Three key fears to investing in China

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Declining Growth

China is experiencing its slowest growth for 15 years, and may not meet its 7.5% target for 2014. The International Monetary Fund typifies this caution, and in June lowered its 2014 growth forecast from 7.3% to 7%.

We are not extremely worried about slowing growth, providing growth is accompanied by reforms that put the Chinese market on a better long-term footing. Over the previous decade, the earnings growth of Chinese companies had been(has been) diluted, with capital having been channelled towards breakneck expansion rather than generating shareholder value.

Ultimately, slower economic growth brings benefits: lower capex spend for companies will mean a reduction in the pressure to issue new shares, allowing EPS growth to come back into line with earnings growth. Capital itself can be turned to more profitable ends or returned to shareholders.

Tide of debt

There are serious concerns the economy is being kept afloat on a wave of debt – credit creation has increased 16% year-on-year, more than double GDP growth.   Since the crisis, China’s economic rescue efforts have (has) produced three credit-fuelled investment booms: in infrastructure (2009), real estate (2010), and mining and manufacturing (2011). Growth was sustained through pump-priming the predominantly state-owned enterprises in these areas, creating excessive leverage.

The government now has to perform the delicate manoeuvre of streamlining the state-owned enterprises, while deflating the credit bubble in a controlled fashion. This will allow efficient companies to effectively compete, but at a pace that does not cause indebted state-owned enterprises to collapse before private industry can take up the slack. This may explain the recent mini-stimulus and seemingly slow pace of reform over 2014.

Property Bubble

China over the past quarter century has become the world’s largest building site. Despite a slowing in infrastructure spend; rapid housing construction has resulted in market glut and a sharp fall in housing prices. This has sparked fears of a major property bubble.

However, there are policy options available for dealing with the property bubble, such as shanty town relocation to areas with high vacancy rates. In addition, reforms providing the huge unregistered workforce with work permits would both create housing demand and increase labour force participation in more skilled industries.

Conclusion

Over the long term, we believe China is on the right path. But currently there is short-term pain as the market digests the new realities of the economic outlook.

Our Hermes Global Emerging Markets Fund has a 30.1% allocation to China, which is almost a 10.6% overweight against the MSCI Emerging Markets Index. We are exposed to the Chinese consumer, internet user, and business services user – areas which continue to grow robustly – with minimal exposure to the high-risk areas of property and banks.

 

Gary Greenberg is head of Hermes Emerging Markets

 

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