A marginally more upbeat tone to recent business confidence readings, alongside some tentative signs of stabilisation in the property market has seen the MSCI China index return close to 17% since the beginning of May in dollar terms. Over the same time, the wider MSCI Emerging Markets index has returned 7%, while developed markets are more or less treading water. Nonetheless, of these three indices, the MSCI China is by some distance the worst performer over the last five years, weighed down by some of the aforementioned fears.
In recent years, only Spain and Ireland have managed to grow their debt piles as quickly as China has in the last five years. That this surge in credit has taken place alongside a slowdown in the economy’s growth rate has understandably prompted many to fear the worst for the Chinese economy. To such critics, policy makers seemingly face an impossible conundrum – if they don’t curb credit growth to a pace in line with nominal GDP growth, the economy faces the sort of bad debt fuelled economic melt down that parts of the Western world are still labouring to put behind them several years on. If, on the other hand, the authorities do decide to curb credit growth to a more palatable level, economic output will plunge anyway. Widespread social unrest and political upheaval are all but inevitable?
The authorities seem so far to have chosen a different path, allowing credit growth to continue, albeit at a marginally lower trajectory, while pursuing an ambitious reform agenda. Key to understanding this policy path is the fact that a large proportion of this credit mountain is owed by two main actors in the economy – the state-owned enterprises and the local governments. In the case of the former, the absence of a more vibrant competitive environment has tended to create turgid corporate monoliths; in more recent times boosting leverage in an increasingly futile attempt to prop up ailing returns.
For the latter, part of the problem is a simple mismatch between revenues and expenditures. The central government generally expects local governments to be responsible for over four fifths of total government expenditure, though only receiving half of the revenues. In large part, local governments have been funding this gap off balance sheet, by grabbing land and selling it on to local developers.
Allowing credit to continue growing faster than economic output in the short term is essentially buying the authorities time to enact the necessary reforms to these two segments of the economy. For local governments, the likely protracted birth of a municipal bond market may serve the dual purpose of bringing funding back on balance sheet as well as forcing a greater degree of transparency and governance. For the latter there are a number of measures; last month, trials of a mixed ownership structure were announced, again perhaps helping to force greater accountability and enhanced corporate governance. Moves to level the playing field in terms of access to capital will also be important in letting the more dynamic private sector play a larger role in the wider economy.
Or economic adolescent?
Also important in buying the authorities’ time is the fact that China remains, in economic terms, an adolescent relative to the US. For example, China has only just passed the milestone of more of its citizens living in cities than in rural areas, whereas the more developed economies in the West now house closer to 80% of their citizens in cities. The pace of urbanisation will naturally slow from here, accentuating existing mismatches in the property market, but it still serves as a good example of the medium term growth headroom that the Chinese economy still enjoys. Growth tends to allow an economy to more comfortably sustain a higher level of aggregate indebtedness than a slower moving, more mature, economy. The UK economy in the early 19th century is a good example of this.
However, part of this theoretical economic headroom is based on the idea that the authorities start to allow the market a greater role in allocating capital to where it will be used most effectively as the pilot reforms mentioned above would suggest. Official statistics show that Chinese annual corporate failures (as a proportion of all its existing corporations) persistently run at a little over half the level of US annual corporate failures and three quarters of the level seen in the UK. Data shows the sector distribution of those corporate failures, supporting the idea that the state is still playing a dominant role in how capital is allocated in the economy. Part of the continuing success of the US economy is based on the idea that intense competition for capital results in its relatively efficient use. That these forces are slowly being unleashed in the Chinese economy is a positive, even if it does suggest a greater level of uncertainty.
Longer term reasons for optimism
Data illustrates how little of China’s past GDP growth has actually reached corporate earnings, relative to the US quoted corporate sector. The more decisive role to be played by market forces in pending reforms may start to slowly change this – in such a world, a lower pace of economic growth might actually support more generous returns from the Chinese quoted corporate sector.
Not only do we expect a greater proportion of economic growth to be reflected in the corporate sector’s earnings line, but we also have good reasons to be positive on the long-term trajectory of the economy.
While many would point to the relatively less attractive demographic profile of the Chinese economy over coming decades as a reason to prepare for a bleaker future, we would argue that the potential to make better use of the human capital they already possess is a reason for significant optimism.
Julian Simon, one of the less dismal economists of the last two hundred years, was known for his belief in mankind as the ultimate resource. This belief was founded on our track record of perpetual innovation and problem solving – we essentially can’t stop ourselves from looking for ways to improve everything we do. This ability, as we have regularly suggested in this publication, is behind the near constant and broad-based improvements in living standards over the millennia of recorded human history.
The implication is that life gets better as populations get larger, because this means more human capital capable of innovation. Education is obviously a vital input to maximising human capital’s potential and this is an area where China (and the wider emerging markets) is catching up rapidly. In just over a decade to 2011, China increased the population enrolled in tertiary education by over three times, equating to over 20 million people.
Some of this educational catch up is already being translated into greater innovation, reflected in the number of patents submitted. As ever greater numbers of Chinese citizens gain access to a better education, it is hard to imagine the long-term economic trajectory of both China and the wider world not being influenced positively.
We know that much of the misallocated capital of the last few years in China is yet to come home to roost on bank balance sheets – much recent lending is unlikely to ever earn investors the promised returns. We know that, at some point, the Chinese government needs to subsume at least some of those debts on to its own relatively less strained balance sheet, thereby freeing up capital to chase more profitable investment. This process is unlikely to happen without causing some upset in capital markets. Furthermore, the actual aggregate level of gross indebtedness of the Chinese economy is still a matter of guesswork, while the reform agenda would be daunting for an economy a fraction of the size and regional influence of China. The widening net of the ongoing anti corruption drive may even have unpredictable political ramifications to add a further item for investors to worry about.
Nonetheless, the recent bounce in Chinese equities looks easily justifiable, as the housing market stabilises, business confidence indicators point to brighter times ahead and the equity market trades close to a standard deviation below its rolling average trend forecast price to earnings ratio (PE). There can be no doubt that many of the sectors that have dragging the index down over the last few years, deserve to be trading on low single digit multiples -financials, for instance, are trading on little over 5x forecast earnings for a good reason, as investors probably rightly doubt the forecast earnings/book value. However, if the Chinese authorities continue to effectively manage the required slow down in credit growth over time, while allowing the market forces a more decisive role, today’s level will likely prove an attractive opportunity in the years ahead.
As noted above, Chinese equities remain a bet for those able to look beyond a still very uncertain short-term time frame and focus on the likely fruits of ongoing economic liberalisation. For now, the potential for a policy misstep, a further set back in the housing market and looming monetary policy normalisation in the US and UK to suck more footloose capital from the region are among the reasons holding us back from a more positive near-term stance.