What if China slips?

Australian Financial Review, July 2008

For years, China has been the answer to everything.  Can the commodities boom keep running? Sure, because China needs fuel and metal. Is world banking doomed? No, look at the rise of the Chinese consumer. Can Australia’s economy continue to grow healthily? No problem – we’re being pulled along by China.

But what if China was to slip? A growing body of research suggests that China is heading for slowdown or, in the extreme view, recession. If that happens, it’s going to have a big impact on Australia – our economy, our stock market, our currency.

The latest data shows a slowing economy, though clearly not yet one in any trouble. Second quarter GDP was up 10.1% year on year, compared to 10.6% for the first quarter and 11.9% for all of last year.

Opinion on China’s health is far from uniform. An example of the bleakest assessment came from Kenneth Rogoff,  a Harvard economics professor, and former International Monetary Fund economist, in February. “China’s remarkable resilience to both the 2001 global recession and the 1997-8 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable,” he said then. “In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50.”

The biggest challenge to China today is unquestionably inflation. It’s true that food prices, and hence headline CPI, fell in data released this month (from 8.5% year on year in April to 7.7% in May), but as HSBC’s China economist Qu Hongbin points out, both producer and wholesale price indices are above 8% year on year and still accelerating. The pegged exchange rate, which keeps the renminbi within a close band against the US dollar, has had a series of knock-on effects: it’s been great for exports, which have slowed but are still growing at better than 20%, but it’s also led to what Rogoff called “rampant money supply growth, the flipside of the country’s $1,400 billion accumulation of foreign currency reserves. The real surprise is that inflation did not sprout earlier.”

Other arguments for headwinds in China include the difficulty of using normal monetary policy controls in a still tightly controlled financial market;  problems caused by severe income inequality in China, which causes strain on the political system, particularly when there is a danger some individuals can no longer afford soaring food prices; the danger of policy slippage away from market-oriented reforms; and huge environmental challenges. On top of that, there’s the real threat of US and European recession, which will unquestionably hit exports; and the alarming state of China’s domestic stock market, which has more than halved in value since October. (An argument does get made that a post-Olympics hangover could be another problem, although with Beijing accounting for just 3% of national GDP, according to AMP, it’s unlikely to have any significant effect on the overall economy.)

One could argue, of course, that a drop to 6% growth or less is hardly the end of the world. It’s considerably better than most developed economies. Fund managers tend to think in these terms. “We believe the growth is here to stay,” says Stephane Mauppin-Higashino, head of a product specialist team including equities at Credit Agricole Asset Management, which offers a global emerging markets fund in Australia. “Whether it’s nine or 10 or 11 or six, China will grow. It will average seven to eight per cent annualised growth through the cycle and we don’t have much of an issue with it falling below the trend, even to five per cent, if it were to happen.

“The issue we have had with China is the price: valuation, and inflation. It’s been a fantastic story but too expensive.” (Mauppin’s fund has instead put its energies into Brazil and Russia, seeing greater opportunities at a better price there.)

But the fact is, a fall like that would have a big impact, particularly on places like Australia, because of the kicking it would likely give to commodity prices.

Slowing is clearly happening, but it’s all about the degree. “In terms of the economy, most indicators suggest that China’s growth rate has cooled down from last year’s blistering pace of near 12%, and is now heading to around 9.5% or so,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors. Oliver is by and large an admirer of Chinese policy – “I actually think that China has better control of inflation than many other Asian countries where both headline and underlying inflation are still rapidly rising,” he says – but he does see a clear threat to Chinese growth from what’s happening elsewhere in the world. “The biggest risk for China probably comes from a sharp global slump and particularly from the US,” he says. “If the US went into a severe tailspin and this dragged Japan and Europe into recession then I think China could see growth slide to around 7 to 8%.”

And that’s a big difference. Slowing to 9.5% would, Oliver says, be “great news” because it would probably bring oil prices down, which would help most of the world economy. But if it gets down to the 7 or 8% level, “that would be more negative for commodity demand – and hence the Australian economy.” Barclays Capital, to give another example, has a forecast of 8.8% for 2008

The frustration of this possibility is that Australia can’t really do anything about it. Stuart James, associate director at Aberdeen Asset Management in Sydney, thinks the Reserve Bank has tackled inflation relatively early, but that the local stock market and economy are still vulnerable. “China and India remain key drivers for demand in resources, so any major slowdown in those economies will eventually be felt here,” he says. Also at Aberdeen, Hugh Young, the managing director of Aberdeen Asset Management Asia in Singapore, is bearish on China and actively avoids most domestic Chinese stocks. “At the company level, we really don’t have a clear view of earnings because of the lack of transparency,” he says. “Aside from that, so much depends on policy action: the level of stamp duty, the pipeline of IPOs, the release of non-tradable shares, and so on.”

