Ashburton insight - China – that feeling of déjà vu

We thought it high time we put our head back above the parapet, and communicate with our clients and investors about the torrid last few months that our Chindia Equity Fund has endured. Emerging markets (and particularly Asian emerging markets) have been taken to the cleaners thus far this year, even though the epicentre of the latest financial and political storm lies far away. However, what has prompted us to put pen to paper now is the more recent hysteria concerning China and its supposedly imminent collapse.

A well respected China strategist from Macquarie has, in my opinion, hit the spot when he says:

“Chinese economics sometimes (admittedly not often) feel like high fashion: trends from an earlier age fade away, only to return a few years later, just presented in a fresher, cooler guise. In Chinese economics, the classic fashion of recent years seems to be talk of hard landings, a discussion that was the rage of 2008, and has suddenly made a comeback in the last week or so.”

Paul Cavey, The China Diviner, 3 October 2011.

Indeed, the last couple of weeks certainly do remind me of October 2008, not only in the unrelenting selling of stocks, but also the recent appearance of a deluge of reports from brokerage analysts out-competing each other in their predictions of doom for the Chinese economy. I think, on this basis, it is useful to briefly remind ourselves of the situation in China in 2008 and to see what lessons we can learn from the subsequent events afterwards.

There is no doubt that the Chinese authorities in 2008 were slow in understanding the severity of the Lehman’s induced financial crisis, and unnecessarily continued tightening domestic policy. Like today, authorities were concerned about inflation and property. And also like today, policy was tightened via both orthodox and unorthodox measures. This, in combination with a collapse in the global economy (and hence falling Chinese exports), led China to slow dramatically. The bears predicted the impending political and economic collapse of China, as they believed a property collapse, working in combination with the view that Chinese growth was simply a function of US growth, meant that China was heading for a hard landing. This view led to a sharp sell-off in Chinese share prices.

But obviously these concerns proved misplaced. The government’s policy U-turn in late 2008 was centred on a reflation of property and massive infrastructure build-out, with the result that China’s economic momentum began to pick up well before a recovery elsewhere in the world. This policy

U-turn has become known as the Wen Jiabao Put. In other words, there was an expectation that if growth slowed too much, the authorities would step in to ensure the economy wouldn’t collapse.

So the key questions we have to ask ourselves today are i) are the hard landing concerns misplaced, and ii) will the government undertake another U-turn if the economy starts to materially slow?

As already mentioned, today’s hard landing concerns are remarkably similar to 2008. Thus, once again, the argument goes that Beijing won’t loosen policy until it is too late – property prices are still too high, and inflation is still stubbornly above the comfort zone. In addition, we have all seen stories about excess leverage in the system, provided for by China’s shadow banking system that is supposedly operating outside of the authorities’ direct control.

The shadow banking sector is certainly the source of much of the recent angst. We hear reports of stress in the system as financing costs have risen, leading to defaults in various parts of the private sector. Shadow banking has grown very strongly over the last few years and it is outside the formal loan quota system that exists in China. Of course, shadow banking is not unique to China and has been practised globally for decades – think of financing of consumer goods by consumer goods manufacturers (Ford, Toyota, GM) or credit given by manufacturers of industrial goods to their clients.

In fact, most of this informal lending has been carried out by the state owned Chinese banks themselves and, crucially, it has been done with the implicit backing of Beijing. One of the most valid criticisms of China’s loan quota system is that it encourages wasteful lending, without a proper regard to loan pricing. This is why the shadow system is important – in many respects it is a government approved experiment in the proper pricing of capital that, in the long run, is essential to China’s development.

The last time we were hearing of similar stresses in the financial system was again 2008, so it really is no wonder that stock prices have been so weak recently, as hard landing concerns have intensified. So this brings us to our final point, will Beijing exercise its policy put?

The market, at current levels, is implying either that Beijing has no further policy options available, or that simply it is too late to do anything anyway. This, in our opinion, is wrong. The lesson from 2008 should tell us that policy can be changed very quickly if growth is in real danger of a dramatic slowdown.

The data and situation on the ground today doesn’t yet indicate that the economy is on the buffers. Sure there is plenty of anecdotal evidence of rising hardship, but this is still fairly focused on certain sectors and is not yet broad-based across the wider economy. Indeed, only last week senior government officials were still saying their primary focus was on fighting inflation. I think what this is telling us is that there are still no signs of anything approaching a hard landing and the fact that, according to local media, retail sales are up 26.2% (compared to last year) in Shanghai over the first three days of Golden Week would seem to confirm this view!

Therefore, without any signs of an imminent collapse of growth, we are unlikely to see a dramatic

U-turn in policy just yet. It is our belief that China is comfortable with a slower rate of growth, which will still exceed 8% next year. But if the global economy does head back into recession, Beijing has the political will and fiscal firepower to launch a new stimulus. China’s fiscal deficit was less than 2% of GDP in 2010, with revenues up 31% this year (after rising 21% last year). But this is still not our core view – we still argue the case for a soft landing.

So with these views in mind, how is Chindia faring? It is fair to say we have been caught somewhat by surprise by the severity and speed of the sell-off in Chinese stocks. Selling has been brutal and indiscriminate across all sectors and all quality (we heard that one trader yesterday had a panic sell order of US$100 million worth of China Mobile!). Whilst our Indian stocks have been performing well, the performance of our China stocks recently has certainly been disappointing. It is extremely frustrating when, at times like these, good fundamental research seems pointless. Whilst we have pared back some of our more high beta positions, we are loathe to sell companies that we continue to like due to price action alone.

However, as we have said a number of times recently, if we can just look a little further than the end of our noses, there is fantastic value appearing for the genuine long-term investor.