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Bitcoin’s from time to time, coverage of China rises to a crescendo in the popular media. China coverage reflects some of the same schizophrenia that afflicts much of the media’s output. At many points in the past several years, according to the media, China has been a tottering giant whose economy is a bubble fantasy that threatens to pop and take the rest of the world with it. At other points, China has been an unstoppable economic powerhouse with ravenous geopolitical appetites, ready to take down the current global hegemons, fill Africa with military bases, conquer the South China Sea, and topple the dollar from its throne, elevating the yuan as a new world reserve currency. Sometimes we just wish financial media would make up their minds!
In all seriousness, though, there is a lesson for investors here: most media, especially financial media, sell fear and hype in an effort to attract readers and viewers. As we see it, our job in this newsletter is to point out what’s actually worth paying attention to, and subject it to some careful critical analysis — so that investors will not be swayed to irrational fear or irrational exuberance.
We don’t want to oversimplify; China is a subject of inexhaustible complexity even just from an investment perspective, never mind history or geopolitics. But in a world of overwhelming complexity, our approach has always been to follow the most insightful analysts as proven by a long track record, and to use their analysis to identify the critical elements of any subject. If we have a grasp of the critical elements, we don’t need exhaustive analysis to be able to navigate the investment landscape effectively.
So What Knowledge About China Is Critical?
In a nutshell, our favorite China analysts — those who we have seen to have the best analytical track records — say this: probably, there are no radical changes coming in the next five years, whether internal or external. And further, most predictions of imminent collapse in China are based on outright misunderstanding of the current Chinese economic situation. Much of our analysis below follows that of Jonathan Anderson of Emerging Advisors Group.
This means that investors can put aside their fears — first, that necessary reforms will be neglected, and second, that one or more commonly promoted boogeymen will tank the Chinese economy, and through it, the economy of the developed world, which depends on it as the engine for its growth. With those fears aside, investors can make tactical or strategic decisions about investing in China. (We think Chinese stocks look technically favorable at the present juncture, as we’ll describe below.)
China and Reform: “Zombie Companies”
What about reform? The received wisdom is that the Chinese economy is doomed to a “hard landing” — a disruptive collapse in growth — unless reforms are enacted. These supposedly necessary reforms include internal measures; one that’s mentioned often is the reining-in of inefficient, unproductive, debt-strapped state-owned enterprises (SOEs) which are supposedly dragging down growth in the economy as a whole. The trouble with this claim is that while there are inefficient SOEs in China, they are not a significant problem for the Chinese economy. First, look at net profit margins for China as a whole versus other emerging-market economies since 2002:
Source: Emerging Advisors Group
Overall, the profitability of Chinese companies is in line with their emerging-market peers and follow similar macro trends — that is, there’s nothing specifically “Chinese” to worry about here.
But do loss-making “zombie” firms comprise a large part of the Chinese economy? Again, the answer is no. When you add together outright loss-making firms and firms that are at risk (with low and falling margins), the U.S. itself actually ends up looking worse off:
Source: Emerging Advisors Group
Further, it isn’t the state-owned enterprises as such that are the problem; the loss-makers in China are simply companies in capital-intensive heavy industries, regardless of whether they’re state-owned or not. And the profitability of all such companies across the entire emerging-market world has been falling over the past decade. It’s not a specifically Chinese problem.
If the Chinese government implemented stringent reforms that pushed all of these companies into profitability or out of business; it would kill 1.2 million jobs and add just 0.3% to overall industrial profit margins in China. In short, it wouldn’t be worthwhile, and the government won’t do it… because it just isn’t that much of a problem. So as an investor, you don’t need to sit by the sidelines if the Chinese market starts to look attractive just because you’re waiting for reforms that will tackle “zombie companies” and “loss-making state-owned enterprises.”
China and Reform: Domestic and International Finance
Another area where media may encourage investors to “wait for reform” is in China’s domestic financial system and in its relationship to the global financial system. Here again, the waited-for reforms either (1) have already happened, or (2) will never happen.
On a domestic level, China since 2009 has seen the most rapid and unconstrained financial liberalization in world history. Large state banks have faded into the background, replaced by a bewildering welter of new asset and wealth management products. The “big four” state-run banks have seen their share of financial assets fall from 40% to 20% over the past decade. The financial system in proportion to GDP has doubled in that time. Assets held in non-bank financial institutions have expanded tenfold. China’s domestic financial system is not repressed by totalitarian control; on the contrary, it’s the Wild East. The effects of this liberalization have not been outstanding — domestic financial fragility has increased with relatively little to be shown in boosted GDP growth. But again, this is par for the course for emerging markets that have liberalized their domestic financial sectors in an overly rapid and relatively uncontrolled fashion.
And on the international front, despite faltering and largely symbolic steps, China remains very closed. And it’s going to stay that way. Some of the fearmongering around China’s rise to global power focuses on this point: a claim that China will open its financial system, that the yuan will become a world reserve currency and dethrone the dollar.
But this can’t and won’t happen. China is currently experiencing a massive domestic credit boom, as noted above. In such a situation, having an open financial system is the last thing any emerging-market economy wants, since being open would expose it to the vicious effects of external capital flows and cripple any effort the government could make towards managing its domestic credit cycle.
The End Game
In short, the story on China remains the same as we’ve been describing to you for the past several years. The government wants to maintain stability and its own hold on power by ensuring that growth continues and brings more of China’s poor into its growing middle class. The problem isn’t “zombie companies,” so there won’t be any significant efforts to rein them in. If there is a problem, it’s an ongoing struggle with the risk of financial instability that has arisen over the past decade with the government’s effort to support growth through radical domestic financial liberalization. That risk, in turn, means that there’s no reason to fear a rising China as a global financial superpower: they are not opening their financial system to the world any time in the foreseeable future, and the yuan will not become the new world reserve currency. Rather, the next five years, like the last five years, will see slowly declining growth and slowly rising risks of domestic financial instability. While there is a reckoning ahead, and in coming years China will likely suffer a domestic financial crisis, that crisis is not yet imminent.
Investment implications: When it comes to investment in China, here are the principles we use. First, use sober analysis to judge macro conditions; as we outlined above, we think such an analysis today is favorable. With that hurdle cleared, remember that the Chinese stock market is small and underdeveloped compared to developed-world stock markets; the total capitalization of the Chinese stock market at the end of 2016 was about 48% of GDP, versus nearly 150% for the U.S. This means that it is a market driven by the sentiment of retail investors; therefore we like to wait for a bull market to be confirmed before we seek exposure to Chinese shares. (The Shanghai Composite Index is currently up 24% from its 2016 low.) While Chinese stocks are not driven by fundamentals in the same way that developed-market stocks are, when they are in a bull market, fundamentals can become relevant as they affect the psychology of retail investors. In this preeminently sentiment-driven market, at this juncture we prefer the shares of China’s rapidly growing disruptive technology companies. Investors should bear in mind that accounting practices in China are often lax and financial reporting can be untrustworthy for other than the largest firms; therefore we recommend that outside those large firms, investors diversify by using one of the many sector-specific China ETFs that are available.
To learn more about Guild Investment Management, please go to www.guildinvestment.com.
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