Still, the plunge in China’s stock markets, headline-grabbing though it is, is something of a red herring when it comes to diagnosing China’s overall health. That market more than doubled between 2006 and October 2007, so all but the most recent buyers are still ahead on their investments. Additionally equities represent a small proportion of financing in China, and most Chinese households are not excessively exposed. “While the Chinese share slump is a warning of slower Chinese growth ahead it is not necessarily a precursor to a collapse in Chinese growth,” Oliver says.

If a heavy slowdown in growth does happen, who suffers in Australia? Most obviously the resource stocks. In July data showed that China imported 20.4% less coal in the first six months of this year as it did in the first six months of 2007. That has a clear impact on coal producers in Australia; indeed, Reuters recently quoted an executive of MacArthur Coal as saying that this would be a good time to dispose of an interest in a coal company. The big guys, Rio Tinto and BHP Billiton, would suffer if China suffers, although they lock in agreed prices for commodities some time ahead and are both well diversified businesses geographically.

Some analysts have seen this coming for a while. Two Standard & Poor’s analysts, May Zhong and Anthony Flintoff, wrote this back in November: “China’s penchant for everything from alumina to zinc has sparked a golden era for Australia:  there the economy has been going gangbusters. The flipside, of course, is that Australia’s exposure to China – the world’s fastest-growing major economy – has increased dramatically.” Their report concluded: “A significant slowdown in China’s economy, therefore, would have an adverse effect on Australia’s economy, miners, and other companies hanging on the coat-tails of the resource sector.” These analysts noted a quadrupling of China exposure in five years at BHP Billiton. And with resource stocks so important in momentum in Australian stocks generally, a fall in those stocks would obviously drag the whole market down.

Iron ore is an area where Australian providers have done particularly well, and there is no sign of a problem there yet: according to Morgan Stanley, Baosteel has agreed to price hikes of up to 96.5% for iron ore supplies this year – a sixth consecutive year of increases.

Instead, coal is perhaps the commodity whose exporters would suffer most from a Chinese slowdown. Last year China shifted for the first time from being a net exporter to a net importer of coal, which had a big impact on coal pricing, particularly seaborne thermal coal. If a slowdown were sufficient to reverse that swing, a good proportion of the pricing shift might well unwind too.

All things in perspective, though: some things about China are unarguable. The industrialisation of a nation of 1.3 billion people, growing in wealth and consumer spending, is not going to go away, although it may slow. China is still going to grow. It’s just a question of how quickly.

BOX: CHINA PRODUCTS

In recent years a proliferation of products geared towards China have appeared in Australia’s mutual fund market. They’re all struggling this year. All the following performance numbers are provided by research group Morningstar.

The Challenger China Share Fund became part of the Challenger stable when it took over a group of funds from HSBC Asset Management, and it remains under the management of HSBC’s investment management team in Hong Kong, which is now called Halbis.

 Like every China fund, Challenger’s has suffered in the last year: it is down 17.62% in the year to June 30 and 35.99% in the last six months.  But those who got into the fund early will still be sitting pretty – it has done 21.99% a year over three years, even after the recent losses.

The Fidelity China Fund has not been around as long, so does not have those initial gains to boast since it has no three-year number. It is down 9.2% in the last 12 months – actually quite an achievement given what’s happened to Chinese stocks – and is down 30.94% in the last six months.

Another product, the Premium China Fund, is down 18.46% in the last 12 months and 29.78% in the last six. And the China Opportunities Fund from Aberdeen Asset Management is, according to Aberdeen’s own website, down 7.76% in the last 12 months, 8.18% in the last three months, but up 11.44% a year over the last three years, all net of fees.

These funds generally don’t invest in A-shares – the name given to domestic Chinese shares that trade on the stock markets in Shanghai and Shenzhen. Instead, they tend to buy stocks listed in Hong Kong: either H shares (Chinese companies listed in Hong Kong), red chips (Hong Kong companies but with ownership and business substantially in China), and in many cases regular Hong Kong companies that get a lot of their revenue from China. For example, the top two holdings of the Aberdeen fund are Swire Pacific and Jardine Strategic, neither of them actually Chinese companies.

The only product widely available in Australia that does invest in China’s domestic markets is the AMP Capital China Growth fund, which uses a listed investment company structure and is listed on the ASX. This fund really has demonstrated the volatility of China’s markets: it started out with a net asset value of 96 cents at launch, got as high as $2.18 on August 31 last year, and was down to $1.12 by June 30 (although when distributions are considered, it is still up over 25% in NAV since inception). Moreover, it trades at a considerable discount, and closed at just 88 cents on Friday.

Numerous Asian equity products have exposure to China, though again this is mainly through the Hong Kong Stock Exchange.

Disclosure: the author owns shares in the AMP Capital China Growth Fund