Five key indicators for the Chinese economy
The speed with which volatility originating from China’s capital markets spread across the world in August 2015 demonstrated how important it is for investors to understand developments in China and account for them in their asset allocation strategies. No matter where investors’ portfolios were held, this summer their value was affected by asset-price moves in the onshore markets and policy decisions made in Beijing. In fact, we think that the People’s Bank of China’s move to devalue the renminbi on 11 August was probably the biggest realised tail risk for global markets in 2015, and had wide-reaching implications for investors.
We believe that a major challenge for international investors seeking to understand China is that policy can appear to change rapidly from quarter to quarter, and few of the economic indicators are clear.
Beijing is taking an experimental approach to economic and financial policy. To maintain stability the government is making small, regular adjustments to various policy levers, even reversing reforms if a policy is not working, or it becomes concerned that a new move might destabilise the status quo. We expect the State Council to favour stability over pushing further reform and market liberalisation until the National People’s Congress meetings in March 2016. Beijing’s focus on stability should help quell some of the market volatility that its incremental policy approach has appeared to export to the rest of the world as investors struggled to understand the implications of changes.
The macroeconomic picture is also mixed. The most recent data has continued on a downwards trend. Indicators like industrial production and manufacturing purchasing managers’ indices pointed towards further growth moderation. But the picture is not universally bearish. China’s consumer, financial, services and technology sectors appear to be growing. But it is still unclear whether these can grow fast enough to take up the slack created by shrinking manufacturing and capital-intensive development in the construction and infrastructure sectors.
In the long term, we believe that China’s integration into the global financial system will be a fundamental driver of the fortunes of the world’s capital markets. In thinking about the risks that this process may bring to global portfolios, we believe investors need to retain a balanced view: neither underestimating the global impact of the ongoing economic slowdown and rebalancing, nor overestimating the risk of an imminent large-scale crisis of the kind we saw in Western economies in 2008, or in emerging markets in the late 1990s.
Mark Evans, one of our Emerging Market Fixed Income investment analysts, recently travelled to Beijing, Chengdu and Shanghai to get an on-the-ground perspective on China's policy direction and economic outlook.
Our Emerging Market Fixed Income team and 4Factor™ Equities team have identified five data series that they think are worth monitoring to get a steer on how China’s economy may evolve over the next six months.
Being on the ground in China gives you a different perspective from the view in London. Policy moves that seem opaque and have been poorly communicated become clearer. Here are a few of my thoughts from my recent trip to Beijing, Chengdu and Shanghai.
While Beijing’s incremental policy response may be unfamiliar and confusing from the outside, on the mainland the intention is clear: underlying all China’s economic policy lies the desire for social stability. The authorities have little tolerance for fluctuations in the business and financial cycles to the downside, which could result in rising unemployment. This goal was clear in China in October, but it has now been underlined by President Xi Jinping confirming Beijing still intends to achieve its goals of doubling people’s average income and the size of China’s economy between 2010 and 2020, which would require a minimum of 6.5% GDP growth annually for the next five years.
Maintaining stability and achieving the growth target, will be a major challenge for Chinese policymakers over the next 12 months, particularly as it is not yet clear that consumer spending will be able to take up the slack of the slowing manufacturing economy. With the new five year plan commencing in 2016, we could see some outperformance of economic activity versus expectations as new projects announced in the plan get front-loaded in order to buoy growth.
However, the desire to maintain stability will likely mean that the pace of reform will slow. The relatively fragile state of the economy and the global implications of so-called big-ticket reforms, like the change in the fixing methodology of the renminbi on 11 August, have reduced the State Council’s appetite for immediate change. We’ve already seen how stability trumps reform, with some backtracking on fiscal policy, financial market, foreign exchange and monetary policy and capital account reform all within the last few months. Eventually, policymakers will roll out much-needed reforms, but they will try to wait until conditions are more conducive.
