Questions from a China sceptic

John Wyn-Evans

Head of Investment Strategy

For this week’s issue, I put myself into the shoes of a China sceptic to pose some questions to our Head of Research, John Haynes, a self-confessed and unabashed (although commendably objective!) optimist about the investment opportunities associated with the country.

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China seems to be the prime target of Donald Trump’s “Trade War”. How do we think it will be resolved?

America’s relationship with China prior to Trump’s election was conducted under the umbrella of the Strategic Economic Dialogue – a framework of regular meetings of highest level officials from both governments where all contentious issues could be discussed and resolved quietly. Donald Trump decided that this does not work and has dispensed with this approach in favour of public confrontation. This is initially a shock for observers, underlined by the actual imposition of tariffs as an opening shot, but our perspective is that it is mostly a change of negotiating style – albeit to one with far higher risks of an adverse outcome. The important thing to remember, however, is that both sides have more to lose than to gain from any escalation. Donald Trump has clear support both inside and outside America for achieving progress on a number of issues (including market access and intellectual property protection), but there is also a mutual interest in sustaining a good relationship, since China is the world’s second largest economy and the biggest contributor to global growth. It supplies American (and other) consumers with affordable goods both directly and as a co-ordinator of the global supply chain. In short, rather than issues being resolved behind closed doors, robust public skirmishing is likely to be the style for the duration of the Trump presidency.

 

There is an increasing focus on the amount of debt in China’s economy. Will this lead to an inevitable crisis similar to what happened in the West in 2008?

Not for the foreseeable future. China’s debt explosion (from around 150% to over 270% of GDP) occurred in the immediate aftermath of the Great Financial Crisis when demand for consumer products in the West plunged. China reacted to the demand precipice with a Keynesian infrastructure construction boom, which could be viewed as “bringing forward” necessary spending on urban infrastructure needed to accommodate the ongoing urbanisation of China. The money was spent “inefficiently” from a short term perspective (the economic returns of a new underground rail network are initially very negative) but the longer term (social multiplier) effects are often far more positive. In addition, the goal of keeping China working succeeded. Nevertheless, it remains true that the money spent was borrowed from Chinese banks and savers and it must at some stage be paid back. How will this occur? The answer is slowly, with any (inevitable) write-offs taken over many years. The key is, however, that not only are all the borrowings sourced from local savers, but the banks themselves are largely government owned and many of the loans are ultimately government backed. There is no reason for Chinese savers to fear that they will not get their money back, and no flighty “foreign money” in the system. In short, China is self-funding and can afford its own mistakes. Hence there is no reason to fear a funding “run” on the banks in China, which, in the wholesale bank-to-bank lending market, is what ultimately caused the financial crisis of 2008 in the West.

Source: FactSet
FTSE 100 Weekly Winners
Evraz 11.4%
British American Tobacco 8.9%
Imperial Brands 8.8%
Rentokil Initial 7.1%
Burberry Group 5.0%
Old Mutual 5.0%
Pearson 4.9%
Source: FactSet
FTSE 100 Weekly Losers
Anglo American -3.8%
Glencore -3.1%
Barclays -3.0%
Paddy Power Betfair -2.6%
Legal & General Group -2.5%
Mediclinic International -2.4%
NMC Health -2.4%

President Xi recently changed the rules to allow him to rule, at least in theory, for as long as he wishes. Should we be concerned about this shift to what appears to be a more autocratic leadership?

Not in the short term. Chinese politics is a mystery wrapped in an enigma, and many Western watchers view China sceptically through a lens of human rights controversy and fears of increasingly assertive global political presence. Both he and his agenda, prioritising environmental issues and anti-corruption, enjoy enormous popular support. He is very well qualified for the job, with more than 30 years of demonstrated competence as a high-level government administrator and also a personal experience of the perils of power as witness to the Cultural Revolution. I think Xi is a good leader and the right man to run China now, so an extended term for him does not concern us, but a two term limit was put on the presidency to ensure that Mao did not happen again. President Xi may be no Mao Zedong, but who can guarantee the next man may not try to be?

 

What danger signs should we monitor as a sign to reduce investments in China?

If the Chinese lose faith in their own growth model, then it would no longer be “self-funding” and the worries about debt sustainability would crystalise. The Yuan/Dollar rate is a key canary in the coal mine.

 

Anything you would like to add?

Having integrated itself into the world’s trading economy in the first decade of the millennium, China is now engaged in the process of integrating itself into the world’s financial system. This is a complex process involving both explicit verbal debate with economic partners and an implicit ongoing debate with financial markets which are judging their success. However, the end goal for China - developing a prosperous consumer economy - is not at odds with our own interests. Although the language of engagement may become more fractious, perversely as the Chinese leadership passes successive tests, the process is likely to feel less of a high wire act. The prospect is that from an economic perspective at least, China, which has long been thought of as a source of instability, will increasingly be thought of as a source of stability.

Finally, Smith Volcano is in The Philippines.This week, Imelda Marcos, former First Lady of The Philippines was noted for her extensive collection of what?

Year-to-date market performance

Year-to-date market performance
*Lagged to latest UK IPD Total Return All Property Index (Jan 2018)

FTSE 100 Index, past 12 months

FTSE 100 Index, past 12 months
Source: FactSet
Past performance is no indicator of future performance

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