Don’t bet against China – at least in the short term!

A common big picture theme so far this year has been the generally positive news out of the US and developed nations offset by a series of disappointing numbers and articles about China. Even our Reserve Bank Governor commented on slowing growth in China in the 1 April decision to keep rates on hold at 2.5%. The issues facing China can be broadly grouped under three headings:

• Credit issues

o    First default in China’s corporate bond market since it began in its current form.

o    The so called “shadow” banking system (essentially loans to businesses outside of the banking system made by investment products offered to the general public) being described by some as being out of control.

o    Possible further credit tightening that could affect buoyant property prices.

• Growth issues

o    Typically, growth is weaker around the Chinese New Year holiday, but the latest HSBC PMI (Purchasing Managers Index) released on 31 March 2014 came in at an eight-month low of 48 (figures below 50 broadly indicate slowing growth), although the official Government numbers are a bit higher.

o    Has the massive infrastructure build and urbanisation that fuelled growth reached its peak?

• Structural issues

o    China has lost competitiveness as a low income, export led economy and must change in order to keep growing. For example, in the last six years exports have fallen from 38% to 25% of GDP. 

o    To move from an income per head that ranks below Brazil, Mexico and Botswana (and only 13% of the US) the Government recognises the need to develop its financial system, including currency liberalisation, to more developed standards, fight corruption and pollution, work on the problems caused by urbanisation and generally increase standards of living.

o    Household consumption at 36% of GDP is amongst the world’s lowest, although consumption is increasing from these lows at a healthy pace.

Why does China matter? Apart from being the second biggest economy in the world and moving forward to also becoming a financial powerhouse, it is worth recounting the trade numbers.

Australia's main export destinations, 2012-13
1	China	31.6%
2	Japan	18.8%
3	Republic of Korea	7.7%
4	India	4.6%
5	United States	3.6%

Australia's main import sources, 2012-13
1	China	18.8%
2	United States	11.8%
3	Japan	7.7%
4	Singapore	6.1%
5	Thailand	4.7%

Source – Australian Government Department of Foreign Affairs and Trade

From China’s perspective, its biggest export destination is the US, followed by Japan. Australia only ranks 12th in terms of China’s exports and 6th in terms of imports.

So where is this giant juggernaut of an economy headed?

Talking to some of our portfolio managers just back from mainland China and our economist, and reading some of the mountain of research that pours into our office every day, really highlights just how big and complex this question is.

In terms of the credit issues described above, there will be more defaults and in many ways this is akin to China’s capital market system maturing and starting to price credit according to true risk. Importantly, and very much unlike the US sub-prime debacle, we think there are enough reserves in the banking system and Government to handle any likely problems with credit and the shadow banking system. In a negative scenario, the Government can effectively order the strong banks to assume the debt of weaker entities. 

The growth question is a big one. Continuing growth in the US, Europe and Japan will definitely help China’s exports (many are saying Chinese export growth will pick up by 1.5% due to these factors). In the short term, the Government can also easily up its infrastructure spend to ensure that they “dial in” the stated growth target of 7.5%. The longer term growth question is more related to how successful China will be in transitioning form “old China” (low value add exporter, with massive infrastructure build-out and urbanisation) to “new China” (growing middle class, appropriate legal systems, more value add production and services, growing and open financial system etc.).

From an investor’s point of view, this growing economy should lead to multi-faceted investment opportunities. The bottom line is don’t bet against China achieving its growth targets in the short term, but keep an open mind on how it will develop from here and where the real investment opportunities lie over the next several years.

Weekly Indices:

The Australian All Ordinaries Index has moved down decreasing by -0.1% since closing last Friday to 11:40 pm today.

The rest of the world as measured by the MSCI index decreased -3.7% in A$ from closing last Friday to end of trade Thursday.

Have a good weekend,

The team at IPS