Investment Strategy  

30/05/2017

CIO Viewpoint: China: Growth, Debt and Global Ambitions

Stéphane Monier Head of Investments, Lombard Odier Private Bank

Stéphane Monier
Head of Investments, Lombard Odier Private Bank

As the US steps back from global economic leadership, there are signs the world’s second-largest economy may be stepping up. China’s ‘One Belt, One Road’ project expresses the vast ambitions of President Xi Jinping. We are long-term believers in China’s growth and investment story - the backbone of our current overweight to emerging market debt and equities. As China enters a politically charged summer, we set geopolitical and financial risks against the significant promise for investors.

Breakneck economic growth – and its legacy

China’s recent economic rise is a story of unparalleled achievement. In the years following 1978 (when significant reforms were implemented), China’s economy grew at almost 10% on average annually until 2014, lifting an unprecedented 800 million people out of poverty. Today, China is the world’s second largest economy, and its largest in purchasing power parity terms. While its economy is slowing, in line with an ageing demographic and waning productivity gains, the authorities still expect growth to hit 6.5% this year1, as the economy continues to rebalance from manufacturing and exports to domestic consumption. This creates huge opportunities for investors facing low single-digit returns across much of the developed world.

Of course, China’s growth has come at a cost: pollution and environmental damage; unequal gains between the developed coastal east and the rural west; a rapid accretion of debt and bad loans in the banking system; underdeveloped institutions and court systems; frothy urban housing markets; and a net imbalance – albeit in China’s credit – towards the rest of the global economy.

As history repeatedly illustrates, managing breakneck growth is always a dangerous balancing act: witness stumbles made by China’s neighbours Japan (a property/stock market bubble that burst in 1992) and South Korea (a 1997 foreign exchange shock) during their own economic development. Indeed, the world continues to fret about China, most recently in late April and early May, when stocks fell, sovereign bond yields hit their highest level in two years, and bond defaults hovered at record levels.

Geopolitical and financial risks

We recognise that investors have good reason to be concerned by politics in the region. China is situated in one of the most geopolitically risky regions on earth, where the ambitions of the world’s three largest economies: the US, China and Japan, intersect with the opaque motivations of North Korea, and the aims of a number of rising Asian nations. There is no overarching strategic umbrella to resolve regional disputes, and it is impossible to say how North Korean moves, or disputes in the South China Sea or East China Sea will work out. We would only note that a new South Korean government may herald at least a more stable diplomatic framework ahead, and that China’s ‘chequebook diplomacy’ may ease the concerns of some of its southern neighbours, notably the Philippines, over its expansion in the South China Sea.

In our view, the biggest issue for would-be China investors in the next 3-5 years is financial risk, as the country deals with its rapid accumulation of debt. This surpassed 250% of gross domestic product (GDP) in 2016, and is held largely by corporates and households. In recent years, authorities have struggled to deal with bad debts and systemic risk in the banking sector, and continue to support a number of failing businesses or ‘zombie companies’, particularly large state-owned firms. Not all of this debt can be honoured in the medium term. This leaves policymakers with an unpalatable choice: accept significantly higher inflation, which would act as a tax on households that already save 40% of their income; or accept defaults on a significant portion of debts, a tough and politically risky decision.

Opportunities in the ‘Year of the Rooster’ and beyond

Yet for now, we are not worried about a ‘hard landing’ for the Chinese economy. Indeed, volatility in late April and May was driven largely by Beijing’s efforts to squeeze out some of the leverage from financial markets. Much of the banking credit is funded by deposits, and mortgage debt as a percentage of GDP remains low. We believe there is much to admire in China’s recent economic planning and policymaking efforts, and the authorities retain sizeable fiscal and monetary policy levers with which to continue supporting the economy, including 3 trillion US dollars (USD) in foreign currency reserves2.

This year more than most, they have reason to hold a steady ship, as November sees the Communist Party’s five-yearly National Congress. This year, largely by dint of an ageing leadership, a significant portion of the upper echelons of power could be replaced, and President Jinping will seek to install new allies, tighten discipline and make his mark on long-term party philosophy. At such a crucial time politically, the authorities will be more keen than ever to avoid sharp falls in stock prices, currency movements, or over-aggressive tightening in the property market.  

Meanwhile, much of US President Donald Trump’s touted trade protectionism has not materialised, and as the US withdraws from the Trans Pacific Partnership (TPP), there are signs that China may step into the breach. China has recently stepped up its efforts to conclude a Regional Comprehensive Economic Partnership (RCEP) in Asia, which, although narrower in its scope than the TPP, would provide a regional free trade framework. Meanwhile, President Jinping’s ‘One Belt, One Road’ campaign marks him out as one of the most ambitious leaders in China’s modern history. This planned series of infrastructure projects would form an unequalled network of trade and investment linking China by land through central Asia and Russia to Europe, and by sea through Africa and the Mediterranean (see graphic below). While details are sketchy at present, and many projects may never be realised, it looks at the very least to be a shrewd political move, inspiring regional goodwill and promising gains for China’s neighbours and wider trading network.  

In the longer term, of course, China retains a position of strength as a net creditor to the world, with large trade and current account surpluses. It also boasts some impressive companies leading the way in ‘new economic’ sectors such as e-commerce, renewable energy and electric cars. We believe China’s physical and technological infrastructure should continue to support its economy, as we see growth gradually slowing to a more sedate 3-4% in the coming 10-20 years, providing plenty of long-term opportunities for savvy investors.

1Official Chinese government target
2Official figures for April 2017

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