Why the crisis prediction industry is wrong on China


This month marks the 20th anniversary of the Asian financial crisis, while this year is the 10th anniversary of the global financial crisis and the 30th anniversary of the 1987 crash, so naturally the crisis prediction industry has been eager to predict this year’s crash.

Most appear to have settled on China as the likely source of global instability, focusing on a misleading figure for debt to gross domestic product and obsessing that any slowdown in GDP will precipitate a banking crisis and some sort of 1997 financial meltdown.

Of course history never repeats exactly (as Mark Twain put it, it rhymes) and generals always fight the last war. Arguably the reason that we missed the 2007 crisis was an obsession with not repeating the 2000 dot-com bubble and today Asia generally and China specifically are in a very different position than they were in 1997. Most importantly, they are running current account surpluses rather than deficits and are far less exposed to borrowing in foreign currencies.

Moreover, and importantly for investors, the countries themselves are far more economically developed than they were back then. China A shares may have just been granted admission to the MSCI Emerging Markets indices, but emerging market economies today are in a very different place than they were even 20 years ago.

Surprisingly strong

The obsession with risk has made many observers blind to the opportunities for return, the latest data out from China showed second-quarter real GDP growth of 6.9 per cent. In nominal terms, this was 11.1 per cent higher and appears to reflects strength right across the economy.

Consumer confidence remains high, the wealth effect from housing is combining with strong wage growth to drive household consumption, with retail sales growth of 11 per cent now at an 18-month high. Export growth too is up over 11 per cent, further undermining the claims from only 12 months ago that a 40 per cent depreciation of the yuan was necessary to stimulate exports and by extension the Chinese economy.

Indeed, all motors seem to be firing, fixed asset investment, particularly infrastructure remains strong and even real estate, which was expected to slow, grew by 7.6 per cent.

Many people were actually expecting a slowdown in growth due to recent monetary tightening and a reduction in the public sector stimulus compared to a year ago. However, while the public sector stimulus did slow, fixed asset investment (FAI) in state-owned enterprises fell back sharply for example, what is clear is that the private sector took up a lot of the slack.

Moreover, while central government spending dropped sharply, local government FAI remained pretty stable. Equally, while those watching non-bank credit growth noted its slowdown in recent months, reinforcing the view for a slowing economy, it now appears that the more traditional credit system picked up more than expected as shadow banking loans were brought back on the balance sheet.

Wide diversity

The reality on China is that one aggregate GDP number is as relevant (or not) as a single number would be for Europe, after all China is around the same size physically as Europe, has equally diverse geography, climate and dialect, albeit with more than twice the population and has regions and regional governments as big as European sovereigns.

To get an aggregate of 6 per cent, therefore, we can have half the country growing at 12 per cent and half not growing at all, which is indeed, not far off the case.

Equity and credit investors in China accordingly need to be very sector and even company focused, as the “strong” GDP number will not necessarily translate into positive profits for all. This is why we like to talk about China 2.0, the shift from export and production, which are still currently strong, to import and consumption, which are even stronger.

The upcoming Party Conference in October/November, is broadly acknowledged to mean that the authorities will do everything they can to maintain the appearance of stability, so we would not expect the Q3 number to stray very far from the current level.

The fact that we have now had ten straight quarters with growth inside the band of 6.7- 7 per cent will undoubtedly fuel cynicism over the data. However, I suspect that while the real GDP number may be being smoothed, the nominal GDP number probably isn’t and the real discrepancy will thus be in the assumptions of volumes versus prices, since the broad nominal demand figures do appear to tie in with bottom-up observations on sales growth.

Investors, however, need to learn to look past the aggregate data as well as the constant predictions of a financial collapse. Twenty years ago, China’s GDP was around $US700 billion, about the same size as Switzerland. Over the last two years it has grown by more than its total size in 1997.

There is risk, but that is the scale of the opportunity.

by Mark Tinker
Mark Tinker is head of Framlington Equities Asia at AXA Investment Managers in Hong Kong.
Financial Review


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