Jason Pidcock fund manager of the BNY Mellon Asian Equity Fund at Newton, part of BNY Mellon, looks at the outlook for China amid signs of weakening in its economy.
“The Chinese equity market has been subdued for most of 2013, underperforming the rest of the Asia-Pacific ex Japan region; investor concerns over slowing Chinese growth and tighter liquidity conditions have driven this weakness,” says Pidcock. “In addition, investors have shied away from investing in Chinese equities despite the relatively „cheap‟ valuation of the market compared to other regional indices because of increased government involvement in the economy. For example, the government seems intent on clamping down on corruption and excessive spending and entertainment by officials; this has caused Chinese retail sales to be more restrained, led by lower demand for luxury items such as watches and high-end Chinese wine,” he explains.
Striking a balance
“We are increasingly cautious on the outlook for the Chinese economy due to the structural imbalances that are at risk of causing a sharper slowdown in growth, or even a wider destabilisation. For example, the potential level of non-performing loans in the banking system is something that worries us, as it is a data point for which it is very difficult to get an accurate measure.” He continues, “If the banks are less compliant in rolling over debt to both state-owned enterprises and small- and medium-sized enterprises then we could see some corporate bond defaults, which could spark panic. The issue is that after years of very cheap financing being available, companies are invested in projects that would be uneconomic at a normalised cost of capital. The government realises it needs to liberalise the interest rates in China to address this, but this will have to be a very gradual process,” Pidcock explains.
“As such, we are happy to have limited exposure to China and do not hold any Chinese banks or property developers. We also avoid areas of the economy which are in structural oversupply; for example, the steel sector or auto manufacturers and airlines,” he says. “Although Chinese retail sales growth has slowed down, we still believe that in the long term, consumption is an area of the economy to which we do want exposure and therefore prefer to hold companies which should be able to weather a downturn.”
“If China has a significant slowdown then the effects would, of course, be felt across the region. However, the effect would vary on a country-by-country basis; for example, the Philippines, which has seen the services component of its economy built up for some years now. The country now has a large BPO (business process outsourcing) industry – this is of higher value than simple call centres – indeed, many large global investment banks are moving their back offices there, reflecting the high skill set and English language levels of the Filipinos,” adds Pidcock.
“India is another country that is likely to be less affected; it is currently suffering from internally-generated problems of a fiscal deficit and current account deficit, and a resulting weak currency,” he explains. “Politically, it has been slow at implementing the necessary reforms to boost infrastructure spending and investment by companies, contributing to the slowdown in GDP growth. However, if a slowdown in China caused deflation to be exported and put pressure on the prices of commodities such as oil, then India may benefit as a net importer. Meanwhile, we believe that more open economies with export -dominated industry such as South Korea and Taiwan will be those most affected by a potential Chinese slowdown; we are happy to limit our exposure to these countries,” Pidcock concludes.