Country in Focus: China

February 26, 2016 | Emerging Markets

As long-term investors, we aim to see the big picture globally and keep our focus on the structural characteristics that should affect a country over time. China remains one of the countries where we see scope for continued outperformance in terms of economic growth, as well as a destination for many profitable investment opportunities. It has an enormous and increasingly educated population, continued urbanization, and rising wealth. China also has displayed a relentless climb up the value chain since the opening of its economy with its ascension to the World Trade Organization in 2001. Another positive is that the country has a clear-cut development plan, and its leaders have been implementing a broad-based, sweeping, and transformative reform agenda. In this sense, China is one of the few countries that largely controls its own destiny with regard to the sustainability of its economic development going forward.

This idea of “control” is of particular importance when it comes to analyzing China’s investment outlook, especially in regard to understanding the big picture. China’s one-party political system gives the government a degree of control that arguably no other major country can claim to match. There are several implications of this political structure that we must consider when investing in China as well as global industries—especially commodities—since the Chinese economy is now so large and important. While China’s form of government clearly comes with a host of issues (not least of which is a higher propensity for corruption and the potential for popular discontent), it also creates a form of uncertainty for outside observers who are not used to such a form of organizing a society and economy. This uncertainty leads to periodic anxiety about the short-term outlook for China, and markets have become more hypersensitive to certain developments as China has grown in economic prominence and clout. This dynamic has led to no shortage of declarations in recent years that Chinese authorities have “lost control.” These sensationalist headlines have periodically created buzzwords or phrases that have appeared throughout financial media, only to exit the popular lexicon within a year or so. A look back at coverage of China since the global financial crisis will yield such (not so) timeless classics as “ghost cities,” “housing crash,” “wealth management products,” and everyone’s favorite: “shadow banking.”

Given the opaque and mysterious nature of China’s political environment, it is not surprising that these concerns rise to the fore. However, given the level of control as well as the massive pool of resources available to China’s economic policymakers, it is also not surprising to see these issues fall off the front page and then out of the conversation all together. This is certainly not to make light of any of the new risks that do arise—and we investigate each with rigor—but the point is to keep our eye on the big picture and recognize the level of control that authorities have to manage short-term challenges. So despite a failure of any of the various fears du jour to materialize, we must acknowledge that China does have some serious issues to deal with. China’s growth since 2009 has been extremely reliant on debt creation, and its subsequent growth deceleration has been pronounced and impactful to global markets. In 2015, China grew at the slowest pace in 25 years, and the deflationary forces affecting the global economy have rendered China’s nominal growth even worse. China has again become a source of volatility in global markets, and the concerns are once more in the crescendo phase.

Our view is that recent volatility stems from two issues that have become increasingly intertwined: speculation regarding the future of China’s currency policy and the government’s heavy-handed intervention in stock markets. The narrative, which is becoming increasingly louder, is that given the weakness in the Chinese economy, authorities will seek to take an easy way out and massively devalue the currency so as to boost competitiveness and support the economy though the export sector. Chinese authorities have allowed the currency to depreciate some against the U.S. dollar in recent months, but we caution against extrapolating these moves to mean that a large scale devaluation is imminent.

While we do agree that in theory a weaker currency is tempting from the perspective of releasing pressure on the system, we also believe that the hurdle for such a drastic move remains quite high for several reasons. First, a strong currency is indeed consistent with China’s stated goals. They are seeking to manage a transition of the economy away from a heavy reliance on investment and exports to instead focus on household consumption as the main driver of growth. In our view, a strong currency would be beneficial to the consumer, as imports become more affordable. However, pegging its currency exclusively to the world’s strongest currency (the U.S. dollar) makes little sense given the current difficulties tied to the rebalancing and transition of the economy. We would expect China to target broad stability on a trade-weighted basis rather than wear a proverbial hair shirt by pegging its currency to an excessively strong U.S. dollar and making the transition more difficult. By following the U.S. dollar higher in the past year, China has indeed suffered a loss of competitiveness versus many of its regional trading partners, as measured by the surge in its trade-weighted real effective exchange rate. We think it makes sense for China to broadly aim for a strong currency, but not necessarily the strongest currency in the world over any particular time period.

