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The importance of China to UK investors

It might seem geographically and culturally removed, but China matters to UK investments. It matters a lot.

From childhood to manhood

The Chinese economy has grown from $1.1tn at the beginning of the year 2000 to $10.9tn at the beginning of 2016 (1), making it the world’s second largest economy this year after the US ($17.9tn) and sending it streaking past the likes of Japan ($4.1tn), Germany ($3.4tn) and the UK ($2.8tn). China’s industrial boom made it the world’s largest consumer of raw materials including 60% of the world’s concrete consumption, 54% of the world’s aluminium consumption, as well as around half of the world’s consumption of nickel, coal, copper and steel (2).

This provided a significant boost to commodity-exporting countries: the gross domestic product (GDP, i.e. the size of the economy) of Australia, Brazil and Indonesia rose by between 280% and 550% during the period 2000 to 2013. In addition, China developed a huge current account surplus, so it put that money to work by investing, for example, in US government bonds providing a considerable stimulus to the US economy. This helped US GDP to grow by around 70% over the same period, despite the blip in growth during the financial crisis.

So, the spectacular growth of the Chinese economy lifted the global economy as a whole, taking investments across the world up with it; the FTSE Global Equity Index rose from 177.68 in December 2003 to a peak of 645.45 in July 2013 (3). With Chinese economic influence appearing more likely to grow than to diminish, the outlook for Chinese development and the factors affecting it are relevant to every investor.

Middle-aged spread

The spectacular growth of the Chinese economy has had many significant effects that have made it necessary for the country’s policymakers to drive fundamental changes.

One of the factors that drove growth in China was the abundant availability of cheap labour; GDP per person in 2000 was $949, this grew to $6,807 in 2013. The growth has not been evenly spread across the population, but Credit Suisse estimated that China has 1.3m millionaires (4) while consultancy McKinsey estimates that the country has a middle class that has grown from 4% to 68% of urban households (5).

Unsurprisingly, there has been a huge migration from rural to urban living in China, with the urban population increasing by 500m people in the past three decades according to The Economist, “the biggest movement of humanity the planet has seen in such a short time.” (6)

These factors have engendered a more sophisticated populous with higher social expectations and lower tolerance of poor working conditions relating to safety and pollution. And that means increased labour costs which have helped to make China less competitive as the world’s factory floor. The nature of the Chinese economy is changing again.

Total foreign direct investment in China fell 3.7% in 2012 according to the Ministry of Commerce in January 2016, that’s the first annual decline since the global financial crisis in 2009. Retail sales in China have increased by an average of 13.2% between 2010 and 2016 according to figures from the National Bureau of Statistics of China. At the same time, consumption of raw materials has fallen as reflected in the GDP totals for Australia, Brazil and Indonesia which have declined by between 6% and 28% since 2013.

China is in the advanced stages of a giant leap forward in social and economic sophistication, and this is changing what it buys and from whom. However, this is a double-edged sword. The Chinese authorities want to shift to higher-value production and to see incomes rise, but they are under pressure to find jobs to replace those being lost by any erosion in the manufacturing sector.

UK companies affected

To put this into context as to how it could affect UK investors, shares in commodity-related companies such as BHP Billiton, Glencore and Anglo American suffered as a result of the rebalancing of the Chinese economy falling in value by between 66% and 89% during the two years from 2013. Since then, those companies have begun to address their over-expectation of increasing demand and have started to reduce their debt burdens. It’s not just commodities companies that are affected. According to analysis by Citigroup quoted in The Guardian, “ARM Holdings, Burberry, HSBC, Intertek and Standard Chartered all generate more than 20% of their sales from China and the far east”, so they are very keenly attuned to the future of the Chinese economy. All the companies mentioned in this section are listed on either the FTSE 100 or FTSE 250 indices.

