The first week of the New Year saw a precipitous drop in China’s stock markets, triggering a “circuit breaker” to halt trading. with repercussions in markets around the globe. Matthews Asia experts share their perspectives 011 this event in the context of the overall health of China’s economy.
David Dali, Client Portfolio Strategist
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Andy Rothman, Investment Strategist
Teresa Kong, CFA, Portfolio Manager
Andrew Mattock, CFA, Portfolio Manager
Matthews Asia Analysis Of Market Events In China
Q: What do you think were the causes behind the recent sharp drops in China’s stock market, and What does this volatility say about the Chinese economy?
Andy Rothman: I think volatility in the Remninbi/US. dollar exchange rate was the key driver of retail investor anxiety in China, compounded by a poorly designed A-share market circuit breaker, which was subsequently eliminated by the regulator. I believe very strongly that this volatility and armiety do not reflect new weakness in the Chinese economy. In fact, the macro data has been stable in recent months, and the biggest part of the Chinese economy, the consumer and services sector. remains very healthy.
The A-share market, the main domestic stock market in China, has never been an accurate reflection of the Chinese economy. It is especially volatile due to the fact that it is very much driven by small-scale retail investors and too focused 011 the old part of the economy, namely state-owned companies. rather than the private and service sector firms that employ most people. drive consumption and generate growth.
I also don’t think that this volatility reflects a loss of control by the Chinese government. The remninbi’s depreciation is driven primarily by the dollar’s strength. not by significant or new macroeconomic weakness. The biggest ongoing problem is poor communication by the Chinese Central Bank over its exchange rate policy, resulting in a serious loss of confidence 011 the part of the Chinese people and the risk of capital flight. There is no sign of that now. but the odds of continued market volatility are very high.
As for the overall economy. I expect it will continue to decelerate this year, with GDP growth of 6% to 6.5% – slower than the three previous years but still pretty fast.
Teresa Kong: It’s worth noting how the Asian bond markets reacted to these events. Asian bonds have held up relatively well. In fact, if you held U.S. dollar-denominated bonds of Asian companies, you have actually made money since the beginning of the year. In times of really large, systemic moves in the markets, we would expect to see a little more volatility, but that hasn’t been the case in US. dollar-denominated Asia debt.
To Andy’s point about China’s exchange rates, most people, including the Chinese government, have traditionally thought about the remninbi relative to the US. dollar, but that has changed over the last decade. The Chinese are now managing the currency to a basket that reflects their trading partners. That means that, instead of having an anchor, they are now managing a currency to a floating target. So we should be prepared for greater volatility and not be surprised if the Renniinbi depreciates substantially as this basket depreciates relative to the dollar.
If you have a longer than two-year view, I think this could be a great entry point. If you have a one- or two-month view, hold on tight. It is going to be very volatile, I think, over the next few months.
Q: If China were to devalue the RMB by 10%, how would that impact other Asian economies, or would it at all?
Teresa Kong: Because we’re no longer in a pegged currency world, but one in which currencies are moving relative to other currencies, there is the potential for very large gaps, either up or down. If the renminbi were devalued by 10%, a lot of the other basket currencies would most likely also be devalued similarly. That would indicate to me that commodity prices have continued to fall and there is increased uncertainty driven by geopolitical events that we have not priced in. In that type of environment, most likely a lot of other high-beta currencies would be hurt.
Q: Renminbi depreciation would favor the old Chinese economy. If they’re looking to change the economy towards consumption and services, why would the government devalue the currency?
Andy Rothman: The government is not devaluing the currency for any reason other than in response to a strong dollar. This is not what they wish to do. If the dollar is flat this year, the renminbi will be likely flat against the dollar as well. At the same time, I do not think that devaluation is going to create a problem for rebalancing the economy. The peak in investment in construction of infrastructure and new homes has already passed. The exposure of the average Chinese consumer to imported goods is actually quite low. I expect this will be the fourth consecutive year in which services and consumption will be bigger than manufacturing and construction, and I would guess that we’re likely to see consumption contribute roughly 60% of China’s GDP growth this year.
Teresa Kong: China is now the biggest importer and the biggest exporter in the world. So we need to recalibrate our understanding of the economy, instead of just thinking about it relative to the dollar. There are two real secular trends in China. One is that the growth rate is slowing, but the second is that the value added in Chinese companies is increasing. They are back-solving a lot of technologies they have gotten from places like Korea and Japan, and they are now producing components and parts they did not produce before, all the way up and down the value chain, from low value-added goods like steel to much higher value-added goods like precision parts and high-tech products.
Q: Recent media articles have been casting doubt on the health of the Chinese services sector. Are services slowing?
Andy Rothman: Pretty much every part of the Chinese economy is decelerating. Even the biggest and healthiest and fastest growing parts of the economy are going to be growing a little bit more slowly each year. The fact the services sector is a little bit slower this year should not surprise anybody, but the growth rates are still fantastic, off of a base that is getting much bigger. One of the best bits of evidence of the health of the consumer and services part of the economy came in the second half of last year. The A-share market declined sharply in June, over 30%. The second half of the year saw the best performance in the consumer part of the economy. This tells us, again, that the indexes don’t reflect the economy. Income is still growing, household debt is very low and consumer sentiment is quite healthy.
