CHINESE growth over the last two decades has largely been driven by government directed and led investments. Some of this investment has resulted in the creation of an excellent export oriented infrastructure. However, in many industries, it has led to excess capacity, excess leverage and low returns. This is limiting the role the government can play in China's growth. There is a strong recognition that the growth model needs to change to one that is more consumption-led, with more private sector participation and driven by increased productivity and innovation. A shift from quantity to quality of growth is the new mantra. The government has several ongoing initiatives to make this transition to a more sustainable and environmentally friendly growth path. For instance, institutional processes are being strengthened and the service sector is becoming a larger part of the economy.
However, the transition will only unfold over the medium term. Meanwhile, China faces a sharp slowdown as exports weaken and the traditional investment drivers of the economy are losing momentum. So far the government has tried to strike a fine balance between reverting to the old investment-led model on the one hand and risking a sharper-than-palatable slowdown on the other. A sharp slowdown will highlight malinvestments, create bankruptcies and force restructuring. This will test the government's resolve to restructure the economy. But the other alternative - a reversion to the old model would be even worse in the long run.
Economic growth of 7 per cent per annum is no longer likely to be the central estimate for the Chinese economy. A number closer to 5 per cent is more likely the sustainable growth rate for the next decade. The sheer size of the economy, the weaker demographics, and the huge share of the export market all point to slower growth. However even a number short of 7 per cent would still leave China as one of the fastest growing economies in the world.
Is a crisis inevitable?
While risks have increased, there is nothing inevitable about an economic or financial crisis in China. It is certainly impossible to predict a timetable for such an event. When the renminbi trading band was widened on Aug 11, and the currency weakened by 4 per cent subsequently, the market was in panic. The bears confidently predicted that this was the straw that would break the panda's back. Some have been even as bold as to suggest that a crisis will unfold within a year. Our view is more constructive.
The leadership is very aware, motivated and unafraid to implement change when required. China's economy is also buffered by a diminishing but substantial current account surplus and the fact that a substantial portion of Chinese debt is in local currency and owned by locals. On a positive note, reforms in the banking sector, financial markets, social security, and healthcare are all moving in the right direction. Institutional structures are being strengthened and the private sector share of the economy has grown. The biggest change in China's situation is that the room for policy mistakes has shrunk considerably compared with a decade ago. The market is slowly getting to grips with this new reality and re-pricing China's risk.
Isn't the Chinese stock market a casino?
It certainly feels like that - especially the local A-share market. After a meteoric rise of 130 per cent over a one-year period to June 2015, the Shanghai index fell by 40 per cent between June and August. While the fall seems precipitous, the market is still up 40 per cent over the last 12 months and currently trades at a 5 per cent discount to its seven-year median price/book ratio. What has caused consternation amongst investors is the government's reaction to the fall. All possible measures were used to stop the fall, including a ban on short selling. The suspension of trading for a large number of stocks was alarming. What was seen as an imminent introduction of the A-share market to global indices has now been pushed back by at least a year. Many investors who were scrambling to get ready to invest in A-shares are now re-evaluating their risk assessment of the Chinese A-share market.
Our view is that Chinese markets, like the Chinese economy, will continue to broaden and deepen. The regulatory framework will continue to improve and move closer to global norms. It will take time but we can see the role of institutional investors growing slowly and the market being driven increasingly by fundamentals over the medium term.
Are there any investment opportunities in China?
Yes, many. As investors in China, our aim is to find the companies which can create value through disciplined application of capital and intellectual property. We find these more in the service sector where there is limited presence of state-owned companies. Many of these private sector companies are run by first generation entrepreneurs who have built successful businesses over the last two decades. There is significant evidence of innovation, customer focus and product or service relevance. These companies are found in industrial automation, Internet, leisure travel, healthcare, environment protection and other new sectors.
With the stock market decline, valuation has corrected to a degree which makes the investment case interesting for select companies. The H-share index now trades at a 25 per cent discount to its seven-year price/book ratio. There is no doubt there will be continued volatility especially with the new-found realisation by investors that the Chinese currency could further weaken after the recent reset. However for the disciplined, long term investor who is willing to undertake deep research, and has the emotional resilience to deal with Chinese stock market gyrations, opportunities are beginning to emerge.
- The writer is head of Emerging Markets Equity, NN Investment Partners (Singapore)