The living dead

Protecting jobs is one of the reasons that China’s legacy of state-owned enterprises (SOEs) continue to exist. In a damning article entitled “The state-owned zombie economy”, the Financial Times takes the example of China Ocean Shipping Group which ordered 11 new vessels in 2015 at a cost of $1.5bn, most of which will come from government subsidy. The increase in capacity comes after the company directors themselves acknowledged in their annual report that “overall demand in the shipping market weakened” while “oversupply in shipping capacity continued.” With such managerial decisions being made it is, perhaps, unsurprising that the company made a $580m loss in the first nine months of 2015. What’s also very worrying is that it has a debt-to-equity ratio of 206% at the end of September 2015, contrasting with the 66% average of Shanghai-listed companies (7).

This creates a three-fold problem. Firstly, money that should be going to more efficient and competitive companies is being syphoned into “zombie” companies. Secondly, this is creating a huge pile of high-risk debt that could create a sudden financial shock when the bill finally has to be paid or when the banks that are lending the money can no longer continue in business due to being overburdened with non-performing loans. Thirdly, business for any efficiently run company competing with an SOE is unsustainable because the SOE can keep getting bank loans or government support allowing it to continue to undercharge customers.

On the flip side, as the Financial Times article points out, if overcapacity in the coal and steel industries were to be addressed, 1.8m jobs would be lost. Apply that across a range of massive industries and you’re facing a huge loss of employment and a significant up-swell of socio-political pressure.

But if the Chinese economy is to avoid a nasty crash, the zombies have to be eliminated or brought back to life by the healing sunlight of competition and shareholder interest.

Signs of life

There are signs that this is being addressed albeit inconsistently. According to, Jason Bedford, China Analyst at UBS, “the process has started…we estimate that from 2013 to 2015, the banking sector disposed of 1.65tn to 1.80tn yuan of impaired loans and raised 620bn yuan in capital.” (8) Bedford recognises that while this is a “good start” more needs to be done and the whole exercise of bank recapitalisation would be academic “if SOE reforms aren’t pursued and credit growth continues to outpace GDP growth by two- to three-times.”

Also, it’s not clear what is happening to the newly raised capital. Bedford goes on to suggest that an increasing amount of it could be being used to meet interest payments on older loans as corporate earnings and cash-flows worsen. This is a worrying sign as it adds to the problem.

However, there is a simple trend developing in the corporate SOEs themselves that might lead to a positive outcome. According to Bernstein’s Michael Parker (9), the total pay packets for managers in the 20 largest SOEs has been in steady decline since 2009. This could tempt the more talented managers to join other non-SOE companies leaving the less talented managers in place and inclined to run the SOEs “in a more conservative manner, producing more cash, and strengthening their balance sheets as a result.”

Finally, according to BCA Research, the government has plans to strengthen the social safety net which would help to reduce the pain of unemployment and provide an incentive to domestic savers to reduce their extremely high rate of saving. This could enable more money to circulate in the economy and potentially stimulate growth. What’s more, the rate of saving seems to have peaked at more than 50%, so an improved welfare provision could help to speed the reduction of savings rates (10).

Rejuvenation

The reform agenda has also just received a more concrete potential boost courtesy of the International Monetary Fund (IMF) finally agreeing to include the yuan as one of its reserve currencies. This is something that Zhou Xiaochuan, head of the Chinese central bank, has been pursuing for a long time. According to Tom Mitchell in the Financial Times (11), this helps to fulfil Mr. Zhou’s dual agenda of “reducing the global dominance of the US dollar while also overcoming domestic opposition to currency reforms at home”. As well as raising the status of the Chinese currency, it means that the yuan will join the dollar, the euro, the yen and the pound as one of the IMFs official lending currencies in official bailouts. Within China, it will mean that opposition to reforms will constitute opposition to the IMF i.e. global finance, rather than just disagreeing with a fellow countryman in Mr. Zhou.

