China is a nation in transition. It’s trying to move from low cost, low value-add exports and state-financed construction into a provider of high value industries and services and increased domestic consumption. And with this change comes some inevitable risks borne out of a precarious balancing act between debt, property, a strong currency and global demand (where have we heard this before?). Neal Smith, fund manager at SIM Global, explains to us why they still see opportunity in the nation that has come to be known as the global growth engine. – Candice Paine
This special podcast is brought to you by Sim Global. I’m sitting with Neal Smith today who is a Portfolio Manager at Sim Global and we’re going to be discussing China as an investment opportunity. Neal, China’s not only the economic growth engine of the world but it’s also in huge transition. They are attempting to move from low cost/low value-add exports and state-led investment, into construction to high value-add services and industries and predominantly, to increase their own domestic consumption. However, this all comes with some risks. Not only to them, but to global growth in general.
Candice, I agree. As you mentioned, China is the global growth engine. For the last 35 years, GDP has grown at a compound annual rate of around ten percent in U.S. Dollars and currently contributes around 12 percent to global GDP. Any slowdown in China therefore has a material effect, considering that even though GDP growth has slowed down, it still contributes over 50 percent of global growth. If you look at the Chinese market, it has underperformed the World Index and other markets over the last four years – quite significantly – and when you look at it, its earnings growth has outperformed quite materially. The market is starting to discount some rather large risk, though. Included in those are the property market bubble (potential property market bubble), shadow banking risk, and as we mentioned, slowing economic growth. What’s really going on? Well as you mentioned, China has been very dependent upon low value-add export growth as well as state-led infrastructure and real estate construction. During the global financial crisis, the global export boom came to an end and the government used huge credit expansion to support the economy, putting that money into the hands of real estate developers, private companies, and state-owned enterprises. As a result, China’s overall balance sheet has expanded more significantly, with total debt-to-GDP over 200 percent. If we go through some of the risks, we talk about the debt accumulation. A large of the credit lending has happened in the shadow banking system, which is really a conglomeration of unregulated entities, which take money off the man in the street and lend it onto state-owned enterprises, and private businesses such as real estate developers. They do this by offering a higher return in a deposit kind of product and the man on the street is actually not aware of the risks.
Neal, is this not what brought us to our knees in 2008?
Similar… One of the large problems with it is that there’s a duration mismatch on the product so if the end consumer starts demanding the money back, it’s very difficult for the shadow banking system to liquidate their positions and get it out, which can cause an effective credit squeeze.
How is all of this linked to the Chinese property market?
It’s a good question. Over the last two years, the Chinese property has done exceptionally well and that’s been supported by accumulation of debt. However, if you look at the market as such, the Tier 1 and Tier 2 cities are suffering from housing shortages while Tier 3 and Tier 4 seem to have excess supply. The last while, prices have probably been coming down, but it doesn’t tell you the whole picture. The picture I’ve just mentioned to you has been compounded by the fact that migrant workers find that they can’t afford the property as they move into the cities, so there’s a regional mismatch plus the unaffordability issue.
Real estate is a huge part of the Chinese GDP, contributing round about nine percent directly and you’ve also stated that about 60 percent of Chinese household wealth is invested in property. Is this why the Chinese property market is so important to China, and could be one of the huge risks that they’re facing going forward?
Absolutely. You mentioned nine percent of GDP. That’s the official figure, but there have been some estimates. If you add on the ancillary industries, that amount is as high as 25 percent. What China is really grappling with, is that they recognise that the amount they spent on infrastructure…the projects are largely done. They’re still ongoing, but they’re slowing as a percentage and the property market has run. Now, to keep growth going, they need to transition the economy away from that (and as you mentioned in the beginning) to higher value-added services and most importantly, domestic consumption.
They’re doing this in the face of slowing global demand and a very strong currency. What impact does this have on investment opportunities in China?
You’re quite right. The Chinese Renminbi has been pegged to the U.S. dollar effectively, for a long time and the recent strength of the Dollar has meant the Renminbi has appreciated relative to the rest of the world currencies, which has undermined China’s export competitiveness. Now, there’s been growing speculation that at some state, the People’s Bank of China may be forced to allow the Renminbi to depreciate to stimulate export growth at this time where growth is slowing. It’s desperately needed. It’s not as simple as that, though. I agree that the probability of that happening is increasing, but I think that it’s more complex because China is very geared and the corporate sector is very geared, and many of those corporates have foreign denominated debt. To allow the Renminbi to depreciate, would put a lot of pressure on a sector that’s already under a lot of pressure.
Okay, so you’ve painted quite a gloomy picture of the Chinese economy, which will obviously have an effect on commodity prices around the globe. You, as a Portfolio Manager, need to find opportunities to invest in. Tell us what you’re seeing, given that China has underperformed for the last four winds, and the headwinds that you’ve explained.
The first thing I’d point out is that what you and I have been speaking about, is not new news. People have been speculating about this for a number of years and the market has underperformed, so people have attempted to price these risks in. However, in any economy, there are subsectors that perform well. Given China’s scale, there’s immense opportunity and we are very optimistic about the medium to longer term. We’ve uncovered a number of industries and companies that are performing very well in this environment and the valuation is very attractive. The example I used was (if you think about it in the South African context) companies like Capitec, Shoprite, and Spur have been excellent examples of companies that have done well in a very challenging environment. We’re looking for similar kinds of models, which are high barriers to entry and very cash-generative with good management that can grow well.
What you’re saying is in the short term, China’s facing certain risks but in the long term, you still see opportunities in the Chinese market for investments within the offshore funds that you run at Sim Global.
Absolutely, and we look forward to sharing some of those with you in the future.
Neal Smith, Portfolio Manager at Sim Global. Thanks so much for your time.
