China’s Debt Levels – Staying The Course by Kenneth Lowe, CFA – Matthews Asia
As an investor within Asian capital markets, the years since the turn of the decade can be most aptly described as volatile. “Volatility” has certainly become one of the most utilized phrases to explain the current zeitgeist of financial markets and, frustratingly, I can empathize with its overuse. For many of us looking at emerging markets, the proclamations of a vastly growing emerging middle class and GDP growth that is superior to our home market of the United States have struggled to provide investors with meaningful returns of late, and most certainly have provided its fair share of panic inducing drops. The peaks and valleys associated with our markets have not lessened with time and have given our clients an understandable reason to pause and ask themselves the question of whether they need to have such exposure.
For me, there are a few questions that are worth musing on. What is causing all of this volatility? Is it here to stay and how does it get resolved? But most importantly, can we find companies that cannot just weather this storm, but come out the other side of it even stronger?
The first of these is both easy but complex to weigh in on. A confluence of factors have influenced market moves over the last few years with highlights that include the divergence of U.S. monetary policy in relation to the rest of the world, a deflationary and weak aggregate demand backdrop in Europe, the introduction of negative interest rates and potentially dangerous and experimental monetary policy from central banks such as the Bank of Japan, not forgetting the outlandishly large debt levels that have been accumulated in China alongside a slowing domestic economy and instances of currency devaluation. This latter issue has also helped to drive the end of a commodity super cycle that lasted for most of the 2000s, and has caused many challenges for currencies and economies in those geographies with large exposure to the sector such as Brazil, Indonesia, Malaysia, Australia et al. I would also be remiss as an Asia investor to fail to mention the political changes in geographies such as India as having a powerful influence on sentiment.
This incomplete laundry list of issues has helped to shape a change in the multiples that investors are willing to pay for Asian markets. From a price-to-earnings (P/E) standpoint, the market has fluctuated from a high of around 13.6x earnings in April 2015 to a low of 10.8x earlier this year and about 12.1x at the time of writing. Although a change in valuations is often the largest driver of near-term market moves, we have also witnessed an above-normal change in the fundamentals of companies and their ability to deliver on earnings. We have talked before about the perennial overestimation of earnings growth within Asia, and this cycle has been particularly vicious with earnings estimates for 2016 having been cut by over 14% during the last couple of years. This has led to an environment where, despite Asia’s promise, earnings growth for the overall market is likely to be paltry in the near term.
It is less the sentiment-driven movement in market multiples that worries this investor, after all, we generally believe in the mantra that volatility is the opportunity generator for our strategies. However, it is indeed the downtrend in profitability for Asian corporations that is somewhat concerning. Returns on Equities (ROEs) have been in decline for over four years, partially due to an index composition that is too heavily weighted toward commodity sectors, but also partially due to top-line misses, overcapacity and a lack of sensible capital allocation policies in many areas. And this drop in ROEs is despite leverage ratios that have mushroomed across the region ever since the global financial crisis. Prior to 2008, debt levels across most of Asia were very manageable. This is true even for the country that has become the poster child for rapid rises in debt—China. In 2007, the nation had only US$7.4 trillion of debt, which was equivalent to approximately 158% of GDP—a number somewhat within the realms of sensible expectations. Fast forward to just mid-2014 and McKinsey estimates that Chinese debt has expanded by more than 120% of GDP and to around US$28 trillion in debt, or around 4x the quantity that existed previously. More recent estimates are obviously substantially higher, with January 2016 alone witnessing a rise of US$519 billion.
China’s Debt Levels
Now, an expansion should be partly expected (albeit we would hope it to be at a much slower pace) as many Asian countries such as China have high savings rates and therefore the necessary liquidity to allow some increase in credit. Further, we know that the level of financial deepening often moves in tandem with the development of an economy. But that does not mean that we shouldn’t be concerned. According to the IMF paper “Dealing with credit booms and busts,” in the aftermath of credit booms something “goes wrong” about two times out of three” in the over 170 cases that they examined. Further, Morgan Stanley claims that an economic slowdown followed all 30 of the most extreme credit binges since the 1980s. For China, some of the higher risk factors such as a weak current account, high external borrowings, and high inflation rates are not issues, but the pace of credit expansion, its longevity and the standards of bank supervision are worrying.
