Will China flourish in the Year of the Rat?
The latest Chinese lunar year begins on 26 January as the Year of the Rat takes over from the Year of the Pig. In theory, China already has something to celebrate, in the form of the phase one trade deal signed with the US on 15 January.
In return for Beijing agreeing to substantially increase imports of agricultural and industrial goods from the US, America scrapped a third round of tariffs and cut the duties imposed on $120bn of Chinese wares from 15% to 7.5%.
This gives President Trump the perceived win that he wanted, 10 months before the US election. It gives President Xi the chance to avoid further economic damage and work on supporting economic growth as China prepares to mark the Communist Party’s centenary in 2021.
However, this initial agreement is fairly limited in its scope.
– American tariffs on around $360bn of Chinese goods are still in place, or about 85% of the total, as are retaliatory Chinese duties. US imports from China fell by 22% in 2019, so they are hurting.
– The allegations of intellectual property misuse, or outright theft, by Chinese firms remain largely untackled.
– A phase two deal designed to address these and other issues may not be ready until after the US presidential election on 3 November.
This leaves China with much work to do if it is to placate its global economic rival on the one hand, yet maintain economic and therefore political stability at home on the other.
The Rat comes first in the cycle of the Chinese zodiac, which associate rats with wealth and surplus – rats are seen as good savers, even hoarders. Whether this means Chinese equities will have a good year or not is another matter entirely.
Fundamentals matter and questions are gathering over the quantity and quality of Chinese GDP growth.
Chinese GDP growth came in at 6.1% in 2019, the slowest growth rate since 1990. Some perspective may be needed – most countries in the West would be delighted with 6.1% growth. And that increase still equates to $815bn, which is a bit bigger than the entire output of Saudi Arabia, the world’s largest economy.
Even so, the Chinese stock market seems far from impressed. The Shanghai Composite index is no higher than it was in March 2007.
QUALITY OF GROWTH
Economic growth is not the be-all and end-all, even when it comes to picking emerging markets, and doubts about the quality of Chinese GDP growth continue to linger.
The headline growth number of 6.1% does not sit easily alongside sliding imports and exports, a second straight drop in car sales or weakness in the Li Keqiang index, which is based on the (potentially more reliable) bottom-up indicators of electricity use, bank loan growth and railway cargo volumes.
In addition, much of the recent increase in GDP has been funded by debt. According to the Institute of International Finance, government debt represents just 55% of GDP. But once borrowings at state-owned enterprises, private businesses and consumers are thrown in, and the so-called ‘shadow finance’ or non-bank credit industry taken into account, total debt-to-GDP is 310%.
China is doing its best to keep the plates spinning, cutting both interest rates and the amount of capital that banks have to hold (thus boosting their ability to lend) but some economists argue that the debt numbers mean China simply cannot grow at its current rate for much longer.
Some even argue that the country is facing its own Minsky Moment, as its economy reaches the third stage of the debt cycle outlined by economist Hyman Minsky in his 1993 paper The Financial Instability Hypothesis:
Hedge finance, where a mix of cash flow and equity help borrowers to fund interest payments on debt and eventually pay off their liabilities
Speculative finance, where debtors have enough money to cover interest but cannot repay the original loan, which must be rolled over
Ponzi finance, where borrowers are unable to pay off the interest, let alone the principal debt and resort to asset sales to pay the bills
Investors may think this sounds a little apocalyptic, but it may help to explain why the Shanghai Composite index is going nowhere fast.
In 2018 and 2019 stock market index constructors such as MSCI and FTSE Russell began to include onshore Chinese A-class shares, and not just Hong Kong-traded H shares, in their benchmarks. This increased the weighting given to Chinese equities and raised the possibility that a wall of money from passive index trackers would be obliged to buy. That may have been the case but so far passive buyers appear to have been accommodated by plenty of willing sellers.
It seems highly likely that the Communist Party will ensure GDP growth looks (and feels) decent with the 2021 centenary in mind.
But how it manages to sustain growth without piling up too much debt, or cutting interest rates to the point that the stock market becomes bubbly (as per 2007 and 2015) or the renminbi weakens (as per 2015-17 and 2019, leading to trade troubles with America) will be fascinating to watch. In the end it feels as if something will have to give, especially if Minsky is right.