The ongoing saga of the Chinese economic downturn has been a tale of startling twists and turns. Three months ago, things looked stable for the world’s second-largest economy. In the 12 months to June 2015, the Shanghai Stock Exchange Composite had risen by 150%, more than any other benchmark index. Then, in the same month, a punishing three weeks saw A-shares (see box for definitions) plummet by 30% and trillions wiped off the stock market.
The Chinese Government’s initial response was to take a series of fairly drastic measures to stem the torrent of withdrawing investors. On 28 June, the People’s Bank of China (PBOC) slashed the benchmark lending rate by 25 basis points to a (then) record low of 4.85%. It has since cut the interest rate to 4.6% following ‘Black Monday’ on 24 August, which sent tremors throughout world markets: the FTSE 100 crashed by 2.8% and the NASDAQ suffered a similar tumble. The Chinese regulator has come under criticism for failing to buoy investor confidence, instead leaving investors waiting on its next move. Whatever the next move is, blink and you might miss it, such is the rate of change.
As investors, economists and journalists scrambled to keep up with developments, the PBOC devalued the renminbi against the US dollar three times in as many days in mid-August. With the dollar appreciating ahead of anticipated interest rate hikes, and with the renminbi laxly pegged to it, the price of Chinese goods inexorably rose compared with currencies in other Asia-Pacific countries. The devaluations sparked fears of a currency war, while some
saw it as a legitimate way to boost exports.
To many who are following the media coverage, the steep drop in the markets and everything that has followed – dubbed the ‘Great Fall of China’ – seems shocking and unforeseen. But Peter Kinsella, Head of Emerging Markets Economic and Emerging Markets FX Research at Commerzbank, told the Review
recently that to think this would be a mistake, saying: “The plunge wasn’t a shock in the sense that valuations were clearly overstretched and therefore a correction was inevitable.”
His thoughts echo those of prominent investor Neil Woodford, who recently told Investment Week
: “These events, which triggered [the] global equity panic, have been embedded in [our] expectations. . . for the stocks we have chosen to invest in – and indeed those that we have chosen not to.” He reminded readers that the Chinese economy has looked subdued for at least a year.
In fact, Kinsella says: “Despite the significant decline in the region, the overall stock index is still significantly higher than at this time last year – over 70%. So, while headlines focus on the recent plunge, they ignore the bigger picture.”
Nevertheless, the Chinese Premier, Li Keqiang, has stated that growth for this year will be 7% – strong compared with the UK but China’s most sluggish rate for 25 years. In the storybook of the Chinese economy, 2015 will sit glumly opposite 2008, when China enjoyed an infrastructure investment boom, and 2011, when the nation reaped the benefits of a commodity surge.
Although it is widely agreed that measures to upend the decline have slowed its velocity, they have failed to stop stocks falling. Take, for example, policymakers’ decision to open up pension funds managed by local governments to the stock market. Previously, pension funds could only invest in bank deposits and treasuries; now they can invest up to 30% of their net assets in stocks and other funds. Government estimates suggested that by opening up pension funds to stocks, a hefty ¥600bn would be injected back into the market. This was not enough to revive investor sentiment, and the following day the Shanghai Composite dropped by 8.5%.
Other measures to stabilise the market have produced better, but still so-so, results. China suspended ten IPOs on the Shanghai Stock Exchange and 18 on the Shenzhen exchange. Freezing IPOs that are midway to flotation and not disclosing how long that freeze will last means that private firms will eventually have to seek out more costly backers. It may boost merger and acquisition activity, but China runs the risk of undermining its long-term goal of internationalising its currency. The move, says Kinsella, is a sign that the authorities “are still not fully comfortable with market-determined prices” and will intervene when market conditions are troublesome for Chinese firms.
All part of the plan
Following years of economic triumphs, Chinese policymakers have had their mettle tested and credibility questioned.
Again, at least that is what the world’s media would have us believe. Eswar Prasad is Senior Professor of Trade Policy at Cornell University and former Head of the IMF's China division. He says that it is not the case that policymakers have lost their Midas touch; rather, it is all part of the plan.
Prasad told the Review
: “For all the troubles that are wracking the Chinese economy, it is important to recognise that policymakers are continuing – in their typical piecemeal and gradual manner – to undertake certain reforms that they have committed to.”
With the triple devaluation of the renminbi, you might assume that China's determination to internationalise the currency, which has been headed for the IMF’s basket of reserve currencies with special drawing rights (SDRs), is no longer on the cards.
Quite the opposite, says Prasad: “The Government is making slow but steady progress towards removing restrictions on capital inflows and outflows and liberalising the interest rate on bank deposits. . . The PBOC has effectively defanged the US and the IMF by offering just what has been asked of it: more currency flexibility. All of these reforms will strengthen the case for inclusion of the renminbi in the SDR basket.”
Kinsella agrees: “The authorities’ actions could affect the timing of membership of the SDR basket, but I see renminbi inclusion in the basket as being a question of when, rather than if.” So, the prospects for the renminbi are still strong, even if the economy looks forlorn right now.
A mirror image
Where does that leave investor sentiment? Given that A-shares can only ostensibly be traded by Chinese mainland companies by Chinese investors, the drop in these shares primarily affects Chinese firms and individuals (more than 100 million stock market investors in China are amateur individuals). Contagion risk is therefore limited, but will investors want to invest in B-shares and N-shares in the aftermath?
conducted by Allen&Overy at the start of this year, when the turbulent events from June onwards were yet to unfold, found that three in four corporate CEOs were not comfortable with conducting trade in renminbi. As yet, there has been no equivalent research since the downturn. But Kinsella imagines that in light of the turmoil, even if the Government’s measures prove ultimately successful, full investor confidence in the Chinese economy will remain some way off. “Ultimately speaking, the strength of the financial sector will be a mirror image of the strength of the underlying economy," he says. "It will clearly be a while before we see incredibly strong financial markets and investor sentiment in China.”
Referring to the country’s myriad policy measures, Prasad concludes: “Once again, China has succeeded in making opportunistic progress on its own terms and at a time that is convenient for its own economy, but rather inconvenient for the rest of the world.”
|Chinese economy jargon buster
A-shares: Renminbi shares of companies based in mainland China that are listed on the Shenzhen and Shanghai stock exchanges. They have historically only been available to mainland Chinese citizens, but foreign investment in A-shares is now permitted via tightly controlled channels and quotas.
B-shares: Shares that are traded on the Shenzhen and Shanghai stock exchanges and are eligible for foreign investment. B-Shares are denominated in US dollars.
CNH: Renminbi that is traded outside of mainland China (or ‘offshore’) . Although the renminbi is just one currency, different exchange rates apply depending on where it is traded.
CNY: Renminbi that is traded ‘onshore’. CNY stands for China yuan renminbi.
H-shares: Shares in companies incorporated in mainland China that are traded on the HKEx. Although regulated by Chinese law, H-shares are denominated in Hong Kong dollars as per other equities listed on the Hong Kong Stock Exchange.
N-shares: Shares of Chinese companies incorporated outside of mainland China, generally in foreign markets, that are listed on the New York Stock Exchange (NYSE), the NASDAQ or the NYSE MKT.
Shanghai-Hong Kong Stock Connect: A channel launched in 2014 that connects these two stock exchanges. Traders on either market are free to trade select stocks on the other using local brokers and clearing houses.