Quarterly Perspective: China – not all doom and gloom


China’s economy is slowing down due to both structural and cyclical factors, its equity market has been on a rollercoaster ride and its foreign exchange reserves have been falling. These problems have been on all investors’ minds this year and have recently spilt over into the global financial markets. But we believe there is more to the China story than a potential “hard landing.” Of course, the world’s most populous country does face major economic and financial challenges. But the stabilisation of the real estate market, growing middle-class consumption and the rise of the services sector should all provide some stability to the economy going forward. The recent fall in the equity market also offers an opportunity for active investors to take advantage of long-term growth opportunities in key sectors, which remain in place.

Industrial slowdown is not the whole story

There has been plenty of bad news coming out of the Chinese economy lately. Industrial production grew by only 6.1 per cent year on year in August. In dollar terms, exports have shrunk by 1.4 per cent year on year in the first 8 months of 2015, while imports have contracted by nearly 15%. Efforts to stimulate growth by reducing reserve requirements and lending rates for banks have also seemed less effective than in the past, perhaps because companies and local governments are already sitting on too much debt.

China’s services sector is becoming increasingly important and looks more resilient than manufacturing.


But this is only one half of the picture. Though retail sales have recently decelerated, the more consumer-oriented service sector is doing much better and its importance is often understated. Services accounted for 48% of China’s GDP in 2014, up from less than 40% in 2000, as shown in the chart above. In recent months there has been a clear divergence in the trend of the Chinese purchasing managers’ index for manufacturing and for services. The Chinese property market also appears to be stabilising, with inventory levels continuing to decline for major cities and transaction volume and prices starting to pick up.

Currency and credit risks need to be kept in proportion

When China devalued the yuan this summer, it was one of the last global currencies that had not adjusted to the strength of the US dollar. Some further downward move in the currency against the dollar is likely in the medium term, because the authorities would like to avoid the wide swings in the trade-weighted value of the currency that come from being closely pegged to the dollar. Allowing the currency to move with market forces would also make the case for the yuan’s inclusion in the International Monetary Fund’s special drawing rights currency basket.

However, China’s policy makers have a great interest in keeping any adjustment in the currency gradual and relatively controlled. If the yuan massively depreciates in the short term, local spending power would be affected first, which would be a grave concern given the government’s emphasis on domestic consumption. The authorities are also mindful of the difficulties that a rapid depreciation would cause for Chinese companies that have borrowed in dollars.

China has seen a sharp increase in private sector debt since the global financial crisis. This is likely to cause problems for China and its financial sector in the future. But China’s very low level of public debt and substantial foreign exchange reserves put it in a much stronger financial position to resolve these issues than that of the developed economies in 2008, even after recent capital outflows. With China’s capital market still fairly closed, it’s also worth remembering that the direct exposure of the rest of the world to China’s corporate debt problems is relatively small.

China has a corporate debt problem, but the rest of the world has very little direct exposure to it.


Chinese equity market swings are not all bad

The massive rally and subsequent decline in the Chinese equity market has illustrated the volatility and capriciousness of a stock exchange driven by margin lending for retail investors. While the losses of this summer were staggering, they are unlikely to have a major impact on the economy when only a small proportion of Chinese household assets are held in equities.

Short-term market volatility is likely to continue, especially in the onshore A-share market. But in the internationally-accessible parts of the market, the price declines in the past three months provide long-term active investors with a good opportunity to capitalise on positive structural growth opportunities in key parts of the economy.

The stock market’s gain and loss of the past 12 months has been massive, but the average Chinese household only invests 7% of its assets in equities.JPMGraph-13

Investment Implications

  • China’s shift from an investment-led to consumption-led economy is bound to cause some weakness in data releases, but investors should look beyond the headline figures to get a clearer picture.
  • Volatility is likely to remain high for Chinese equities due to policy uncertainties and investor base, but the deflating of the equity market bubble makes this a good time to find opportunities through active management.
  • More attractive valuations strengthen the case for selecting companies with solid balance sheets and strong earnings potential, particularly those in consumer services that are poised to benefit from reforms.

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