China’s trade surplus is almost back to its record high. But markets last week weren’t talking about the export side of the equation. Instead, investors focused on sharply lower import growth as evidence that the economy is cooling.
This won’t have come as a surprise to MoneyWeek Asia readers. We’ve been tracking the early signs of a slowdown for some time. And now the evidence is starting to look overwhelming.
It wasn’t just exports. Other numbers such as industrial production and urban fixed asset investment still looked solid on a year-on-year basis, but are clearly decelerating month-on-month.
So the question now is no longer, “Will China slow?” It’s “how will China deal with the slowdown?”
And here things are not so clear …
Government policy is getting tighter
So far, there’s no sign of the government loosening policy to buoy the economy. The property clampdown remains in place. And recent actions elsewhere won’t boost growth either.
For example, over 2,000 outdated steel mills, smelters, cement works and other plants have been told to shut down by next month. The timing of this is intended to allow China to meet a deadline for improving energy efficiency. But it’s also the most public salvo in an ongoing fight to reduce obsolete overcapacity in these industries.
More significantly, regulators have ordered banks to bring around RMB2.3trn in loans made via trust companies onto their balance sheets. I’ve written about this a few times. But in brief, these are loans that have been made through intermediaries and then sold on to investors. This removes the loans from the banks’ balance sheets. Disclosure is poor, but data from Fitch Ratings suggests that this type of lending has grown rapidly in recent years (see chart below).
This has enabled banks to dodge capital adequacy rules and to get around quotas on the maximum they are supposed to lend. If they now have to bring the loans back on balance sheet, that will put capital ratios under pressure. That in turn will force banks to raise more equity on top of the heavy issuance already planned – the five largest banks have already raised or are planning to raise $60bn. If banks were to be forced to stick to the RMB7.5trn new loan quota for this year, it would mean a sharp slowdown in lending which would certainly hurt GDP.
Time for a showdown?
So what will China do? Will the crackdown continue? Or will the government relax the squeeze in the next few months, ease up on the property market, and allow banks to lend more?
The truth is that no-one actually knows. This call will be made in the Standing Committee of the Politburo and China’s leaders don’t divulge the details of their deliberations. We shall have to wait and see.
My guess, based on the mix of announcements we’re seeing, is that policymakers will ease off if the economy slows significantly, but probably in a targeted way. In other words, banks will be allowed to lend more – but things will probably remain tight in property.
If the economy needs a new round of stimulus, the government will probably target infrastructure and development in the west of the country, where there is still a great deal to do. They’ll try to force through more low-income housing development, although that will be something of a fight. Local governments tend to oppose this, as it brings in less revenue (and fewer backhanders for officials).
If the government does try to steer policy in this direction, that would be a good sign. It would be rather less encouraging if they were to reopen the lending floodgates fully and simply opt for another indiscriminate spending splurge if things get tough.
The loan boost and other stimulus measures were crucial in helping the economy get through the worst global downturn since the 1930s. It also helped the rest of world by boosting Chinese demand and imports. But different measures are called for this time round. We need to hope that China takes the right course.
What about the market outlook? Does it still make sense to buy Chinese stocks into a slowdown? I believe so – valuations are still fair in some areas.
However, I would be cautious on some of the high-profile growth names. I’m talking about firms such as food group Tingyi, personal care company Hengan, healthcare stocks Sinopharm and Shandong Weigao Medical Polymer, and travel company Ctrip. These are good companies in good businesses, but the valuations make me blanch. I want to invest in most of them at the right prices, but can’t help but feel that I’ll get to do so more cheaply.
What if China takes the other route and allows lending and real estate to roar away again? In the short term, the obvious beneficiary would probably be the property sector. Chinese real estate plays in Hong Kong such as China Overseas Land & Investment (COLI) and Guangzhou R&F Properties have lagged the market in recent months, as the chart below shows.
This could be interesting for traders who think the government lacks the willpower for a prolonged crackdown. Notably, both COLI and Guangzhou R&F have options available on the Hong Kong exchange, which could provide a capped-risk way of taking this bet.
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Another step forward for the renminbi
Moving from China’s immediate future to a longer-term question. This week Haitong Asset Management announced details of the first renminbi-denominated bond fund aimed at retail investors in Hong Kong.
Why should we care? Here’s why. Just now there are strict controls on converting from foreign currency to renminbi, and limits on investing in Chinese markets. For example, only outsiders who have a Qualified Foreign Institutional Investor (QFII) quota can invest directly in mainland-listed A shares. These quotas add up to a total of around $17bn. That’s tiny compared with the market. And foreigners would like to invest a lot more.
