Has there ever been a country with an expected economic growth rate of 7.5% that has caused so much angst among investors worldwide? Then again, has there ever been an economy like China’s?
In the three decades-plus since Deng Xiaoping launched reforms that gradually reintroduced China to the global economy, China has experienced unprecedented growth that has averaged 9% annually as it zoomed up the charts to rank as the world’s second-largest economy behind the U.S. And conventional wisdom holds that it’s on pace to someday supplant the U.S. as top dog.
But China’s growth story has slowed (a relative term given its still-robust prospects), partly because its sheer size means it can’t possibly maintain past growth trends and partly because of the government’s stated goal to slow down the train and create more sustainable economic growth by emphasizing domestic consumption fueled by the consumer and service sectors rather than its prior reliance on exports and fixed investment assets such as infrastructure, buildings and machinery.
Of late, the Chinese economy’s aura of inevitable supremacy has been replaced by an air of doubt as the increasing number of red flags associated with the country have nothing to do with its national flag. The laundry list of concerns over the Chinese economy can fill a paragraph such as this one: slower growth highlighted by declining industrial output and exports; enormous private-sector debt, a bloated banking system and a growing, nebulous shadow banking system; opaque accounting practices; fears of a possible real estate bubble; endemic corruption and, recently, bank runs and its first-ever domestic bond default.
And for good measure, there’s also rampant pollution and bubbling social unrest that play into the economic picture. Given China’s importance to the global economy as the straw that stirs the drink, particularly for the commodities trade, what happens in China doesn’t necessarily stay in China.
So for investors accustomed to viewing the country as a modern-day El Dorado, the issue boils down to three questions: Is China a ticking time bomb capable of taking down the global economy? Can the central government’s strong hand continue to deftly guide the economy through its many challenges and safely engineer the soft landing of slower, more sustainable growth? And despite the headwinds, how can one make money in this vast market?
If you’re expecting easy black-or-white answers, you’ve come to the wrong country. “It’s a pretty complicated place,” says John Rutledge, chief investment strategist at Safanad, a global private investment firm. “But you can’t ignore China because it’s the number two economy and eventually will be number one.”
Leveraged Growth
In recent years, China has been a paradox where economic growth and stock market returns haven’t jibed. The Chinese stock market, as measured by the Shanghai Composite Index, has slumped more than 40% since August 2009. That was after the Chinese government launched a roughly $650 billion stimulus package to prop up its domestic economy and ultimately helped boost the global economy following the financial crisis.
Although China’s stock market has been a loser in recent years, the country’s economy doubled from a $4.5 trillion annual gross domestic product to one that was roughly $9.2 trillion in the five years since the global financial crisis thanks to a credit boom focused mainly on real estate and infrastructure projects. Much of that leverage has been in the private sector, mainly via bank loans and credit trusts (i.e., non-bank financing through shadow banking channels). According to Newedge, a global multi-asset brokerage business, China’s total private and public debt as a percentage of GDP in 2012 was 189%.
Robbert van Batenburg, Newedge’s director of market strategy, believes China has created a no-win situation for itself by leveraging the country to the hilt to grow the economy. And as the government tries to wring the speculative excesses out of the markets by tightening credit and allowing defaults to occur, van Batenburg asserts that it risks causing a domino effect that could significantly harm the economy.
Indeed, manufacturing in this year’s first quarter slowed to the point where Chinese officials this spring undertook stimulus measures––including spending on railways, low-income housing and tax breaks for small businesses––to help revive flagging growth and keep the economy on course to reach the government’s forecasted growth rate this year of 7.5%.
But the stimulus measures highlight the government’s tightrope act of trying to create a more market-based, sustainable economy even as it intervenes to keep the economy from slowing too quickly. “China has done everything to manufacture growth and has doubled the economy through enormous leverage, including foreign inflows,” van Batenburg says, adding that China could be facing “a day of reckoning because credit cycles this large aren’t easy to stop once they’re set in motion.”
Changing Tires
China has more moving parts than a Swiss watch, and up to now the single-party leadership of the Communist Party has managed to keep things running relatively smoothly. As spelled out in a white paper from Matthews Asia Funds, the new leadership of President Xi Jinping and Premier Li Keqiang realize the country needs to open up its capital markets, encourage private enterprise and decrease its reliance on state-run entities to achieve its long-term goals of growth and prosperity.
And they also realize they can’t afford to let the natives get restless.
“China has a history of peasant revolts,” says Rutledge, an old China hand whose résumé includes being an advisor to Chinese officials. “When you talk to Chinese leaders privately about policy, they always talk about what policies would be good for stability, and the Chinese government wants stability because it wants to be king and because China needs to compound its growth over a long time period to lift people out of poverty.”
One way the government is trying to achieve stability is by clamping down on local corruption, combating pollution, addressing property rights and health care in rural areas, and relocating industry to China’s interior to spread economic opportunities around the country.
