Co-founder of MBMG Group
A developing story – Funny business in the Year of the Monkey
China is in the midst of structural transformation from a
manufacturing-driven economy to a consumption-led one; from a state-directed
command economy structure to being market driven. It’s also gradually
working towards a more liberalized or more convertible currency. But can its
economy continue to grow?
Economic uncertainty and a likelihood of further ‘surprise’
currency depreciation has dramatically increased outflows which hit
USD170bn, or equivalent to 5% of its foreign reserves in December 2015
The RMB remained too tightly pegged to the USD for too long. This has
created some major structural imbalances which will need to be unwound.
These structural shifts are occurring during a time of dangerously high
corporate debt; a continuing slowdown in economic growth; collapse in
several commodity prices (somewhat artificially buoyed up by China in the
first place); a corruption crackdown; and eye-opening interferences in the
capital markets which overall has led to sporadic, dramatic losses for the
investing public: many people have rushed into stock margin-loans.
Depending on which figures you believe, corporate debt accounts
for between 140%-175% of GDP – even the lowest estimate is one of the
highest in the world. A lot of which is at the state enterprise level: a
contributory factor to the unknown but presumed high level of non-performing
loans (NPL) within the banking system.
Inter-bank (HIBOR) lending rates recently spiked up to around 70%,
comparable to countries in the months preluding a full-blown financial
crisis. They then fell sharply, highlighting the sheer volatility and
uncertainty attached to China. It’s not clear exactly which banks were
lending to each other at these rates: rates which tend, at various times to
be manipulated to the low side by huge injections of state liquidity and can
cause subsequent spikes if withdrawn again. Such unknowns only amplify the
lack of transparency and lead to damaging mal-investment and speculation.
In addition to this, export growth has been slowing in USD but grew more
than 2% in Renminbi terms according to the country’s latest data. Also,
labour costs have been creeping up, reducing job demand. This confirms my
long-held suspicions that excess capacity (caused by excessive investment in
fixed asset formation following the onset of the GFC) has resulted in highly
marginal and sometimes negative manufacturing profit margins.
GDP is another hotly-debated subject. Many economists consider the published
growth rate to be higher (perhaps significantly) than the reality and may
have been for some time. If this is true, hiring rural immigrants may not be
enough for manufacturers to improve results. This is strangely relevant
because rural consumption expenditure levels are significantly lower than
their urban equivalent: once workers move from the countryside to the cities
there’s often a sudden jump in their consumption, thus an increase in
overall GDP growth. A lower rate of consumption, coupled with a slower GDP
growth caused by China’s attempts to move from its moribund export model
(global trade is now back to levels preceding the great China boom of the
noughties), would further diminish economic growth.
The Chinese authorities are still likely to continue monetary
easing through 2016 to maintain growth. This will pile further pressure on
the RMB to continue to weaken further – but the consensus isn’t particularly
helpful with many economists seeing the currency weakening by 5-20% in 2016.
To what extent the Chinese will be prepared to support the Renminbi given
the alarming draw-down on its foreign reserves in 2H 2015 is also an
unknown. Still, any rapid draw down in foreign reserves would further
That doesn’t mean that the policy tools available can’t give the impression
of a fully functioning economy and capital market in China for the remainder
of this year and possibly even longer. The only structural fix for China
that I envisage involves the genuine write-off of unpayable debts, the
bankruptcy of rotten businesses (state, publicly and privately owned), the
unwinding of government manipulation of capital markets and a huge amount of
economic and financial pain, before China can build a solid base for the
next stage of its economic resurgence.
SocGen’s Albert Edwards is predicting that Chinese equity markets will fall
by 75%. That could easily be right but is more likely to be understating or
overstating how bad things need to get before they can structurally get
I feel that the range in possible currency and market performance is really
too wide to be able to refute or confirm whether China would be a
terrible/bad/OK/good/amazing place to invest this year.
For the short term, any exposure to China should be considered as
speculative. I firmly believe that in the medium term, China’s economy and
markets will face exceptional difficulties and potential losses and thus
should be seen as dangerous. For the longer term, it could be one of the
more attractive high risk opportunities available. Therefore the key to
investing in China is really how well that matches your own expectations and
My best guess looking ahead is that the Renminbi is set to weaken further
and that this will damage confidence, pushing down along with it Chinese
share prices, as well as currencies of neighbouring economies, with far
reaching ripple effects for all capital markets. Although, if investors
believe that a weaker currency is the panacea for all Chinese woes, this
could just as easily lead to an equity rally, in which case the recently
launched currency hedged China ETFs would perform strongly.
But if not, I wouldn’t be surprised to see the Shanghai stock market (SSEC)
drop significantly below 3000 points in 2016.
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contained herein is correct, MBMG Group cannot be held
responsible for any errors that may occur. The views of the
contributors may not necessarily reflect the house view of MBMG
Group. Views and opinions expressed herein may change with
market conditions and should not be used in isolation.
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