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Why China isn’t the “death star” everyone thinks it is

Jan Dehn, head of research at Ashmore Investment Management, explains why he is “extremely bullish” on China over the long term, despite widespread market fears.

Lauren Mason

By Lauren Mason, Senior reporter, FE Tru...
Friday June 16, 2017

China is by no means the “death star” of the global economy, according to Ashmore’s Jan Dehn, who is extremely bullish on the country’s long-term prospects and has labelled it a “winner” amid his investable universe.

The head of research said fears surrounding China’s growth slowdown and building debt levels have led to unnecessary capital flight from the country, despite ongoing reforms spelling a brighter future for both its economy and its market.

He is also positive on Chinese fixed income over a short-term time horizon as, following the country’s fiscal tightening at the start of the year, the currency has gradually appreciated against the dollar and bond yields are beginning to fall. 

Performance of currency vs US dollar in 2017

 

Source: FE Analytics

“The view on China is that it’s a death star, it’s going to destroy us all and it’s evil scum,” Dehn (pictured) said.

“I think this negative sentiment about China is completely wrong. First of all they don’t have a systemic fundamental debt problem to begin with; they have about 270 per cent domestic credit to GDP, which is very high.

“But you have to take into account that they also have deposits in the banking system of 200 per cent of GDP because they have a savings rate of nearly 50 per cent of GDP.

“When people put 200 per cent of GDP into the banks, what are the banks going to do with this money? They’re going to lend it out. So, they take 200 per cent of GDP deposits and they lend out 270 per cent – it isn’t a very levered banking system. Our banks take a 1 per cent deposit and lend out 10, that’s a risky banking system.”

Rather than a debt problem, Dehn said the real reason for China’s well-documented slowdown is that the developed economies previously dependant on QE will inflate and devalue their way out of debt.

He described this as a “disaster” for China’s export-led growth model as high inflation could cause negative disposable income across these developed economies and, as a result, a fall in their domestic currencies relative to the renminbi. If this is the case, he warned that China’s exports will no longer be competitively priced.

“If China doesn’t rotate away from export-led growth then it’ll have no growth at all,” the head of research explained. “As such, they are looking for alternative ways to grow and there are only two ways for them to do this.


“You either sell to foreigners or you sell at home, hence the higher savings rate is quite useful because obviously you can then increase consumption. But if you increase consumption, this in itself poses problems.”

In order to control consumption, Dehn said China will have to further liberalise interest rates. While this should in theory improve pricing in the Chinese credit market, he warned that it will create an enormous amount of uncertainty over the short term.

While some companies would indeed prosper, he pointed out that companies and local governments in China would have to get used to borrowing amid market-determined rate movements, which could lead to defaults, nervousness and ultimately a deferment of investment.

“The interest rate liberalisation itself is one of the reasons why growth is slowing,” he added.

The second reason China’s growth is slowing, according to Dehn, is because it is increasing productivity through price liberalisation in what he has described as “the biggest of all productivity enhancement reforms any country can do”.

Using the Cold War as an analogy, he said: “If you were in East Germany in 1988 and you were a factory worker, you would know you had a job for life, you would produce parts for some car that nobody wanted to drive and couldn’t compete with anyone else around the world. A completely useless job, but you would have a job. And then, with that meagre salary you would be able to buy a bowl of gruel. You would eat this every night and you wouldn’t have much luxury in your life, but you would have a lot of security.

“Then you roll time forward to 1991 and price liberalisation and, suddenly, you’ve lost your job because obviously the car parts you’ve been producing are completely useless, your neighbour bought the factory for nothing from a corrupt official and is now stinking rich, and you can’t even afford your gruel any more.

“That is the kind of process that happens when you have price liberalisation; suddenly resources are allocated according to their marginal product and it creates a lot of uncertainty for investors.”

While he explained that price liberalisation will eventually enhance productivity, Dehn said it creates nervousness as wages and therefore consumer pricing power fluctuates.

“The third reform they’re rolling out is increasing consumption,” he continued. “Eventually China knows that starting with a 50 per cent savings rate, if savings eventually drop to about 10 per cent then consumption will rise so much that China will have a current account deficit.

“If it is going to have a deficit, it needs to open its capital account to finance it, just like the US does. That’s why I really think China is going to start looking a lot like the US.”


Another way in which China is following in the footsteps of the US, according to Dehn, is by aiming to open up its domestic A-share stocks to foreign investors through its bid to include them in the MSCI Emerging Markets index.

Performance of indices over 10yrs

 

Source: FE Analytics

While he said there is currently asymmetry between Chinese nationals’ desire to invest outside of their home country and foreign investors’ desire to invest in China, he said this power balance is likely to change.

“What is going to happen as this process gets underway is that the Chinese will gradually get their fill of foreign assets so the flow out of China will slowly dissipate, and foreigners will – against their better judgment – be forced to increase their exposure,” Dehn explained.

“Nobody is invested in China because China is meant to be the complete disaster story of our time. It’s really unfair to the Chinese who are trying to join the global financial markets on our terms – they’re not bullying their way into it, they’re just trying to do the right thing.

“They have never opened a capital account before and we are treating them like dirt. It’s just not fair. It’s a good thing for us if China joins the global financial markets, but the markets are so conservative and xenophobic when it comes to China it is ridiculous.

“They’re up against it and, in many ways, many of these prejudices are what we’re seeing across emerging markets as a whole as well.”

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