GLOBAL RISK - China Credit Risk Overshadows Outlook for Emerging Equities
China Credit Risk Overshadows Outlook for Emerging Equities 07-24-14 John-Paul Smith is a London-based emerging- market strategist at Deutsche Bank AG via Bloomberg Brief
China’s soaring debt and questions about the health of the Chinese economy have become a liability for the entire emerging-market asset class. China’s economic growth exerted a strong impact on the top lines of the emerging-market corporate universe and was the single biggest force behind the emerging-equities bull market during 2002 to 2007.
The dramatic oscillations in sentiment toward China are still a major driver of fund flows into and out of emerging equities. The overall lack of clarity surrounding the eventual outcome to the Chinese growth story has meant that the MSCI Emerging Markets Index has been locked in a trading range since the end of 2009.
During the five years through 2007, the MSCI China index rose close to 500 percent. With a plethora of initial public offerings, the index became the largest constituent of global emerging markets, currently at about 19 percent of the MSCI Emerging Markets Index compared with just over 6 percent at the start of 2002.
By 2007, the so-called “Beijing consensus” of state-directed growth had gained broad acceptance by policy makers and investors alike. Positive sentiment toward state capitalism reached its zenith when Chinese state-controlled banks led a massive monetary stimulus in late 2008. Within two and a half years, the ratio of bank credit-to-GDP rose to 175 percent from about 130 percent in 2008.
Commentators proclaimed that China had indeed saved the world from a prolonged slump. Unfortunately, these claims proved hubristic. The emphasis on state-led devel - opment across much of global emerging markets had come at the expense of pro - ductivity-enhancing reforms. This became clear in 2010 from an examination of the slump in the real rate of return on invested capital across the emerging-markets cor - porate universe.
The deterioration accelerated in the wake of the Chinese stimulus, and the obvious implication was that the macroeconomic forecasting community was far too optimistic about the medium-term rate of sustainable economic growth for emerging markets, including all of the BRIC nations.
In the four years since 2010, all four BRICs have undergone downgrades of growth by 300 to 400 percentage points. Meanwhile, the MSCI Emerging Markets benchmark has underperformed the MSCI U.S. index by 70 percent.
Economists and investors are now belatedly focusing on prospects for structural reforms to both sovereign and corporate governance. In China, Russia and Brazil there is a clear need to reduce the role of the state through deregulation, while the priority in India is to make the role of the state more effective.
China became the poster child for this reform process following the Communist Party’s third plenum in November 2013 and the flurry of policies announced in subsequent months. The difficulty lies in distinguishing rhetoric from real implementation. To date, there appears to be little attempt to enforce market-led disciplines over the priorities of central and local governments at the listed-company level.
China’s stock of credit has risen to higher than 200 percent of GDP. Since the over - whelming proportion remains internally financed, the consensus view is that it has not yet reached crisis levels, albeit potentially dangerous.
The beginnings of a debt trap are discernible in some key industrial sectors, which may have repercussions for the stability of the broader economy.
The exchange-listed material and industrial sectors have both been generating negative free cash flow for a number of years, and their overall leverage has now reached problematic levels. The majority of individual companies have responded by cutting back capital expenditures as a percentage of sales in order to conserve cash.
The unintended consequence of their collective actions has been further to weaken demand in the economy, so that many companies are faced with the prospect of even lower capacity utilization — the exact opposite of their intended result.
The result is a ‘stop-go’ policy cycle in the Chinese economy, which is unable to grow at a rate deemed acceptable by the government without ever more frequent stimulus programs. The situation is unlikely to be resolved until policy makers tackle the root causes of industrial overcapacity with comprehensive reforms, or until the funding mechanisms are exhausted.
Deutsche Bank sees a better-than-even chance that the emerging-markets index will eventually break out and decline, and hopes to be proved wrong by more decisive policy implementation from Beijing.