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gains. The price advances in Tier 3 cities have been much slower, only just creeping into positive y- o-y territory in Q2 2016, apparently reflecting higher inventory levels in China’s regional cities. During the last month there have been targeted tightening announcements in some Tier 1 cities where price advances have been most extreme (e.g. higher down-payments, and restrictions on buying second and third properties), but not across the entire country. Given elevated inventory levels in China’s lower tier cities, the rebound in housing starts has been much slower compared to previous real estate cycles, which in turn has been reflected in lacklustre demand for raw materials. Indeed, this seems to have been one of the main reasons that Chinese growth has been so slow to pick up despite the massive credit impulse over the last 18 months. Policymakers are still actively promoting inventory destocking across the country, and households have been encouraged to take on more debt to buy housing. More than 70% of new bank loans made in July and August were for new mortgages. 8 Such developments seem to imply that China’s authoritative person and his concerns over rapidly rising debt are being disregarded. Indeed, statements from other policymakers have emphasised that deleveraging is too risky, and even if corporate indebtedness seems high, there is still room for the central government and households to pick up the slack. 9 With such a view apparently gaining ascendancy, we see no reason that China’s credit-driven stimulus should stop any time soon. Even if China’s real estate market is now past its peak (with selective tightening measures being implemented in the frothiest regions), economic activity still seems likely to pick up in coming quarters in a ‘delayed reaction’, as property inventories finally fall and real estate developers get back to work. This should support demand for raw materials and support Chinese growth in the coming months. To some extent – given high valuations in onshore stocks, as well as the recent rally in HK stocks and most industrial metals – it might be said that China-related markets are already pricing in a cyclical rebound scenario. Indeed, the rally in commodity prices this year does seem to reflect a tighter supply-demand dynamic, and we would be unsurprised to see resource stocks make further gains in coming months. However, China’s wild stock market gyrations have seemed increasingly detached from fundamentals in recent years –how much sense does it make to ask whether equities reflect underlying economic growth and liquidity conditions? China’s domestic equity markets went on a tear from mid-2014, rallying aggressively for the next 12 months even as most measures of Chinese activity and credit fell precipitously into early 2015. Towards the peak of this bubble, domestic markets also exerted a gravitational pull on Hong Kong stocks, which spiked in Q2 2015. Note that this does not seem to have been a case of equity prices moving ahead of the economy: stocks in China and HK peaked at the end of Q2 2015 before plunging over the next nine months, even as economic growth turned up. Part of the collapse in stock prices reflected a sudden loss of confidence in policymaker competence, given their role in inflating and supporting the 2015 stock bubble and then their notable lack of communication during the sudden Renminbi devaluation. Nonetheless, all too often China’s domestic stocks are led by sentiment and speculation (driving multiple expansion and contraction), rather than by earnings and fundamental data. Perhaps this is unsurprising given that broader monetary aggregates still dwarf the country’s equity market capitalisation, allowing money flows to reign supreme. Will Hong Kong now have to get used to this ‘casino’ dynamic as more channels open up for onshore capital to flow south? Maybe, but we hope that over time, the growing onshore institutional investor base will succeed in taming the market’s wildest excesses. Apocalypse When? Those predicting an imminent debt bust and a financial crisis in China have been frustrated by recent developments. When will the unsustainable debt accumulation come to an end? What will force a ‘final reckoning’? In most debt crises, it is not just the absolute level of debt which causes a 8 http://www.reuters.com/article/us-china-economy-loans-idUSKCN11K15T. 9 http://www.bloomberg.com/news/articles/2016-06-23/china-rapid-deleveraging-can-bring-new-risks-says- government. 6
