Teo Joo Wah,
Chief Strategist, Lion Global Investors, OCBC BankMember of OCBC Wealth Panel
The beginning of the year was an eventful one for investors, as it started with a sharp selloff in Chinese equities, with a single-day decline of 7 per cent in local currency terms.
While weaker than expected Caixin PMI (Purchasing Managers’ Index) data for December 2015 may have contributed to the selloff, we believe the situation was exacerbated by the expiry of the selling ban on 8 January 2016 for major shareholders of Chinese corporates. The ban was to manage A-share volatility over July-August 2015 and expired on 8 January 2016.
The decline was magnified by circuit breakers, which sparked a trading halt which led to a worldwide selloff in equities.
Why is China important?
China’s large and expanding market is viewed as an important source of growth for other countries.
Often cited as an economic miracle, its growth is nothing short of phenomenal. China managed to bring its GDP up from US$390b to over US$10,796b in only about 25 years, to become the second largest economy in the world.
No other country in modern history has achieved such exceptional growth so rapidly. For instance, it took the United States 48 years to similarly grow its economy, according to data from Bell Porter.
However, the achievement has come at a price and cracks have surfaced on China’s economy.
Concerns over China
China stunned markets last August by devaluing the yuan out of the blue. The yuan fell almost 2 per cent and stocks, currencies and commodities fall sharply across the region, triggered by fears China’s economy was faltering.
The devaluations come after a run of poor economic data and raised suspicions that China was embarking on a longer-term slide in the exchange rate. A cheaper yuan will help Chinese exports by making them less expensive in overseas markets.
Chinese businesses and individuals reacted by taking money out. China's foreign reserves, the world's largest, fell by US$93.9 billion to $3.557 trillion for the month. Foreign reserves continued to fall in subsequent months and investors have become increasingly nervous that China may surprise with a currency devaluation again.
Another bugbear for China has been the growth in borrowing, or leverage. China remains the biggest concern in Asia when it comes to leverage. China’s credit to GDP ratio has spiked - by 118per cent - since 2008, when its government announced a four trillion yuan stimulus package, the largest in the country's history.
However, the concern is not so much at the magnitude of increase, but more the pace. China’s pace of increase is one of the fastest in the world. While the rate of increase has peaked, China’s credit growth may continue to exceed GDP growth.
China’s investment ratio as a percentage of GDP has also soared to unsustainable levels. It is beginning to taper off but still remains high: 38 per cent versus 27 per cent for Korea and 21 per cent for the U.S. Clumsy policy actions have also served to make the situation worse. Officials were talking up the stockmarket in 2015, resulting in the boom-bust market that year. The poorly thought-out circuit breaker only added to market jitters.
Our view is that a sharp currency devaluation may not transpire, as China’s trade surplus is at an all-time high and its share of world exports has increased. Devaluing the currency may not help much in its efforts to prop up its economy at this juncture and could create financial stress for its neighbours.
The U.S. Treasury put out a “monitoring list” of possible currency undervaluation last month, putting the spotlight on any country that has bilateral trade surpluses worth more than US$20bn, current account surpluses of above 3 per cent of GDP, and making “repeated” net foreign currency purchases equivalent to more than 2 per cent of GDP in any given year. China met the first two criteria but did not meet the last criteria, as its net forex purchases came up to -3.9 per cent only.
If anything, a currency devaluation would only exacerbate China’s capital account outflows, which has a deficit of US$674 billion in 2015 (source: CEIC, Macquarie Research, April 2016).
We expect the RMB to depreciate, but we do not expect a sharp devaluation.
No hard landing
Not all outflows are bad, as about half of the country’s outflow is due to unwinding of carry trades which should taper off. In addition, the central bank’s tightened controls of the country’s financial borders should help reduce Chinese appetite for foreign assets.
Also, China’s external debt remains low, lower than that of the Asian countries during the financial crisis in 1997.
There will be structural headwinds from over-capacity and high debt level, but fears of a hard landing are overdone.
Better Policy Handling
On the whole, it does look like the government has improved over policy actions, going by how it quickly raised transaction fees and margins to limit speculation in the commodity sector.
The rising number of onshore bond default cases is another indication of positive reform. However, it could be a double edged sword. While allowing companies to default results in better pricing of risk, we believe the government may step back if the increasing bond default lead to systemic risk for the bonds market.
While recent moves have been positive, until the various regulators and agencies learn to coordinate and communicate better, investors have to brace themselves for policy missteps, and be vigilant on how this could affect them and the global economy.
China needs to rebalance its economy and while the transition has been and will be painful, it has started to yield results. The services sector has grown faster than the manufacturing sector and consumption is contributing more to growth than investment in recent years.
Economic stability is paramount to China, but it is still learning to strike a balance between reforms and managing the economic slowdown.
Thus, don’t be surprised if China takes two steps forward and one step back, as it studies to find the perfect equilibrium for its economy.
Volatility will be a given, as a result.
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