Of course, a strong government balance sheet does provide a much-needed cushion for China and there are levers for them to pull on. Policies that appear to be gaining traction are capital controls to ensure that liquidity remains plentiful, as well as rate cuts, a clamp down on non-bank lending, and debt-for-equity swaps. In more recent weeks, it also appears that the government may make another attempt at raising the level of the equity market in order to try to deleverage an economy that even China’s Central Bank Governor Zhou admitted had lending as a share of GDP as “too high.” Frustratingly, few of these can be regarded as the reform required to enhance the market’s role within the economy.
In truth, it remains likely that we’ll see plenty of volatility-inducing headlines about high Chinese debt levels for the foreseeable future until we get some form of resolution—deleveraging, a debt crisis or otherwise. Ultimately, much of the worrying corporate debt resides with the state-owned enterprise (SOE) companies that still make up about 30% of Chinese GDP. Despite the country’s many steps forward over the last 30 years, these businesses continue to enjoy greater access to funding alongside what are often cheaper financing costs. Although nonperforming loans within the country are nominally containable at 1.67% of total loans, many are aware that there appears to be a rolling over of loan maturities as well as credit being provided to pay off old debt and even operating costs—a practice that may well be hiding the “true” number as metrics, such as debt-to-operating cash flow, the lengthening of receivables days, and a rising incremental capital output ratio are worrying. With recent years indulging in such poor capital allocation based upon state direction and a belief that the banks will not bear the full risk of bad debts, akin to China’s last banking meltdown of the late 1990s, it is important that Japanese-style “zombie” company creation is avoided. In order to sidestep this, we need to see an improvement in banking supervision standards alongside enhanced credit and underwriting analysis by financial institutions, including a greater weighting toward a company’s cash flow generating ability. Further, the much-heralded SOE reform does need to see action undertaken through a combination of mergers, privatizations and bankruptcies in order to force change and reduction in overcapacity, essentially eradicating those businesses that fail to make the grade. This process, however, will likely be messy, given the mainland’s challenging bankruptcy laws that tend to be lengthy, costly and somewhat murky, especially when it comes to foreign interests. A result of such policies can be seen in statistics from the country showing there were only 2,613 business insolvencies in 2014, compared to the U.S. where there were 26,983. Although difficult to stomach, defaults are a needed part and parcel of economic restructuring.
Of course, it is not just China that needs to engage in institutional reforms across the political, social and economic sphere. In India, we have political wrangling that continues to impede real decisions being made to alter draconian and inefficient labor, tax and land laws as well as a banking system that is in dire need of capital. For many other countries in the region, the spillover effects of a decline in commodity prices has led to some calling for more populist policies to appease the masses during a difficult near-term economic environment. But it is a continuation of Asia’s longer-term, secular supply-side reform and liberalization that needs to drive these economies and create more sustainable, productivity-led growth, not populism. Fundamentally, wage growth and the transition of these economies toward more domestic demand and services-oriented structures can only occur if we see productivity growth that justifies these wage gains. The last five years have shown little progress here.
So what about those businesses that can thrive in a set of geographies with reasonably high leverage, slowing growth, weak export demand, and a mixed report card on supply-side reform? That sounds like a challenging prospect. Well, first and foremost, it is important to note that, despite my macroeconomic musings above, we are long-term, bottom-up investors. We spend our days trying to evaluate businesses and their owners. Many claim to have such a time horizon but rarely do we see this invoked in a world that favors, as Dominic Barton of McKinsey so pertinently put it, “quarterly capitalism.” There remains significant pressure from markets to maximize short-term results, and this makes it very difficult for managers of businesses to ignore this pressure. When we are analyzing companies, we are always asking ourselves whether a management team is investing in their business on a multigenerational time horizon and whether it is in the best interests of minority shareholders such as ourselves. This may come at the cost of near-term relative performance for our own strategies when compared to a benchmark, but we are firm believers that patient capital is a competitive advantage that can drive wealth creation for our shareholders over the course of an economic cycle. Why are we able to do this? Well, as fund managers at Matthews Asia we are given autonomy and leeway to act as such, as well as employing compensation structures that reward longer term performance over short term. Further, we invest our own money along with yours. Portfolio managers don’t just own a stake in their own strategies, but also equity in Matthews Asia itself.
