Could China spark a second Asian Financial Crisis? July 2017

In 1997, Thailand’s currency rapidly devalued and sparked an outflow of capital across the Asian region as investors spooked and equities fell 60% in value in the year to August 1998*. High government and corporate debt levels in countries including Thailand, South Korea and Indonesia led to severe recessions and, eventually, International Monetary Fund bailouts.

At the time, China avoided ‘contagion’ due to capital controls, weaker currency and lower debt levels. Now, the situation has changed. Should we be concerned another regional crisis is on the cards? We asked Mark Williams and Carolyn Chan, managers of Liontrust Asia Income, for their views.

Do investors need to worry about China’s debt levels?

“When the crisis occurred 20 years ago, much of the region’s debt was owed overseas. So when currencies devalued, this became a major problem. Today, the vast majority of China’s debt is funded domestically, which means that a sudden disappearance of funding sources is unlikely.

“Across the region, companies are now less reliant on high levels of foreign debt and an assumption of fixed exchange rates. Corporate debt to equity ratios are now much lower. Also, while China’s gross debt is very high, it is primarily owed by the state (meaning state-owned enterprises) to the state (meaning state-owned banks). This makes it far easier for the debtors and creditors to reach agreement in the areas where debt is unsustainably large.

“It also means that the state’s assets can be an important offsetting factor. China has huge forex reserves (making a forced currency devaluation unlikely) and a centrally-directed economy that can, in our view, withstand a lot of stress without any systemic problems developing.”

How has China’s investment outlook changed over the past 20 years?

“Back in 1997, Hong Kong was a key investment market. The Hong Kong handover from Britain to China took place the same summer as the Asian Financial Crisis. At that stage, China had yet to really emerge as an investment destination, but Hong Kong was already an established developed market constituent of the MSCI All Country World Index.

“Over the last 20 years, however, China’s economic transformation has overshadowed Hong Kong’s own strong economic growth. Hong Kong is still a large economy – its GDP is around US$320bn. But while this represents a rough doubling in the last 20 years, China’s GDP has grown more than ten-fold over the same period to over US$11tn^.”

What is your investment outlook on China for the next 20 years?

“In the short term, our base case for Asia is a further, desirable, economic slowdown. China itself needs to remove its reliance on inefficient, debt-driven investment and become more reliant on domestic consumption as a growth driver.

“This means that if Asia Pacific shares merely remain at their current fair valuations, there is the potential for about 10% expected earnings growth to be passed through in the form of share price appreciation. Growth rates will still be very high by Western standards.

“In the longer-term, we expect to see further rebalancing from external to domestic demand. While US influence in Asia is on the wane, China is expanding its influence, making huge infrastructure investments, which include the One Belt One Road project (US$900bn). It has also set up the Asian Infrastructure Investment Bank.

“All will not be plain sailing in China’s growth story, though, and economic and financial transitions will have negative effects in some areas of the economy – so you need to be very selective in terms of where you invest.”

Where are you finding income stocks in the region?

“There is a deep pool of Asian companies offering an attractive combination of yield and growth potential. If we screen globally for companies forecast to yield more than 4% and post earnings growth too, we find that over a third of these companies are located in Asia Pacific ex-Japan.

“This pool of potential investments is likely to grow, partly due to the improving dividend culture in the Asian region. China is showing signs of a maturing approach to dividends and minority shareholders, both at the corporate and political levels, and South Korea is slowly making tentative steps in the same direction. This is important as it often forces capital discipline on companies which can ultimately be of benefit to shareholders.”

*MSCI Asia ex-Japan, quoted in Liontrust Asian Income update, 28 June 2017
^Source: IMF, quoted in Liontrust Asian Income update, 28 June 2017