Its economy is still experiencing slump in exports and a downturn in investment growth
CHINA, China – oh the big elephant in the room that is difficult to ignore.
A slowdown in the world’s second largest economy is a certainty.
Whether or not that momentum will result in a screeching halt or gentle thud is still uncertain, although fears are progressively dissipating.
For now, the economy is still trudging through a slump in exports and a downturn in investment growth thanks to an overhang of debt.
Here are the facts:
Last year, China posted its slowest gross domestic product (GDP) growth in 2015 at 6.9%. Its first and second quarter growth both came in at 6.7%. The third quarter GDP results will be out in mid-October.
If GDP growth slows further to below a tipping point of 6.5% , markets may once again start to fret and worry about another bout of deflationary shock.
It’s now been a year since China’s central bank embarked on an unprecedented devaluation of the yuan by 1.8 percentage points. Not only was that the biggest such move since 1994, but China’s decision to devalue its currency on Aug 11 sparked concerns that the government was struggling to offset a slowdown in the economy.
As a result of that devaluation, the Shanghai Composite Index fell 29% in the third quarter, the biggest decline since the first three months of 2008. The devaluation of the yuan has also caused havoc in the rest of the emerging markets and developed world.
Certainly, a cheaper yuan will make China’s exports more competitive against other emerging markets, giving its economy a boost. On the other hand, Malaysia, as well as its regional peers depend on China for its export growth.
At the same time, the depreciation of the yuan has fuelled huge capital outflows, causing the People’s Bank of China to spend vast tracts of reserves to defend the currency.
China’s currency defence budget is huge.
Undeniably it still has the world’s largest foreign exchange reserves, somewhere in the order of US$3.2tril (RM12.8tril).
However, propping up the yuan has come at a heavy cost, with foreign reserves falling by around US$700bil (RM2.8tril) since mid-2014.
Standard Chartered is estimating non-foreign direct investment capital outflows at US$320bil (RM1.28tril) in the first half of 2016, versus US$750bil (RM3tril) for all of 2015.
While the currency’s moves have become far less worrisome for global markets, investors aren’t still completely pacified that China has turned the corner.
The main concern has always been that the fast devaluation, coupled with another big drop in commodity prices, would cause even greater deflationary pressures and quickly transform into a full-blown global financial crisis. Emerging market currencies would be beaten down, and defaults and bankcruptcies may rise
So fast forward a year, and those proclaimation of apocalypse have not been fulfilled despite China having achieved its goals of weakening its currency.
In July, the yuan hit nearly six-year lows against the US dollar, and last week, record lows against the months-old currency basket.
However, what’s undeniable is that most of the bad news for China has been priced in.
“Year to date, the currency is down about 3% versus the dollar and 6% versus a trade weighted basket of currencies.
“The yuan’s move this year should enhance the competitiveness of China’s goods and services compared with previous years, when the currency consistently appreciated against both the US dollar and a basket of currencies. We believe that the benefits of a weaker yuan have not yet fully materialised, and that net exports will make a positive contribution to GDP growth in the second half,” said Shuang Ding, head of economics, Greater China for Standard Chartered.
“China’s currency policy, as we have noted previously, retains a clear weakening bias. However, capital outflows seem to have reduced and markets appear unperturbed by the ongoing weakness of the renminbi. All of this makes a big devaluation less likely, and we expect further gradual depreciation over the foreseeable horizon,” said Schroders chief economist and Strategist Keith Wade.
Burgeoning debt
Now the other issue which has been talked about is China’s debt levels and how that will affect emerging markets which are heavily reliant on its trade. Transparency issues also continue to plague China.
Since 2008, total debt in China across government, households, and private enterprise has risen 118%, from 135% of GDP to 254%. China’s “shadow banking system” has grown almost 25% per year since 2009.
In mid-June, the International Monetary Fund warned that Chinese corporate debt, which totalled about 145% in absolute terms was rapidly growing, and it urged China to implement immediate reforms to address it.
The fact that much of this debt is held by Chinese state-owned enterprises has not boosted investor confidence. With Chinese economic growth slowing, non-performing loans, in gross terms, have risen steadily since 2012 from little more than 0% to more than 2%.
After reviewing the recent developments around the debt issue, Pioneer Investments’ economist Qinwei Wang says that they have not changed their view that China can still avoid a systematic crisis in the near term, as the issue remains largely a domestic problem and in the state sector.
“Looking into the composition, China’s debt issues are largely within the country, unlike typical cases in emerging markets. Its external balance sheet still looks relatively resilient as China continues to run current account surpluses. China has also been building up net foreign assets over the last decade, and is one of the largest net lenders in the world and domestic savings remains high enough to fund investments,” said Wang.
