Economic commentary: Silver linings in China's market jitters

On 1st July 2021, the Chinese Communist Party celebrated its 100th anniversary. China has come a long way during those 100 years, particularly since 1978 when Deng Xiaoping initiated policies to modernise and open up the economy, a process that was accelerated by the country’s accession to the World Trade Organisation in 2001. Following a period of rapid growth, China has become the world’s largest exporter of goods and the second-biggest economy. Moreover, Chinese companies typically make up around one third of emerging market equity indices1 and investor exposure to the country has risen sharply in recent years2.

It therefore goes without saying that what happens in China matters for the world economy and the portfolios of global investors. One might have expected 2021 to be a good year for investors in China. The widespread disruption from coronavirus appeared to be in the rear-view mirror, and the defeat of President Donald Trump in the November 2020 US election held out the prospect for an end to the US-China trade war and better relations between the two countries. Alas, this has generally not been the case; the iShares MSCI China ETF is down around 5% year to date, compared with gains of around 13% in the US and Europe3.

There are a number of reasons that help explain this poor performance, including geopolitical, economic, and regulatory factors. 

US-China decoupling

Anyone hoping for a thawing of US-China relations under US President Joe Biden will have been disappointed. Most of the tariffs on Chinese imports imposed under President Trump remain in place4 and, in some areas, the so-called “US-China decoupling” has accelerated under Biden. This has been particularly apparent in the area of technology (e.g., the blacklisting of several Chinese tech firms, and curbs on US investment), but tensions over a range of factors (e.g., Hong Kong, Taiwan, the treatment of Uyghurs in Xinjiang) have also risen.

Credit curbs

Concerns regarding a dialling back of stimulus have also played on investors’ nerves. As China was the first in and first out of the pandemic, and because much of its economic rebound occurred during 2020, the country has been early in seeing a ‘normalisation’ of both policy and economic growth. With Beijing still wary about financial stability and elevated levels of debt, last year’s rapid ‘V-shaped’ recovery has enabled the authorities to refocus away from pandemic support measures and back to deleveraging. Rather than tighten policy via traditional hikes in interest rates, this drive to limit the build-up in debt has come about via tighter regulation, a clampdown on so-called ‘shadow banks’ (including peer-to-peer lenders and fintech companies), and curbs on lending5. As a result, measures of credit growth have seen a significant slowdown during the first half of the year6.

Slower growth  

Given the key role of debt in driving the Chinese economy in recent years, weaker credit growth has given rise to fears that the economy is about to experience a sharp slowdown. Growth data for the second quarter were not as weak as some had feared (GDP rose 1.3% q/q after a 0.6% expansion in Q17 ). However, one measure of activity, the Caixin composite PMI, showed the economy expanding at its weakest pace in 14 months in June8. Although exports have remained strong (despite disruption at ports due to recent covid outbreaks), domestic demand has lagged as a result of weaker growth in household incomes and tighter lending conditions9

Corporate bond defaults

In turn, a more challenging growth and credit backdrop has resulted in a rise in companies defaulting on their debt repayments. According to the ratings agency Fitch, corporate bond defaults by Chinese companies rose to a record Yuan 62.6 billion during the first half of 202110. Moreover, with defaults by state-owned enterprises (SOEs) increasing markedly, there is a growing concern amongst investors that the authorities are no longer prepared to guarantee debt that was previously thought of as government-backed, and therefore safe. Furthermore, heightened investor caution has meant that, unlike in the US and Europe, Chinese companies have found it difficult to issue bonds with longer maturities, with the result that they face sustained risks in rolling over and refinancing debt11

Tech crackdown

Perhaps the most visible factor weighing on Chinese equity markets this year has been Beijing’s crackdown on the big internet companies. During recent months, Beijing has stepped up regulatory efforts in three broad areas: antitrust (several companies including Tencent, Alibaba, and Meituan have been fined by regulators for anti-competitive practices, including acquiring stakes in other companies that might increase market power12); financial technology (fintech companies such as Ant Group have been subject to increased scrutiny and forced restructuring13); and data protection (Didi Chuxing, a Chinese ride hailing company that had recently listed its shares on the New York Stock Exchange, had its app removed from Chinese app stores following alleged illegal collection and use of personal data14). 

Unsurprisingly, companies that have drawn the attention of the authorities have seen their share prices hit, and policy uncertainty has undermined sentiment in the online sector more broadly. According to a recent Bloomberg report, over US$800 billion has been wiped off the market value of China’s large internet companies since their share prices peaked in mid-February15. Given that the internet giants make up such a large share of some Chinese equity indices (Tencent, Alibaba, and Meituan alone account for 31% of the iShares MSCI China ETF16) recent falls have been a big factor behind recent underperformance. 

Quality vs. quantity

Given such a long list of risk factors, it is not surprising that Chinese markets are suffering a bout of the jitters. However, politics aside and from a pure investment perspective, it might be possible to see a silver lining in some of the recent news flow. Beijing’s current focus on the quality of economic growth and its deleveraging campaign (evident in this year’s seemingly unambitious ‘above 6%’ GDP growth target17) might make for a more financially stable economy that is less prone to boom and bust. Similarly, the removal of implicit government backing for state-owned enterprises and the associated rise in bond defaults could ultimately reduce the number of loss-making ‘zombie’ companies, and thereby lead to a more efficient allocation of capital and more productive investment. 

Policy limits

Investors are understandably worried that Beijing’s push for increased political control and long-term financial stability may come at too high a price. A tamed and subservient tech sector might stifle innovation and curb expansion in the digital economy, which has become an increasingly important source of economic growth in recent years. Overly aggressive curbs on credit could see the economy slow sharply while rising corporate bond defaults could result in contagion and heightened systemic risk. 

The question then becomes whether Beijing will change tack if the near-term risks to the economy and financial markets become too great. Certain events of late might suggest that such policy limits are starting to be tested. For example, the fact that Beijing has stopped short of letting Huarong Asset Management – a troubled, but systemically important, financial conglomerate which unnerved investors earlier this year when it failed to release its accounts for 2020 – miss its debt repayments18 might suggest that the authorities are still willing to support companies whose failure could trigger short-term financial turbulence. 

Moreover, the decision by the People’s Bank of China to cut the reserve requirement ratio (RRR - the amount of cash that banks must hold as reserves rather than lend out) by 50 basis points from 15th July19 suggests the authorities are moving to ease monetary policy in order to support the financial system and the economy. A pessimistic interpretation of the move – which will release around Yuan 1 trillion of liquidity – is that the banking sector and/or the economy is in worse shape than is immediately apparent. A more optimistic reading is that the easing, and the possibility of more to come, will ultimately facilitate a loosening in financial conditions, a pick-up in lending, and stronger economic activity going forward. 

Indeed, some observers, including analysts at UBS, take the view that the recent pull-back in Chinese equities represents a good entry point for investors, citing attractive valuations and a favourable earnings outlook20. Moreover, although recent attention has focused on the woes of the tech mega caps, some other parts of the Chinese market have fared better. By way of example, the iShares MSCI China Small Cap ETF is up 13% since the start of the year21. All of this suggests that, despite the recent string of negative headlines, China has and will continue to provide opportunities for investors.

20th July 2021



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