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Don't be shy, catch China's transformations
ONCE bitten, twice shy." This can be used to describe global investors' general attitude towards China. In between debt, an opaque political system and frequent negative headlines, many investors have chosen to avoid the market.
Meanwhile, historic transformations are taking place in China that would markedly elevate its representation in global capital markets in the coming years. Investors, shy or not, should consider positioning for a world where Chinese equities represent a much larger share of the global portfolio.
We see three main transformations taking place; economic structure, financial sustainability, and capital flows.
Consumption and services account for a majority of China's economy, at 55 per cent and 52 per cent of GDP respectively. This has taken place when fixed investment growth fell to the slowest on record. Exports grew at a healthy 7.8 per cent clip in 2017, but imports outpaced that at 16.4 per cent, thereby narrowing the trade surplus by nearly US$100 billion to US$415.5 billion.
Anecdotally, this transition is also highly visible. Singles Day sales on Nov 11, 2017 for example, amounted to US$45 billion on just two online platforms compared to US$8 billion on Thanksgiving and Black Friday in the United States. The two largest Chinese companies -Tencent and Alibaba - have led the way in building online ecosystems that could service nearly every aspect of consumers' lives, and these companies have little debt.
China is also leading the way in the development of innovative technologies including fintech, artificial intelligence and genetic engineering among others that have, and will continue to transform, the way we live, work and play.
Despite the structural changes, the most frequently cited economic headlines on China still centre on debt. A case in point is China's large corporate debt load, which stands at 163 per cent of GDP in 2017. This has actually come down from 167 per cent in 2016. Policymakers, in line with President Xi Jinping's economic objectives outlined at the 19th Party Congress, have deployed powerful measures to contain systemic risks.
China's central bank has tightened monetary policy much more than any other major economy and the country's banking and securities regulators have relentlessly attacked the shadow financing industry. As a result, onshore interest rates have risen 150bps over the past 15 months, and the pace of M2 money supply growth has fallen from 11.5 per cent to 8.2 per cent, the slowest pace on record. In addition, corporate debt is rising less than GDP growth, and households and governments are increasing leverage from below 50 per cent of GDP, which is very low by global standards.
Yet, China's GDP growth held up well at 6.8 per cent in 2017 and is poised to grow by about 6.5 per cent in 2018. This shows that China is becoming less dependent on credit-sensitive growth and the tightening is enabling greater sustainability of the financial system. Banks have seen credit demand return from the shadow, while higher rates have enabled wider margins, which together help to digest legacy asset quality problems.
There are some worries as to how much deleveraging policymakers intend to push for. This depends on how well the economy functions in the process. Policymakers have no appetite for dogmatic austerity, which means it can be eased when necessary. The economy's resilience, based on what we have observed, has improved efficiency which is positive for companies' profitability.
MEMORIES OF THE BITE
A key reason why investors might not recognise these positive developments may be the memories of the market events from 2014-15, which are still too fresh. The toxic blend of deteriorating growth and accelerating margin leverage, with a rigid exchange rate regime amid sharp USD appreciation, created a bubble of epic proportions.
Today, however, we are seeing earnings growing at the fastest pace since 2011, with continued rising earnings per share estimates in January 2018. Margin leverage is rebounding, but remains far lower than 2015, and the authorities are already tackling the problem. Valuations are still cheap, especially after the correction in early February 2018, with CSI 300 and MSCI China forward PE multiples both at about 12.8x, versus peaks of 19x in 2015, 27x in 2009 and 35x in 2007.
On the FX front, China has tightened capital account controls substantially and is now in the process of gradually easing those controls. The RMB has been very strong amid a broad retreat in the USD, which we believe could last another few years. Arbitrary intervention in the currency has been cut back, with the suspension of the "counter-cyclical factor". FX reserves have rebounded by US$140 billion in the past year, which is enough to remove it from headlines that tend to only report when they are falling.
BENCHMARK CLIMB AND CAPITAL INFLOWS
The most important transformation for investors is the benchmark climb. China has been accepted into several international clubs, but its representation continues to be much smaller than the weight of its contributions. When the MSCI adds A-shares (equities listed onshore in China) later this year, the weight would be 0.08 per cent within the MSCI World benchmark.
Meanwhile, A-shares account for 11 per cent of global equity market capitalisation. China offshore shares (those listed in Hong Kong and the United States) have a bigger weight of 3.5 per cent in MSCI World, while the actual share of global equity market capitalisation is 5 per cent.
In sum, China gets about 3.5 per cent of MSCI benchmark for an actual share of global equity market capitalisation of 16 per cent. Even compared to the 3.5 per cent current MSCI benchmark, global investors are underweight on China. Together with Taiwan and Korea, China is among the three biggest underweight markets for global mutual funds that have an emerging markets mandate. This is not just an equity issue as bond investors (aside from sovereign funds and central banks) are also found to have negligible exposure to China.
In the next decade, we expect China's weight in global equity and bond benchmarks to climb substantially. This would result in significant portfolio inflows that are likely to last well beyond the current business cycle. Investors who wish to capitalise on this benchmark climb should start increasing their exposure to Chinese equities.
- The writer is Asia investment strategist, Citi Private Bank