China estimated net capital flow, 2013-2016
Source: Bloomberg, March 2016
China foreign exchange reserves, 2013-2016
Source: Bloomberg, May 2016
While tighter capital controls have helped quell the pace of capital outflows, more money has now been stuck in the mainland markets. With nowhere to go, surplus cash has inflated asset bubbles. Having learned from last year’s spectacular stock market crash, day traders and yield-hungry wealth managers avoided A-shares, instead pouring money into China’s lightly regulated commodities’ market. Daily trading volumes in some commodity futures contracts, such as iron ore, were so large that they sometimes exceeded China’s annual imports. There’s also been large capital flows into selective real estate sectors, particularly in tier-one cities where demand for housing exceeds supply.
Last quarter, The China Indicator argued that to ease the economic headwinds facing China’s rebalancing supply-side reforms should be run alongside supportive demand-side measures. But announced measures have been softened, which is likely to make the eventual and necessary reform process even more difficult.
This situation seems to be largely of political making. President Xi’s priority appears to be creating a stable one-party state. The Chinese authorities do not seem prepared to face the challenges to stability – primarily large-scale unemployment – arising from following through with necessary and effective reforms to state-owned enterprises (SOEs) in major industrial sectors, such as coal mining, steel and cement manufacturing. Consequently, President Xi has continued with popular manoeuvres, such as his anti-corruption drive and claims on the South China Sea.
There is also some evidence of policy discord within the party. On 9 May, the state-run People’s Daily newspaper published an interview from an unnamed “authoritative person", who said that China must face up to its non-performing loans and other risks associated with soaring debt levels. A day later, the same publication ran a transcript of a January speech, in which President Xi said China needed to focus on cutting inventory, paring excess capacity and reducing debt. We believe this incident exposes rising tensions between the president and others in his cabinet over prioritising growth over reform.
Last quarter’s China Indicator addressed corporate deleveraging as a key pillar of reform in mainland China that would help spur economic growth. But money and credit growth continues to outpace real economic activity. Some of the flow has been used to issue new loans or refinance zombie companies, but it has also been channelled into commodity and real estate markets, so the efficacy of the new credit continues to fall.
How much of a problem is the expansion of debt likely to be? The March Quarterly Review from the Bank of International Settlements suggests that Chinese corporates have been paying back foreign-currency debt. They have been replacing foreign currency loans that generally had interest rates of 7% or 8% with RMB-denominated loans with far lower rates. For the moment at least, this substitution takes the pressure off their balance sheets. The challenge then becomes that China’s debt problem is a domestic one, much like the situation in Japan.
China cross-border claims, 2010- Q3 2015
Source: Bank for International Settlements, March 2016
But shifting the burden is putting pressure on the Chinese banking sector. John Holmes, analyst in the 4Factor™ Equity team, says that the team is “becoming incrementally more bearish on Chinese banks and we have been reducing our holdings. The very strong growth in total social financing in the first quarter of 2016 suggests that the can is being kicked down the road again.” In other words, Beijing will continue to rollover or decide to write-off the debt for zombie companies rather than forcing a default.
However, with the debt now being domestic, non-performing loans may become less of an immediate issue. The government can write them off or roll them over. But, as Mark Evans, analyst in the Emerging Market Fixed Income team points out, it’s not to say that defaults aren’t happening. “An unprecedented ten companies have defaulted in the onshore bond market this year, already exceeding the tally for 2015. But it’s likely to be in selective industries like steel and coal, which are drivers of the old investment-led, export-driven economy from which China is trying to rebalance.”
The EMFI team also recognises that there has been more price discipline in the onshore lending market. Defaults are picking up from a very low base, but the levels they observe are not as bad as many headlines would have us believe. Wilfred Wee, Portfolio Manager of the Asian and onshore and offshore renminbi bond strategies, says that “on balance, we would see this as a positive development. One or two years ago, everyone was sceptical as onshore bonds ‘never defaulted’. Now that small-scale defaults are happening more frequently, sentiment has swung to the other extreme.” The EMFI team believes that the maturing and deepening of China’s capital markets is a multi-year process and that these swings in sentiment will continue to occur for years to come.
