China - Will China have a hard or soft landing?

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%

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Ruth Emery

Interactive Investor

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