What Mr. Zhou appears to have recognised is that China has to reform if its economy is to withstand the potential threats of falling productivity and rising debt. According to the Financial Times’ David Keohane “for any nation, the pace of potential growth equals productivity growth plus labour force growth. In China, labour force growth is heading to zero” (12). For productivity to take on the mantle of growth on its own, the importance of allocating capital to the most productive people and business opportunities is essential, and that means not propping up lame SOEs that, in effect, provide nothing more than state benefit for its employees and, some might argue, a comfortable existence for the respective companies’ cadres.

This is ultimately an internal political battle, the outcome of which is unknowable at this stage. But if the Chinese Politburo can drive reform through all levels of national and local government, then the rebalancing of the Chinese economy is likely to bring some short-term pain in the form of increased unemployment and reduced economic growth in exchange for a positive outlook for sustainable growth and the avoidance of a severe economic crash. That would be good for China, and what’s good for China can often be good for UK investments.

Pros and cons

Pros include economic sentiment which is improving with more evidence of stabilisation. Consumer expenditure is ahead of forecasts with sales of vehicles and property increasing year-on-year by more than 27% and 16% respectively. Heavy industry output has adjusted which is helping steel and cement prices to rise to more realistic levels. Also, inflation is running at a moderate rate of around 1.3% (13). However, the more significant development relates to factory gate prices, or “producer prices inflation” (PPI). Chinese PPI has been negative (i.e. in deflation) since March 2012, but it is set to return to positive in November 2016. One of the reasons that this is important is that inflation makes it easier to repay debt because rising prices erode the real value of the debt. So if manufacturers are able to put their prices up, it could lead to them being better able to pay down debt or invest for the future.

Cons include risks pertaining to the Chinese currency, the yuan, and financial stability. Chinese policymakers rattled international investors in August of 2015 when they unexpectedly devalued the currency by 1.9% against the dollar. Not only did this raise concerns of deflationary pressures being triggered worldwide, it also encouraged some investors to withdraw capital from China in order to place it where the currency might be less subject to any further losses of value. China needs to retain capital in order to bolster investment and growth, so the country has a degree of vulnerability to a financial shock, such as might be triggered by a rapid rise in bond defaults.

Outlook

The outlook for equity valuations in China is improving. Stock prices have not risen at the same rate as those of other emerging markets, but they have begun to do so of late. Industrial sectors that we feel might benefit from further growth include those of technology, real estate, banks and consumer discretionary, while we feel that the outlook is less positive for telecoms, energy, consumer staples and utilities. An example of this rebalancing of the economy can be seen in the growth of the consumer discretionary sector. Sportswear giant Nike has reported that, excluding currency changes, Greater China (which includes the likes of Hong Kong, Taiwan and Singapore) accounts for 24% of future orders, much the highest regional contributor and way beyond Nike’s native North American contribution of just 6% (14).

(1) Measured in current dollar value, source: World Bank/ Bloomberg 6 October 2016. (2) Source: Visual Capitalist, 10 Sep 2015. (3) Source: Bloomberg. 6 October 2016. (4) “Global Wealth Report”, Credit Suisse, reported in “Countries with the most millionaires”, CNBC 13 October 2015. (5) The number of urban households earning between $9,000 and $34,000 a year. (6) Source: McKinsey report, “Mapping China’s middle class”, June 2013. (7) “The great sprawl of China”, The Economist January 2015. (8) “China: The state-owned zombie economy”, Financial Times, 29 February 2016. Source: “Of Chinese bank bailouts, SOE pay scales and credit cycles”, Financial Times, 22 August 2016. (9) Ibid (10) Source: “Strategy Outlook: Fourth quarter 2016”, BCA Research, 7 October 2016 (11) Source: “China’s renminbi joins elite global reserve currency club”, Financial Times, 30 September 2016. (12) Source: “Of Chinese bank bailouts, SOE pay scales and credit cycles”, Financial Times, 22 August 2016. (13) Source: JP Morgan “Global Asset Allocation” 6th Oct 2016. (14) Source: Nike Inc fiscal 2016 fourth quarter and full year results, 28 June 2016

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at October 2016. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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