Should the recent slowdown in Chinese growth worry investors?

09 August 2018

What’s driving the recent slowdown in Chinese growth, and whether investors should be concerned.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • What’s driving the recent slowdown in Chinese growth.
  • Why financial stability risks are such a key focus among Chinese policymakers.
  • How Chinese policymakers are expected to react to the ongoing growth slowdown.

So far, both media and investor attention has been predominately focused on the evolving trade spat between the US and China. However, China-watchers have recently highlighted another source of worry – a slowdown in the domestic economy. At the same time, China’s currency, the yuan, has weakened significantly. While a combination of these prompted a global market sell-off three years ago, investors appear more sanguine today. This week, we discuss whether investors are underestimating the risks of a Chinese slowdown.

Signs of a slowdown

Signs of a slowdown began to emerge in Q2, with activity indicators such as fixed asset investment and retail sales showing signs of slowing momentum. To us, the ongoing slowdown had its origins in the recent wave of financial regulatory reform implemented by authorities. Financial stability has been a persistent concern since 2009, when China underwent one of the largest credit booms in modern history in a (largely successful) effort to spend its way out of the Great Recession.

Since 2007, non-financial debt in China has increased from $6 trillion to nearly $30 trillion, while banking system assets have increased six-fold over the same period to over 300% of GDP. Historically, such a rapid build up in credit tends to be followed by a financial crisis or extended periods of below-trend growth. Policymakers have long acknowledged that a systemic financial crisis poses the greatest threat to China’s growth sustainability, and have recently introduced a range of regulatory reforms designed to reduce economy-wide leverage and curb financial stability risks.

Casting a light on the shadows

One sector particularly targeted by regulators was the so-called ‘shadow banking’ sector. The shadow banking sector is an outgrowth of China’s unique credit system – an interconnected web of financial firms that exist primarily to circumvent China’s often complex and fractured regulatory backdrop.

Shadow banking firms perform similar functions and assume similar risks to conventional banks, but outside the normal regulatory framework. This means that the shadow banking sector operates under less stringent regulatory restrictions, hold less capital on their balance sheets, and lack the usual safety nets guaranteed to the conventional banks (eg. deposit protection schemes, access to emergency funding from the central bank, etc).

Over the past few years, shadow banking activities have led to a proliferation of complex and opaque financial products that are increasingly interconnected with the wider financial system, thus posing a clear risk to financial stability. The recent reforms being rolled out by regulators are designed to slow the proliferation of these products, while improving transparency amongst existing ones.

So far, these efforts have had success – some measures of economy-wide leverage have begun to stabilise. However, the deleveraging campaign also had the side effect of tightening liquidity and reducing credit availability, and their effects are starting to feed through the real economy.

Borrowing costs have risen, leading to rising default rates among the more vulnerable firms. Fixed asset investment – a sizeable sector of the economy that’s relatively dependent on local government borrowing – has been particularly hard hit.

Investment conclusion

Chinese policymakers have long recognised the trade-off between ensuring long-term financial stability and maintaining short-term growth, and they have an immensely difficult job in balancing the two.

We believe policymakers have sufficient controls over key levers of the economy to prevent an over-tightening scenario – recent actions pay testament to that. For example, the central bank has loosened monetary policy by lowering interest rates and increasing banking sector liquidity. The pace of the clampdown on shadow banking activities has slowed, with domestic banks given more time to implement the new regulatory requirements required of them.

Lastly, authorities have allowed the yuan to depreciate beyond its usual allowable range. These actions signal a level of coordination among policymakers to support growth as the financial system adapts to the new regulatory environment. Based on the latest set of activity indicators, the ongoing slowdown has so far been gradual, and the risk of it turning into a more serious downturn remains low. We retain our positive view on emerging market Asian equities as a leveraged bet on global growth, and are positioned as such within the portfolios we manage on behalf of our clients.

These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance.

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