have valuation discounts reached a level that creates an opportunity for investors to increase exposure? 

This is a question we can debate at length.  In the near term, our answer is yes. The market is pricing in considerable risks.  For investors with a view of the medium term, expectations should be modest.  China’s economy can only decelerate, and there is little visibility on how structural risks will be reduced.