Will China have a hard or soft landing? It's a question
that's been often debated this year, as the world's second-largest economy
attempts to gently slow growth down to a sustainable level, and avoid a crash
that would send shockwaves through the rest of the world.
Soft landings are notoriously
difficult to engineer. Through monetary tightening, China has managed to put
the brakes on its growth: its economy grew by 9.1% in the three months to the
end of September from a year earlier, down from 9.5% in the previous quarter,
marking the slowest pace of growth in two years.
But some economists and fund
managers are warning that problems bubbling below the surface mean China could
be set for a spectacular crash, rather than the smooth slowdown it is aiming
for.
In terms of 'hard or soft', Dr
Jim Walker, an expert in the Chinese economy and founder of Asianomics, a
consultancy group, has a simple answer. "I don't believe in soft landings.
It'll either be hard or no landing," he claimed at a recent investor conference
in Hong Kong. He added that China would collapse next year, with GDP growth
falling to between 0 and 3%.
"In two years' time people
will write about China being a catastrophe, not about China saving the
world."
Chief concerns for Walker are
China's inequality between rich and poor ("the inequality gap rivals that
of Brazil"), "authoritarian capitalism" and a looming
inflationary bust.
Inflation concerns
Consumer Prices Index (CPI)
inflation slowed to 5.5% in October, down from 6.1% in September, but it's
still well above the 4% limit set by the government. Food prices in China have
risen around 30% year-on-year. But Walker argues that the real inflation
picture could be far worse.
"China has inflated
dramatically - that's how it's grown. It doesn't show up in its inflation
figures though as most of the prices in the CPI basket are government set. You
need to look at money and credit instead and there you will find inflation
aplenty."
Even the Chinese authorities
admit that they've got a big problem on their hands with inflation. Lu
Zhongyuan, vice president of the development research center of the State
Council, a Chinese government agency, recently said (as reported by Beijing
Review): "Inflation pressure remains big due to loose liquidity conditions
at home and abroad, and imported inflation and rising costs at home.
"Even if we tighten our
monetary policy and freeze extra domestic liquidity, rising labour costs and
imported inflation will still be a long-term problem we have to tackle.
"A close eye still needs to be kept on food price
hikes."
Export figures coming out of
China have also triggered fears of a hard landing. Exports from the country
fell by 0.7% in the third quarter of 2011. This is a rapid turnaround from the
6.4% growth rate three months earlier. It's not that surprising when you
consider that the regions China exports to - the Western economies - have
problems of their own, and demand for Chinese goods has slowed as consumers
have been squeezed.
Robin Parbrook, head of Asia ex
Japan equities at investment manager Schroders, is also worried about the
credit boom and the state of Chinese banks.
"There won't be a
financial crisis in China but there are a lot of bad debts and banks need a lot
more capital," he says. Non-performing loans (NPLs - in other words, loans
that are in default or close to being in default) were less than 2% of GDP last
year, but Parbrook expects that figure to rocket. Fitch Ratings also warned in
the summer that Chinese NPLs could rise to up to 30% of GDP. This comes after
banks went on a lending spree in 2008 and 2009, spurred on by Beijing's four
trillion yuan (£398 billion) call to boost the economy.
Much of that money financed new
railways and was loaned to property developers. "There are plenty of white
elephant projects in China, such as empty airports. China financed its
railways, and that will never be repaid. China still thinks banks are part of
the government; the banks are an adjunct to China policy, so you can't value
the banks," says Parbrook. Schroders is underweight Chinese banks across
all its funds, he adds.
Property bubble
Meanwhile, there are growing
fears over the property sector. House prices have rocketed over the past few
years as demand has soared from Chinese high net worth individuals. Over the
past few months prices have started to stabilise though, with Beijing,
Shanghai, Shenzhen and Guangzhou house prices remaining flat during the third
quarter of this year.
But economists are still
warning that there is a property bubble, and when it bursts it could be
catastrophic.
According to the International
Monetary Fund, the property sector is central to the Chinese economy, making up
some 12% of GDP. So if the bubble went pop there would be repercussions across
the country, and especially for banks, as credit they receive from mortgages
and property developers would quickly dry up.
Fen Sung, manager of the
Premier China Enterprise Fund, comments: "My concern is [property]
oversupply, and whilst this will lead to falling prices, which is good, it will
also lead to unsold properties and ultimately a rise in non-performing loans.
Therefore, a housing market crash in China would have much deeper effects on
the economy than initially thought."
Get in-depth analysis of
property at home and abroad, as well as tips on how and where to invest, in
Interactive Investor's property special.
For Laura Luo, fund manager of
Schroder ISF China Opportunities, China's investment bubble has left her
cautious on banks, property, materials and many industrials. She says China
faces policy and economic headwinds, and it's worrying that operating cash flow
is declining in companies yet capital expenditure is increasing.
All of these economic woes are
keeping the Chinese stockmarket particularly bouncy. Raiffeisen Capital
Management says ups and downs of 4-6% on a daily basis were not unusual in
September, with the fluctuations being driven by banks and real estate
companies. "The former are suffering from pressure due to worries about
higher defaults on loans, while the latter are under pressure due to falling
sales and fears about financing bottlenecks in the future," says Angelika
Millendorfer, head of emerging markets equities at Raiffeisen.
