Expect slower growth in China

No boom without a slight bust
Chinese economic growth is successively gearing down in the longer term, while the pursuit of short-term growth is intensifying, which is likely to exacerbate imbalances in the economy. Greater imbalances mean greater instability in the financial system, thereby setting the scene for future pockets of volatility in the financial markets. From growth of 7.3 percent in 2014 and 6.9 percent in 2015, it seems not unrealistic to expect the growth rate to gradually shift further downward towards 4.5-5.5 percent by 2020. Much of the high historical growth has been driven by credit expansion, which is hardly sustainable in the long term.

This has led to record debt and widespread problems in the banking system. According to the Financial Times debt increased at a record pace during early 2016, and total debt has increased to almost 250 percent of GDP, according to data from the Bank of International Settlement. This level is lower than in industrialised nations, but much higher than the average for emerging economies, and the pace of increase is unprecedented, from around 150 percent of GDP in 2007. Although growth will be significantly slower than we are used to seeing, do not expect a total collapse in China's growth. There is plenty of political will invested in ensuring continued high growth, supported by fiscal and monetary policy measures if needed. This, combined with strong underlying momentum built up over a long period, is likely to be sufficient to avoid a recession in the coming years.

The Chinese economy continues to rebalance, away from manufacturing and towards services and private consumption. Wage growth is high, and many non-Chinese companies are now leaving the country to find production in other nations that have lower labour costs. At the same time, domestic companies are advancing their positions higher up the value chain through strong innovative vigour, particularly in the technology sector. Industrial transformation places heavy demands on policymakers, and does not leave much room for serious political errors. The recently presented 5-year plan includes reform of how the Chinese state is governed, urbanisation, modernisation and streamlining of the financial system and the debt and balance sheets of state-owned enterprises.

China's problems exist on several levels. There is widespread corruption despite the newly introduced death penalty, extensive environmental degradation, demographic problems, a lack of deregulation leading to inefficient allocation of capital and resources, imbalances in the property market with overheating in some regions and large vacancies in others, and a banking system with a rapidly increasing proportion of problem loans.

Irrespective of whether economic growth is 4 percent or 6 percent in 2020, China is an economic powerhouse to be reckoned with. The Chinese system is largely closed, with the government controlling most economic and political developments. If we look at how China's society has evolved in recent decades, the majority of the population is in a better position and, on the whole, there is some degree of satisfaction with what has been achieved in terms of economic development. Since power is so concentrated around President Xi Jinping, who is also judged as a strong leader, there is a highly pronounced determination and expression of will that no problem should be too difficult or too big to be resolved.

Speculative equity market
There is no doubt that the ground is currently being laid in China for future Fortune 500 companies. The middle classes have grown rapidly over a short time, and the needs of these people have been expanding exponentially. Consumption demand has shifted from simple consumer goods to more expensive and more advanced products and services. The sectors growing rapidly are entertainment, education, healthcare, financial services and IT, where tomorrow's share-price winners are currently developing. These sectors are now completely or partially deregulated, and represent huge growth potential for well positioned companies.

The sectors having a tough time are property, banking, mining, oil and gas, and base metals. The extensive system of quotas makes it tricky to directly access the domestic Chinese stock market, and even if this access is obtained it is a huge task to understand company accounts. Moreover, the state regularly changes tax legislation and other rules of play arbitrarily and unpredictably. Any potential investor from outside China is very distant from the economic and political arena. The key to successful investing is to find local asset managers with a high level of knowledge and significant proximity to the Chinese market, where the political and economic shifts occur at lightning speed, both centrally and locally.

Investments in the various forms of index-related product risk being too blunt as they currently offer far too much exposure to the banking and property sectors. Accessing Chinese growth through investment in international companies with manufacturing or sales in China has proved more difficult than originally thought. A large number of companies, both manufacturers and exporters, seem to have given up on the Chinese dream of rapid growth and quick profits since they view the corruption, unclear rules and favouritism of domestic companies as far too challenging. Investing via Hong Kong is simpler, but the underlying problems of transparency remain. At the same time, individual Chinese people use the stock market like a giant board game, with substantial leverage resulting in a high level of unpredictable volatility. The government's decision to cool down the level of speculation by reducing leverage on equities was a major contributor to the selling pressure felt during June/July 2015 and in early 2016.

Good value fixed income
The Chinese fixed income market is the third largest in the world. Interest rates are relatively high compared with other countries, and a ten-year government bond is currently trading at around 3 percent. Considering the extremely low global interest-rate environment, Chinese bonds look to be good value, both in their own right or as a spread against US government securities, since inflation is under control (1.4 percent in 2015). Inflation is not expected to rise significantly in the short term. Chinese government securities will be included in various forms of bond indices in the not-too-distant future, which is likely to boost buying interest among both active and passive investors (ETFs and index trackers).

More stable currency
The Chinese currency has historically been pegged to the US dollar, which has resulted in significant strengthening in pace with the rise of the US dollar. In August 2015, a decision was taken to make the currency (renminbi/RMB) more market-oriented and to value it against a basket of currencies, which can be seen as a step towards creating a more liquid and better functioning exchange rate policy. The decision of the IMF to enter the RMB into its Special Drawing Rights programme (which means the IMF now includes the currency in its foreign exchange reserve fund) must be seen as a step towards a more transparent and market-oriented exchange rate. This should contribute to lower volatility and less correlation with the US dollar.

Summary

•  The nation's size in terms of population, geography and economy provides a complex picture that is difficult to analyse.
•  Assume the economic growth rate is lower than the official forecasts since aggressive historical debt-funded growth is, and will remain, unsustainable.
• Comprehensive reform and deregulation are crucial right now in order to build the economic foundations for the future.
•  Expect large volatility, particularly on the stock market, as a result of the high degree of speculation and ever-changing rules from the government, which is in turn likely to continue to greatly affect the world's financial markets.
•  Do not underestimate the political will to maintain China as an economic and political superpower. A one-party state with a strong leader can force through decisions that are both unpopular and poor in the short term.
•  International threats come primarily from a lower willingness of foreign investors to invest, high volatility in international capital markets and lower commodity prices.
•  Domestic threats may arise from uncertainty about exchange rate policies, which could in turn exacerbate already extensive capital flight out of the country. Reliance on private consumption is significant, and may be adversely affected by increased unemployment or lower wage increases alongside reforms to unprofitable state enterprises. Social unrest due to widening gaps in society.

These impressions are based on a fact-finding tour to Beijing, Shenzhen and Hong Kong, arranged by Nordea in the week commencing April 18. In Beijing we met with CIC, NDRC, CICC, Cinda Asset Management and representatives from Harmonicare Medical Holding, Forsyth Barr Asia, Beijing Capital Group, Asian Development Bank and Thomson Reuters. In Hong Kong we met representatives from VStone Capital, McKinsey, Eastfort Asset Management and Standard Chartered Bank. Company visits were made to Huawei and Kingdee in Shenzhen.