It’s Time For A Reality Check On China’s Bad Press

GAVIN WENDT: Every economic and market presentation I have attended for the past six months or more has a slide showing a diminishing percentage rate of growth in the Chinese economy.

There’s no doubt that the world’s second-biggest economy is decelerating. However if one takes a step back from the conflicting daily headline numbers, a different economic reality emerges.

China is in the midst of an ambitious and risky rebalancing act – away from its old growth model of credit-fuelled, investment-led and export-powered growth – that generated 10 per cent annual average GDP gains from 1980 to 2012.

Reality Check on China’s Bad Press

Not surprisingly given the media’s predilection for sensationalism, there has been a lot of negative press written about China over recent times.

Even the US share market plunge was blamed on China, without for a moment considering that the US market was long overdue for a correction.

The performance of both the Dow Jones and NASDAQ indices over the past five years clearly justified a correction – a situation that is a necessary and healthy component of sustainable market appreciation over the medium to longer-terms.

With regard to China, there are a lot of overnight experts espousing all sorts of doom-and-gloom commentary with respect to the nation’s economic outlook and its share market travails.

Interestingly, most of these observers were oblivious to China’s astonishing share market run over the past 12 months, but have become instant experts in the wake of recent market volatility.

Sadly, negative news always captures the public’s attention, so scribes have been busy penning stories of China’s demise.

The key point here is to differentiate between the respective health of China’s share market and its economy.

China’s Economy

We all know that Chinese authorities for some time have been transitioning the nation’s economy away from construction-driven growth to an economy more focused on consumer spending and growth in services industries.

Authorities have also set out to engineer lower and more sustainable growth rates throughout the broader economy.

Between 2011 and 2014, the size of the service sector in China as a share of GDP rose by about 4 percentage points to 48 per cent, whilst at the same time the share of the industrial sector dropped to 43 per cent of GDP.

This is a marked change from a decade ago, when the industrial sector accounted for 47 per cent of the GDP and the service sector only accounted for 41 per cent of the economy.

The long game in the eyes of China’s authorities is to transform China’s $10.4 trillion economy into a more sustainable one, featuring a vibrant service sector and a more diversified finance industry that doesn’t rely so heavily on state-owned banks to allocate capital.

China’s Sharemarket

Commentary with regards to China’s stock market volatility needs to tempered by taking into account a few very important facts – China’s Shanghai composite index had risen by 152 per cent since July 2014 and 59.7 per cent since the start of this year, while the Shenzhen SME board had risen by 138 per cent since the start of this year. In such a situation, a market correction of the type we’re now witnessing is inevitable (indeed, it’s almost a necessity).

Aside from fundamental reasons such as monetary easing and market reforms, the China market rally has also been driven by new liquidity from retail investors and momentum, as well as a belief that supportive policies from the government. This led to a situation where stocks were clearly becoming overvalued.

In my view, the sharp correction in the stock market should have a limited impact on the stability of China’s overall financial system, which is dominated by the banking system.

Even though banks may have become involved in the equity market through various wealth management products and OTC channels, even the highest market estimate of potential bank exposure (up to RMB 2 trillion) is dwarfed by the RMB 180 trillion in banks’ total balance sheet.

One of the really interesting aspects of China’s current share market rally has been the participation of ordinary retail investors.

Household participation in the stock market rose sharply in recent months, with the latest official numbers suggesting there are about 175 million A-share accounts, with 29 million accounts classified as active.

The government may be concerned that large and widespread investment losses could lead to a notable negative wealth effect, which could weaken consumption.

China household wealth – June 2015

I believe the current stock market turmoil will ultimately only have a limited impact on China’s real economy.

The primary justification for this is that despite the recent surge in stock market prices and participation, equities still account for only about 20 per cent of overall household financial wealth, compared with 54 per cent in deposits.

If we throw in property, the equity share goes down to 12 to 13 per cent.

However, considering that stock prices rose by more than 150 per cent between July 2014 and mid-June 2015, the +30 per cent decline over recent weeks should have a relatively modest impact on general household wealth. Those hardest hit will (as in all bull markets) be those who joined the market late and with significant leverage.

The importance of equities in household wealth has shot up over the past three quarters by an estimated six per cent.

Moreover, only ambiguous empirical evidence can be found regarding the correlation between consumption and stock prices.

Interestingly, the correlation between Chinese consumption and equity prices is not historically strong, partly because investors have not typically depended upon equity investment returns as their primary source of income. Instead, wage growth has provided the vast bulk of incomes.

Gavin Wendt

 

MineLife Pty Ltd 
www.minelife.com.au

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