China shocked markets early this year, when it unexpectedly raised its reserve requirement ratio (RRR) for banks twice over a span of just one month. Though analysts had been expecting some form of tightening measures, it took place earlier-than-expected, spooking investors.
The hike came hot on the heels of talk that several state-run Chinese banks had been ordered to suspend new lending, suggesting a coordinated effort by Beijing to manage state banks' torrid lending at the onset of the year. Banks extended about 19 per cent of this year's 7.5 trillion yuan lending target in January alone, which has worried policy makers who want to avert asset bubbles.
China's benchmark Shanghai Composite Index has fallen about 8 percent this year* on concern that increases in consumer prices and asset bubbles will spur the central bank to tighten monetary policy further and increase borrowing costs.
The curbs on lending also came after China announced a higher-than-expected economic growth rate of 8.7 per cent last year, comfortably above its 8 per cent target. Now, as the government appears to be winding down the bank-led stimulus programme that helped it to weather the global economic slowdown, it begs the issue if China will continue to curb credit flows as fears of an asset bubble brewing in China gather momentum.
We posed the question to Ms. Martha Wang, a portfolio manager with FIL International (“Fidelity”) and Ms. Janet Liem, Head of Asia Pacific Equities with Lion Global Investors Limited (“Lion”), both of whom have an in-depth understanding of China.
On the whole, our experts remain unfazed by the developments taking place in China, and feel that the correction in Chinese equities merely enhances its appeal from an investment perspective.
No hard landing expected
Lion is hopeful that China will be able to engineer a soft landing, given the country's good economic fundamentals and the government's track record in managing previous economic cycles; and continues to believe in China's secular growth trend in the medium to long term.
According to Ms. Liem, China's 10.7 percent growth rate in the fourth quarter of last year was largely driven by solid investment and retail sales growth, and a notable upturn in the export sector. The headline growth rate was also helped by the low base in late-2008.
“While we acknowledge that there are areas showing signs of overheating and maintain a cautious view on the China market over the next few months given the early stage of the tightening cycle, we do not see a systemic risk or a hard landing for China's economy,” she added.
Ms. Wang's optimism stems from the fact that the underlying intention of the Chinese government has not changed despite concerns over the speed of economic growth.
“Some of the measures the government has taken, such as curbing loan growth, were necessary in order to avoid an asset price bubble and to contain non-performing loans and hence can be viewed in a positive light,” she highlighted.
She believes that the PBoC is aiming for a controlled and reasonable growth rate for the next decade, rather than erratic, spectacular growth that could hurt China's long-term growth prospects, and the pre-emptive inflation fighting moves are in line with this aim.
“China's speed of growth has been a concern for the last 6 to 7 months and various measures have been employed to dampen the inflationary pressures,” said Ms. Wang.
“Although managing inflation is now a main focus of the Chinese government, the underlying intentions have not changed, in that the government is still pursuing growth,” she added.
Ms. Wang points out the recent tightening moves are already beginning to have a cooling impact on China's hot property market, with real estate related MSCI China components seeing a significant decline since the beginning of the year. She does not expect the government to relax its property policy until there's a meaningful correction in property prices and homes become more affordable.
Policy measures likely to favour domestic demand
Instead, Ms. Wang expects monetary policy to be further fine-tuned in line with the uptrend in inflation. Both fund managers also expect the current inflationary environment to lead to a gradual appreciation of the Chinese currency.
“We do not expect a surprise move of a one-time major currency revaluation, given the Chinese government's preference for gradual currency movement and the tentative nature of China's export industries,” said Ms. Liem.
A surprise, one-time major currency appreciation would hurt China's export industries the most, Ms. Liem said, and the country will have to accelerate the transformation to a domestic-demand driven economy.
She added: “In general, the export-related equities would take the biggest hit, while those whose earnings are positively correlated to the yuan's appreciation would benefit. Meanwhile, export-oriented economies in Asia are also likely to benefit.”
“I do not expect a meaningful change in domestic demand-boosting policies adopted since onset of the financial crisis, as the positive effects can be seen from the strong growth in sales of appliances and automobiles,” said Ms. Wang.
She expects some of these measures to continue, such as the VAT rebate for appliances, and the cash rebate for scrapping old automobiles that do not meet the emission standards.
Ms. Wang added: “Old-for-new subsidy is a key driver of the recent improvement in sales in home appliances, accounting for about a third of total revenue in participating cities for certain companies. The Chinese government is now assessing whether it needs to expand the programme to cover more product categories and regions for an extended time. If that goes through, it would be a major positive for the industry. Additionally, in 2010, the strength of consumption will likely come from recovering employment and income growth.”
Risk-reward profile more attractive after recent correction
Both fund managers think that the correction in the market has made it attractive for those with little or no exposure to China to consider investing in Chinese equities.
Said Ms. Wang: “With the MSCI China Index and H shares down significantly so far this year, the risk-reward profile of Chinese stocks certainly looks more interesting now. The recent dampening moves have caused some correction in Chinese equities, but the long-term fundamentals have not changed. Unlike the market rally in 2009, which was characterised by cyclical factors, firms with high quality balance sheets and strong fundamentals should perform better than average going forward.”
However, investors need to be prepared for inflation risks due to rising commodity and food prices, Ms. Liem cautioned. Tightening would be another concern, added in Ms. Wang.
“As the government becomes concerned over the possibility of overheating stemming from last year's aggressive expansion of credit, excessive tightening remains a risk,” Ms Wang said.
“Still, as mentioned earlier, it is unlikely the government will jeopardise the economic recovery given that external demand remains weak. Also it is unlikely to administer hard measures unless inflationary pressures become excessive,” she added.
China still a good long-term proposition
“We are optimistic about China's prospects in the long term, given China's sturdy economic fundamentals, ongoing urbanisation and industrialisation, shifting growth model, stable political environment and effective policy transmission mechanism,” said Ms Liem.
She added: “Nonetheless, barring unforeseen circumstances, we expect that it could take over twenty years for China to become the biggest economy in the world. The challenge for the country in the medium- to long-term is to transform to a domestic demand-led growth model from the current export-driven and resource heavy model, and to prepare for the aging society which is expected to come around in about 15 to 20 years.”
Lion recommends that investors with exposure to Chinese equities stay invested, as the current correction is cyclical and short-term in nature.
“Investors may look into adding positions in Chinese equities, when there are clearer signs of the soft landing being achieved in China, when inflationary pressure plateaus later this year, and when the tightening cycle comes to an end,” said Ms. Liem.
“The nature of China's growth is changing and although China still derives a lot of its growth from exports, it needs to promote domestic consumption for it to sustain its growth in the future,” said Ms. Wang.
She added: “Therefore, my long-term themes supporting China's growth remains the domestic consumption angle, continued investment and industrial consolidation and upgrading. These are long term trends that I believe offer a significant amount of growth potential in China.”
China's ongoing transformation to its economic model means that investment will continue to be one of the major growth drivers, according to Ms. Wang. This means there is still a significant amount of room for growth, for instance where inner land investment is concerned.
She added: “Another trend that I am favourable towards is industry consolidation, where industry leaders are strongly positioned to benefit. Tougher markets will tend to drive out smaller inefficient players, leaving the higher quality and proven companies to outperform. Furthermore, there are growing barriers to entry due to environmental and safety concerns.”
Conclusion
Despite short term concerns, both fund managers remain positive on China for the long haul and do not see the Chinese economy or its asset markets poised for a hard landing. They also see the recent correction as an opportunity to buy into Chinese equities for those with a strong risk appetite and long term horizon.
* Year-to-date up to 12 Feb 2010; Source: Bloomberg
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