Are fears about China overdone?

Despite some hiccups, economic rebalancing and reform momentum should not be derailed.

The Shanghai Composite Index fell more than 30% in less than a month in mid-2015 and the Chinese currency sustained an unexpected 3% “depreciation”, causing even firm believers in China’s economic miracle to waver in their convictions. Months after, investors are still reassessing China’s growth prospects and many fear a “hard landing”. We believe such concerns are overblown, but the recent episode is a reminder that the road ahead will remain bumpy.

The road ahead

The Chinese economy is walking a precarious path from investment-led to more consumer-driven and market-based growth, while the authorities are also attempting to correct economic and financial imbalances. As the IMF puts it: this represents “a challenging set of objectives”.

The financial imbalances stem partly from the explosion of debt since 2007. The Chinese authorities responded to the global financial crisis in 2009 by trying to offset faltering foreign demand with credit-driven domestic debt. Debt raised by local government entities increased from 10% of GDP in 2003 to 40% in mid-2015, while private debt – mainly issued by Chinese companies – jumped from 120% of GDP in 2007 to 190% in mid-2015.

Of course, in rapidly-growing economies, high levels of debt are easier to sustain. But what seems sustainable when the economy is roaring ahead at 15% a year (nominal rate) – as was the case before the financial crisis - becomes more challenging when GDP growth is half that. With this lower rate of growth, to stabilize the debt-to-GDP ratio the flow of private borrowing as a share of GDP has to fall from 25% to 15%. This 10 percentage points shock gives an idea of the deflationary headwind the Chinese economy is now facing. The necessary future reduction in debt throws into doubt China’s aim to keep growing the economy at 6.5% in real terms in order to double GDP and household income between 2010 and 2020, one of the objectives in the latest Five-year Plan.

 

Policy action already in evidence

To meet the growth challenge, Chinese authorities still have a lot of policy leeway – both on the fiscal and monetary front. They have already started to act: monetary policy has significantly eased over the last months, while public spending by local government entities has increased and some taxes have been lowered. As a result, activity is showing tentative signs of improvement: consumption remains resilient, property sales have picked up and infrastructure investment is gaining traction. This shows without question that when growth slows down alarmingly, the Chinese authorities are ready to do “whatever it takes” to avoid a hard landing.

Rebalancing the economy

To maintain sustainable growth, China also needs its economy to become more service-oriented. The good news for investors in China is that the necessary journey to market-based, consumer-led growth is under way and the Chinese economy has already become more service-oriented and less reliant on the industrial part of the economy. The share of the tertiary sector is up from 40% of GDP at the beginning of the 2000s to more than 50% today.

 

This explains why, despite a struggling manufacturing sector, the economy managed to grow at 6.9% year-on-year in the third quarter of 2015. During the quarter, the services sector expanded by some 8.4%.

However, the financial sector alone contributed more than 1.5 percentage points of GDP. Without this contribution, GDP growth would have been barely above 6.3%. Not only that, but strong deflationary pressures can also be seen in the large fall in the GDP deflator – which measures the level of all prices –to negative territory in Q3 2015, from a high of more than +9% in 2011.

Turbo-charging the service sector

Encouraged by the direction so far of its rebalancing efforts, and taking account of the slowing growth rate, China is now seeking to further stimulate its services sector. Its 13th Five-Year Plan, announced in October (with further detail due in March 2016), aims to shift the economy further away from increasingly uncompetitive low-end manufacturing and more towards higher value added products and services. In the process, 70m Chinese more citizens should be lifted out of poverty and take their place as consumers in the domestic economy.

 

Innovation is high on the agenda of the Five-Year Plan, and will build on a series of action plans. For example, the “Made in China 2025” initiative was launched earlier in 2015 with a focus on everything technology- and internet-related – including social media, the internet of things, e-commerce, online-to-offline commerce, Big Data and biotechnology. If evidence were needed of the power of allying hundreds of millions of Chinese consumers to innovative technology, it was provided by Singles Day, an annual event in China in which online retailers cut their prices. Online sales on (Alibaba’s) Singles Day on November 11, amounted to RMB91bn (EUR 13.4bn) in 2015, more than double last year’s RMB45bn and four times the size of 2013 Singles Day’s sale.

Innovation also encompasses increased focus on environment-related investments, such as clean and alternative energy sources. State-owned enterprises, which can be inefficient, will be reformed and refocused on growth.

Other state-sponsored initiatives

Allied to the domestic innovation drive, are outgoing initiatives like the “One Belt One Road” initiative, which seeks to redirect the country’s domestic overcapacity towards regional infrastructure development, with the aim of increasing trade with neighbouring Asian and other emerging countries and, in the process, extending China’s geopolitical influence in these regions. To support its domestic economic ambitions, China has signalled it will pay more attention to social issues - easing the one-child policy, and increasing spending on social security, healthcare, education and pensions.

The full details are not yet known, but the implementation of the newly-presented Five-Year Plan will likely be accompanied by a mixture of growth-supporting measures like tax credits, tax cuts and targeted lending policies. Mortgage lending easing and tax cuts on the sale of smaller cars, for instance, have already been instituted. Of course, executing the plan will not be smooth, simple or quick, but China’s single party system at least enables it to implement strong measures without being challenged by opposition parties.

Tailwind for newer stocks

As is often the case in China, government initiatives have had and potentially will have significant implications for Chinese equities. The focus on innovation and services will give impetus to technology-, infrastructure- and consumer-related companies - the latter being those with an emphasis on tourism, smartphones, cosmetics, sports and culture, e-commerce, financial services education, and so on.

“Old China” sectors like materials, mining and energy stocks may underperform. But investors should keep an open mind: as out-of-favour stocks sink to historic lows, at some point they may present buying opportunities. At the same time, some sectors may become overheated, so keeping an eye on valuations and diversification is critical to stock market success in China.

Stocks should also be supported by important index changes, such as the inclusion of Chinese American Depositary Receipts (ADRs) in the MSCI China and Emerging Markets indices in November 2015 and May 2016. China’s weighting in the MSCI Emerging Markets index will increase from around 23% now to probably more than 26% in May 2016. This has the potential to lift the share prices of US-listed growth companies such as Baidu, Alibaba, VipShop, NetEase and others.

A further lift could be provided by increased foreign access to the huge local A-share markets, following expectations around the future Shenzhen-Hong Kong Connect, the sister project to Shanghai-Hong Kong Connect, whose launch in 2014 led to a strong surge in Shanghai stocks. If successful, the inclusion of A-shares in the benchmark indices could follow.

Hard landing averted?

Will these measures avoid further sudden lurches in the Chinese stock market? Probably not. But policymakers will have learned from their policy mistakes: so the government will be less likely to overstimulate the market and encourage leveraged investments, as it did in early 2015.

And there are signs that the announcement of the Five-Year Plan, in tandem with fiscal and monetary policy, are already having a positive impact. Monetary policy has significantly eased over recent months, while public spending by local entities has risen (partly through increased bond issuance instead of bank loans) and some taxes reduced. Even though this has not resulted in large gains in stocks yet, the market has the potential to remain supported as the weak economy will imply further monetary and fiscal stimulus, and consumer and service stocks deliver. Nothing is certain, of course, but the will of the Chinese authorities to avert a hard landing should not be under-estimated and their willingness to use all available policy measures to prepare the country for the future - if only to ensure social stability and the future survival of the Party - is not in doubt.

Jan Boudewijns
Head of Emerging Equity Management