The supply-side reform progress continues to be stop-start. The private sector, which has historically had limited access to bank funding, is already reducing excess capacity in key “old economy” sectors such as steel, coal and cement, as well as in industrial sectors such as machinery and construction. Firms are cutting capacity and costs or going bankrupt.
On the back of private enterprise China’s service sector is now growing faster than manufacturing, despite still being dominated by SOEs in financial services, real estate, traditional wholesaling, and transport. To stimulate growth Chinese companies need to continue to move up the value chain to more dynamic professional, IT, business, health and education services. These are the sectors that the 4Factor Equity team find attractive. “We focus on those parts of the economy that are growing and doing well,” says Greg Kuhnert, Strategy Leader for Asia in the 4Factor Equity team. “We favour consumer-facing sectors and services such as food producers, automobiles, appliance manufactures, leisure and gaming companies, pharmaceutical and healthcare companies. And let’s not forget the internet companies!”
China gross domestic product growth by industry, 2012-2016
Source: Bloomberg, March 2016
SOEs need to catch up. Greg believes that change may be upon us. “Senior government officials are openly debating these issues in the local press,” he points out, referring to the 9 May interview in the People’s Daily. “The government has come out with capacity closure targets in the steel and coal sectors, and is experimenting with various non-performing loan resolution (NPL) mechanisms, including debt to equity swaps, securitised NPL issuances.”
The risks, he believes, are that the government’s appetite for reform wanes once the impact on the local economy materialises. There are also resources available to the government such as the closed capital account and monetary policy that will enable it to avoid systemic risk. In this environment, the EMFI team believe that it is better to invest in high-quality debt, rather than take on the riskier and more cyclical sectors until the upturn in growth becomes more meaningful.
That said, some attempts to address supply-side reform are better than none. While more reforms would be preferable, large-scale write-offs are not desirable. The EMFI team thinks that we need to recognise that in this second-best solution of stop-start reform, there is always the risk that reforms will not go as planned and may be reversed. It is unlikely that the sequencing of reform will always be right.
Regardless, inefficient SOEs in heavy industries continue to attract too much of the financial resource of the economy. As long as this is true, China will struggle to compete for international capital. According to a 2015 McKinsey Global Institute report, the three-year rate of return on invested capital (ROIC) in China is 8.6%, as against 11.0% for India and the Association of South-East Asian Nations (ASEAN), a regional economic bloc. Moreover, since 2000, ROIC in China has shrunk by 1.3%, compared a growth of 3.6% for India and ASEAN.
Despite the renminbi gradually depreciating in May, the last three month period has been relatively stable for the currency. This has mainly resulted from a weakening US dollar in earlier periods. In March, the offshore RMB, mainly traded in Hong Kong, finished its best three months in more than three years, a far cry from the elevated levels in early January. But we believe that this rally may not last given April’s weak economic data.
Offshore vs onshore and renminbi exchange rates, 2013-2016
Source: Bloomberg, March 2016
To address the flood of capital outflows seen in recent months Beijing tightened the enforcement of controls over capital outflows, to encourage domestic investors to keep their money onshore. As we suggested last quarter, it has also incentivised major institutions, such as central banks and sovereign wealth funds to invest by providing greater access to the onshore interbank bond market.
Wilfred Wee points out that “last year’s lesson was that the causes of capital outflows by domestic investors were endogenous: when the currency depreciated quickly, local traders quickly parked their money offshore.” As a result, China is likely to continue to control the exchange rate closely, rather than taking the official line of making the daily fix more market-based. Re-emphasising the RMB’s stability may also be a boon to trading partners who worried that a weaker currency would boost Chinese exports at the expense of those produced elsewhere, particularly in South East Asia. The EMFI team believe that it is unlikely, therefore, that there will be another one-off devaluation, as we saw in August 2015.
But Beijing still seems to be trying to undertake too many reforms at once. Opening capital markets and internationalising the RMB at the same time as trying to undertake major supply-side reforms to boost services and consumption will likely lead to less than optimal results on all sides. The authorities need to do more to provide incentives for investors to hold RMB-denominated assets to boost return on investment, rather than more capital controls, which seem to work to maintain the status quo.