Hugh Young: China is back from the dead – but not out of the woods

Hugh Young

Chinese stocks are back from the dead. Shares in Shanghai and Shenzhen are trading around their highest levels in over six months, while equity markets in Hong Kong were flirting with 2016 peaks even before the approval of a trading link between Shenzhen and the special autonomous region.

This is a far cry from the start of this year, when plunges in mainland stock prices tripped newly-installed circuit breakers to curtail trading sessions twice in a single week. Markets around the world tumbled that first week of January as the panic spread further afield.

Back then people were worried about the renminbi. Currency weakness, it was argued, clearly indicated some sort of devaluation – a sure sign that something was amiss. The real reason – that a weaker yuan was a symptom of currency liberalisation – found few supporters.

For much of last year, investors convinced themselves that policymakers would do whatever it took to support share prices. However, when the time came for officials to take action, their response failed to live up to expectations. Their assurances about the state of the economy would sound increasingly hollow as scepticism grew.

But fast-forward a few months and things look very different. Share prices have stabilised and, in a yield-hungry world, Chinese bonds look attractive (if you can navigate the credit risk). Away from the financial markets, government stimulus is bearing fruit, even if that means slowing the pace of reforms crucial to long-term development.

The property market has picked up; housing inventory levels are starting to clear and construction activity has been recovering. The pace of capital outflows has been decelerating because of capital controls; expectations of a weaker dollar tempering declines in the renminbi also help.

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When the renminbi has weakened, investors have not panicked. Better policy communication means more people understand why this is happening: with the Chinese currency now guided by a trade-weighted basket of 11 currencies, its relationship with the dollar will be more volatile.

So does this mean China has turned a corner? Not really, unless you ignore a long list of problems that include declining corporate profitability; a huge change-resistant state sector; and ballooning debt that is a legacy of earlier rounds of stimulus.

China’s debt – an intricate web connecting government-linked businesses, state-controlled banks and the bond markets – is probably the most alarming. Nobody really knows how much may go bad. Guesses range from nearly 7tn yuan (£792bn) to some 23tn yuan (£2.6tn), depending on different assumptions. That is around 10 per cent, at the lower end of these estimates, of the US$10tn economy.

Although President Xi Jinping is thought to favour a hard line approach – shutting unviable state-owned companies, imposing discipline on government-linked borrowers – China’s solution so far has been to unleash more stimulus, albeit on a smaller scale than previous rounds. While this buys time, it also creates more debt.

So will there be a debt-inspired meltdown soon? Probably not.

Most of China’s debt is denominated in renminbi which means, in the worst case scenario, the central government can print money to bail out government-linked borrowers deemed systemically important. Beijing can direct lending at the government banks so this source of financing will not dry up.

China is also a net exporter and lender of capital, which means the economy does not rely on fickle foreigners to fund any deficits. However, stimulus can only be a temporary solution. It can help delay the sudden pull-back of credit financing or abrupt asset value depreciation that have been catalysts of past financial crises. But stimulus cannot replace the reforms needed to fix the massive distortions created by the misallocation of capital into unproductive industries and investments.

To China’s credit, policymakers have made some progress here. They are tackling the problem of moral hazard in the bond market by letting a handful of state-owned companies default on repayments; debt pricing better reflects credit risk which, while still early days, is a breakthrough for local markets.

Policymakers have achieved some semblance of stability but this should not become an excuse for dithering over reforms. What happens now will have far reaching consequences.

Hugh Young is managing director of Aberdeen Asia