Fears of a hard landing in China as the country transitions from an investment-led economy to consumer-led economy have been a persistent drag on investor sentiment toward emerging markets.
In my view, the transition to a more sustainable economic growth model is necessary. Over the past decade, China has experienced an investment boom, which has in turn fueled a commodity super-cycle. At 44%, investment as a percentage of gross domestic product (GDP) in China has reached levels never before witnessed during any modern country’s development, and it seems poised to contract (figure 1) as the efficacy of additional borrowing on economic growth is decreasing. In other words, while 10 years ago, one unit of debt growth in China yielded four units of GDP growth; today, one unit of debt yields less than one unit of GDP growth, which points to a problem of over-capacity.
Investors’ concerns revolve around the possibility China could follow the same path as other countries that experienced similar development models, such as Japan or Korea. In those countries, GDP growth collapsed in the 10 years after investment as a percentage of GDP peaked.
In addition, successive policy missteps and a lack of transparency have undermined market confidence in the Chinese government’s ability to successfully conduct this transition.
However, the picture is not so dark, in our view. The largest parts of the economy (the service- and consumer-related sectors) remain strong while the weaker parts are showing signs of stabilization. In addition, the much-feared residential property market has been on a path to recovery for several months, responding well to stimulus measures taken late in 2014 and early 2015, with transaction volumes and prices rising and unsold inventory falling rapidly in T1 and T2 cities. The number of cities where property prices have been rising month on month has shown remarkably steady improvement.
So, while there are indeed serious challenges associated with the economic transition, we believe it is important not to ignore the progress made, as well as the government’s commitment to support the economy and the room it has to maneuver.
As for the Chinese yuan (CNY)—which has been the center of currency, equity, and bond market turmoil since its unexpected devaluation in August 2015—we believe investor expectations of further devaluation have been overly bearish.
Four factors argue against competitive devaluation: China’s record 2015 trade surplus of $600 billion, the health of the Chinese consumer, the absence of unemployment, and China’s relentless rising market share of global exports. And, the CNY doesn’t appear to be fundamentally overvalued, as shown by its closer parity with its nominal effective exchange rate, or NEER (fig. 2). Consequently, we don’t believe there is an inherent pressure for a significant CNY depreciation.
That said, expectations of continued currency depreciation have been a drag on foreign-exchange (FX) reserves. And while current FX reserves still stand at very high levels, $3.2 trillion as of end of March 2016, the acceleration in capital outflows has rung alarm bells about the pace of depletion of these reserves—approximately $ 790 billion left the country since the peak in July of 2014. But we expect the pace of outflows to abate as Chinese authorities are actively tightening rules to limit capital outflows and capital flight by Chinese corporations (which very rationally decide to pay down their U.S.-dollar-denominated debt in anticipation that further CNY weakness) should moderate over the next few months.
Of course, China isn’t the only concern depressing investor sentiment about emerging markets. I’ve already discussed two other factors—disappointing economic growth in emerging market countries and the potential impact of U.S. interest-rate hikes and a stronger U.S. dollar—and I’ll discuss the collapse of the commodity complex another time.