But Beijing’s desire for stability might be undermined by some potentially concerning trends in China’s capital markets. With the ongoing challenges in the equity and property markets, more capital is being allocated to fixed income as monetary policy remains on an easing bias. Given the current relatively low yields, to get more bang for their buck some investors, particularly managers of wealth management products (WMP), have been resorting to buying of bonds on a leveraged basis (we heard reports of WMP leveraging from anywhere between two and nine times). Now that the equity market is recovering somewhat, the concern is that investors will start to sell duration again for equities, tightening financial conditions as yields rise, offsetting the transmission of counter-cyclical policy and potentially crimp growth further. This situation has become more acute since the summer’s sell off in the equity market, with the potential to result in a very volatile cycle of asset price swings.
On the positive side, on 30 November, the International Monetary Fund announced that the renminbi would be included in its Special Drawing Rights (SDR) basket of currencies from 1 October 2016. It was clear from our meetings that this was going to be a political, rather than an economic decision, so we don’t expect this to be a game changer in terms of its implications for the short-term evolution of China’s macroeconomic policy framework. Nevertheless, at the margin this will bring in more flows via the capital account via reserve rebalancing from global reserve managers.
On the whole, it is a mixed picture and Beijing has its work cut out to maintain the economic stability that it seeks.
China fixed asset investment (excluding rural households) cumulative YoY, 2000-2015
China property sales vs new starts cumulative YoY, 2011-2015
The health of China’s builders is an important indicator of on-the-ground activity. But the signals are mixed. “Although traditional leading indicators of construction like housing sales and new fixed-asset investment (FAI) projects have turned up, the actual measures of activity continue to move lower,” says Mike Hugman, strategist in Emerging Market Fixed Income. “Based on historical relationships the lags should have cleared and there should now be more activity. If the lags are getting longer and activity picks up this quarter, it could be a multi-quarter growth relief rally.” But he warns that if those leading indicators have disconnected from final activity the situation might be more bearish.
“The question is are we stuck in a liquidity trap of sorts, where a combination of balance sheet overhangs, excess commercial property inventory and public-sector finance blockages are preventing the usual sequence of credit-driven activity rebound?”
Watching out for the continuing disconnect or realignment between FAI starts and real activity will be key over the next quarter.
China fixed asset investment by sector, 2012-2015
Throughout 2015 there has been a growing divergence between the various forms of construction investment in China, as illustrated above. Mark Evans, an analyst in Emerging Market Fixed Income, notes that “although state-driven FAI in infrastructure remains robust and will likely remain so under the new five year plan, in other areas, such as real estate and manufacturing, FAI continues to slow.” Evans notes that the divergence between investment in infrastructure and other capital-intensive industries marks a breakdown in historical correlation between FAI in the three sectors. He believes that this trend will continue over the medium-to-long term as over-capacity in many manufacturing industries and excess inventory levels in residential real estate for smaller cities and commercial property continue to be worked through.
As China continues to rebalance its economy towards services, watch for the continuing decoupling of FAI as real estate and manufacturing slow, but the government continues to support infrastructure spending under China’s thirteenth five-year plan.
China gross domestic product by sector, 2012-2015
Industrial and investment growth has slowed more rapidly than China’s overall economy as economic rebalancing has continued. But Greg Kuhnert, Asia portfolio manager in the 4Factor team, believes that services are on the up. “The consumer and services sectors remain in good health,” he says. “The services sector has been the largest contributor to growth this year.” But while China’s services PMI reached an 11-month high in July, it has since stagnated. While the services PMI still shows expansion, it is not yet clear whether services can carry the economy forwards. Kuhnert says that boosting consumption and services “is behind a number of policy announcements to boost growth”, he cites reductions in mortgage down-payment restrictions and interest rates to increase disposable income, as well as tax cuts on purchases of compact cars.
Keeping an eye on services’ continuing growth both as a percentage of GDP and absolute activity will indicate whether the services sector is getting strong enough to power China’s economy.
