‘Schizophrenia or rational exuberance?’
The schizophrenic sentiment that has historically characterised China’s equity markets has been further cemented by the extraordinary rally that has taken place over the past six months. Heading into 2015, a China ‘hard-landing scenario’ and the inevitable shockwaves it would bring to global markets would have been at, or near, the top of potential risks for many investors. Whilst a significant economic slowdown is indeed unfolding, year to date returns for the domestic Shanghai index and Hong Kong H-share index are +32.8%* and 21.3%* respectively, highlighting a stark divergence between economic performance and share price action. An obvious conclusion is that China is hyperventilating, but several recent developments suggest there may be an additional dynamic to this rally.
Much of the rationale underpinning the exuberance around the spill over to Hong Kong has been attributed to the key event of late March when the China Securities Regulatory Commission (CSRC) released a notice relaxing restrictions on domestic mutual funds investing in Hong Kong listed shares through the southbound Stock Connect (funds no longer require Domestic Qualified Institutional Investor status). Previously, People’s Bank of China member Zhou Xiaochuan admitted that policy initiatives were conservative, evidenced by the numbers; only 12% of the total southbound investment quota had been filled.
The net result was a surge in trading activity in Hong Kong, with peak daily trading reaching HK$291 billion or four times the average daily volume over the past 12 months. More significantly, mainland investors began exhausting their daily quota of Rmb10.5 billion to invest in Hong Kong shares through the Stock Connect scheme for the first time since the scheme was launched last November. Going forward, the market is anticipating both a narrowing of the A-H premium that has built up between dual listed shares and further relaxations of policy to support the Stock Connect. To provide some perspective, total assets in the Chinese mutual fund industry that can be invested in equities total Rmb2.1 trillion (source: CLSA). The initial ‘southbound’ quota equates to just 12% of that total.
In addition to the fund flow rationale, several other initiatives falling under the umbrella of reform have been announced. We have discussed the nature and impact of China’s reform agenda in previous commentaries, but the level and speed of restructuring has exceeded market, as well as our own, expectations. First and foremost are Beijing’s efforts to defuse the country’s debt bomb which has been ticking away for a considerable period. China’s banks have been trading at depressed levels for several years, largely because of concerns on asset quality. Net equity for the entire banking system was c.Rmb12 trillion in 2014, compared with local government debt of c.Rmb20 trillion (50% in bank loans), Rmb6 trillion property loans and a highly leveraged corporate sector (source: Macquarie Research).
Earlier this year, the Ministry of Finance carried out a RMB1 trillion debt swap, under which local governments can convert their shorter duration bank loans into municipal bonds with a longer maturity. Should the exercise be deemed a success, the pilot scheme will likely be rolled out later this year. Taken at face value this is negative for banks, who are swapping a high-yield, short-maturity, loan asset with low-yielding, long-maturity bond assets. However, the significance of the move relates to the quality of the loans currently being held on the books, many of which could sour. The net effect is that the asset quality of the banks will improve post the swap, thereby reducing the risk premium of the sector. It should reduce the level of local government defaults in the short to medium term (with the likelihood that government and banks will share any pain) although the longer term problem of how to address continued rapid debt accumulation remains.
On that note, total non-financial debt in China at the end of last year was c.230% of GDP. The household sector is in better shape, relatively speaking, with a debt-to-GDP ratio at 24% versus c.78% in the US. However, it is the level of government debt and in particular corporate debt that is more alarming. Much of the corporate debt has been raised by those companies able to access financing, namely SOEs, leaving the private sector to source funding from alternative channels. In addition, China suffers from an acute shortfall in its pension obligations (total assets are currently measuring less than 7% of GDP), which will be even more difficult to service given the country’s unfavourable demographic profile going forward.
The good news is that the Chinese government also has a plethora of valuable assets. According to the Ministry of Finance, total SOE assets were Rmb104 trillion in 2013, whilst the country also has vast infrastructure investments that could be listed. There is talk Beijing may crystallise the value of these assets and pay down significant portions of its outstanding debt. Other alternatives include listing SOEs or injecting SOE assets into listed companies. Allowing market determined prices side steps the potential problem of transparency. Expect further development of both the equity and markets to become more significant as a source of financing for the corporate sector.
Third, PBOC Governor Zhou Xiaochuan delivered an unexpected statement last month saying that deposit insurance will be established in the first half of this year and it is ‘very likely’ that China will complete interest rate liberalisation this year. By narrowing the margin between deposit and lending rates, the PBOC is forcing the hand of banks to pay savers something akin to the actual market price for cash. The PBOC has also simplified the benchmark structure, increasing competition and giving banks greater flexibility to chart their own course in setting rates. Premier Li also announced that there will be 30 new private banks that will be set up this year to help address the high financing costs facing SMEs.
Fourth, China plans to make the Renminbi capital account convertible by the end of 2015. In Governor Zhou’s words, ‘It is time to change the current policy that restrains Chinese individual residents from buying equity and financial products in overseas markets. Also the current scheme is not flexible enough to satisfy foreign residents’ investment needs on the mainland’. Beijing’s leaders are determined to increase China’s influence of the existing international financial system, which is why there has been a political battle to push forward the Asia Infrastructure Investment Bank, OBOR and RMB internationalisation. All are necessary prerequisites to the goal of Renminbi inclusion in the IMF Special Drawing Rights basket, which will cement China’s status as a global currency.
Finally, Xi Jinping’s One Belt One Road (OBOR) strategy is gathering pace and likely to form the backbone (alongside anti-corruption measures) of his legacy. The heart of the OBOR lies in the creation of a Silk Road Economic Belt that links China’s dynamic Yangtze River Delta, Pearl River Delta and Bohai sea economic zones to the European economy. Key to the success of the concept is the development of an unblocked road and rail network between China and Europe. OBOR will help China improve trade and aid exports for industries that are suffering from crippling levels of overcapacity. The plan leverages the country’s core strengths in infrastructure development and allows it to diversify its massive foreign reserves. The key point to note is that OBOR will have as much of an impact domestically as internationally. OBOR provides a national infrastructure plan for trade and urbanisation that will lead to far greater degree of spending rationalisation, in stark contrast to the fiscal profligacy and capital misallocation that has characterised projects over the past decade.
To sum up, the fixation for many investors towards China’s rally has been easier monetary policy and the CRSC turning on the Stock Connect taps. Whilst we agree that this has contributed to the strong market move, there is a far more significant factor underlying the moves. That is the progression of the reform agenda and government turning to ‘fully supportive mode ‘in relation to the stock market as an attractive alternative investment to historically higher yielding shadow banking products and property. The high number of new brokerage accounts being opened by domestic investors along with uncomfortable levels of margin debt being used to purchase stocks suggest the odds of a correction are rising (which will also negatively impact Hong Kong), but we do not feel that policy or valuations have reached extreme levels.
Overweight positions to China across our core and specialist equity funds have been maintained for some time, with the bulk of our exposure held via Hong Kong listed equities. Our focus within the funds is to concentrate on the key bottom-up task of identifying China’s best companies. In this respect, we continue to focus on strategic policy response beneficiaries (clean energy, e-commerce and mobile, infrastructure, selective financials) where visibility and the prospect of positive structural change are greatest within the practical constraints posed by the current political system.
(*denotes USD Total Return as at 17/04/15)
