Despite encouraging signs of recovery at home, U.S. policymakers are clearly worried about what’s going on overseas. At the top of their list of concerns is China.
China’s economy is slowing, but we knew that already. What’s changed is the confidence investors have in Beijing’s ability to manage this slowdown. More people are leaning towards a “hard landing” scenario than the “controlled descent” alternative.
Three things have triggered a re-evaluation. First are Chinese officials’ clumsy attempts to arrest the slide of an over-valued stock market. Second is their mishandling of a loosening in renminbi policy, which looked to many people like a classic devaluation. Third has been a renewed focus on the discrepancies in Chinese official statistics. Now everyone believes China is lying about growth.
These are all legitimate concerns, but we don’t think investors are drawing the right conclusions. While a slowdown in China could be ugly for commodity suppliers and Asian neighbors linked by production chains, the point is this: China is now an economy dominated by services, not manufacturing.
China is now an economy dominated by services, not manufacturing.
Real estate, finance, hospitality, wholesale/retail, transport, construction and other services accounted for some 55% of gross domestic product (GDP) in 2014, up from 47% in 2006, according to data compiled by CLSA and Citic Securities. Their share will likely continue to rise, and not only because industrial activity is shrinking. The contribution of the service sector to the economy may also be underreported.
However, most people still cling to the notion of China as a country of heavy industry and factory production lines. Disappointing manufacturing numbers make the front page. Falling commodity prices are touted as evidence the economy has ground to a halt.
The Chinese economy is not crashing. It’s slowing, partly because capital was misallocated in the credit boom after the financial crisis and partly because the reforms announced at the end of 2013 require the economy to ease into a lower gear. However, the world’s second-largest economy still manages to expand at a pace that puts rivals in the developed world to shame.
Aberdeen has been of the view all year that the economy is chugging along at somewhere between 5% and 6%. That’s less than the official government number, but still remarkable given everything that has happened.
The Tianjin explosion aside, there has been no catastrophic event this year.
As for the renminbi, a currency that speculators loved because it was so predictable, policymakers are not devaluing their way out of a crisis. This is because if they were to embark upon such a course, the scale of the devaluation would need to be in the order of 20% to 30%. The currency has weakened 2% to 3% against the dollar since August 11.
The renminbi has actually been one of the strongest currencies over the past five years, in both nominal and real effective exchange rate (REER) terms. In the grand scheme of things, we believe a 3% move is neither here nor there.
What’s more, if Chinese policymakers were to use devaluation as a way of making China’s exports cheaper, the move would ruin their credibility (they have previously said they would not) and risks exporting deflation to the rest of the world (leading to weaker global growth and further financial instability, which is bad for China).
We believe the weakening of the renminbi represents another step in China’s ambition to internationalize its currency and is a demonstration of the country’s commitment to financial reform. The renminbi’s value isn’t entirely determined by market forces, and this has been a major obstacle in the way of China’s goal to have a genuinely global currency.
Policymakers on August 11 changed the way in which the renminbi’s value is established. The currency is allowed to trade freely, and at the end of each trading day China’s central bank sets a so-called “reference rate” that does a better job of reflecting the market than the previous system. The key thing to appreciate is that the renminbi should be more volatile. The days when the currency was considered a one-way bet are over.
On a final note, the issue of how accurate output figures are has been a long-standing gripe. Chinese data can be opaque because of a perceived lack of openness on the part of Chinese officials, especially when it pertains to bad news. In reality, though, most analysts devise their own gauges to measure economic growth.
So we believe the economy is not crashing and the Chinese are not devaluing. Is this a call to go piling back into Chinese equities in particular and risk assets in general? Well, no. In our view, stocks are still overpriced and poor corporate governance demands caution. What about other risk assets? It depends on your risk appetite and whether you’re committed to this market for the long term. The most important thing is to try to make as informed a decision as you possibly can.
China matters, and your view of China matters too.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging market countries.
Concentrating investments in China subjects an investment to more volatility and greater risk of loss than geographically diverse investments.