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Chinese yuan

A China Correction

Monday, August 24, 2015

The market shock of the past week has been the major news story across the globe. Markets began this week’s trading sessions down over 5% in the US, while the selling abroad today ranged from -4% in Europe and Japan, to -8% in China. The global selloff was triggered by reactions to slowing growth in China and notably Friday’s release of discouraging Chinese factory activity. The severity and breadth of the rout indicate that the concern includes the ripple effects China’s slowdown will have around the world, particularly in the emerging markets. While investors have obviously been surprised by this new outlook, we view these developments to be largely in line with the long-term economic and social objectives established by China’s policy makers in 2011 in the official 12th Five-Year-Plan.

Our analysis leads us to conclude that the changes to the Chinese economy are not as negative as the markets would indicate. Furthermore, China’s new growth path will have isolated effects on global markets and economies and likely will be moderate for most investors.  We expect that over the short term there will be heightened volatility, but nevertheless, the selloff may well create investment opportunities for selective growth oriented strategies.

While the global market selloff has been the focal point for the past three trading days and China’s economy has come to the forefront since the People’s Bank of China’s (the “PBOC”) move to devalue the Yuan on August 11, trends based on China’s changing economy have been developing for quite some time. The standard exchange traded fund benchmark for large-cap Chinese stocks traded in Hong Kong (FXI) has fallen over 30% since late April and the sell-off has been felt in almost all industry sectors. Emerging markets, which depend heavily on China’s hunger for commodities[1], have similarly declined over 25% since the end of April. It has only been in recent days that the selling pressure has spilled over into stocks of developed markets. But to blame this panicked selling on China would imply that the Chinese government has lost control of its economy and that the slowdown increases the risk of global recession. Some undoubtedly see China’s decline in GDP as evidence to support this.  We believe that the leadership in China foresaw some slowing growth and incorporated these projections into its 2011 Five-Year-Plan to modernize its economy.

A key element of the Five-Year-Plan has been to encourage growth in consumption and to shift focus away from exports, investment, and government spending in achieving the desired level of economic growth. A specific goal has been to increase service sector contribution to GDP from 43% to 47% (still relatively low compared to the 78.1% of the U.S). According to data from the World Bank, this increase is ahead of schedule, coming in at 48.2% in 2014. Another of the Plan’s intentions is to boost industries that require less energy and produce less pollution. Additionally, the jobs in the service sector are often “white-collar,” higher paying jobs that help to achieve the policy makers’ intentions to lift average wages and grow China’s middle-class.

A consequence of this economic transformation to an increased reliance on service industries instead of heavy industries has been a reduction in the demand and price of commodities. This, in turn, has resulted in a significant decline in the economic growth of emerging market countries such as Brazil, Chile, South Africa, and much of Southeast Asia, which are dependent on the production of raw materials. Many headlines in the financial media over the weekend pointed out “the recent plunge in commodity prices.” This is anything but a new phenomenon. The CRB Index, the commonly used index that tracks the price of a diverse basket of commodities, has dropped over 17% since May 15th. While significant, this price performance pales in comparison to the 45% decline since the Five-Year-Plan was approved by the National People’s Congress in March 2011.

Another development has been a steady decline in the overall rate of China’s GDP growth from the heady low double-digit rates prior to the Plan. The policy makers anticipated this decline and built it into their revised GDP growth target of 7%. They expected that this lower level of growth would be sufficient to achieve their underlying social and economic objectives due to the lower required investment and higher-paying jobs in consumer-related and service industries.

Further, the Chinese policy makers were presumably aware that the path to the desired consumption target would be uneven and might require intervention. It is evident that the slowdown in their economy is greater than they desire, and for the past nine months they have adopted initiatives to stabilize the economy and stock market.

  • Since November 2014, the PBOC cut lending rates four times, cut deposit rates, decreased reserve ratios, and injected cash into banks.
  • The Chinese government directly intervened to stabilize the stock market.
  • The PBOC allowed the yuan to depreciate about 3% against the dollar in order to partially offset the yuan’s strength relative to non-dollar currencies and to help stabilize a sharp decline in Chinese exports.
  • China’s leaders initiated numerous targeted stimulus measures designed to encourage consumption.

In the near term, it is difficult to predict the success of these stimulus initiatives. However, the policy makers have the determination and tools to take additional steps if further deterioration were to occur. In other words, they have an urgent “whatever it takes” mentality and the unlimited authority and resources to achieve their objectives.

We conclude that the changes in the Chinese economy will continue to pressure commodity prices and the economies, markets, and currencies of countries that rely heavily on commodity exports. On the other hand, we think the Chinese consumer will benefit from the changes and provide investment opportunities. Most important, we think the Chinese economic slowdown will not threaten the global economic expansion dating back to 2009 to such an extent that the equity markets of developed economies, including the U.S., will suffer severe and sustainable damage.

[1] In some commodities, Chinese consumption exceeds 40% of global demand.