With China’s post-pandemic economic recovery slowing, there’s been a lot of speculation that policymakers are about to loosen the purse strings. Yet we see no evidence of that happening, and the slowdown could be exacerbated by overzealous regulatory crackdowns and restrictions to contain the new variants of the virus. .jpg)
Rather than China easing in response to a slowing pace of recovery, we think there’s a risk that it could set both monetary and fiscal policy too tight for the prevailing conditions. We can’t see any clear indication from Chinese policymakers’ statements to justify speculation that the government and central bank are about to loosen their approach.
Speaking at the State Council’s regular policy media press conference on 7 September, senior officials from the People’s Bank of China appeared to rule out decisive easing. Instead, they seem to favour various policy tools to support credit extension to small and medium sized enterprises, which form a pillar of the ‘common prosperity’ plan.
One indicator that our analysis suggests has a particularly good correlation with the relative performance of Chinese equities is what is known as the credit impulse. This measures the rate of change in lending to businesses and consumers relative to GDP — and it’s negative at the moment.
It’s not a perfect trading strategy, but Chinese equities do tend to underperform global equity markets when this is the case. Intuitively, it makes sense that a slowing pace of lending would have knock-on effects on spending and investment, and ultimately growth in the economy and corporate profits.
If you combine this credit impulse with the fiscal impulse (the pace of change in government borrowing), it’s even more negative. The risk of more tightening may have diminished, but with credit growth at its slowest in 32 months, the usual lags mean tight credit conditions are likely to remain a headwind for the Chinese and broader emerging markets (EM) in the near term. The MSCI EM Index has tended to underperform when China’s combined credit and fiscal impulses have been negative.
Cracking down
The recent regulatory onslaught in China could exacerbate these headwinds. But we think second guessing Communist Party policy, or assuming that the Washington consensus (free trade, free markets and low regulation) will prevail would both be foolish.
South Korea and Taiwan, the greatest success stories of the later 20th century, succeeded with corporatist and interventionist policies, not liberal ones. Even in the West, the golden age of growth, the boom of the 50s and 60s, was a time of greatly increasing regulation. In other words, Beijing could hit a very profitable sector hard, even if that contradicts economic principles popular in the West, if it believes – rightly or wrongly – that the net effect of redirecting capital elsewhere would be beneficial.
Most importantly, investors shouldn’t ignore what Beijing is telling them. The Didi restrictions followed naturally from the sweeping Cybersecurity Law passed earlier this year. Beijing has also been very clear that it doesn’t want the service sector’s share of the economy to grow to larger than it is already at over 50% (the details are in China’s 14th Five Year Plan).
In addition, it doesn’t want to de-industrialise because it believes that would worsen social inequality and is unlikely to propel the nation out of what economists call the middle-income trap. In this situation, a developing nation loses its competitive edge in the export of manufactured goods due to rising wages and is unable to keep up with more developed nations in high value-added markets.
So, the run of regulations may not be idiosyncratic or company specific but strategic, about redirecting capital to sectors, such as tech hardware, that are part of Beijing’s goals. An article in the Chinese Communist Party’s (CPC) mouthpiece China Daily in September described how “in view of the savage growth and disorderly expansion of some platform enterprises… [the CPC will]… increase anti-monopoly supervision, investigate and punish the monopolistic and unfair competition behaviour of the relevant platform enterprises in accordance with the law”.
Regulatory risks
That means regulation could run and run, not necessarily de-railing the investment case for China or its digital services companies. Certain businesses can still take a greater share of the services pie even if the service pie won’t grow relative to the manufacturing pie anymore.
However, investors should probably demand a higher discount for these companies (lower price-to-earnings ratio) because of the increased regulatory risk. Relative to the MSCI World index, the valuation of the MSCI China index is still in the middle of the same range it’s traded in for the last five years, leaving some scope for underperformance over the coming months. Lastly, China’s zero-Covid approach also risks further restraining growth.
Even though the case numbers look minuscule compared to Western numbers, vaccine take-up is low in China and this raises the prospect of the authorities imposing hard lockdowns to contain the virus. Delta cases have now been reported in over half of China’s provincial-level regions, including Beijing, and nearly all of them were warning against unnecessary travel by late September. This may in turn lead to looser fiscal and possibly monetary policy, but we suspect concerns over a slowing pace of growth in China will persist for now. We’ve had a cautious view on China all year, mainly predicated on the risk that money is too tight. The regulatory and Covid crackdowns add weight to the argument.
Ed Smith is co-chief investment officer at Rathbones and Jing Hu is a senior asset allocation analyst at Rathbones. The views expressed above are their own and should not be taken as investment advice.