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A Long-Term View for China
November 25, 2014
When I meet with clients, one of the most frequent questions I’m asked is, “What do you think about China?” With China’s rate cut this past Friday helping to fuel a global equity rally, we were reminded of how relevant the China question is to the overall health of the global markets and economy. In this post, I’ll discuss the lens through which we view China and how we interpret the daily flood of policy-related headlines coming out of the country to determine what is “noise” and what is actionable.
Our outlook on China remains generally positive. All recent policy actions and reform initiatives suggest the government’s continued commitment to transitioning China to a more balanced and market-driven economy.
However, this transition is a long-term endeavor. Its complexity and magnitude call for slow and coordinated execution, which likely will result in periods of near-term volatility and at times frustrate investors.
During this process, we expect growth will continue to decelerate. Although the official growth rate has been reported as 7.3% for the third quarter of 2014, a number of the key indicators we monitor are tracking well below this level. For example, electricity consumption grew at a reported 1.5% for the third quarter, while rail freight contracted by -2.3%. Among key primary measures, only bank loan growth of 13.3% trended above the official economic growth rate.
Thus far, China has utilized targeted policy actions and stimulus to moderate the slowdown. While recent policy action was more broad based, we do not expect a significant reacceleration in growth as the government’s focus remains on unwinding credit and investment bubbles while promoting consumption and private sector growth. Last week’s rate cut is consistent with the reality that the system is too fragile to risk a hard landing.
While the Chinese economy faces challenges, our positive outlook is predicated on our view that China will avoid a near-term credit crisis and that significant opportunities exist for companies and industries exposed to the country’s positive reform initiatives. As we analyze news out of China, there are broad trends that we monitor for consistency with policy actions. We then identify investable companies and industries that we believe can benefit from these actions. Below, I’ll highlight three of the most important trends.
Internationalization of the renminbi (RMB): In April, the Bank of International Settlements published a paper entitled “One currency, two markets: the renminbi’s growing influence in Asia-Pacific.” The authors suggest that China’s influence throughout ASEAN countries has expanded beyond the real economy, with movements in the currency markets creating faster and more volatile impacts on these economies. This becomes intuitive given the increased use of the RMB for settlement in China’s trade, up from 3% in 2010 to 18% today. To put it in perspective, Japan’s current use of the yen for settlement is less than 15%.
As we review policy actions, China has consistently promoted the RMB as a trading currency, which supports the longer-term goal of making the RMB a reserve currency for the Asian region. For the RMB to become a reserve currency, we believe China will need to create open, well-regulated, and deep capital markets. The first signs of this include the creation of the “dim sum” offshore RMB bond market in 2007, which has allowed investors, including Calamos, to invest in CNH-denominated debt of global multinationals and Chinese companies. The development of this market represents an important step in promoting trade in the RMB, as it provides China’s trade partners with higher-yielding options for the RMB they were receiving from trade with China. Since then, we have seen an acceleration in RMB bilateral swap agreements, the introduction of the Shanghai-Hong Kong stock market interconnect, and removal of RMB conversion caps for Hong Kong residents. We have sought to participate in this longer-term positive trend via exposure to brokers, exchanges, asset managers, and other potential beneficiaries of the increased flow of capital into and out of China.
Transition from an investment-focused economy to one that is more consumer-driven:
Many have raised concerns that as China’s GDP-per-capita has increased, the country is no longer the world’s preferred low-cost labor market, as countries including Cambodia and Vietnam take share from China. While this is true, China continues to introduce policies and reforms to move the country’s manufacturing up the value chain, resulting in higher productivity. Higher productivity leads to higher per-capita GDP, which ultimately results in higher consumption.
One such recent policy initiative is the “Guidelines to Promote National IC Industry Development,” which provides central government targets and long-term support for domestic developers, designers, and manufacturers of integrated circuits. Over time, this should promote more high-tech design and manufacturing locally, but for local consumption and exports. And to further promote consumption, China is implementing affordable housing, deposit liberalization, and land reform policies.
We have positioned global and international portfolios to benefit from this transition via increased exposure to consumer, technology, and health care—all sectors markedly under-represented in popular Chinese indices.
Transition from a government-driven to a market-driven economy: In our opinion, this trend provides the most potential benefits, both from an individual-company investment perspective as well as from a broader economic perspective. We believe that capital flows to where it is treated best, which is why our investment process focuses on return-on-invested capital and the marginal return of capital. China is in the process of implementing broad reforms to state-owned enterprises (SOEs) that should promote SOEs’ marginal cost of capital to be above their cost of capital. This creates value as opposed to destroying value, as many SOEs have done historically. Some of these policy actions include the removal of implicit government guarantees, anti-corruption campaigns to enhance supervision and governance, improved ownership structures and management compensation schemes, and provisions that allow the government to re-deploy SOE capital into more appropriate areas, like public welfare. We have identified investments both in SOE companies that are undergoing this transition as well as in private sector companies that we believe are benefiting from the “SOE retreat” as monopolies are removed and new opportunities emerge.
In conclusion, these three broader trends provide a valuable lens through which we can view the myriad policy changes and announcements coming out of China daily. Guided by this perspective, we continue to identify investments in China that we believe can harness these trends as long-term growth tailwinds.
*Bank for International Settlements, Chang Shu, Dong He and Xiaoqiang Cheng, “BIS Working Papers No 446, One currency, two markets: the renminbi’s growing influence in Asia-Pacific,” April 2014
ROIC (return on invested capital) measures how effectively a company uses the money invested in its operations, calculated as a company’s net income minus any dividends divided by the company’s total capital.
Dum sum bond is a bond denominated in Chinese yuan and issued in Hong Kong. Dim sum bonds are attractive to foreign investors who desire exposure to yuan-denominated assets, but are restricted by China's capital controls from investing in domestic Chinese debt. The dim sum bond market is still in its infancy but is expected to grow rapidly over time. (Investopedia)
CNH is the offshore renminbi currency market that came about as China began trying to internationalize its currency. (Business Insider)
Marginal cost of capital (MCC) is the cost of the last dollar of capital raised, essentially the cost of another unit of capital raised. As more capital is raised, the marginal cost of capital rises. (Investopedia)
Cost of capital is the cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. (Investopedia)
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors. As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.