What happens to Australia if China falls?

Australian Financial Review, May 2008

You will be familiar with the argument: it’s all about China. Chinese growth, and Chinese demand for resources, are sustaining both Australia’s economic boom and global growth generally. China is what’s protecting us from US slowdown; it is the new engine that keeps the world ticking over even if much of the western world falls into recession.

But is it? There are more and more murmurings about the robustness of Chinese growth, with domestic stocks there having halved in value in six months and inflation becoming a real problem. If China does take a fall, we can expect the rest of the world – and few places more than Australia – to fall with it. Then again, if this is just a correction, then perhaps instead it represents a buying opportunity for people who missed the chance to get exposure to China a few years ago. Which is it?

Firstly, the bearish scenario. In a single week in April, the A share market – that is, the domestic stock markets in China, based in stock exchanges in Shanghai and Shenzhen – lost 12%, its biggest one-week fall ever, taking total falls to 50% in six months. Surely no market does this unless there are real fears about economic and corporate fortitude in the country? After all, we’re all talking about problems in the US, but in the year to May 18 the CBN 600 (a Chinese market index) had lost four times more than the S&P 500 in the USA.

On top of that, economic growth is slowing in China, as is loan growth, and inflation is high at 8.3% year on year in March, although that did represent a moderation from 8.7% the previous month. On top of that, no matter how strong China is, it is exposed to western markets: the US and Europe between them account for 41% of exports, and the figure is higher if one considers that many exports to other Asian markets are then assembled for further export to the US. Therefore it’s exposed to a US or European slowdown. And if corporate profits fall too, along with house prices, we could see a knock-on effect on the banking sector, which has been hit before by problems with bad debts.

That’s the bearish case. Now for the other side of the coin. Yes, growth has slowed – to 10.6% a year! While that’s lower than the 12.4% peak it hit in the June quarter last year, it’s hardly a sign to man the lifeboats. Secondly, look again at that export number: the 41% exports to Europe and the US combined are now less than exports to Asia (47%), which is a very positive development. In fact, the US accounts for only 18% of total Chinese exports these days, making it much less vulnerable to a US slowdown than might at first appear to be the case.

Additionally, Chinese macro policy is trying to deal with these challenges. A recent 0.5% reserve requirement hike, and the issuance of RMB110 billion in central bank paper, shows an effort to moderate inflation (and it is coming down, gradually). A slowdown in growth is in part deliberate – hence the fact China has been allowing a faster appreciation in the value of its currency, the renminbi – to try to slow inflation down a touch.

Then there’s the markets. For a start, you and I almost certainly are not invested in A shares – we can’t. There is only one product in the entire Australian market, a listed fund from AMP Capital Investors, which gives Australians exposure to A shares. “A shares were a no-go area, a bubble waiting to burst,” says Brett Jollie at Aberdeen Asset Management, which offers China, Asia and emerging markets funds. Instead, the funds available here (see box) invest in H shares (Chinese companies listed in Hong Kong), red chips (Hong Kong incorporated companies with Chinese management, business or ownership) and in some cases just companies that do a lot of business with China. They’re all down too, but not nearly as much. “They had run up as well but provide us with more value now,” says Jollie.

And here’s the other thing to consider: if markets have plunged but the fundamentals are still OK, is this actually a good time to buy?

“The market’s back at valuations tracking below their long term average, yet we’re expecting roughly 30% earnings growth this year,” says Luke MacRedmond, general manager of investment alliances at Challenger, which runs a China fund with investment management conducted by Halbis Capital Management in Hong Kong, part of the HSBC group. “For those investors saying: ‘I wish I’d invested there, have I missed it?’, a 50% correction in our opinion represents a good opportunity to get exposure to China.”

“Longer term, we are still bullish on China,” MacRedmond says. “All the key factors that have been driving the market in recent years still apply: the rising rate of urbanisation, increasing wealth, the population becoming more affluent, a private sector on the rise, the country still being competitive.”

Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, takes a similar view. “Structural forces – such as rapid urbanisation, huge competitive advantages and strong consumer demand – will ensure that Chinese growth and its contribution to global growth will remain very strong for many years to come,” he says. He argues it will take several decades at current growth rates before China catches up to developed country living standards, which is when you would expect growth rates to slow. “That doesn’t mean China won’t have cyclical fluctuations and it certainly looks like China will slow a bit over the next year, but the conditions for a Chinese recession are not in place.” Oliver says China has plenty of room to tighten monetary policy if it needs to and inflation is “way below past problem levels. Some commentators have been calling a Chinese recession for years now, but I can’t see it happening any time soon.” Time to buy? “Chinese shares (both A and H shares), after the huge slump since last October, are now good value again.”

In April, China started to intervene in its stock market to try to prop up valuations, basically limiting the circumstances in which people can sell. “This is the first time that the government has sent a message of its extreme concern about a freefall in the A share market,” says Lan Xue, an equity strategist at Citi in Hong Kong. “We believe this should provide temporary relief to the market” – although Xue notes it may also trigger fears about future policy changes.

In short, China as an investment case is much as it ever was: volatile, uncertain, offering enormous potential but plenty of risk too. The only difference now is that valuations are lower than a year ago.

BOX: INVESTING IN CHINA

Challenger China Share Fund

Challenger took over this fund from HSBC Asset Management in Australia, and the investment management is still done by HSBC’s team in Hong Kong, now called Halbis. Has previously been one of the best-performing investment products in Australia, and is still up 27.73% a year in the three years to March 31, but has been smashed like the rest of the market this year, losing 29.55% in the first quarter alone. Has around A$70 million under management but is part of US$7 billion Halbis runs in Chinese equities. Luke MacRedmond at Challenger says the fund has a preference for sectors exposed to the local economy rather than exports, so consumer, retail, infrastructure and commodities. Management fee is 2.3%, or 1.25% plus a 20% performance fee in the wholesale version.

Aberdeen China Opportunities Fund

On Aberdeen’s own numbers this fund was up  7.9% after fees in the year to March 31, despite a 17.07% net loss in the first quarter of the year. The Aberdeen fund is notable for having a lot of Hong Kong companies that have China business, without necessarily being Chinese companies themselves: its top holding on March 31 was Jardine Strategic followed by Swire Pacific, both as blue-blooded Hong Kong colonial as it gets, with China Mobile (5.4% of the portfolio compared to 8.84% of the Challenger fund on March 31) the biggest truly Chinese company. Management expense ratio is 2%; has only A$10.25 million under management, instead putting greater effort into promoting its regional or emerging markets products.

Fidelity China Fund

On Morningstar’s numbers this fund was up 23.83% in the year to April 30 despite losing 25.14% in the last six months – a sign of just how hard these funds were running in early 2007. Has 29.6% of its holdings in the financial services industry and another 20.8% in energy. Management fee of 1.2%.

Premium China Fund

Australia’s biggest China mutual fund by assets, with A$369.37 million under management as of April 30. Managed by a group called Sensible Asset Management, which in turn is part of Value Partners Group, an asset management business listed in Hong Kong and focusing on Greater China. This fund’s holdings look most unlike its peers: top holdings on April 30 were Anhui Conch Cement, China Shipping Development and Denway Motors, none of them accounting for more than 3% of the portfolio, and with China Mobile nowhere to be seen. Management fee is 1.88%, plus a 15% outperformance fee. On Morningstar’s numbers, up 9.79% in the year to April 30, after a 19.61% in the last six months. Also available through the Skandia platforms.

AMP Capital China Growth

This is a fascinating product. Over the years many banks and investors have been given a strictly limited window to invest in China’s domestic stock markets, called A shares; typically allocations are around US$100 million or so. The vast majority of institutions, when given this allocation (called QDII), have opted to give it to selected clients or invest for their own book. AMP is one of the very few groups that chose to use their allocation to launch a fund open to retail investors – in fact by listing it it’s open to anyone who can by shares. We know of only two other products in the world that look anything like it and it is the only way most people can get exposure to A shares.

Being in A shares these days, though, is a bit of a mixed blessing. The fund’s net asset value was $2.18 on August 31; by April 30 it was $1.51, although it must be said that’s still a great return on the $0.96 at launch in December 2006. Remember, though, that listed vehicles often don’t trade at their net asset value; in fact, at April 30, the $1.26 share price was a 16.5% discount to the actual value of the fund’s holdings.