meltdown, but rather a rapid increase in debt over a short period of time, funded by liability positions which prove to be unstable and trigger a crisis when they are unwound. Many Emerging Market debt crises have involved a massive rise in external liabilities (i.e. foreign currency debt), but when these lenders realise that this debt cannot be serviced, the withdrawal of foreign capital causes a collapse in the exchange rate and domestic asset prices (e.g. the 1997 Asian Crisis). Although China’s authorities came close to triggering widespread capital flight early in 2016, on balance this sort of crisis seems less likely for China in the near-term given the substantial fall in the country’s cross-border net liabilities from late 2014 to early 2016, 10 as well as the substantial tightening of capital controls since earlier this year. 11 (However, that is not to say that banks and other financial institutions in US Dollar-pegged Hong Kong won’t suffer as the credit quality of their cross-border debt exposures to mainland China deteriorates, and as the Renminbi weakens.) Another flavour of debt crisis involves an unsustainable build-up in domestic debt, increasingly funded by short-term and unstable liabilities, until a ‘Minsky Moment’ arrives to trigger the crisis (e.g. the 2008 Lehman Crisis, characterised by a mismatch between longer-term poor quality mortgage-assets, and short-term wholesale financing liabilities). We would not rule out such a crisis in China at some point, given the recent proliferation of short-term liabilities within NBFIs, together with their complex and growing links to China’s lower tier banks. A lack of reliable data means that it is difficult to predict in advance exactly when a crisis of this sort might occur, and so we think it makes more sense to focus on early-warning signs. 12 Real estate serves as collateral for most loans, so property prices are an important determinant of asset quality. Given the vital role that debt plays in greasing the wheels of the economy (and allowing property prices to levitate), a contraction in credit presents serious risks, and we are extremely sensitive to potential policy errors arising from ‘overtightening’. It is thus important to keep an eye on broader credit aggregates and regulatory initiatives (e.g. to rein in NBFIs or bring quasi-debt back on bank balance sheets), and monitor the more vulnerable and opaque parts of the system, e.g. corporate bond yields and default rates, as well as asset quality and funding stress among weaker banks and NBFIs. If these are the risks, we also see plenty of things to be optimistic about as long-term equity investors in the Greater China region. The opening up of the Shanghai and Shenzhen stock markets to foreign investors should, over time, provide numerous interesting investment opportunities. The Shanghai-Hong Kong Stock Connect currently allows northbound investors to access 686 stocks with a total market capitalisation of US ~$3.9t, while the Shenzhen-Hong Kong Connect launch, slated for late 2016, will bring more investment opportunities. 13 We have started to do our homework on various China domestic-listed stocks that match the fund’s quality criteria. It is still early days, but as yet we have not found any quality domestic China stocks trading at sufficiently attractive valuations for us to get involved. Our work continues nonetheless, and we are cautiously confident that in the coming months and years we will be able to find good quality domesticallylisted China stocks trading at valuations which also provide a sufficient margin of safety. In the meantime, our long exposure to China consists of two ‘deep value’ positions in China stateowned enterprises (in shipping and telecoms) where we are also hopeful of imminent stockspecific catalysts. We also have a small position in a niche Taiwanese consumer company which has 10 Many Chinese companies paid down their US Dollar loans over this period, exchanging them for Renminbi debt. For more details, see: http://www.bis.org/publ/qtrpdf/r_qt1603u.htm. 11 Despite the tightening of capital controls, it is interesting to note that capital outflows still continue (albeit in smaller size since the Renminbi panic subsided). China has a current account surplus and should be accumulating US ~$250b in foreign exchange reserves a year. However, forex reserves have been flat (rather than rising) since the Renminbi panic subsided in Q1 2016, which suggests that outflows continue, albeit in smaller size. 12 Some commentators have predicted that a crisis is still many years away, as the Loan-to-Deposit Ratio (LDR) for China’s financial system is substantially lower than for other countries which have experienced debt crises in the past. However, we do not have strong confidence in this approach, not least because there is wide variation in the figures for system-wide LDRs calculated by different economists (presumably because of data issues), and since China also has somewhat unusual and convoluted financial market ‘plumbing’. 13 This compares to 3,905 listed stocks in Japan with a combined market cap of US $5.8t. 7
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