China: UBS

We appreciate the opportunity to work with great partners, and that certainly includes the team at WallachBeth Capital.  They have proven instrumental in enabling us to effectively implement our ETF strategies.  Erik Ambrose, from WallachBeth, connected me with Matt Collins and Curtis Tai at CSOP Asset Management.  They were kind enough to introduce me to Harrison Hu, the China Economist for UBS based in Beijing. 

John Lunt with Harrison Hu

Harrison is incredibly knowledgeable about the Chinese economy.  I filled almost an entire notebook from our meeting at Harrison’s office!  Harrison has been gracious enough to allow us to share some of his recent research—you won’t want to miss it!

Here are some of the highlights from our discussion:

China is facing the great challenge of trying to balance growth and reforms.  Policy makers are attempting to engineer a soft landing.  Policy support is needed in order for the government to have the ability to push through structural reforms.

Property is experiencing a downturn in China.  This downturn is different, as it was not triggered by policy tightening, but by the underlying supply and demand.  As property boomed, there has been too much supply, but demand has been stable.  In the past, investment demand could cover this gap.  (This has been a repeated theme—past wealth flowed to property, driving prices higher).  Now, there are other opportunities than just real estate for investment capital.  Harrison expects a 10% drop in prices this year, and this will be felt across the Chinese economy given its overall importance.

The government doesn’t have the tools to completely offset this downturn.  Harrison expects 6.8% GDP growth in 2015 before ultimately bottoming out in 2016.  Property and exports have been the two engines of growth in the Chinese economy, and both are moderating.  Both rising labor costs and appreciation for the RMB (Chinese currency) are slowing exports.  However, Chinese exports are still gaining market share—growth in the developed world is slowing.  Chinese manufacturers are moving up the export chain and are benefiting from lower cost imports.

The government would like to move to a more “consumption-based” economy.  However, the consumer sectors can’t be relied on in the short-term.  This will require the government to focus on infrastructure investment in order to keep the economy from slowing too significantly.  Local governments are struggling, and they don’t have the capacity to make infrastructure investments.  The central government will have to fill this gap. 

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While policy tools are limited, monetary policy easing is providing abundant liquidity.  While the real economy is sluggish, the liquidity is causing a boom in the stock market.  The household sector has invested in trust products (with their implicit guarantees).  The underlying assets in these trust products are related to property and infrastructure.  With the decline in property, the risks associated with these products are making them less attractive.  This is causing assets to flow into financial assets. (Harrison noted that recently there had been some profit-taking in financial markets that had put money back into tier one property markets).

While monetary easing has not stimulated the entire economy, it has safeguarded the financial system and contained financial risks. 

Monetary easing is likely to continue—deflationary pressures are pushing up real interest rates.  With such a large debt overhang in the economy, monetary policy cannot tighten (this would create a negative feedback loop). 

This is clearly impacting equity markets, and a higher stock market is a better environment for banks to raise capital.  The service sector can get financing from a booming stock market.  There is a sense that the government wants the stock market higher.  This implicit guarantee also creates risks.

Without concrete progress on structural reforms, the “tail risk” associated with slowdown in the Chinese economy will remain.  This year and next year will be hard for the Chinese economy, but targeted policies will try to buy time for reforms.  The “old model” is gone, and the “old” growth sectors are in deep recession.  The service sector is growing, but it is too small to compensate.  The government hopes to use new technology to transform old sectors to make them more competitive in global markets.  It is unclear if this will succeed.

There is a general view that the RMB (Chinese currency) is fairly valued.  Joining the IMF’s SDR basket is a priority for Chinese policy makers, so they will do their best to maintain stability in the exchange rate.  This removes the possibility of RMB depreciation as a significant tool, and China will try not to join the global currency wars.  This will be difficult if the U.S. Dollar strengthens (pulling the Chinese currency with it), making China less competitive against some of its Asian neighbors.

These were just some of the great insights that came from my discussion with Harrison.  While China’s economy is slowing, it is triggering an accommodative policy response that has been favorable for Chinese financial markets.

 
 

Special thanks to Brennan Staheli, Devin Lindley, and the Lunt Capital team for their contributions to this report.