When it comes to China, it is not simply about the capital markets. China sports the world’s second largest economy and is often the largest buyer of many seaborne commodities. And so far in 2016, it has been a gong show including complete market closures, changing investor rules and most recently some good old fashioned government market intervention. Global markets have reacted to this source of turmoil, but the question remains: “Does it really matter to us as North American based investors?”
When looking at the Chinese equity markets, we’re not sure we should care too much about the actual market. Global markets have clearly not reacted well to the two daily declines of 7% this past week and halting of the entire exchange. The first catalyst was a rumour that the regulators were going to suspend a short sale ban that has kept a reported ~$185 billion off the market. Subsequently, they decided to extend the ban in order to calm the markets. The second driver was a significant devaluation of yuan by the People’s Bank of China (PBOC). China has also backtracked on that move. Basically, the Chinese markets are confusing…
That said, the volatility is not surprising considering how unsophisticated China’s market is. One university study found that 2/3 of the new investors at the end of 2014 did not have a high school diploma. Along the same lines, individuals account for at least 80% of trading on the mainland exchanges. In other words, there are many speculators and few investors. China’s markets are undeveloped and relatively unimportant. Nonetheless, they may offer some clues into consumer sentiment and the government’s ability (or inability) to control the economy.
The Chinese Economy is the bigger issue than their young equity market. The economy is slowing and becoming more balanced, but this continues to have global repercussions. Government investment has been a big part of China’s economy. Massive amounts of stimulus went into factories, leading to overcapacity in sectors such as coal and steel. This is making it very difficult for companies that operate within those sectors to make profits – both domestically and abroad. Fiscal stimulus also went into housing and infrastructure, which are both clearly overbuilt. Despite the overcapacity, gross capital formation still represents ~46% of GDP. That is more than twice as high as it is in both the U.S. and the European Union.
China’s aggregate debt level is one of the highest in the world. On the surface it may not seem very high; China’s government debt to GDP ratio is 55%. To put that in perspective, the U.S. and Japan are at 89% and 234%, respectively. Even so, it is always prudent to consider a country’s debt composition. When we take into account China’s non-financial corporate debt (125% of GDP), financial institution debt (65%) and household debt (38%) the picture looks quite different. The grand total is an astounding 282% of GDP, or $28.2 trillion. The rate of debt growth is also a concern. Non-financial corporate debt, increased from 72% to 125% of GDP from 2007 to 2Q14 — a 73.6% increase.
China’s debt load is a global risk because of how tightly managed its economy is. The government has allowed unprofitable companies to stay in business. As such, defaults have been very limited. At some point, China will have to let these companies fail. Otherwise, it will suffer as a result of high debt servicing costs (~30% of GDP).
The PBOC has been very active trying to support the economy. It has cut rates six times since November of 2014. Likewise, it has been lowering its Reserve Requirement Ratio. At the same time, China has been selling its foreign reserves in an attempt to prevent excessive devaluation of the yuan (CNY). They are down more than $400 billion (from a peak of ~$4 trillion) since mid-2014.
FX is also a risk because Chinese companies have a lot of USD-denominated debt. In mid-2015, non-bank borrowers held ~$1.2 trillion worth of it. This is an issue because Dollar debt becomes more expensive when USDCNY rises, which is exactly what the markets expect to happen.
China’s anti-corruption campaign is a step in the right direction. That said, it is a big political risk. High profile businessmen and officials have been disappearing while others are being investigated. Moreover, securities regulators have been cracking down on market manipulators, “ensnaring some of the nation’s most high-profile money managers and announcing more than 2 billion yuan of fines and confiscated gains” (source: BBG Brief). Critics of the campaign suggest that it may deter business while failing to address the corruption that exists amongst the ruling party.
Implications
As investors, we should be concerned because China is one of the biggest economies and the world’s leading trader. Therefore, if it slows down too much, global growth will be impacted. China is also important because it is a massive source of demand for many commodities, and their slowing growth, plus movement to less infrastructure and housing related expansion impacts many resource tilted countries. This all appears manageable from a global perspective, with the biggest concern being the risk of debt problems.
We remain cautious on the whole emerging market space as we head into 2016 and China does little to change this view.
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