China – Meltdown or Slowdown?

I'm often asked about China as an investment opportunity. Mainly because its economy has such an impact on both emerging and Asian equities, but also increasingly more on global equities.

So, it was with interest that I attended a meeting with Matthews Asia last week. As their name suggests, they are specialists in Asian equity investing and the two fund managers in attendance – Yu Zhang and Lydia So – did not disappoint when it came to expressing their views. As you would expect, they were upbeat on the outlook for the region. But at the same time, they were honest about the challenges faced.

Almost the very first words from Yu Zhang were in response to the question about whether or not China will have a melt down. His answer was: “The risk is very real”.

The managers expanded on the fact that the Chinese financial system is indeed vulnerable, particularly shadow banking and local government debt, as well as the growing property bubble. But, they said, this is all priced into the market and explains why China is currently cheap. The market is still valued at less than half than it was in its 2007 heyday. According to the managers, the worse-case scenario of a meltdown has been priced in.

The banking system is still very simple, which is good. And, according to Zhang, the amount of credit in the system is not the issue – the pace of credit growth is. And when you look a little more closely, you can see why, very clearly. Local government officials used to be incentivised by the level of their regional GDP numbers (how fast their local economy was growing). If they wanted a promotion, they simply spent money to help the economy grow. That has now been changed and instead, they are rewarded for cleaning up their environment and making growth more sustainable. So local government debt growth is slowing.

In addition, households have very low debt levels and as long as the consumer balance sheet is in good shape, there is a buffer, should there be any wider financial distress.

Another worry amongst foreign investors is whether China has over-invested. Ghost cities and empty motorways are often mentioned when looking at the massive infrastructure development, but the Matthews Asia managers argued that if China had over-invested, deflation would be raising its ugly head, and it's not.

There is also more talk these days of Chinese labour – once very cheap and attractive to foreign companies, now becoming expensive and the reason why many companies are 'reshoring' closer to home. But there are positives to find here too. Wages are rising but workers are more productive – fuelled in part by the fact that the working population is now more educated. There are no fewer than 6 million college graduates each year. And this is where the move from an infrastructure and heavy industries-based economy to one with a larger services sector will help. The service sector can create a lot of jobs. This will help limit social unrest, increase consumer spending and actually lower energy resource consumption.

The meeting finished with the summary that yes, there is no doubt that China is at an economic crossroads, but a slower, balanced and more sustainable economy will be better for investors in the long term. The credit dragon still needs to be tamed and more transparency is required so that we can trust the data coming out of the economy. And there will be hiccups along the way as the economy transforms.

However, the right actions are being taken and to presume that China is losing control and that the present slowing of growth is unplanned would be wrong. Whatever one feels about the reforms, they are anything but haphazard. Perhaps we just need to be patient and more realistic.

For the first time in a long time, some of my doubts over China were calmed, but not banished completely. I'm still sitting on the fence some degree. It won't be plain sailing but, if investors can be patient and realistic that returns simply won't be as huge as they once were, money could still be made over the very long term.

And here, a habit ingrained in British investors and companies could come to the fore once again. Dividends. In a slowing economy, these payments can make a huge difference. As elsewhere in the world, Chinese companies paying dividends tend to have more conservative management who don't waste money and the dividend pool there is growing fast, with a six-fold increase since 2000. If you can get 3-4% per annum in income, you only need mid-single digit growth to get a very attractive combined total return. That's much more realistic.

By Darius McDermott, managing director, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius' views are his own and do not constitute financial advice.

Published on 25/03/2014