Future of China

Despite China's strong GDP growth relative to the West, its equity markets are likely to remain weak with downside bias. This is despite the Chinese government reversing its contractionary monetary policies to fight inflation as well as its readiness to deploy stimulus measures to keep the economy growing so as to provide continued employment for its massive population. Why then are the equity markets in the West rallying even with anemic economic growth while the Chinese equity markets are sliding as its economy expands?


A few concerns play out here:


1. Banking System under stress. China's economic and banking reforms slowed after it successfully cleaned up its state banks' balance sheets and launched their IPOs to strengthen their capital structure. The boom years of 2006, 2007 further lightened pressure on pace of reforms (complicated by bureaucraftic turf battles) as focus turned to the impact of an appreciating renminbi on exports instead. By 2008, at the onset of the financial crisis, it became concerned with how the global economic slowdown will impact on China exports. Given its huge production capacity and workforce, China may face massive unemployment and instability (especially a sizeable migrant population lives in its big cities, estimated at over 300 million). China then embarked on a massive stimulus program (relative to GDP, it far exceeded the bailout in the US) that forced banks to aggressively lend once again - just a few years after cleaning up their balance sheets. While this helped prop up the economy, this also led to much economic waste on financing un-economic projects and directly creating a real-estate bubble. Banks in the heat of lending could not perform proper due-diligence and they are now again riddled with assets of dubious quality. The concerns in the stability of its banking system and its ability to weather through an asset bubble burst are bearish enough for the equity markets.


2. Slower economic growth. With Eurozone likely to impact on China's growth in the near-term, Chinese government will be concerned about how best to further stimulate the economy without worsening the asset bubble as it has to keep a tight reign on food, energy and housing prices affecting many ordinary Chinese. Managing demand-side economics through stimulation of consumer domestic consumption will require time. Though the Chinese government is in a strong fiscal position to embark on aggressive expansionary policies, given the constraints outlined here, China may have to settle for a slower growth rate (7% region instead of 9%) as being sustainable for the country. Slower economic growth translates to slower earnings growth for companies in China, which will likely translate to lower stock prices ahead.


3. Limited liquidity participation from overseas. Over the past 3 years, much liquidity remained in the US system because it is still the "safest and most liquid" market to invest, despite its ballooning budget deficits and rating agency downgrades. The low interest rate environment and record high bond prices brought about by the US Quantitative Easing altered the risk-reward attractiveness for the US equity markets. Consequently, a US equity bull market ensued, surprising many. While there were some funds which did flow out of US in search of "higher growth elsewhere", they went largely to commodity and oil producing/exporting countries rather than to China (China also has capital controls). Australia, Canada, Mexico, Brazil, Malaysia, Indonesia, India and Russia benefited when funds flowed out of the US markets, but China did not. Capital controls in China effectively limited meaningful foreign participation in its markets and devoided its markets liquidity coming from overseas.


4. Fewer domestic growth opportunities. China, with its leninist-style Government and centrally-planned economic model, may be more responsive to a crisis, as shown in 2008. Today, there are plans to develop mega-cities in China as well as building more airports, rails and highways. However, longer-term, two factors will contribute to slowing economic growth for China. One is aging population exacerbated by its "one child only" policy and the other is the already substantial infrastructural build-up compared to other emerging countries like India. As economic growth plateau, so will corporate earnings and stock prices in the longer-term.


5. Lack of investor confidence. Investors are also concerned about the quality of earnings reported by corporate China. China is aggressively pushing for adopting GAAP accounting standards in its own PRC accounting codes. This will take time. Meanwhile, more accounting fraud continue to be uncovered. Quality of earnings is suspect. With SOEs consisting a large part of overall market capitalisation, private investors could be rightly concerned about the sustainability of corporate earnings growth independent of government support or participation. All these impact on investor confidence in Chinese companies and equities.


6. Alternative investments and reduced liquidity in equity markets. Consequently, Chinese would prefer to park their investible cash in real-estate or other forms of exotic investments like antiques, paintings, vintage wine and coin collections. Gold, as a store of value during inflationary times, is also diverting liquidity away from equity markets. With tightening economic policies of past years, and the reigning in on SOE, businesses and individuals taking borrowed money from banks to speculate in the stock and property markets, another important source of liquidity and leverage in the equity markets have been removed. This, together with competing asset classes for investible funds, have exerted further pressure on the Chinese equity markets, which have also been operating at a much higher PE than Western markets.


China is a huge and complex country to manage. Navigating through the headwinds has its difficulties and challenges.  China has a long history, its feudalistic mindset is deeply entrenched. Decades of centrally planned economy also added bureaucratic complexity. These pose definite challenges to necessary reforms ahead. But the resilience, determination and commitment of the Chinese people and its government to modernise China and propel it into the forefront shaping the new world order will be China's great strength.


The global economy will expand as world population grows and technology and innovation will continue to help boost productivity, boost living standards and sustain an ever larger world population living on limited resources. China understands this must be the best time for it to re-invent itself for the new century. The collective leadership in Beijing knows reforms are needed and they must not miss such a golden opportunity to re-establish China's rightful place on the world stage. The future for China is bright. It will weather the headwinds and eventually cruise in a safer plane on to much greater heights.