Another way is by promoting the country’s service sector. “Services have slower productivity growth and need more bodies, so they employ more people over time than manufacturing,” Rutledge says. “They will have to move a lot of people into cities for these service jobs, which generally require more education than manufacturing jobs. So China is going through a lot of changes while the economy is slowing from 10% to 7%.”
In other words, China is trying the change the tires on a vehicle that's decelerating from 80 to 60 miles per hour. And doing so implies a sense of trust that the strong central government knows what it’s doing and can keep things on track. At the government’s Third Plenum policy setting conference last November, it established a blueprint for 2020 comprising 60 reforms in 15 major areas, including the development of a market-oriented economy, greater support for private-sector economic growth and less control by the central and local governments. It also includes social measures such as relaxing its one-child policy.
Free marketeers usually decry interventionist policies from central governments. But at least for now, most observers have nodded their approval for the Chinese Communist Party’s version of capitalism.
Eye On Consumers
Nick Beecroft, a Hong Kong-based portfolio strategist with T. Rowe Price specializing in emerging markets and Asia, says China’s credit growth is concerning because the vast interlinking among various industries means there’s a likelihood some of these debts could go bad and ripple through the economy.
Nonetheless, he says T. Rowe Price’s base case scenario is that the government has enough knowledge and policy levers to pull to gradually work their way out of this situation. “The massive difference between China and the West is that in China the government has control over everything, including the banking system, and they have a huge amount of money at their disposal so there’s lots they can do to control this,” Beecroft says.
But while he believes the worst-case scenario would be very serious for China, he doesn’t believe it would cause a massive global financial meltdown. “Almost all of the debt in China is local-currency-denominated, and most of it is held by domestic investors, so there’s less external pressure than there was during the global financial crisis.”
Commenting about the T. Rowe Price New Asia Fund, which as of the end of February had China as its largest country weight at 21% of the portfolio (with Hong Kong second at 18%), Beecroft says the fund is heavily underweight Chinese banks because they don’t have enough earnings visibility as the country moves through its credit cycle. “We try to avoid sectors we think could be most at risk from a macro slowdown or from the credit cycle,” he notes.
Beecroft says he’s focused on sectors he believes have strong tailwinds––Internet-related companies, those tied into the broad consumption theme and clean energy companies in the areas of gas distribution and wind power.
Richard Gao, a longtime portfolio manager at Matthews Asia, says investors need to understand the backdrop to––and consequences of––the changes in China’s growth pattern as the government emphasizes quality rather than quantity of economic growth. “We expect the 9% to 10% topline GDP growth from the recent decades to be more like 6% to 7% going forward,” Gao says in an interview. “Along the way, we’ll see slowdowns and some negative impacts from this general rebalancing of the economy.”
As lead manager for the Matthews China and China Small Companies funds, Gao says he and his team are focused on consumer-oriented names among automakers, department stores, supermarkets and dairy producers, along with service-oriented sectors such as education, health care, leisure and tourism.
Gao also sees opportunities in Internet-related companies engaged in e-commerce, online gaming and mobile services. Leading Internet-related names including Baidu and Tencent Holdings, both large holdings at Matthews, have zoomed during the past year, while investors are licking their chops over this year’s anticipated initial public offering of Alibaba, an e-commerce giant that’s been described as China’s version of Amazon, eBay and PayPal rolled into one.
But many consumer-related names have been under pressure in the current economic environment, as the slowing economy has caused weakened consumer spending and hurt some industries such as department stores and supermarkets. In addition, many consumer-oriented companies that historically sold at higher valuations versus other sectors in the economy have been given haircuts by investors.
“We think the weakness in consumer sentiment and spending is a cyclical slowdown rather than a structural problem,” Gao says.
Discount Price
The general weakness in the Chinese economy has put a damper on Chinese stocks so far this year. Returns on the Shanghai Composite Index (“A” shares trading in Shanghai and open mainly to domestic investors only) and the Hang Seng Index (“H” shares of Chinese mainland companies trading in Hong Kong and available to overseas investors) were both negative as of mid-April.
Mutual funds and exchange-traded funds, generally a safer way to invest in China, not surprisingly have also suffered this year with the overall China-focused mutual fund category tracked by Morningstar down 3.7% as of mid-April. Meanwhile, the vast majority of China-related ETFs were also in the red.
Beecroft believes the recent downturn in Chinese stocks has created compelling valuations. As of the end of the first quarter, Beecroft says the Chinese market traded at about eight times forward earnings, versus about 11 times for Asia ex-Japan and about 15 times for the U.S. “You can debate the slowdown in China and some of the risks, but you need to ask what’s in the price,” he notes. “A lot of the bad news has been discounted in China, so there’s valuation support for the market.”
It’s hard to ignore the steady drumbeat of bad news coming out of China, but it’s also hard to ignore its huge economy, which someday will likely become the world’s largest. For investors with long-term horizons and an understanding of the changing Chinese economy, this is a wall of worry that might be worth trying to climb.