China Confidence Crisis

Chinese markets had a weak start to the year in line with the sell-off in most global risk assets in January as investors focused on: the weak oil price, the future trajectory of US interest rates and, close to home, policy confusion and the uncertainties surrounding the renminbi and capital outflows.

We believe there has been a confidence crisis due to the opaqueness of recent policy decisions centred on two issues. First, the inappropriate timing of the introduction of circuit breakers which was intended to smooth the volatility but instead created more volatility given that the market volumes are dominated by retail participants accounting for some 80% of total volume. The circuit breaker rule was quickly pulled out on 8 January as policy makers understood it exacerbated volatility; we feel this is a positive move to allow the market to seek its true natural level.

Second, the renewed weakness in the renminbi since December after the surprise change in the government’s currency policy regime in August 2015 raised concerns as to whether China was resorting to devaluation of its currency to boost its economy, thus exacerbating the global competitive devaluation pressures of the bank of japan and the European central bank. The US has just started to raise interest rates so its divergent policy compared with the rest of the world means US dollar strength and emerging market capital outflows, hence it is inevitable to see some renminbi weakness. Besides, the currency has also appreciated so much since 2005 (from RMB8.3/USD in June 2005 versus RMB6.05/USD in the first quarter of 2014 at the RMB’s peak strength, then to RMB6.576/USD as of Jan 29). And it is but natural to see some reversion in light of the US dollar strength. Note that year-to-date the renminbi has depreciated just 1.3%, but the reaction of equity markets in January was extreme.

We blame this on poor communication rather than a continued deterioration in fundamentals. Authorities are walking a tight rope trying to stimulate enough via fiscal and monetary policies so growth slowdown is cushioned, yet are constrained by debt and currency parameters. And on a big picture scale, the government wants to continue with structural reforms to shift from an investment/export led economy to a consumption/services led one. They have started to emphasise supply side reforms and we hear more news of eliminating capacity in the cement and steel sectors. But we hope to see more action, transparency and material execution. Therefore, a policy to significantly weaken the renminbi seems counterintuitive to us.

To conclude, we remain constructive on the economy in that the transformation towards a services-based economy is occurring before our very eyes. Yes, it’s a two-speed economy as the rust belt/ old economy areas remain challenged with overcapacity issues as well as the structural demand slowdown. FX volatility largely reflects the government’s inaptitude in handling sensitive government policy communications (the move to a basket weighted index from one that is linked solely to the US dollar) as well as benign US dollar strength. Valuations are once again at the bottom end of their historical trading range and for a long-term investor present an interesting entry point.

Michael Lai – Investment Director Asia – GAM