January 2015
Talking Point
China woes create Asian buying
opportunity
Robin Parbrook, Head of Asia ex Japan Equities
What’s happening with China’s currency?
The immediate cause of the current wobbles or “crisis” in China is the currency, which has now fallen quite
sharply. Fear is rising that the authorities are losing control over the renminbi exchange rate and that this will
prompt a further rise in capital outflows. Capital flight has been significant over the last few months with $108
billion flowing out in December alone (Chart 1) and we are now rapidly approaching the $3 trillion level of
foreign exchange (FX) reserves, which in the past some China commentators have indicated to be a
significant mark.
Chart 1: China foreign exchange reserves are falling fast
Source: PBOC, CEIC data, CLSA
Why does all this matter so much? Primarily because China has a pegged exchange rate (even if it is trying to
move to a “dirty” float). As all long-term investors in Asia know, trying to run an independent monetary policy
with a pegged exchange rate is a contradiction in terms and what caused the Asian financial crisis in 1997/98.
Because China is trying to defend the renminbi in the face of mass capital outflows we have reserve money
shrinking as the authorities buy renminbi and sell dollars.
Despite significant intervention the currency is still falling. This is not a good place for any central bank to be
in, particularly when you are coming off the end of one of the largest credit bubbles ever seen in the history of
modern finance. The tightening of liquidity is of course raising worries about the fragile financial system and
causing a selloff in risk assets. Chart 2 sums up the situation well - China has now moved into the bottom left
quadrant.
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Talking Point: January 2016
Chart 2: Four stages of EM Crisis
Source: CHA-AM Advisors
Where next?
So where does China go from here? If the outflows continue, we think the consequences could be significant.
The problems of an over-lent banking system and, in particular, a weak and overleveraged corporate sector
will soon become apparent.
We now think the authorities are running out of options (hence the policy flip-flops and uncertainty). However,
with equity markets in China off very sharply we have at last moved on from the false belief that many pundits
in financial markets used to peddle that the authorities had some magic wand to make all the problems
disappear.
The end game looks increasingly clear – a more material fall in the renminbi is likely, significant bad debts will
start to appear, and nominal GDP growth will be sub 5% (at best). We are likely to see further falls in A-share
equity markets which still look very materially overvalued and we can in due course expect volatility in the
Chinese bond markets both on and offshore.
No full-blown financial crisis
We plan to discuss in more detail how we see the Chinese credit bubble potentially unravelling in our soon-tobe-published “Year of the Monkey” annual report. We should, however, highlight that we still think a full-blown
financial crisis is unlikely in China unless we see further significant policy mistakes and flip-flopping. China still
controls the banks, runs a large current account surplus, has a starting point of relatively low central
government debt/GDP so can absorb some of the bad debts and has a high savings rate with a partially
closed capital account. On a positive note, we are also seeing some rebalancing in China as services growth
outstrips industrial growth, and the Eastern seaboard (the “good” provinces) look much healthier than inland
and Northern provinces.
Asian equity valuations reflect gloom
With markets starting to discount a very gloomy outlook for China and panic setting in we have started to raise
the equity exposure of some of our portfolios. The outlook for the region may be poor but as mentioned above,
we don’t forecast a renewed financial crisis. Lower commodity prices should eventually help Asian economies
and Asian stockmarkets are now back to the levels they fell to during the eurozone crisis of 2011.
In a nutshell, we increasingly believe a pessimistic outlook is discounted in the region. We have reduced our
hedges and started to accumulate selected blue chip names in Taiwan and Hong Kong – mostly Asian-listed
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Talking Point: January 2016
global leaders in the technology and manufacturing space, often stocks that should benefit from a falling
renminbi. We have also added to defensive yield names, some of which have been sold off heavily due to
redemption pressures on income funds.
We remain cautious on ASEAN equities, however, where valuations in the main look high and earnings
expectations are still unrealistic (consensus expectations are for an acceleration in 2016 earnings growth
despite rising deflationary pressures and sluggish economies). China is relatively easy – we are staying very
much on the sidelines. We are happy to wait and see if “good” China (private sector technology, internet,
service, consumer related) names come our way as the panic and turmoil spreads.
Overall we will use further falls in Asian equities as an opportunity to invest in good quality businesses. The
situation is not pretty and China is truly in a difficult spot but investors should always remember there is no
correlation between GDP growth and stockmarket returns in Asia – least of all in China as Chart 3 most
dramatically shows.
Rising bad debts, collapsing Asian equity markets and turmoil in China are, we believe, a buying opportunity
as the long awaited economic cycle and creative destruction kick in.
Chart 3: Maybe a ‘new’ China economic model will lead to better stockmarkets
Source: MSCI, Factset.
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