China: Growth in an air pocket
China’s acceleration of financial market reforms over the past two years has been a source of sustained positive headlines during a difficult period for both economic growth and capital market performance. The government has set out development of QFII and RQFII, onshore and offshore RMB bond markets and other improvements for institutional investors. It has established a clearer framework for key issues such as capital account and interest rate liberalization and articulated a larger role for capital markets in the economy. Overall, these developments have helped maintain investor interest in the China story.
“Significant regulatory reforms were implemented for both the QFII and RQFII programmes in 2012 and early 2013, which aim to attract more foreign investors by relaxing the requirements on the inflow and outflow of investment funds of QFIIs/RQFIIs,” according to David Livdahl and Jenny Sheng, partners with Paul Hastings LLP in Beijing.
Continuity at key top regulatory posts during the once-in-a-decade senior leadership transition has also helped. Despite some uncertainty in the broader political situation, China’s financial authorities have made a point of pushing ahead on the reform agenda, with measures such as another QFII roadshow, streamlined approval processes and better structures for managing onshore-offshore fundflows. The senior leadership has mentioned improving the consistency of implementation of government policy and overcoming excessive bureaucracy.
Significant development Two of the most significant developments have been the removal of the $1bn ceiling investment quota for sovereign wealth funds, central banks and foreign monetary institutions and ending the need for approval by the SAFE for fund remittance by open-end China funds.
“The SAFE made several important amendments in its revised version of The Rules on Foreign Exchange Administration of Securities Investments in the PRC by Qualified Foreign Institutional Investors issued last December. Meanwhile, certain limitations have been imposed on the repatriation of funds by QFIIs,” Livdahl and Sheng added. QFIIs have also been given limited access to stock index futures and the interbank bond market.
But despite this evolution, China’s capital markets development still lags its economic development and foreign capital penetration remain low as a percentage of total - the QFII quota expansion brings foreign A-share holdings from 1% to 2% of the market capitalisation. Recent reforms have done little to address critical deficiencies in the regulatory architecture, while macro-economic performance has also been disappointing.
As demonstrated by the sizeable underperformance of both A-shares and H-shares versus the global index in the first quarter 2013, structural issues continue to weigh heavily on investor sentiment toward China. These include uncertainty over the tax regime, persistent concerns over the debt burdens and credit worthiness of domestic institutions, and the economic slowdown associated with the shift towards a more consumption-driven economy. Drag on growth China’s growth rebalancing is dragging on growth, while capital market development remains too gradual to pick up the slack on the short term. Stock pickers may find some value as the cycle bottoms out, while opportunities are also being created by the growth of a high-yield bond markets. However, most stock indices remain heavily weighted toward banks and industrials, meaning long-term investors are still limited in their options when it comes to China beta plays.
Reflecting the more cautious bias on China’s headline growth numbers, Daniel Murray, EFGAM’s Chief Economist, says recent weakness has been due to a confluence of cyclical and structural economic forces. “It’s easy to confuse the cyclical and structural elements of Chinese growth.
“For example, last year cyclical and structural slowdowns occurred at the same time which magnified concerns about the economy. Policy loosening in the second half of 2011 and first half of 2012 resulted in an uptick in the cyclical element late last year, but that has now stalled and growth might not be as rapid in 2013 as we previously thought.”
So far, Beijing seems unconcerned by the slower GDP growth numbers, emphasising the need for a more consistent and moderate approach to economic development. As the working population’s rate of expansion slows and turns negative, the authorities are able to tolerate slower job creation. Moreover, less heavy industry fixed asset investment lowers the resource-intensity of GDP and leads to more sustainable domestic growth. EFGAM’s Murray thinks there is still scope for Chinese productivity to increase in the years ahead. “I think that China’s growth rate is still rapid and will remain so for a long period of time. However, growth will be less rapid than that experienced over the past 10 years as part of a natural slowdown. Once the stock of capital reaches an appropriate size and quality, then productivity gains will become harder to achieve.”
Issues of creditworthiness also continue to cloud the outlook for China’s financial market reforms. In spite of ambitious plans for bond market development, China is faced with a various potentially destabilising pockets of debt, including local government financing, informal banking and trust financing. Estimates in the market put these liabilities at a combined total of 40% to 60% of GDP. Domestic ratings agencies remain opaque entities, and many listed companies are still reliant on their state-owned parent entities to remain solvent, creating confusion as to who is the ultimate bearer of associated credit risks.
On the other hand, China’s aggregate debt to GDP remains relatively low, and the sovereign remains asset rich. According to Mansfield Mok, Portfolio Manager at EFGAM’s New Capital China Equity Fund in Hong Kong, the government still has the capacity to any control financial risks. “For me, China’s debt problem is a question of asset-liability mismatch rather than bad assets. So long as growth is reasonable, the number of bad debts will be limited. The government has mechanisms to help mop up the asset-liability issue, such as issuing three-year bonds to refinance the debt.”
As the economy cycle bottoms out and China mops up these debt issues, confidence could return to the market.
Pace of change More broadly, on the ground, the pace of change remains uneven, and several key aspects of the regulatory architecture remain unclear. Most of the major forthcoming announcements have already been well signposted, meaning an incrementally positive newsflow may become harder to sustain. Material progress is now needed on breaking the “old monopolies” in key industries, while wide-ranging changes are also due in the personal and corporate tax regimes, welfare system and resource pricing mechanisms. Given these uncertainties, the question remains as to whether Chinese markets have reached a definitive bottom, or whether underlying uncertainties will continue to undermine A-shares’ risk-reward profile.
EFGAM’s Mok, whose $140m equities fund has returned 13.7% since inception last year, argues the moderation of investor expectations of China’s future growth and development, both at a macro-economic and company level, means opportunities for long-term investors exist at current rock-bottom valuations. The slowdown in heavy-industries is helping to increase the GDP contribution of new growth engines. As markets become more accustomed to the slower-growth environment, China’s new growth themes should become more clearly visible in the investment landscape.
“China’s economic growth engines are changing but the analytical models investors use may not be,” Mok says. He remains bullish on the consumption theme, seeing selective opportunities as incomes rise in the region. “Across Asia, higher minimum wages are fuelling the move toward domestic consumption on discretionary products, which has a high multiplier effect.”
Mok notes a change of focus from hard to soft commodities, while non-bank financials are also set to benefit as China moves towards a more diversified social financing structure. “Many of the companies that enjoyed strong growth are now becoming mature companies. For equity investors, there’s a new wave of Chinese companies that offer growth potential based on the consumption play,” he adds. This is ultimately beneficial in terms of building out a portfolio, with both yield and growth stocks available to institutional investors as domestic markets mature.
Overall, there is an emerging acceptance that the Chinese government is serious about improving the quality of economic growth and this means lower returns on the mid-term. Institutional reforms aimed at improving regulatory structures are likely to continue, although the pace may be varied and uncertainty will remain a feature of the market. Both trends will keep foreign investors cautious on a short to medium-term view, and the role of foreign investment will remain limited in the economy for some years.
Yet despite these concerns, interest in China exposure remains strong. By any other standards, economic development remains extremely rapid, and there are tentative signs that new growth motors are gaining traction. Long-term opportunities undoubtedly exist, and early movers may have some advantage in identifying them. Indeed, the new normal of slower, more rational growth could ultimately make them easier to discern.