Investing in China: responding to the sceptics

Investing in China and investments
John Wyn Evans Investec By John Wyn-Evans, Head of Investment Strategy, Investec Wealth & Investment

14 May 2018

Many commentators remain sceptical of the attractions of investing in China. Maybe it’s through envy, or possibly because they fear the rise of a new superpower. We have looked at a few of the main gripes and tried to address them.

Donald Trump’s declaration of “Trade War” has been one of the big upsets so far this year. How bad can it get? America’s relationship with China prior to Trump’s election was conducted under the umbrella of the Strategic Economic Dialogue – a framework of regular meetings of highest level officials from both governments where all contentious issues could be discussed and resolved quietly.

Donald Trump decided that this does not work and has dispensed with this approach in favour of public confrontation. This is initially a shock for observers, underlined by the actual imposition of tariffs as an opening shot, but our perspective is that it is mostly a change of negotiating style – albeit to one with far higher risks of an adverse outcome.

The benefits and risks of investing in China

The important thing to remember, however, is that both sides have more to lose than to gain from any escalation. Donald Trump has clear support both inside and outside America for achieving progress on a number of issues (including market access and intellectual property protection), but there is also a mutual interest in sustaining a good relationship, since China is the world’s second largest economy and the biggest contributor to global growth.

It supplies American (and other) consumers with affordable goods both directly and as a co-ordinator of the global supply chain. In short, rather than issues being resolved behind closed doors, robust public skirmishing is likely to be the style for the duration of the Trump presidency.

China has accumulated a lot of debt since the Great Financial Crisis, and some are worried that this will lead to a similar financial sector meltdown, but we don’t see this as an imminent risk. China’s debt explosion (from around 150% to over 270% of GDP) mainly occurred when demand for consumer products in the West plunged.

China's future economic development

China reacted to the demand precipice with a Keynesian infrastructure construction boom, which could be viewed as “bringing forward” necessary spending on urban infrastructure needed to accommodate the ongoing urbanisation of China. The money was spent “inefficiently” from a short term perspective (the economic returns of a new underground rail network are initially very negative), but the longer term (social multiplier) effects are often far more positive. In addition, the goal of keeping China working succeeded.

Nevertheless, it remains true that the money spent was borrowed from Chinese banks and savers and it must at some stage be paid back. How will this occur? The answer is slowly, with any (inevitable) write-offs taken over many years. The key is, however, that not only are all the borrowings sourced from local savers, but the banks themselves are largely government owned and many of the loans are ultimately government backed.

There is no reason for Chinese savers to fear that they will not get their money back, and no flighty “foreign money” in the system. In short, China is self-funding and can afford its own mistakes. Hence there is no reason to fear a funding “run” on the banks in China, which, in the wholesale bank-to-bank lending market, is what ultimately caused the financial crisis of 2008 in the West.

An overview of China's economy

Recently, President Xi changed the rules to allow him to remain in power, at least in theory, for as long as he wishes. Some see this as an unwelcome shift towards autocracy, with echoes of the Mao era and all the horrors that accompanied that period. Chinese politics is a mystery wrapped in an enigma, and many Western watchers view China sceptically through a lens of human rights controversy and fears of increasingly assertive global political presence. But Xi and his agenda, prioritising environmental issues and anti-corruption, enjoy enormous popular support.

He is very well qualified for the job, with more than 30 years of demonstrated competence as a high-level government administrator and also personal experience of the perils of power as witness to the Cultural Revolution. We think Xi is a good leader and the right man to run China now, so an extended term for him does not concern us, but a two term limit was put on the presidency to ensure that Mao did not happen again. President Xi may be no Mao Zedong, but who can guarantee the next man may not try to be? This is a situation to monitor in the long term.

We are far from complacent, and we do watch out for danger signals. If the Chinese lose faith in their own growth model, then it would no longer be “self-funding” and the worries about debt sustainability would crystalise. The Yuan/Dollar rate is a key canary in the coal mine, reflecting capital flight from the country.

In conclusion, having integrated itself into the world’s trading economy in the first decade of the millennium, China is now engaged in the process of integrating itself into the world’s financial system. This is a complex process involving both explicit verbal debate with economic partners and an implicit ongoing debate with financial markets which are judging their success.

Key takeaway points

However, the end goal for China - developing a prosperous consumer economy - is not at odds with the West’s interests. Although the language of engagement may become more fractious, perversely, as the Chinese leadership passes successive tests, the process is likely to feel less of a high wire act. The prospect is that from an economic perspective, at least, China, which has long been thought of as a source of instability, will increasingly be thought of as a source of stability. If that is the case, sceptics, and investors, could be pleasantly surprised.

This blog is one of a series of articles from our commercial partners.
The views expressed are those of the author and not necessarily those of ICAS.


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