We have long been confident that China’s policymakers could steer the nation towards sustainable growth – no matter how rough the road. But has stock-market turbulence, excess debt and the industrial slowdown forced us to change our view?
Excessive leverage in the system, coupled with over capacity in a number of sectors, represent two of the major risks that China is facing. On top of these domestic issues, capital flight and pressure to maintain the renminbi at what is probably an overvalued level – which requires spending hard-earned reserves – put China’s policymakers in an unenviable position.
We believe China's leaders recognise the mistake made by stimulating the economy during the financial crisis and are clear in their intention to reduce overcapacity by initiating supply-side reforms. The problem is that this will inevitably result in a further industrial slowdown, and, we calculate, several million new unemployed people. If China can weather this slowdown in the medium term – and we think it can – this structural economic change should support growth based on market demand and environmental exigencies.
We have been waiting for this to happen for the last several years. It is starting late, in the middle of a global industrial slowdown and where Chinese leverage is very high. The rebalancing that needs to take place is of epic dimensions and the economy still adds too little value to its production. State-owned enterprise reform, which we have focused on in an earlier commentary, and the reduction of excess capacity represent important steps towards a more efficient economy, but will result in job losses restraining consumer purchasing power and making the transition from an investment led to a consumption led economy somewhat more difficult.
New industries and ageing workers
Chinese leaders are focused on fostering innovation, intellectual property-based products and services, and seeing domestic businesses move up the value chain in order to maintain a decent level of growth. China’s key position in the global electronic supply chain, not to mention its status as the world's second-largest economy, suggest that it will continue to progress towards these objectives. However, its lack of an open financial system, and the absence of a cluster of experienced angel investors to support innovative technologies, will make competing with Silicon Valley - not to mention Taiwan - a tough challenge. In addition, a weak external environment will provide little support from exports. Finally, demographics have turned from a tailwind into a headwind, as the population ages and the economy passes the Lewis point, meaning that the advantages from urbanisation will become much harder to come by.
What to do with the renminbi?
China, therefore, faces difficult policy choices. If the central bank decides to let the renminbi find its own level (which could be between 5% and 35% lower) all at once, it could boost China’s competitiveness but would serve a deflationary shock to the rest of the world, wreaking havoc on China's trading partners and thereby negating any real benefit. Recently, we have been reflecting on how China will weigh the cost of releasing this shock against the prospect of spending (perhaps most of) its foreign-exchange reserves defending the currency. According to some estimates, $700bn to $800bn has already left the country in 2015 and more could follow if greater capital controls are not put in place. We understand the attraction of letting the currency float freely and find a "natural" equilibrium, wherever that may be.
We believe that China’s problems are not insurmountable and that its policy makers have the necessary tools to deal with them. It may take time for the volatility in the markets to recede; particularly since the risk of a serious devaluation of the renminbi cannot be ruled out. Multilateral pressure to maintain an orderly depreciation of the currency, however, is difficult to handicap. Therefore we have decided to adopt a neutral weight and stay with our existing Chinese positions, which include a number of exporters and fundamentally strong companies which we think will weather the storm, should it occur.
The views and opinions contained herein are those of Hermes Emerging Markets, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.
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Gary Greenberg, CFA
Head of Hermes Emerging Markets and Lead Portfolio Manager