What is going on in China?

During August investors dusted off their research reports about China as well as their text books on how a large economy makes the tough transition from investment/export-led to service/domestic demand-led growth. It appears the Chinese authorities intend to move away from a managed currency peg to a more ‘market-based’ exchange rate, in line with the IMF’s guidance on SDR (special drawing rights) basket eligibility. This likelihood triggered a major selling of risk assets as investors started to price in a ‘China Crisis’ on the basis that the idea of a smooth rebalancing is wishful thinking.

ChinaEquityMarket

Source: The Economist, Bloomberg, BNP Paribas Investment Partners

The economy

For us, China’s economy is entering a ‘new normal’ growth phase that will be more resource-efficient and involve higher domestic consumption and more ‘free’ market pricing for financial assets.

Source: Bloomberg, BNP Paribas Investment Partners

This is never going to be easy as such a transformation requires significant reforms in areas such as anti-corruption, local government control and the reduction of over-capacity.

Such changes will be positive in the longer term, but en route will have negative short-term impacts such as lower nominal growth.

The financial markets

We have seen a small devaluation of the renminbi, with a bigger reaction in the forward rates, but this has done little to reverse the currency appreciation against non-dollar currencies.

RMBVeryResilient_vs_USD

Source: Bloomberg, BNP Paribas Investment Partners

At the start of the year, the government undertook to rescue property companies as their debt burden became unsustainable. Since then there have been several interest rate cuts and shadow bank lending has been curbed by reform programmes. These factors have helped to reduce the interest rate burden.

ChinaBenchmarkDepositRateAndBankRRRRatio

Source: Bloomberg, BNP Paribas Investment Partners

At time of writing the A-share equity market has risen and fallen by 30% since the start of the year, returning to the level where it began. Valuations no longer look expensive against developed market equities, although the pressure on domestic earnings remains intense due to rising labour costs and lower overseas revenues because of the relatively strong renminbi. The one bright spot is that commodity prices have fallen, which should feed through into cheaper costs for manufacturers and consumers.

CyclicalAdjustedPE

Source: Bloomberg, BNP Paribas Investment Partners

What’s next?

China’s central planners still have many traditional policy tools to avoid a ‘hard landing’. We expect their next moves will be to cut rates, release more funds for the banks to lend, let the renminbi weaken and, as a final resort, return to the old ways of direct fiscal stimulus.

Doubtless there will be more pain as the investment boom overcapacity is closed, which will squeeze employment and put pressure on bank balance sheets (because of bad debts) and local government finances.

We anticipate a drawdown in FX reserves as the government attempts to stabilise financial markets. The unintended consequence is that US Treasuries will become a funding asset as reserves are drawn down, delivering a de facto tightening in US monetary policy.

We do not expect commodity prices to recover any time soon based on demand from China.

Conclusion – the rise and rise of China?

Our central case scenario places us firmly in the “China-will-be-fixed-in-the-longer–term” camp, but shorter term concerns remain. However, we believe the slowdown will not drag the global economy into either a recession or a deflationary spiral; in our view, the more likely conduit is through the financial linkages if China needs to repatriate overseas assets to stabilise the banking system or domestic asset prices.

We are at the point in the cycle where the pain of reform and economic slowdown have been priced in but the benefits of lower commodity prices and better governance have not yet borne fruit, so this upside is less recognised in asset prices.

 

Colin Graham is head of Active Asset Allocation, MAS at BNP Paribas Investment Partners

Tina Yao (HK) is portfolio manager, MAS at BNP Paribas Investment Partners

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