China: the elephant in the room

“Twenty years on from the Asian Financial Crisis, the question remains: did China escape the crisis or simply defer it?”

It all started with Thailand. Following a period of high, largely credit fuelled growth, concerns began over the state of the country’s economy throughout 1996 and particularly in the first half of 1997, putting pressure on the Thai Baht. On 2nd July 1997, after the government had depleted reserves to fight against speculative currency attacks, the decision was made to stop propping up the currency. This was the catalyst for a series of devaluations across the region, and so began the Asian Financial Crisis. Thailand, Indonesia, South Korea and Malaysia, four of the faster growing economies in the region, were the hardest hit, but China came out the other side relatively unscathed.

Soaring debt levels
High levels of debt contributed to the downward spiral of the crisis. High domestic interest rates led companies to borrow in foreign currencies at low interest rates, so when local currencies started to fall it became a vicious circle where huge levels of debt became much harder to pay back. This led to the International Monetary Fund bailing out some of the most affected countries in an effort to stabilise their economies.

China did not reach this level of despair. It remained unaffected by the problems of overvalued currencies, current account deficits and falling returns on investments. It managed to bypass the so-called “Asian Contagion” and remain insulated from the effects of the Thai-led crisis. But the question we must ask ourselves is: did China escape the crisis or just simply defer it?

Hindsight is a wonderful thing
This shocking period brought about change for the former Tiger and fast growing Asian economies. The severity of the event inspired a change that a mild recession may not have done. Since then, we have seen corporate governance and dividend pay-out ratios improve across the region. The average ratio has increased from 30% to 40% in 2001[1] and has remained around this level ever since. Arguably, corruption and nepotism that was apparent in some of these countries during that period has been seen to improve.

However, countries that weren’t affected didn’t learn so much. Debt levels in China have grown the most rapidly over the past eight years, whereas countries elsewhere have been shy about taking on more debt and especially foreign debt as they still bear the scars of the Asian crisis.

Capital controls, a weaker currency and lower debt levels may have protected China from the crisis two decades ago, but concerns are growing that the country’s current financial situation leaves it vulnerable to a full-blown crisis that could have a ripple effect across the entire region. The government’s preferred method of propping up the economy each time a downturn has appeared to be imminent over the last decade or so has been to increase in infrastructure investment. However there are limits to this as further spending is likely to have less of an investment case then in the past i.e. returns on investment are likely to be lower looking ahead as so much has been invested already.

China’s total debt-to-GDP ratio soared to nearly 280% by the end of 2016[2]. Unprecedented levels of leverage are building up in the system, and in my opinion, China’s debt-fuelled growth is simply unsustainable – a view that is shared by ratings agency Moody’s who downgraded Chinese sovereign debt just last month, citing the same concerns.

Outlook for China
Predicting the future of a command economy is extremely difficult, but history shows that every economy eventually has to go through a recession at some stage. A period of high growth cannot simply transition to a period of low growth. If China were to see its economy contract, it would cause major headaches for other countries as it is by far the biggest economy in the region. It would be those closest to it geographically, and those who trade with it, that would be the worst-affected. For example, somewhere like the Philippines probably wouldn’t be affected as much as Brazil, and Thailand not as much as South Africa.

A significant difference between the crisis twenty years ago, and a potential one now, is that it would stem from economically very different sized regions. Today, a relatively small economy like Thailand wouldn’t have the same contagion effect as it did twenty years ago, but the downturn of a major player like China would have vast implications for Asia and the rest of the world.

Investor opinion
We, like many investors, are fully aware of the issues that exist in a command economy like China. That does not go to say that we do not see the potential for investment, but we choose to have a medium-to-long term view, which does call for some caution. An issue we are particularly mindful of is the potential for market bubbles. Capital controls in China prevent savers from taking their money out of the country easily; as a result, they tend to pile their capital too easily in the ‘hot market asset’ of the moment , until momentum builds and a bubble is created. When the bubble bursts, they move on to the next ‘hot’ investment opportunity. As an investor looking at the medium to long-term, these bubbles are pitfalls that need to be avoided.

Jason Pidcock, manager of the Jupiter Asian Income Fund

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