In addition, looking at domestic markets, Wang says that the situation still looks manageable.
This is because the borrowers have been largely in the state sector, directly or indirectly, through various government entities or state owned enterprises (SOEs).
“The lenders are also mainly state-linked, with banks making loans, holding bonds or channelling a big part of shadow activities. The People’s Bank of China has prepared plenty of tools to avoid a liquidity squeeze, with capital controls still relatively effective, at least with respect to short-term flows.
“Ultimately, the government has enough resources to bail out the banking sector or major SOEs if necessary to prevent systemic risks,” he concludes.
In the near term, Wade says that the state has sufficient resources to contain any flare ups in the economy or financial system, where risks abound. The International Monetary Fund (IMF) estimated that ‘debt at risk’ in the economy amounted to 15.5% of total loans, with the potential for losses equivalent to 7% of GDP.
“What is missing for the moment, however, is a trigger. Bank funding is largely stable and derived from household deposits, although reliance on interbank funding is growing), and
strict capital controls trap funds in the system while also greatly limiting the entry of foreign money,” he said.
“Financial crises are typically triggered by a sudden stop of capital flows to the financial system. Given the composition of funding, we think this is very unlikely in the next six months. We would be less sanguine over the next three years,” said Wade.
Standard Chartered’s Ding is of the opinion that a further rise in the debt-to-GDP ratio is likely to be the price China will pay for meeting its growth target, aggravating financial risks.
“We estimate the total debt ratio at about 250% at end-2015. Corporate debt, at more than 120% of GDP, remains the key cause for concern, especially given SOEs’ worsening profitability. As credit growth continues to outpace economic growth, the debt ratio will likely reach 300% by 2020,” he said.
Ding added that a large part of new credit appears to have been used to refinance old debt, raising questions about the quality of loan assets. Thus, disposing of non-performing loans, which Ding estimates to be 5% to 8% of the total loans, shutting down zombie enterprises, and imposing hard budget constraints on SOEs are necessary steps to put debt on a sustainable path
Lazard Asset Management believes that investor fears about Chinese debt and a credit crisis may have been exaggerated.
“While debt levels are high and recent rates of growth are unsustainable, China’s debt, as a percentage of gross domestic product, is lower than in developed markets, including the United States and Europe.
It adds that China’s shadow banking system is less than 50% of GDP, compared with the United States and the eurozone, where shadow banking exceeds more than 150%.
China’s current economic growth rate also exceeds debt growth, which gives it some room and flexibility to manage its debt and may make it easier to implement a solution over the longer term.
Lazard is encouraged that most of China’s debt is in its local currency, deposit funding is available, and China remains a relatively closed financial system with access to strong domestic funding.
It believes Chinese policymakers will seek to manage NPLs in ways that minimise market panic and limit further policy missteps. As a result, public defaults, nationalisation of banks, or the privatisation of state-owned enterprises are unlikely.
Not so bad after all
Wade said that having reviewed and updated its scenarios, Schroders is now dropping the ‘China hard landing’ scenario and adding ‘secular stagnation’ its latest Sep strategy report.
“We still see a risk of a hard landing in China, but not a significant one within the timeframe of our scenarios which would require the event to start within the next two quarters.
“We also believe that the authorities have the means to deal with most short-term dips in the economy by adding stimulus. We remain concerned about the build up of debt in China and believe that the authorities will have to find a means of resolution, but this is a multi-year process,” said Wade.
It is not all a bed of roses though.
Ding says that China’s net exports may become a positive contributor to growth in the second half, as export momentum has improved.
He adds that while GDP growth remained stable at 6.7% in the first half, downside risks to private investment are growing.
“Fiscal policy appears more expansionary than the budget; budgeted deficit will likely be exceeded. We maintain our 2016 growth forecast at 6.8% on supportive policies and a weaker currency,” said Ding.
Meanwhile, Wang says that the private sector does not appear to present big concerns, at least for now. In particular, on the property side, following the major correction since 2013, the health of the sector looks to be improving, although there is still a long way to go in smaller cities.
“Households have been leveraging up, but their debt levels are still relatively low with saving rates remaining high,” he sais.
Wang isn’t too concerned about existing troubled debt, as there are possible solutions to clean it up while avoiding a systemic crisis, and the implementation process has already started.
“The more challenging issue is how to prevent the generation of new bad debt,” he says.
