Will China flourish in the Year of the Rat?

The latest Chinese lunar year begins on Saturday 25 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 Wednesday 15 January.

In return for Beijing agreeing to substantially increase imports of agricultural and industrial goods from the US, the US scrapped a third round of tariffs altogether and cut the duties imposed on $120 billion 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.

  • US tariffs on around $360 billion 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.

  • “[The ‘phase one’ agreement with the US still] 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.”

    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.

    Good savers

    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 and advisers and clients will not be surprised to learn that lunar cycle has had no influence at all over the performance of the Shanghai Composite index during its relatively limited lifespan.

    Rats may be savers but lunar cycle has no bearing on Chinese stock markets

    Source: Refinitiv data

    It is fundamentals that matter and questions are gathering over the quantity and quality of Chinese GDP growth.

  • Quantity of growth. Investors will have seen how Chinese GDP growth came in at 6.1% in 2019. The headlines that came out of that referred to how this was the slowest growth rate since 1990. However, some perspective may be needed here. Any country in the West that you can think of would be delighted with 6.1% growth. And that increase still equates to $815 billion, which is a bit bigger than the entire output of Saudi Arabia, the world’s largest economy.

  • At face value, the numbers might now be quite as bleak as they seem. Even so, the Chinese stock market seems far from impressed. The Shanghai Composite index is no higher than it was in March 2007.

    “The Chinese stock market seems far from impressed [by the country’s GDP growth record]. The Shanghai Composite index is no higher than it was in March 2007.”

    Shanghai Composite is unchanged from 2007 levels

    ource: Refinitiv data

  • Quality of growth. This just goes to show that economic growth is not the be-all and end-all, even when it comes to picking Emerging Markets, and lingering doubts about the quality of Chinese GDP growth continue to linger.

  • The still-robust-looking 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.

    Li Keqiang index remains subdued

    Source: Refinitiv data

    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 are taken into account, total debt to GDP is 310%.

    Debt cycle

    “China is doing its best to keep the plates spinning […] but some economists are arguing that the debt numbers mean China simply cannot grow at its current rate for too much longer.”

    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 are arguing that the debt numbers mean China simply cannot grow at its current rate for too much longer.

    China is trying to keep credit flowing to maintain growth by lowering interest rates and banks’ regulatory capital requirements

    Source: Refinitiv data

    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, whereby a mix of cashflow and equity helps 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; and

  • 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

  • Advisers and clients may think this sound a little apocalyptic, but it may help to explain why the Shanghai Composite index is going nowhere fast as well. 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.

    Renminbi weakness could be a sign of strain within the Chinese economy

    Source: Refinitiv data

    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 it did in 2007 and 2015) or the renminbi weakens (as it did in 2015–17 and 2019, leading to trade troubles with America) – will be fascinating to watch as, in the end, if feels as if something will have to give, especially if Minsky is right.

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.