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Monday, 22 April 2019

Steady as she goes

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Fears of a hard landing for China’s economy are off the table after the latest official GDP data pointed to a 6.9% expansion. But are investors right to ignore the risks?

Little more than 12 months ago, China was in the headlines for all the wrong reasons. A sliding renminbi, tighter onshore liquidity and a disastrous attempt to control stock market volatility all fuelled talk of an impending crisis that would send its economy into reverse. China bears even triggered heavy selling on Wall Street in January 2016 – recognition, perhaps, of how important Chinese growth is to global GDP.

The situation in 2017 is very different. China has just posted preliminary GDP figures showing a 6.9% annual expansion in the first quarter – above expectations, and even above its own 6.5% target for 2017. Global markets have shrugged off any concerns they may have had, choosing instead to focus on pro-growth promises from Donald Trump’s new US administration.

But are investors ignoring risks that may come back to hurt them? Has China sacrificed its future for the sake of short-term stability?

The IMF in April raised its forecast for Chinese growth this year to 6.6%, up from a 6.2% forecast last October, citing strong momentum from credit growth and public investment. However, its report came with a stern warning for the medium-term, thanks to a “dangerous dependence on rapidly expanding credit, intermediated through an increasingly opaque and complex financial system”.

The IMF does not predict a crash in China, but it has flagged the risk of a “disruptive adjustment” in the medium term stemming from “persistent resource misallocation” and rampant credit growth.

Most economists agree with that assessment.

“China has the administrative and financial resources to address these imbalances without a disorderly adjustment, but its capacity to do is decreasing as time passes without them being addressed,” Fitch Ratings economist Andrew Fennell wrote in April.

The ADB predicts growth of 6.5% in 2017, in line with the government’s target, and notes that the rebalancing of China’s economy has been progressing as planned.

“China is transforming itself towards a more domestic consumption-oriented model, shifting from the manufacturing sector to the service sector. So it’s natural to see some moderation of the Chinese growth rate,” said Yasuyuki Sawada, ADB chief economist.

Consumption is now the biggest contributor to Chinese growth, and industrial investment plunged further in 2016 as China looked to rein in overcapacity in selected industries. Total investment, however, still contributed around 40% of GDP growth – accounting for 2.8 percentage points of 2016’s 6.7% expansion – as heavy real estate investment and public infrastructure spending cancelled out any contraction.

Capital outflows

Foreign direct investment also plummeted in 2016, with net FDI inflows turning negative for the first time in China’s recent history. Outbound direct investment more than tripled to US$211.2bn in 2016 from US$65.0bn in 2012, according to ADB data, while inflows shrank to US$152.7bn from US$241.2bn over the same period.

Capital outflows have clearly caused concern among mainland authorities, prompting a series of measures to combat excessive speculation and new restrictions in January on foreign exchange transfers of more than US$50,000.

“The government had legitimate worries over whether some investments in services would generate good returns,” said Juzhong Zhuang, deputy chief economist at the ADB. “Even if it’s a private company, the sums involved can affect everyone.”

Overseas mergers and acquisitions stalled in the first quarter as capital controls prevented Chinese buyers from moving money overseas. Dalian Wanda’s US$1bn purchase of Dick Clark Productions fell through in March, while LeEco’s US$2bn bid for US television maker Vizio was scrapped in April because of “regulatory headwinds”.

China’s State Administration of Foreign Exchange started vetting bank transfers of US$5m or more last November and increased its scrutiny of outbound acquisitions to stop capital flight. In the first quarter of 2017, Chinese companies announced US$21.6bn of outbound acquisitions, roughly a quarter of the US$85.7bn total seen a year earlier.

M&A lending in the first quarter slumped to just US$1.1bn from two deals, according to Thomson Reuters LPC data, in sharp contrast to the first quarter of 2016, when 15 facilities totalling US$12.3bn were completed.

Capital outflows eased markedly in the first three months of 2017, but are expected to continue as more Chinese companies look to expand overseas. Major investments are still possible: Reuters reported in April that Chinese state investors were preparing to invest billions of dollars in the IPO of oil major Saudi Aramco, while Fosun International’s planned purchase of a substantial stake in Russian gold producer Polyus also looked to be moving ahead.

Reforms needed

While some analysts have called for reduced public investment to ease the risk of asset bubbles, rating agency S&P argues that funds need to be channelled to more productive uses.

“Investment in China needs to be rationalized and redeployed – not necessarily reduced, at least not drastically,” said Paul Gruenwald, Asia-Pacific chief economist at S&P. “This objective, in turn, requires changes in policies that allow the redeployed investment to be financed.”

The capital markets have a role to play in allocating capital efficiently, but China’s efforts to limit volatility following the 2015 stock market crash have delayed reforms. The IPO pipeline is open, but at artificially low prices, and recent measures limiting companies to one equity financing every 18 months have also restricted companies from deleveraging their balance sheets or financing growth.

Gruenwald in an April report called for policymakers to reduce credit growth and accept a “more realistic” GDP growth target, together with more defaults from unproductive companies. A move to a sustainable growth trajectory would then allow investment to be reallocated.

“China’s investment challenge, and ultimately its long-term challenge of achieving first-world-economy status, (…) is to redeploy investment toward the less-developed areas of the country, with a view to building out their infrastructure quality across a number of metrics and thereby driving a continued national convergence in productivity and per capita income,” Gruenwald said.

There are signs that China is tackling these problems. Central bank governor Zhou Xiaochuan has been “forthright” in his aims of curtailing excessive credit growth, says Mark McFarland, chief economist for Asia at Union Bancaire Privée, noting that the gradual liberalisation of interest rates has led to an effective monetary tightening. While the People’s Bank of China has not changed its prime lending rate, Shanghai interbank rates have risen, especially at the short end.

“The rapid increase in the level of interbank rates across the curve is evidence that the PBoC is deliberately using tighter funding constraints as a means of reining in credit ahead of the October convention of China’s Communist Party,” said McFarland.

US President Donald Trump summed up the turnaround in sentiment towards China by declaring he would not label the country a “currency manipulator”, reneging on one of his key promises during last year’s election campaign. A move away from his earlier anti-trade rhetoric may be good for Chinese exports, but it also gives global investors plenty to think about. Fears of a hard landing in China may not have disappeared for good, but for now fund managers are more focussed on US policy moves and rising geopolitical tensions.

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To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.

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