Wang says that a first step in this direction is to improve the efficiency of resource allocation. Ongoing financial reforms, including the liberalization of interest rates, bond markets, IPOs, private banking, a more flexible FX regime as well as the opening of onshore interbank markets over the last couple of years are positive attempts.
Catalyst – Lifting of Aggregate Cap on the Shanghai-Hong Kong Connect programme.
On the opportunistic front, Nomura Global Research is seeing another potential catalyst for some chinese stocks. It believes consensus has yet to price in a recent meaningful game changer – the lifting of the aggregate cap on the Shanghai-Hong Kong Connect programme.
The Shanghai-Hong Kong Connect programme is a cross-boundary investment channel that connects the Shanghai Stock Exchange and the Hong Kong Stock Exchange. Under the programme, investors in each market are able to trade shares on the other market using their local brokers and clearing houses.
“On Aug 17, the aggregate cap on the Shanghai-HK Connect programme was lifted, which is equally, if not more, important than the upcoming Shenzhen-HK Connect itself. Previously, even if mainland investors had wanted to buy H-shares for apparent valuation discount to A-shares, the quota had been too small. After Aug 17, a meaningful re-rating of H-shares due to southbound liquidity becomes a real possibility,” said Wendy Liu, Nomura’s Head of China Equity Strategy.
For the uninitiated, H-shares are shares of a company incorporated in the Chinese mainland that is listed on the Hong Kong Stock Exchange or other foreign exchange. Meanwhile A-shares are offered by public Chinese companies trading on the Shenzhen and Shanghai Stock Exchanges or other Chinese stock exchanges.
For some background, after 2007, China let mainland Chinese investors purchase A-shares or H-shares of companies listed on the Shanghai Stock Exchange. Prior to that, investors could purchase only A-shares, even though H-shares were also offered.
Because foreign investors may trade H-shares, the shares are more liquid than A-shares. As a result, A-shares typically trade at a premium to H-shares of the same company.
Liu added that before Aug 17, the 250bil yuan (RM150bil) aggregate quota for southbound was equivalent to 2.6% of the free float market cap or 12.5% of the three-month total turnover of the eligible stocks. Meanwhile the 300bil yuan (RM181bil) of aggregate quota for northbound was equivalent to 3.4% of the free float market cap or 3.6% of the three-month total turnover of eligible stocks.
“We reckon that the new southbound liquidity may narrow the A-H valuation gap with greater impact than before, and drive more theme-based sector rotation. We will have more research in this regard in the near future,” she said.
Analysing China’s latest data
CHINA’S July monthly economic data came in mixed.
China’s July foreign exchange reserve stayed almost unchanged at US$3.2tril (RM12.8tril), a slight decrease from US$4bil (RM16bil).
In terms of price data, the July Consumer Price Index (CPI) year on year came in-line at 1.8%, and Producer Price Index (PPI) surprised to the upside again at (-1.7%) (versus a consensus of (-2.0%).)
In terms of trade data, China’s May export year on year growth came largely in-line at (-4.4%) versus a consensus of (-3.5%), where import year on year growth surprised to the downside with (-12.5%) (versus a consensus of (-7%). )
In terms of real economic data,
> China’s July Industrial Production year on year growth came slightly worse than expected at 6%, versus consensus of 6.2%.
> China’s July Retail Sales y-o-y growth was slightly worse than expected as well at 10.2%, versus consensus at 10.5%.
> China’s July Fixed asset investment year to date growth came in weaker than expected at 8.1%, versus consensus of 8.9%.
“We continue to hold the view the Chinese economy is bottoming (stabilising) in a narrow range and this is sustainable toward end of 2016, given all lagging effects of aggressive policy easing in 2015 and potential easing remaining in the second half of 2016 especially on infrastructure front,” said Amundi Hong Kong Ltd chief economist, Asia ex Japan Mo Ji.
She says that the stabilisation in China’s forex reserves of US$3.2tril is a reflection of stabilisation in yuan depreciation expectation.
In fact, the PPI improvement, following 11 months of a consecutive rise, supports one of Amundi’s major China bottoming calls.
“We can’t only focus on double digit import negative growth, and we should also look at the historical high iron ore imports in July, indicating potential solid demand from China,”
“Among the inline industrial production, what really stands out is the crude steel and finished steel production both registering five consecutive months positive growth, a reflection of while steel capacity is cutting, but steel production is rising. That potential demand truly lies there,” said Ji.
Among fixed asset investment (FAI), Mo Ji says that property investment bottoming out since Dec 2015 is a significant contribution in terms of stabilising fixed asset investment. Furthermore, FAI in railway had a significant pickup in July by 11.9% versus 1.7% in June.
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