It was a good idea at the time. But China’s ‘Go-out’ strategy, to encourage the flow of overseas investment is now viewed as a potential crisis rather than an opportunity.
In other words, Chinese companies on a debt-funded acquisition binge have been stopped in their tracks, as the government saw this activity was beginning to threaten the country’s banking and financial systems. It has therefore stepped in to prevent a potential financial crisis, that could undo the country’s economic achievements. For instance, lenders and regulators have been asked to probe four high-profile companies which have been on a spending spree abroad. Unsurprisingly, this is anticipated to have a negative impact on global mergers and acquisitions, as China has been the only country with excess capital to spend, while the rest of the world has been dealing with the after-effects of the global financial crisis.
However, we believe that private enterprise debt is unlikely to pose a serious threat to the Chinese economy given that the government has acted swiftly to address the problem. It is also tackling the issue through its initiative of debt to equity swap deals, which are aimed at lowering corporate debt as well as the banking system’s bad-debt ratio. While it is still early days, progress has been made. In July Moody’s upgraded its outlook on the country’s banking industry from negative to positive. And that is not the only positive indicator: the combined debt of banks and other deposit-taking institutions fell from 72.4% of GDP at the end of 2016, to 71.2% at the end of March 2017.
In addition, the stricter supervision and the curtailing of large outflows of capital means that foreign exchange reserves are rising again in China, which helps improve confidence in the equity market.
It is one thing for the government to curb what could potentially be reckless corporate spending, but other measures are essential to maintain the growth of the world’s second-largest economy.
China has followed the path of Germany and Japan, in that the interest-rate environment has been kept artificially low to enable the economy to industrialise rapidly. However, we believe it now needs to change its business model to sustain long-term growth by restructuring the economy as a more service-oriented version or to enhance product capabilities within the manufacturing sector. In addition, the private sector must be allowed to flourish, with the government aiming to maintain a level playing field within the business environment. The private sector should also be encouraged to generate ecosystems of businesses that cater to the fast-changing tastes and habits of consumers. Successful businesses like Tencent and Alibaba demonstrate how well this can work.
The government recognises the need to rebalance the economy, with more of an emphasis being placed on the services sector. And it is making headway with this goal. The services sector contributed more than 50% of GDP in 2016, for the second year in a row. The aim is to reach 70-80%, the average for advanced economies. It is taking other steps too. To date, the country’s supply-side reforms have also been successful, and monetary policy has recently been tightened, raising the cost of capital to reduce resources flowing into sectors which have overcapacity problems, such as heavy manufacturing (eg steel, cement and shipbuilding).
Our view is that China is in a ‘sweet spot’ after five years of deflation and that the current reflationary environment has further potential.
The economy remains buoyant despite the tighter domestic liquidity arising from the government's deleveraging campaign – highlighted by the IMF’s revising its China growth forecasts upward to 6.7% for 2017 and 6.4% for 2018. Second-quarter GDP was 6.9%, maintaining the rate of expansion in the first quarter and defying expectations of some moderation. In addition, based on the strong first-half results and with cyclical momentum seeming more sustainable, we believe that GDP growth for 2017 could be greater than anticipated. Nevertheless, challenges remain: in the short term, these are likely to come from external sources such as US interest-rate hikes or instability in North Korea.
However, we believe that the various data we have previously referred to could have a positive effect on market sentiment. Chinese equity investors focusing on sectors leveraged to the robust economy, within a diversified portfolio could benefit from capturing positive themes as they emerge and develop.