In recent years, China’s growth, which had been the envy of the world for decades, began to sputter. China’s debt rose sharply as the government began borrowing money at an alarming rate to finance infrastructure projects and other initiatives to keep its economy humming. For four consecutive years, China issued net debt that was equivalent to more than 30% of its total economy—helping create an economic environment that began to remind some of the subprime credit bubble in the United States.
Investors naturally grew concerned; Chinese stocks, as a group, underperformed the broader emerging market index over the past four years.
But has enough changed to put Chinese equities back on the right track?
We believe it has—enough that investors might want to reconsider China as an attractive investment opportunity.
Why should investors consider China now?
Our position on China is based on both the discounted valuations of Chinese stocks and the leadership's response to slowing growth. To their credit, China's leaders recognized the country's predicament and understood that its former economic model was running out of steam. They knew the country was overly reliant on debt, with not much in the way of a payoff. In fact, from 2009 through 2012 China was able to generate only 0.30 yuan of economic growth for every yuan in new debt, less than half the 0.71 yuan it had generated previously, according to Fitch Ratings.
In November 2013, Chinese officials unveiled a sweeping plan to overhaul its economy, announcing 60 "concrete tasks" to position the world’s most populated country for its next phase of growth. Even if only a small portion of those reforms produce results, they could set the stage for higher-quality and sustainable future growth.
That bodes well for stock valuations, as investors typically reward high-quality growth over a long period of time. And Chinese stocks have plenty of room to rebound, as they are currently trading at a significant discount both to their historic valuation and the broader emerging market universe.
To be sure, the reforms might not immediately jump-start the economy; China's growth might in fact keep decelerating over the next six months or so. But over a longer time horizon, perhaps over the next year or two and through the remainder of the decade, we believe these reforms could help fuel the economy.
The reforms to watch
There are six reforms in particular that bear watching because they could trigger significant changes in China's economy and position the country for higher growth. Three of those could combine to provide a potent boost to consumer spending and productivity. The other three could help transform China's financial sector from a major concern to a strong source of growth.
Land rights. The first reform involves China's rural land rights. Soon, farmers will be able to transfer and leverage land as collateral, which would put money in the pockets of low-income consumers and increase their mobility. This historic reform also might trigger the consolidation of smaller farms into larger ones, which could increase food output.
Household registration. In addition, China is poised to issue urban household registration cards to millions of migrants in small and midsize cities. These cards provide access to public services such as healthcare, primary education, low-income housing, and social security. This reform could increase the mobility of the labor force and, coupled with the land reforms, spur the next wave of urbanization and productivity gains in China.
One-child policy. China is also loosening its well-known one-child policy. Some attention has focused on the potential impact that increased use of maternity leave would have on the economy, including higher social services spending and temporary reductions in the size of the workforce. Overall, we think the biggest impact of the additional estimated one million to two million births will be a marginal boost to consumer spending.
Local government finances. There's a renewed emphasis on shoring up the financial health of local governments. Municipal governments have been responsible for 80% of the country's fiscal spending in recent years but have accounted for a little more than half of its tax revenue, according to The Economist. As a result, local governments have had to lean on the unsupervised, shadow banking system to access funding. In addition, they have had to raise money from land sales, resulting in imbalances in the property market. China is now considering shifting revenues from the central to the local governments, permitting municipalities to access the bond market, and potentially allowing local governments to collect property taxes. Taken together, these steps could reduce both investor concerns about asset quality risk at banks and some of the imbalances that have propelled the property market.
Management of stated-owned enterprises (SOEs). China is also mandating that its SOEs focus on efficiency and return on investment. In the past, SOEs have benefitted from protectionist policies that resulted in inefficient enterprises. These companies, effectively, were arms of the state, there to maximize jobs and full employment rather than profits. The government now is pressing SOEs to adapt to a market-based environment and install better management practices. Additionally, SOEs are being asked to increase the dividends paid to the government. This reform may have trouble gaining traction, because SOE profits could suffer initially as input costs rise to market-based prices and dividends increase. Nevertheless, the potential economic impact is great if the country’s large domestic companies are more focused on profits and efficiencies, and the dividends can be used to help cover fiscal spending.
Financial system reform. Finally, a series of reforms aimed squarely at the financial sector will likely continue to lead the reform agenda. Recently, the government allowed lending rates to move toward market-based pricing. It also signaled that that a deposit insurance plan is forthcoming and that market-based deposit rates likely will be introduced. China also is moving toward a market-based government yield curve, which could steepen and increase both investment returns and profit potential for financials. These and other reforms also could open up opportunities in investment and corporate banking. Of course, moving towards a market-based pricing system has significant risks as well as potential for upside.
Overall, the pace of the implementation of such a broad slate of reforms likely will be uncertain and uneven, heightening the odds of increased volatility. But it will only take a handful of the 60 reforms proposed to improve the quality of China's economic growth, and provide a boost to stocks.
Bumps along the way
Of course, investing in Chinese stocks is not risk-free. It is possible that tighter financial conditions and slower growth could increase bankruptcies and the amount of bad debt. Also, the pace of reform momentum could slow or reverse.
Over the next one to two years, a Lehman-like credit crisis in China is a small probability. However, in our view the credit issues are manageable. We believe China's government has the tools to resolve financial and economic issues by using a combination of the following: injecting liquidity into the banking system, devaluing the currency, and stimulating growth by increased infrastructure spending.
What should investors do now?
Risk-tolerant investors should consider overweighting their holdings of Chinese stocks within their allocation to emerging market stocks. We're not suggesting you increase your overall allocation to emerging markets, though, as our view on that stock universe, as a whole, remains neutral.
But low valuations and depressed investor sentiment have created an opportunity in Chinese equities. And the government's dedicated and sweeping reform efforts could provide the impetus for a new phase of growth, even if there are bumps along the way. We think investors should consider buying mutual funds and ETFs that invest in large-cap Chinese stocks, which could benefit the most over the next year or so since they have the most discounted valuations.