But despite being patient, what else are we looking for in more difficult environments like today?
In past issues of Asia Insight, “Defining Quality,” “Kicking the Tires,” and “Anatomy of a Moat” we made mention of a number of areas that we attempt to evaluate. A true competitive advantage of a business should ensure its longevity if that company offers something to its customers that others cannot, whether it be anything from more efficient engineering services, easier to use health care devices or the prestige of a more expensive car brand. We could go on ad nauseam about the various ways in which a moat is created, but at the core of our work is the efforts made to understand this moat and its incremental direction. In Asia, that moat is sometimes even more challenging to build given issues in the quality of human capital, physical infrastructure, political corruption, cronyism and oft-uncertain regulatory environments. It is these that need evaluation, and we spend little time fixating on what our relative allocations to certain sectors and countries are in comparison to benchmarks.
There is also much deliberation in our analysis about the capital allocation and capital structure decisions of management teams. This happens in good times as well as bad, but it is often in these more challenging environments that we see this work bear fruit. Let’s take the example of a consumer company. If that business has been continually reinvesting in its brands at the cost of near-term profit maximization, and not succumbing to the desire to merely boost volumes, as well as running a strong balance sheet then it should be in an advantageous positon. How so? Well, many of its peers may well have made missteps like chasing volumes and ruining their pricing power—an ever more important driver of profit growth in a deflationary world. It may also be running with that deadly but often-apparent combination of both operating and financial leverage. This provides the strong balance sheet company with the ability to buy assets when there is “blood on the streets.”
Businesses that have a strong market position in their respective fields and those that have enhanced it whilst operating with an appropriate capital structure often find that they can use the market weakness of times like today to bully, cull or even acquire the competition. Time and again we witness these “quality” companies winning out over previously high “growth” companies as the easy pickings of growth (through merely increasing penetration) in a sector start to wane. We aim to avoid those businesses where the high leverage levels discussed above become an issue due to the absolute amount of debt carried, the hidden debt carried through contingent liabilities or working capital, or those where currency mismatches exist between assets and liabilities. Ultimately, inappropriate levels of leverage will often result in dividend cuts, a drop in the reinvestment rate into a business and hence degradation in its moat, and can even end up with the sale of physical capital at a discount. We focus on putting your capital to work in those that can actually benefit from such dislocations.
Clearly, valuations and expectations are also core components of what we do in understanding whether a good business makes a good equity investment. For me, this is about evaluation of the intrinsic value of a company, looking deeper than a target price that any one financial metric or discounted cash flow model may ascribe. Although we always need to try to strike that sensible balance between conviction and humility, we attempt to understand what a business is actually worth when incorporating both its tangible and intangible factors. In this regard, we have actually witnessed many of our management teams restructure their businesses in times like today in order to realize value.
I have likely done little to calm your fears that near-term volatility is likely to persist in Asia. I suspect that it will. We are in an era where central bankers influence markets to an ever greater degree, high debt levels need to be dealt with, greater fiscal policy may become more commonplace and liberalization in Asia must continue apace to ensure that the region’s prior 20 years of solid economic and institutional development is continued into the next 20. But Asia has always had periods of volatility and our attitudes as investors do not change—we must maintain discipline. We continue to strive to find those companies that can deliver, and potentially even further enhance, their positioning during such challenging times. Pleasingly, despite this messy backdrop, we still find that these opportunities exist to help us continue to build wealth for our clients over the long term.
Kenneth Lowe, CFA