Hugh Young: Don’t give up on ‘divorced from reality’ China just yet

Hugh Young copy

China has replaced the US Federal Reserve as the biggest concern for many investors around the world. Is Asia’s largest economy heading for a hard landing? It is certainly not in dispute that growth is slowing. The economy grew 6.9 per cent in 2015 – a far cry from its double-digit expansion of yesteryear – and it may slow even further.

But is that really so bad? Slower growth is as much by design as by accident, as the economy moves away from an investment-led, export-driven model towards one in which domestic consumption plays the dominant role. The country’s leaders want growth that is sustainable.

China’s stockmarket tumble at the start of the year was blamed on two things: a clumsy attempt to limit losses in an overvalued market, thus sparking panic selling, and poor communication around a loosening in renminbi policy, fuelling suspicions the country is seeking to devalue its way out of trouble.

That said, Chinese equity markets are completely divorced from reality. When share prices are driven by the interaction between state-sponsored market manipulation and the speculative instincts of millions of retail investors, they cease to serve as a gauge of a company’s quality. Nor can they offer a glimpse into the health of an economy.

That is why the Shanghai and Shenzhen stock exchanges will not tell you that, while China needs to work through the effects of a massive misallocation of capital following the global financial crisis, the economy is nowhere near crashing.

Recent renminbi weakness – after an almost 26 per cent advance against the US dollar since mid 2015 – is better understood within the context of ongoing currency liberalisation. Manufacturing weakness is partially offset by the growth of service industries, especially in the private sector.

Real estate, finance, hospitality, wholesale-retail, transport, construction and unspecified “other services” accounted for some 55 per cent of GDP in 2014, up from 47 per cent in 2006, according to data compiled by CLSA and Citic Securities. Their share will continue to rise and not only because industrial activity is shrinking. The contribution of the service sector to the economy may also be underreported.

However, people still cling to the notion of China as a country of heavy industry and factory production lines. Disappointing manufacturing numbers make the front page. Falling commodity prices are touted as evidence the economy has ground to a halt.

China does face considerable challenges: local government and corporate debt are big problems, the state sector is bloated, and the property market remains fragile. But Beijing still has plenty of tools to avert catastrophe.

Our fund managers, both in fixed income and equity, visit companies, speak to officials and quiz consultants around the country. Nothing has gone “pop” in the economy. Where January’s stockmarket turmoil does an excellent job is to serve as a timely reminder of the pitfalls that await complacent investors.

We have been saying this for some time now but, on the whole, it is much harder to find in China the sort of good quality companies we seek.

Chinese companies generally score really badly on corporate governance. Competing priorities such as “nation building” often conflict with making a profit, while management accountability to minority shareholders is weak.

That is not to say there are not any decent companies but investors need to be very careful. It is still safer to invest via overseas-listed companies that do a lot of business in China.

So why bother? Well, despite all the pitfalls there is a handful of companies that deserve serious attention. Some are companies that remained off limits to foreign investors for many years and have therefore largely escaped their notice. Some are large state-backed industry leaders that were among the first Chinese companies to adopt international management practices. Despite the odds, these firms have overcome every conceivable reservation that we have about this asset class.

Investing in China is a long-term commitment, not a buy-in-the-morning, sell-after-lunch trade. Not only is the economy going through tremendous change but the mechanisms through which investors can access opportunities (and the institutions that regulate them) are also works in progress. Everyone is learning on the job.

We have always liked the China story – the rise of the middle class, high savings rates, urbanisation and pent-up demand – and there is no reason to believe it will change anytime soon.

But anyone who expected the path to be smooth is as delusional as the small investors in China who thought share prices could defy gravity forever.

Hugh Young is managing director of Aberdeen Asset Management Asia