What to look out for when investing in China in 2017

The Chinese economy has attracted a great deal of negative criticism in the last couple of years. In 2016, growth was at a 26-year low. But it is important to remember that the GDP grew at a very respectable 6.7% in the year. This is several times the level of growth clocked by western economies. Developed countries would give an arm and a leg to be able to replicate China’s “low” growth.

According to the naysayers, the economy grew on the back of large volumes of government investment and an unsustainable real estate boom. Despite this, the long-term prospects for China remain highly positive. A recent report says that Asia’s middle class population will mushroom from 500 million in 2010 to 1.75 billion in 2030. China alone will have a billion people in its middle-class by that year.

Source: Global-is-Asian

Here are some factors that could play an important role in the Chinese economy in the near-term.

 

Outlook remains positive

Although the government has cut its growth target to 6.5% for the year, early signs indicate that the country is on track to stage a recovery of sorts. A statement made by a vice chairman of the state economic planner revealed that industrial output registered a 6% rise in January and February. The “survey-based” unemployment rate in 31 cities was at approximately 5%.

Referring to the recent improvements, Li Wei, the director of the Development Research Center of the State Council, China’s cabinet, said that the economy has moved from a “downward stroke in the L-shape to the horizontal stroke.” But he added that “Our economy still has many difficulties to resolve…”

 

Rising debt levels could pose a problem

A Reuters report issued in October says that 25% of China’s firms did not have adequate profits in the first half of the year to service their debts. The country’s firms owe lenders a massive US$18 trillion, a figure that is 169% of China’s GDP.

How is the country tackling this issue? Banks and other lenders are rolling over loans and allowing borrowers to defer the payment of interest. Roland Mieth, a portfolio manager with PIMCO Singapore, says that this policy of “…kicking the can down the road…” will give the country stability in the short term. However, this practice could have negative implications over a longer period of time. Capital will get misallocated and the mounting debt will become even more difficult to manage.

The country’s real estate sector is especially vulnerable. Chinese developers carry about US$6.2 trillion in borrowings. Some of this debt will be affected by rising US interest rates as it has been raised in Hong Kong and Singapore. Much of the real estate sector is dependent upon constantly rising property prices, something that can’t go on forever.

 

A bubble could be forming in wealth management products

Investments in China’s wealth management product sector total US$9 trillion. Although these amounts are not protected by government guarantees, individual investors hold the view that in the event of a default, the authorities will bail them out.

Referring to this implicit guarantee, a Chinese investor is quoted in a Bloomberg report as saying, “It’s not how the Chinese government does things, and it’s not even Chinese culture.”

Wealth management product volumes have grown exponentially in the last few years.

Source: Bloomberg

The faith that investors have in these products is not unfounded. A total of 181,000 products matured in 2015 but only 44 made losses. Recently issued wealth management products offer a return of 4.3%. A one-year bank deposit pays just 1.5%. Obviously, this record is unsustainable.

A run on wealth management products could throw the entire financial system out of gear. These products carry an average maturity of 127 days. They have invested large sums in the corporate bond market where the average maturity is 7.5 years. This mismatch could prove to be their undoing.

 

Capital outflows

China devalued the yuan in August 2015. Since that date, over US$1.2 trillion has left the country. The reasons for this outflow are many.

• Chinese companies have accelerated the pace of repayment of foreign debt to protect themselves from further devaluation.

• Well-heeled Chinese are buying properties in London, Canada, and Australia to protect their wealth.

• Domestic households are buying other currencies and using more of their annual US$50,000 conversion allowance.

The government is trying to plug the outflows but has met with limited success. Among the steps that it has taken are issuing instructions to banks to temporarily halt cross-border yuan payments till they can balance inflows and outflows. State-owned firms have been told to sell foreign currency and convert their holdings into yuan.

 

Short-term prospects may be mixed

Although China’s strong domestic demand will remain an important growth driver in the coming years, the economy may face headwinds in the immediate future.

Currently, China is undergoing a rebalancing where it is moving from government-led growth to an economy that is dependent to a greater extent on services and demand from its growing middle class. This transition may take many years to complete and this period could see some economic turbulence.

(By Ravinder Kapur)

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