Besides us being of the view that a strong currency helps to achieve China’s goals in terms of rebalancing the economy, there are a couple of other reasons why a large scale competitive devaluation is a low-probability event, in our opinion. It is important to consider that China is seeking to internationalize the use of the renminbi, particularly in trade. This trend remains intact (as measured by the proportion of total Chinese trade settled in renminbi today versus five years ago), and also requires China to develop a pool of renminbi assets in which trading partners can invest. A competitive devaluation would essentially devalue those assets in terms of the local currency of trading partners, and would dramatically damage the trust that is necessary to increase trade in renminbi. Furthermore, we do not believe that competitive devaluations yield as much in terms of export led growth as they used to. There is an increasing amount of evidence that in a weak demand world, where supply chains are increasingly virtualized, countries are not getting as much “bang for their buck,” so to speak, from devaluing. This is likely to be especially true for China, as its share of global exports has grown so large that it will be incrementally harder to gain share by devaluing. All of these factors argue against a meaningful competitive devaluation, and that is before we even consider political pushback from trading partners (especially the U.S.) or the possibility of the renminbi losing its status in the International Monetary Fund’s Special Drawing Right. We expect that the currency will remain broadly stable against a basket of trading partner currencies, and that any fluctuations against the U.S. dollar will have more to do with broad movements of the dollar rather than any decision in Beijing.

The Chinese government’s poor communication of its goals with respect to currency policy has caused fears of devaluation, which has added to selling pressure in stock markets. The failure to allow markets to settle and price risk, despite repeated official promises to let market forces play a more decisive role in the economy, has lead to more jitters, ultimately forcing investors to question whether all of China’s economic bureaucrats are on the same page. This has led to an overall loss of confidence and a negative feedback loop of anxieties over whether policymakers are capable of managing the slowing economy. While the repeated botched attempts at managing stock markets are certainly disconcerting to us, we continue to believe that policymakers have the tools necessary to manage the economy and guide the transition toward a more consumer and service-sector driven system. Although foreign exchange reserves have fallen, China still has a large pool of reserves as well as substantial scope to loosen fiscal and monetary policy, should officials deem such moves as necessary. Additionally, the government has the ability to tighten capital controls should capital outflows continue to put pressure on the currency‘s value.

Our view is that the current thrust of Chinese fiscal and monetary policy is being conducted with the goal of supporting economic growth—or putting a floor under it—rather than trying to meaningfully propel it higher. This is a critical differentiation in our view, and it has led us to thinking about the bigger picture and observing Chinese developments in the context of the broader changes that have taken place in recent years. One such development has to do with demographics. Around 2015, China’s working-age population actually started to shrink, which marked a dramatic reversal from the past decade. The implication is that it is naturally less imperative for policymakers to engineer growth at any cost in order to create enough jobs to keep the people out of the streets. This is one reason why we believe Chinese policymakers have been less radical in their reaction to a softer growth environment. Secondly, we have observed a genuine shift in mindset away from growth at all costs, and instead are seeing a realization among Chinese authorities that there are limits to debt-fueled investment booms. Not only do they result in a burdensome debt load, but such frantic pursuit of growth in the past few years has also led to a relatively new phenomenon in Chinese society: an increased awareness of the environmental costs of rapid industrial expansion. Polls have shown a dramatic surge in terms of people identifying air and water pollution as major issues facing the country.

Finally, no discussion about the Chinese economy would be complete without a thorough examination of the political undercurrents that are driving major policy decisions. Our view is that the most important theme regarding the current political climate is by far President Xi Jinping’s anti-corruption drive. We view Xi’s moves as one of the most important political developments in modern Chinese history. While the anti-corruption drive is part of a reaction to shifts in popular sentiment (corruption joins pollution as one of the top relatively new concerns according to various polls), we also believe that there are some broader political motivations behind the ongoing purge. The shift in opinion polls about the perception of corruption has given Xi a very convenient excuse to consolidate his power. The next party congress is in late 2017, and it is possible that settling political issues is seen as a necessary step and top priority before China’s economic reforms can be carried out in earnest. Therefore, the anti-corruption drive/power grab may be the best explanation that we can offer as to why China has yet to use its full set of tools to stimulate the economy in a big way. We also happen to believe that the intensity of the risks facing China largely emanate from the political realm rather than the economic or financial realm. An historic purge such as the one we are witnessing is extremely unlikely to go over smoothly with many of Xi’s rivals. Since the factionalism in Chinese politics is not laid bare to the extent that it is in U.S. politics, internal political risks remain very difficult to handicap.

Over the medium- to long-term, we expect that China’s GDP growth will probably continue to slow on a structural basis, but as authorities continue to implement reforms, this slower average growth could involve higher investment returns as capital is allocated more efficiently. We expect the government to continue to support the consumer side of the economy, which was suppressed during China’s rapid industrial development. We think that authorities have the tools to manage short-term challenges, and that they will continue to seek to provide an environment that will facilitate the ongoing development of the services sector, which is now the largest component of the economy. Last but not least, we expect periodic fears about China to generate headlines that will come and go. However, if we focus on the big picture, we will be able to see through the short-term fluctuations and identify profitable, long-term investments in a country which we believe still has many positive, structural tailwinds that should play out over time.

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