Q: There has been some discussion about capital outflow from China and the decrease in foreign currency reserves. If foreign currency reserves seem to be going down, does capital outflow automatically follow?
Andrew Mattock: The numbers that we get are based on official currency reserves. That doesn’t include the amount of U.S. dollars deposited in the domestic banks within China.
I think if you add the commercial banks, the extent of the drop in overall U.S. dollar reserves is nowhere near as severe as the official numbers might indicate. There is definitely some capital outflow. The government, as part of its reform process, is allowing some degree of diversification of people’s assets to outside of China, with restrictions as to the amounts people can take out.
Andy Rothman: I would add that the evidence seems to indicate that some of the reduction in official reserves has been just a transfer of dollar assets from the accounts of the Central Bank to the accounts of the state-owned banks.
David Dali: Just to clarify, if you see a drop in foreign currency reserves reported in the news, that doesn’t mean that those dollars are actually leaving China. It could be new dollars that have been transferred to bank deposits.
Q: The Chinese government, broadly speaking, has been fairly successful so far in managing the economy and GDP growth. It has put a lid on company defaults and it has maintained a fairly stable currency. But what are the risks that the government is losing control of the situation at this point?
Andy Rothman: The results of China’s economic reform process over the last couple of decades have been quite good. We’ve seen a tremendous increase in the role of the market, the market sets most prices, more people work for private companies, and people have gotten much wealthier. Nonetheless, there have been mistakes along the way. It seems every quarter for at least 10 years, we’ve seen headlines about how China’s government has made yet another mistake and the end is near. This is magnified by the much greater impact that China has on the world today and the attention everyone is paying to China. There’s always the risk that policy mistakes won’t get fixed, but based on the track record that we have seen over the last couple of decades, I think the odds of that are pretty low.
Q: Should we be worried about cracks in the Chinese financial system due to the rapid rise of debt within the economy, and does this mean that we could potentially have a future credit problem?
Teresa Kong: The total credit growth in China since 2008 has been one of the fastest in history, so there are bound to have been a lot of bad loans made. China has a few positives in its favor, however. The first is that the loans have largely been made by onshore banks and investors, meaning they have not had to go out and borrow in someone else’s currency and be subject to exchange rate volatility.
Certain sectors, notably property, have borrowed U.S. dollars, but in the last six months most of these property developers have refinanced locally at lower rates than the offshore market. There is not an immediate liquidity problem, because the local onshore bond market is vibrant, and a lot of companies have accessed that market over the last nine months.
The big crack in the system from my perspective is the lack of credit analysis. I think that there is still a notion among credit investors in China that, if you’re a state-owned enterprise or a large household name, there is no way your company can default. The state won’t allow it. I think that is a misunderstanding. Defaults are a necessary evil, and I think over time the state will differentiate between sectors that are more strategic and ones that are not, and companies that are in sectors that have too much inventory will need to be restructured.
Another big crack is that we really don’t have any precedent for understanding how the onshore bond market will deal with defaults, and whether there are any mechanisms for bankruptcy or restructuring. We see that reflected, currently, in bond prices. There is not much differentiation between a very good company and a poor company in terms of credit spread. The government is well aware of this issue and is working on fixing it gradually over a period of several years.
Andy Rothman: I expect that the government is going to start letting more companies fail, especially private companies and even some state-owned companies, particularly in the construction-related sectors where there is excess capacity in places like steel and cement and aluminum. This is what they should be doing, and we should be happy about it, but it is going to generate scary headlines. “A company just failed in China!” Well, companies fail in the U.S. all the time and we understand that that is part of the process. But let’s be aware, it is going to create more anxiety and volatility.
Q: What should US investors be thinking about in this market environment?
Andrew Mattock: From an equity market point of view, I think the biggest factor over the last couple of years has been earnings per share growth. Since 2010, earnings per share growth in China has slowed down, based on the MSCI China.
With that slowdown, has come a de-rating of the price people are willing to pay from a P/E perspective. Over the next one to two years, I am looking for that earnings per share growth to come back for people to have confidence at a corporate level in aggregate across China. There is growth in earnings, and as the indexes more accurately reflect the underlying service sector growth and the emergence of new companies, I think that will give people a degree of confidence in the equity market that we’re back in a growth market.
Teresa Kong: When we look at historical data, if you had bought US. dollar-denominated debt of Asian companies at the current level, you wouldn’t have lost money if you have a holding period of greater than two years. If you have a greater holding period, that just means your returns would have been better. If you are able to get exposure to a long-term U.S. dollar credit strategy that doesn’t necessarily have as much of the currency volatility, which we think will continue, we think this is actually an opportune time to enter.
Andrew Mattock: I would add that within Hong Kong, which is where the majority of our investments are at Matthews, the market is cheap.