The rise and ???? of China

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– An economic ‘hard landing’ for China is not our base case scenario.

– China’s policymakers have many options at their disposal to smooth the ill effects of the policies they are pursuing, while also maintaining progress towards a market-based economy.

– Chinese equity valuations no longer look expensive against developed markets. There’s scope for the renminbi to weaken further without it being a drama – the currency has held up much better versus the US dollar than other currencies.


What’s going on in China?

During August investors dusted off their research reports about China as well as text books on how a large economy makes the tough transition from investment/export-led to service/domestic demand-led growth. It would appear that 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.

Exhibit 1: Valuations of Chinese equities (CSI 300 index) for the period from January 2010 – 04/09/15


Source: Bloomberg, BNP Paribas Asset Management, as of 04/09/2015

China’s 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.

Exhibit 2: Changes in the composition of China’s rail traffic illustrate the shift from an ‘old economy’ (where the freight traffic was a bigger part of the traffic) to a ‘new economy’ (where passenger traffic is rising).


Source: Bloomberg, BNP Paribas Asset Management, as of 09/09/2015

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

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

The financial markets

In August we saw a small devaluation of the renminbi, with a bigger reaction in the forward rates, but this has done little to reverse the renminbi’s appreciation against non-US dollar currencies.

Exhibit 3: On a relative basis, the renminbi (green line) has held up much better versus the US dollar than either other emerging market currencies (blue line) or developed market currencies (red line).


Source: Bloomberg, BNP Paribas Asset Management, as of 09/09/2015

At the start of 2015, the government undertook to rescue property companies as their debt burden become 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.

Exhibit 4: Changes to China’s policy rates for the period from October 2006 through July 2015.


Source: Bloomberg, BNP Paribas Asset Management, as of 09/09/2015

Between 1 January and 4 September 2015 the A-share equity market rose and fell by 30%, returning to the levels where it began the year. Valuations no longer look expensive against developed market equities. However, the pressure on domestic earnings remains intense due to rising labour costs and lower overseas revenues (due to 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.

Exhibit 5: On the basis of the cyclically adjusted price/earnings ratio, China’s equity markets are now cheaper than those in developed markets.


Source: Bloomberg, BNP Paribas Asset Management, as of 09/09/2015

What’s next for China?

China’s central planners still have many traditional policy tools to employ in avoiding 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 (via impaired debts) and local government finances.

We anticipate a draw down in China’s foreign exchange 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.

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

Head of Active Asset Allocation and Chief Investment Officer of the Multi Asset Solutions team

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