In the long run, China intends to make the renminbi an international currency. That will involve removing these controls. But it also wants to avoid losing control over capital flows. It doesn’t want to have to deal with large amounts of money rushing in and out, which is a common issue for emerging markets.
So it’s moving slowly. Last year, it began a pilot, allowing a limited number of firms in five cities to settle some foreign trade in renminbi. In June, this was extended to include 20 provinces, a much larger number of firms and a wider range of trade partners.
Of course, renminbi-denominated trade results in renminbi deposits being held outside China. For now, these aren’t very large, accounting for around 1.5% of deposits in the Hong Kong banking system (see chart below).
But as trade grows, so will offshore deposits. The trouble is, there are very limited options for investing renminbi outside China. And the restrictions mean that they can’t be recycled to the mainland for investment there.
So the next step is to develop a more sophisticated offshore renminbi market in Hong Kong. This also creates a market for renminbi services in a much more sophisticated financial system than on the mainland, which could make it a useful testbed for changes there.
So in July, China removed many of the restrictions on renminbi use in Hong Kong. It allowed account holders to transfer currency freely between banks and allowed more innovation in renminbi-denominated financial products – such as Haitong’s investment fund. Several other providers are said to be planning to launch their own vehicles soon.
All this is in the very early stages. Money held in Hong Kong can’t be remitted to the mainland for investment. So funds can only invest in offshore renminbi assets. For now, these are very limited: just 14 offshore renminbi bonds have been sold in Hong Kong. Many other issuers might be keen to follow. But the money raised through these can’t automatically be sent back to the mainland either – special permission is needed.
However, the Chinese authorities seem to be moving to relax this a little. Hopewell Highway Infrastructure recently became the first non-financial firm to issue an offshore renminbi bond, after it was given permission to remit the funds. Investors hope that this is a sign that more firms will be allowed to do the same. There’s also talk of a pilot scheme dubbed ‘mini-QFII’ which would allow a small amount of funds to be channelled into the mainland stockmarket through the Hong Kong units of Chinese brokerages.
These developments are definitely worth watching – not just for the renminbi’s future, but also the profit potential for Hong Kong financial institutions. It’s not yet clear whether renminbi business will grow big enough to be meaningful, but it’s certainly possible. One potential winner would be Bank of China’s Hong Kong subsidiary (which is listed separately), since at present this is the sole clearing bank for transactions between the mainland and the offshore renminbi market in Hong Kong.
Indian companies on the M&A trail again
Before the global financial crisis hit, one of the big themes was emerging-market firms snapping up Western assets. And Indian firms were behind some of the biggest deals: Mittal Steel merged with Arcelor, Tata Steel bought Corus and Tata Motors bought Jaguar Land Rover (JLR).
The crisis stopped that for a while. But now Indian firms’ ambitions are growing again. In the last week, we’ve heard that Mahindra & Mahindra is the frontrunner to acquire Korean carmaker Ssangyong. Meanwhile Vedanta Resources is interested in the Indian assets of Cairn Energy. A couple of months ago, Bharti Airtel, the country’s largest mobile telecoms operator, bought the African operations of Kuwait’s Zain.
Whether these deals are good for shareholders is sometimes questionable. Tata paid a full price for JLR at the peak of the market. The debt it took on to finance the deal left it looking under threat at the worst of the crisis. It’s getting some good press out of the firm’s post-crunch pick-up, but for me the verdict is still out on whether this prestigious but not always profitable brand was a good deal.
Ssangyong looks even riskier: this is a firm that fully deserves the label ‘troubled’. China’s Shanghai Automotive Industry Corporation took a 51% stake in the firm several years ago, but could never turn it around. After severe losses, SAIC now owns just 10%, with banks holding 70% in a debt-for-equity swap and desperate to be shot of the liability. If Mahindra & Mahindra takes this on and makes a success of it, praise will be well deserved.
Still, there’s little doubt that many of this century’s new multinationals will come from emerging markets. And Indian firms are likely to be some of the biggest names. They have the advantage of being politically acceptable in foreign takeovers where often Chinese firms aren’t, while the expertise they’ve developed at home can serve them well abroad.
For example, firms such as Marico and Godrej Consumer Products have the expertise in catering to emerging-market consumers in ways that Western multinationals don’t, from coping with difficult distribution logistics to creating products that are affordable to the very poor. A small deal this week for Marico to buy South African healthcare brand Ingwe didn’t generate as much press as the ones above, but it’s just the latest in a series of investments these firms have been quietly making in Africa and other emerging markets for years.
Most non-Indian readers probably won’t know either of those names – but in a decade, it could be a very different story. Unfortunately, it’s one of the great frustrations of emerging-market investing that India’s investment restrictions mean that these firms and many other promising companies currently aren’t available to foreign retail investors.
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