China gets serious on reform, says Pictet’s Lan Wang Simond

Lan Wang Simond, head and senior investment manager on the Pictet Total Return Mandarin, a long/short equity fund investing in Greater China, says that volatility is to be expected as China adjusts the structure of its economy.

A cash crunch and decelerating industrial activity have fuelled concerns that China’s economy could be facing a sharp slowdown. In this Q&A, the manager of Pictet’s Greater China long-short strategy, Lan Wang Simond, says short-term pain is a long-term gain for investors.

Is China facing a hard landing?

I would say that the probability of a hard landing remains low although it will rise if the government does not execute its reform plans well.

The authorities are sticking to their 7.5% growth target for 2013, but they have also opted for a more risky economic strategy – pushing forward structural reforms to get a long term payoff when facing softening growth at home and sluggish recovery abroad.

This would suggest that Beijing is ready to sacrifice some growth in the short term in order to achieve more sustainable expansion over the longer run. Although these changes will be painful initially, reform is clearly needed, as the current economic growth model – which is heavily reliant on exports and investment – is breaking down. Hence, we think that investors should see these developments as a long-awaited move for the better, and not as a threat.

In many ways, the current situation is reminiscent of the mid 1990s when the Chinese government had to deal with the effects of runaway inflation and a huge, inefficient state-owned enterprise sector. Premier Zhu Rongji, the leader at the time, did not choose the easy way out then and pushed through the privatisation of state-owned enterprises in order to boost competitiveness, at the cost of a surge in unemployment and bad debts in the banking sector. The reforms were extremely painful, but were the necessary condition for the low-inflation boom of the following decade.

As the current government attempts to follow the same path, investors will need patience to see results, especially after years of stellar rates of economic growth. Nevertheless, despite some difficulties ahead, we believe that China will ultimately end up a much more balanced economy than what it is now, with a larger consumer base and less dependent on exports and investment.

What is the cause of the stress in the Chinese interbank market? Is a financial crisis in the making?

Over the past few weeks, the central bank has attempted to impose discipline on banks (especially smaller ones) to reduce leverage and liquidity risk. It chose not to intervene when a liquidity squeeze sent the Shanghai Interbank Liquidity Rate (SHIBOR), the benchmark rate used in lending activities between banks, out of its usual range of 3% to 4% to spike above 13% on 20 June. There have been such spikes in the past, but the People’s Bank of China was always ready to correct the surge by providing extra liquidity. This time around, the central bank deliberately held back its rescue, with the aim of exposing shadow banking and sending a warning to the sector. The cash crunch was therefore a policy signal, engineered by the government.

However, here again reforms are the only real solution to the risk that shadow banking poses to the country’s financial stability. The fundamental way to rein in shadow activity is to deregulate the interest-rate market, thus closing the gap between official interest rates and their market-driven counterparts. There have been signs that the new government may soon take bold action to liberalise interest rates somewhat, which is an integral part of making the renminbi a fully convertible currency in China’s capital account. The government is also seeking to allow private capital into state monopoly sectors and reduce state intervention in decision-making. Such changes will create uncertainties for state-owned monopolies, especially banks.

With these reforms, China could remove the obstacles that hinder the country’s transition to a fully-functioning market economy. Yet the liquidity crisis damaged sentiment, and will probably lead to volatility in Chinese financial markets and some disruption in the allocation of credit, negatively affecting companies’ financing. There will be other longer term implications. If banks heed the authorities’ warnings, they should start to shift more of their lending back onto their balance sheets. Overall credit growth (total social financing) will inevitably slow down and the risk of negative credit events in the non-banking financial system – trusts and irregular lending entities – cannot be ruled out.

It is worth noting, however, that the probability of a damaging systemic disruption in the financial system is fairly low, given that all major banks and financial institutions are state-owned or state-controlled.

What does it mean for markets?

Uncertainty and negative headlines are discouraging investors from allocating capital to China. Confidence is also quite low, notably for mainland investors (the A-Share market has been particularly weak), which in turn is affecting sentiment among international investors. But on the positive side, as investors have become overwhelmingly bearish stocks are already trading at single-digit price-to-earnings ratios. Unless profits contract materially, we do not see much downside from current levels.

China’s gradual policy steps to adjust to a market-economy will create volatility in the short and medium term. The previous batch of bold reforms paved the way for many years of economic expansion and a massive bull market in stocks. If new macro- and microeconomic reforms begin to bear fruit, a bull market in stocks may well be in prospect, particularly given the low level of equity valuations.

 

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