A developing story – Funny business in the Year of the Monkey

China is in the midst of structural transformation from a manufacturing-driven economy to a consumption-led one; from a state-directed command economy structure to being market driven. It’s also gradually working towards a more liberalized or more convertible currency. But can its economy continue to grow?

Economic uncertainty

Economic uncertainty and a likelihood of further ‘surprise’ currency depreciation has dramatically increased outflows which hit USD170bn, or equivalent to 5% of its foreign reserves in December 2015 alone.

The RMB remained too tightly pegged to the USD for too long. This has created some major structural imbalances which will need to be unwound. These structural shifts are occurring during a time of dangerously high corporate debt; a continuing slowdown in economic growth; collapse in several commodity prices (somewhat artificially buoyed up by China in the first place); a corruption crackdown; and eye-opening interferences in the capital markets which overall has led to sporadic, dramatic losses for the investing public: many people have rushed into stock margin-loans.

Worrying signs

Depending on which figures you believe, corporate debt accounts for between 140%-175% of GDP – even the lowest estimate is one of the highest in the world. A lot of which is at the state enterprise level: a contributory factor to the unknown but presumed high level of non-performing loans (NPL) within the banking system.

Inter-bank (HIBOR) lending rates recently spiked up to around 70%, comparable to countries in the months preluding a full-blown financial crisis. They then fell sharply, highlighting the sheer volatility and uncertainty attached to China. It’s not clear exactly which banks were lending to each other at these rates: rates which tend, at various times to be manipulated to the low side by huge injections of state liquidity and can cause subsequent spikes if withdrawn again. Such unknowns only amplify the lack of transparency and lead to damaging mal-investment and speculation.

In addition to this, export growth has been slowing in USD but grew more than 2% in Renminbi terms according to the country’s latest data. Also, labour costs have been creeping up, reducing job demand. This confirms my long-held suspicions that excess capacity (caused by excessive investment in fixed asset formation following the onset of the GFC) has resulted in highly marginal and sometimes negative manufacturing profit margins.

GDP is another hotly-debated subject. Many economists consider the published growth rate to be higher (perhaps significantly) than the reality and may have been for some time. If this is true, hiring rural immigrants may not be enough for manufacturers to improve results. This is strangely relevant because rural consumption expenditure levels are significantly lower than their urban equivalent: once workers move from the countryside to the cities there’s often a sudden jump in their consumption, thus an increase in overall GDP growth. A lower rate of consumption, coupled with a slower GDP growth caused by China’s attempts to move from its moribund export model (global trade is now back to levels preceding the great China boom of the noughties), would further diminish economic growth.

What now?

The Chinese authorities are still likely to continue monetary easing through 2016 to maintain growth. This will pile further pressure on the RMB to continue to weaken further – but the consensus isn’t particularly helpful with many economists seeing the currency weakening by 5-20% in 2016. To what extent the Chinese will be prepared to support the Renminbi given the alarming draw-down on its foreign reserves in 2H 2015 is also an unknown. Still, any rapid draw down in foreign reserves would further exacerbate outflows.

That doesn’t mean that the policy tools available can’t give the impression of a fully functioning economy and capital market in China for the remainder of this year and possibly even longer. The only structural fix for China that I envisage involves the genuine write-off of unpayable debts, the bankruptcy of rotten businesses (state, publicly and privately owned), the unwinding of government manipulation of capital markets and a huge amount of economic and financial pain, before China can build a solid base for the next stage of its economic resurgence.

SocGen’s Albert Edwards is predicting that Chinese equity markets will fall by 75%. That could easily be right but is more likely to be understating or overstating how bad things need to get before they can structurally get better.

I feel that the range in possible currency and market performance is really too wide to be able to refute or confirm whether China would be a terrible/bad/OK/good/amazing place to invest this year.

Going forward

For the short term, any exposure to China should be considered as speculative. I firmly believe that in the medium term, China’s economy and markets will face exceptional difficulties and potential losses and thus should be seen as dangerous. For the longer term, it could be one of the more attractive high risk opportunities available. Therefore the key to investing in China is really how well that matches your own expectations and outlook.

My best guess looking ahead is that the Renminbi is set to weaken further and that this will damage confidence, pushing down along with it Chinese share prices, as well as currencies of neighbouring economies, with far reaching ripple effects for all capital markets. Although, if investors believe that a weaker currency is the panacea for all Chinese woes, this could just as easily lead to an equity rally, in which case the recently launched currency hedged China ETFs would perform strongly.

But if not, I wouldn’t be surprised to see the Shanghai stock market (SSEC) drop significantly below 3000 points in 2016.