China Foreign Exchange Reserves (US$ billions)
The People’s Bank of China’s decision to reform the country’s currency fixing mechanism on 11 August sent shock waves around the world. Wilfred Wee, portfolio manager in the Emerging Market Fixed Income team, believes that this move “was intended as a reform-oriented measure in line with China’s overall renminbi internationalisation agenda, and to facilitate the renminbi’s inclusion into the International Monetary Fund’s Special Drawing Rights basket.” However, Wee doesn’t expect any further major devaluations given the volatility that ensued in August and growth risk these reform experiments created. Instead, he believes, Beijing will continue to use other monetary policy levers, such as cutting bank reserve requirements and commercial banks’ deposit rates to ease liquidity.
Over the next quarter we don’t expect to see any further material moves in the onshore renminbi exchange rate, as the People’s Bank of China has decided to re-peg the currency for the time being to stem capital outflows and give more room to manage domestic deleveraging.
China debt stock 2001-2015
China’s rebalancing is being complicated by a heavy debt load, under which many local players are struggling. The People’s Republic’s credit growth has been around double that of nominal gross domestic product since 2007, meaning that the debt-GDP ratio has risen by around 120 percentage points. “We estimate the ‘excess’ credit growth above a sustainable trend probably amounts to 35-40 percentage points”, says Hugman. As much of this debt is domestically issued, Beijing’s challenge is to sustain nominal growth while stabilising debt levels. Hugman says the government can do this in two ways. “It can either materially lower the cost of servicing debt through further monetary easing, financial sector reform and maturity extension of lending,” he says, or by “creating frameworks for writing down debt related to excess capacity through industry consolidation or debt re-profiling.”
Over the next two-to-three years, we would expect to see debt as a percentage of GDP stabilise if Beijing is successful, if not it may have a fundamental effect on economic growth.
|Meet the team
Greg is the portfolio manager for the Asia Pacific ex Japan and Asia ex Japan Equity strategies and also co-portfolio manager of the China Equity Strategy in the 4Factor Equity Team at Investec Asset Management.
Greg joined Investec Asset Management in 1999 working as an analyst researching Asian and global equities. Prior to this, Greg spent five years at Ernst & Young inJohannesburg, South Africa, within auditing and consulting, where he specialised in mining and financial companies. He qualified as a Chartered Accountant in 1997. Greg graduated from the University of Witwatersrand in Johannesburg, SouthAfrica, in 1994 and achieved a first-class degree in Accountancy and is a CFA Charterholder.
Wilfred is an investment specialist in the Global Emerging Market Fixed Income team and a portfolio manager. He is responsible for the Asia Local Currency and Renminbi Bond funds. Prior to joining Investec Asset Management, Wilfred worked for the Government of Singapore Investment Corporation (GIC) for nine years, three of which were based in New York. At the GIC, he was a portfolio manager and lead credit analyst for emerging market credit, focused on Asia. He was also a credit analyst and strategist responsible for European financials.
Wilfred holds a Bachelor of Arts (Hons) degree in Economics from the University of Cambridge, a Master’s degree in Financial Mathematics from Stanford University, and is also a CFA Charterholder.
Mike is an emerging market debt strategist for the Emerging Market Fixed Income team. He is responsible for the in depth analysis of major emerging market economies, generating trade ideas including top-down/global themes, quantitative modelling, and building dialogues with policy makers.
Prior to joining Investec Asset Management, Mike worked at Amiya Capital, a global/emerging market equity hedge fund where he was an economist, and before that, he was an emerging market economist and strategist at Standard Bank, London. Prior to Standard Bank, he spent two years working as a technical advisor to the Budget Office, Nigerian Ministry of Finance. Mike graduated with distinction with a Master of Philosophy in Economics and a first-class Bachelor of Arts (Hons) degree in Philosophy, Politics and Economics, both from the University of Oxford.
Mark is an investment specialist in the Global Emerging Market Fixed Income team. He is responsible for analysis and modelling of key emerging market countries in the research universe and is responsible for covering Asia specifically. Mark joined Investec Asset Management as part of the summer internship programme before spending the next three years in the institutional client service team.
Prior to joining the firm in 2007, he went to Loughborough University where he graduated with a Bachelor of Science (Hons.) degree in Accounting and Financial Management. As part of his degree, Mark spent one year in the industry working for AXA Framlington Investment Managers. Mark is a CFA Charterholder and also holds the Investment Management Certificate (IMC).
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