So amid this gloomy picture, are there any attractions in
investing in China's stockmarket?
The ultra-bearish Walker warns
that earnings downgrades have only just started in China. "PMI figures are
signalling that the expansion is losing momentum." China's purchasing
manager's index, which measures manufacturing activity, fell to 50.4 in
October, from 51.2 in the previous month, the first drop in three months. A
figure lower than 50 signifies a contraction.
Despite all the hype around
high returns from emerging markets, Parbrook reveals that over the past 18
years (1992-2010) investors would have lost 40% by trading an index such as the
MSCI China. "State-owned enterprises (SOEs) unsurprisingly tend not to be
big creators of shareholder value. And SOEs make up 48% of the MSCI China
index," he says.
Like his colleague Luo,
Parbrook is steering clear of banks and property. "The bond yield of
Evergrade Real Estate is 17%. So there is a high chance it could default. But
equity market analysts say investors should buy the stock. Maybe the credit
markets know something the equity markets don't," he ponders.
He continues: "There are
some good companies but a lot of China looks distinctly unattractive. We don't
like any cyclical sectors in Asia. Avoid sectors where there are big
state-owned competitors, such as wind power and solar LED."
Luo says that valuations are
polarised within the stockmarket. On one hand, China's consumer stocks are
highly rated and are arguably too expensive.
But on the other, some
companies look cheap. Luo says that energy, financial and telecoms companies
are trading at around 10 times earnings, which is low.
"Are the cheap stocks a 'value trap' given the
policy risks," she asks. "Earnings may be downgraded."
Fellow China fund manager Fen
Sung is feeling more positive though. Despite his negativity towards the
housing and banking sectors, he likes the oil and gas sector. "Oil and gas
will continue to be a vital energy source, and with the recent volatility in
markets, small-cap upstream players like MIE Holdings and Enviro Energy are
trading at attractive valuations."
Coutts also reiterates a lot of
what has been said by other investment managers: buy defensive and high-quality
equities in China, as well as stocks with high dividends and reasonable growth,
while reducing exposure to cyclical sectors.
The jury's out over whether
China will be able to mastermind a calm slowdown and prevent the economy from
crashing to a halt. But it's clear that investors need to exercise caution over
the region, avoiding specific sectors, and making sure they are well diversified
across the emerging markets.
Still bullish: Boom is over but no crash yet
Not everyone is so bearish on
China. Andy Rothman, China macro strategist at equity brokers CLSA, argues that
China is better prepared for this slowdown than the one of 2007/08, and that
there is no evidence of a hard landing.
He claims China is less
dependent on exports now. "This year we expect 9.5% GDP growth with zero
from net exports; in 2007 18% of GDP growth was from net exports."
On the issue of inflation, he
says that incomes have kept pace with rising prices. "Real urban incomes
have grown at least 6%. And rural income growth is accelerating too, as higher
food prices have led to better income for farmers," he comments.
Rothman also argues that the
residential property sector is "healthy" and "far from
bubbly". He says that 89% of property buyers are owner-occupiers and only
11% are investors, while 23% of first-time buyers and 53% of investors pay for
their homes in full in cash. "For those using mortgages, the average
deposit is 44%,' he adds. "There's no Ninja [no income, no job and no
assets] loans or creative mortgages - they are plain vanilla."
He accepts that there is an
inequality gap in the country, but it has got better over the past decade:
"Rural incomes have gone up; and since 2007 spending on healthcare and
education has gone up." Corruption in the countryside is China's big
problem, rather than the inequality gap, he claims.
So will corruption and
injustice spark a crisis like the one in the Middle East in the next few years?
Rothman answers that the risk is "very, very slim", adding that there
is a lot of social mobility in China: if you do well at school in a village you
can move to the city and get a good job.
Rothman admits that things are
slowing down in China, and growth - both economic and wage - is not
sustainable. "The boom is over, but it doesn't mean there will be a
crash." He predicts 9.5% GDP growth overall for 2011 and 8.6% for 2012.
Ups and downs: Fund manager views
We ask three China fund
managers about the risks and opportunities of investing in the country, and
give performance details for all three vehicles.
Fidelity China Special Situations (FCSS), managed by Anthony Bolton
Risks: Poor outlook for
residential property, infrastructure spending, low value exporters and most
commodities.
Opportunities: Domestic growth
potential; finding under-researched companies.
Performance after six months:
-30%
One year: -37%
Three years: n/a
Aberdeen Global - Chinese Equity Fund, managed by Nicholas Yeo
Risks: Poor quality companies;
severe property market correction, which could weigh heavily on banks.
Opportunities: Huge potential
for future economic growth; rapid urbanisation and rising domestic consumption.
Performance after six months:
-7.2%
One year: -7.2%
Three years: +89.2%
First State Greater China Growth, managed by Martin Lau
Risks: Too much money in the
system (after rush of money in 2008); rapid rise in property prices; labour
cost pressure.
Opportunities: Consumption
growth; urbanisation (more consumption, the need for more urban
infrastructure); more innovation and product upgrades (China produces six
million graduates a year).
Performance after six months:
-5.9%
One year: -6%
Three years: +90%
Funds with Interactive
Investor. Get great value for your investments with us; pay no inactivity fees
and search over 2,200 funds.
Ruth Emery
Interactive Investor
Business & Investment Opportunities
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