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Keeping the faith in China

One of the risks to watch: The depreciation of the currency will likely result in a good number of corporate defaults.

THE carnage in China's stock markets at the start of 2016, sparked by downbeat manufacturing data, rattled stocks from the US to Europe. The depreciating yuan is also some cause for concern.

Are the Chinese authorities losing their grip on the economy, and is the world's second-largest economy coming off the rails? Notwithstanding the market rout in China, and the volatility besetting markets, sitting where I am in Asia, I do not believe China is falling off a cliff.

Some people got spooked by China's PMI (Purchasing Managers' Index) data, which stayed around 50, signifying contraction. However, given what China is seeking to accomplish, PMI is the wrong metric to look at, for one important reason: the contraction in industry and manufacturing is being engineered by the Chinese. This is part of a calibrated policy outcome.

For five years, the world told the Chinese they were overinvested, and needed to scale back on overcapacity and manufacturing. There was a clamour for China to shift to a consumption economy. And for the last two years, the Chinese have been focused on trying to do just that. So it should come as no surprise that China's PMI should come in at around 50, and why I think focusing on this metric is not sensible.

The reality is that:

a) China's service sector is growing quite nicely and

b) the slowdown in manufacturing/ investment reflects a need to clean up excess capacity in several sectors, notably construction, steel etc, but this does not mean that China's heydays as an investment destination are over. China's big problem has been a misallocation of resources, and they will need more than a couple of years to address the problems that arise from this.

Nevertheless, it is instructive to note that overall, China's actual investment (capital-output ratio, capital-labour ratio) is a fraction of that of the US. There are large parts of China, including healthcare, services and the environmental sectors, which are massively underinvested. What this means is there is scope and capacity for China to pump-prime the economy, and it has done so with some measure of success.

A lot of people accuse me sometimes of being a China bull and overly sanguine about the risk in China. However, I want to differentiate my view of the macroeconomy from my view of China risks. The two are not the same thing. China risks are real, but they are concentrated in two areas:

a) Financial market volatility due to China's attempt to open up, but still fine-tune through policy actions.

China's authorities are focused on financial sector liberalisation, and the pace at which this has taken place has been faster than expected. For example, the Stock Connect was introduced, quotas on QFII were relaxed, and ceilings on deposit rates removed, all in the last two years. The free flow of markets has impacted many of China's asset classes. It is a truism that when you start to drive financial sector market liberalisation reform, there will be financial market volatility.

This is compounded by the fact that while China is attempting to open up, it is also seeking to fine-tune market responses through policy actions. And these policy decisions are taken by a myriad of people, regulators and government agencies. A lot of people think China is one person: that Xi Jinping makes all the decisions. That would be simplistic in a nation of 1.3 billion people. In reality, the central authority in Beijing, the PBOC, CSRC, CBRC etc, have different agendas. Different people march to different tunes. While policies are broadly orchestrated, not everything is carefully calibrated each time. One may therefore find oneself on the wrong side of policy responses.

b) Credit risk/corporate defaults. Anti corruption, SOE reform and a depreciating yuan will put pressure on many companies.

China is cracking down on corruption, and this drive could create risks for companies related to affected individuals, creating idiosyncratic counterparty risks. China is also pursuing SOE reform, which means less competitive companies will be weaned out.

To top this off, I believe the depreciation of the yuan will likely result in a good number of corporate defaults. This is a risk to watch because there has been a lot of Chinese corporate borrowing, much of which are dollar-denominated, in the last year or two. A lot of this is unhedged. As the yuan depreciates, it is likely that a significant number of Chinese corporates will find their capacity to service debts will be challenged; this would be reminiscent of what South-east Asia saw in 1998.

All in, China has risks, and they are clearly real risks. However, I do not believe that China's macro economy is the point of concern. China's economy is growing at 6-7 per cent, and will continue to grow at this pace. What is more worrying is that the year will be marked by significant market volatility, more corporate defaults and higher counterparty risk. Nevertheless, if one is smart, understands the long game and chooses opportunities wisely, I believe China is still a good place to be invested in.

  • The writer is CEO of DBS Group Holdings