Climbing China's Great Wall of Worry

China’s economic growth model is looking out of date, debt is piling up and capital outflows are rising. Policymakers are walking a tightrope, trying to balance short-term stimulus with tough reforms to ready the economy for the future. We climbed this Great Wall of Worry in discussions with Chinese policymakers, entrepreneurs and academics in Beijing in early May. Our main conclusions:

• We recognise China’s economy is slowing, likely by more than official statistics indicate. Yet we do not expect an economic hard landing or financial market crash in the short term. This is reflected in our overweighting pro-cyclical investments – an implicit belief that China’s economic miracle will last a bit longer.
• The four trends that most influence our investment strategies and thinking are: China’s reining in runaway credit growth; the shift toward a services economy; the risk of a property market downturn; and the government’s ability to stimulate the economy in the near term.
• Many of us believe China can meet these challenges in the short term, with some hiccups along the way. Policymakers appear aware of the risks, and have credible long-term plans (an ambitious reform agenda) and short-term tools (room for monetary and fiscal stimulus) to address them.
   
• China has contributed more than a third of global economic growth since 2008-2009, and its current slowdown is reverberating around the world. We take a peek at Australia, examining China’s effect on the country’s currency and interest rates.
   
• Officials are keenly aware of the dangers of debt rollovers by state enterprises and local governments. They appear confident they can avoid a credit crunch, in part by converting short-term, high-interest local government loans into municipal bonds with longer maturities and lower coupons.
   
• We think the People’s Bank of China (PBoC) will further cut interest rates and historically high bank reserve ratios in an attempt to reignite growth. The government also appears ready to prop up property prices and support the construction industry by investing in infrastructure at home and abroad.
   
• China has committed to opening its capital account by year-end, but it is unclear what exactly ‘open’ means. The risk of capital flight will likely make the country tread carefully, and we do not expect a truly free-floating yuan currency any time soon. Policymakers’ focus on currency stability should anchor the yuan for now.
   
• Investors should think of China as a continent, not as a country. Economic trends, development and policy implementation vary greatly by region. The economy is slowing in the Northeast (heavy industries) and West (mining) but is still going strong in the densely populated and prosperous coastal areas.
   
• It is tempting to simply dismiss buying Chinese assets: too much debt, too little growth and too policy-driven. This is a mistake, in our view. One can worry about the economy and rising risks in the long run but be bullish on markets in the short to medium term.
   
• China’s domestic equity markets look frothy after more than doubling in 12 months. We prefer less expensive Hong Kong-listed Chinese equities, especially small- and medium-sized stocks, because they have suffered a liquidity discount that is set to dissipate. We like selected corporate bonds in offshore markets because of their relatively high yields and limited duration risk.

Read Full Article