Balancing Growth, Risk and Opportunity in China
By Aidan Shevlin, Managing Director, Head of Asia Pacific Liquidity Fund Management, J.P. Morgan Asset Management
In this month’s Executive Interview, Helen Sanders, Editor talks to Aidan Shevlin from J.P. Morgan Asset Management, about the changing investment conditions in China – evolving from a period of uncertainty and currency devaluation to a more steady state albeit with some challenges still in place for corporate investors.
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Aidan Shevlin |
How would you characterise the investment landscape in China today compared with 12-18 months ago?
2016 was a year of negative economic headlines in China, and a rapidly weakening currency. This led to significant concerns amongst foreign multinational corporations, particularly given low on-shore RMB interest rates and increasing credit risks. As such, the trend amongst many was to move money out of China wherever possible. During the second half of the year, the government introduced modest fiscal and monetary policy stimulus, as well as tightened capital controls, which led to greater stability and successfully averted an economic crisis. Although the currency continued to weaken during this period, it did so at a slower rate than we had witnessed during the first half of 2016.
To date, the economic growth has picked up in 2017, with strong momentum in China’s GDP figures and other key economic data, reflecting a broad-based improvement on the position of 12-18 months ago. Unlike other countries in Asia, China has actually tightened monetary conditions, which has resulted in greater stability, as well as an appreciation of the RMB, which many market commentators did not expect to happen.
Although the picture is much improved, what key challenges in China should corporate investors be aware of?
Five key challenges that corporate investors in China should be aware of include:
1) Balancing growth and economic stability
In the coming autumn, the Communist Party Congress will confirm the country’s leadership for the next five years, and it will be important that this decision is made in the context of a stable economy. Although China has benefited from economic tailwinds and an improvement in both global and domestic growth, the focus on stability may result in a slowdown in growth as the country is not making use of all its economic levers; some evidence of this includes the focus on curtailing lending, curbs on the housing market and cutting policy rates – all factors which contain growth. However, while China’s current economic growth may be slower, the stamina of this growth remains robust.
2) Ensuring currency stability
The extended period of RMB appreciation is now over; during 2016, the RMB was devaluing at a rapid rate – up to 8% year-on-year at one point and 6.5% overall during 2016. Meanwhile, from a peak of US$4tr, Chinese foreign exchange reserves dropped by over US $1tr, raising concerns about escalating capital outflows. Logically, currency appreciation could never be sustainable over the long term, particularly as interest rates fell, the economy slowed and the US economy experienced growth, however, the pace and degree of currency devaluation did come as a shock to market observers.
2017 has brought some respite with the currency unexpectedly appreciating versus the US dollar. This has been highlighted in the Chinese government’s promoted use of the new Foreign Exchange Trade System (CFETS) RMB Index which values RMB against a basket of currencies and therefore provides a more holistic picture of currency performance. In addition, as economic concerns dissipate, investors have become more comfortable with increased two-way volatility, and as a result, capital controls have slightly loosened.
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3) Deleveraging the system
One of the biggest challenges facing both China and investors in China is the rapid rise in financial leverage which raises serious concerns about the stability of the financial system and the negative impacts of the shadow banking market.
The level of financial leverage has grown significantly from 100% to 300% of GDP in the short span of two years as banks and non-bank entities such as wealth managers issue high risk and highly leveraged products to investors looking for high returns – all backed by the presumption of government support. This may be an effective strategy when rates are stable, but problems emerge when rates start to pick up, potentially triggering bond losses, redemptions and forced selling, which could all spark a financial crisis.
Consequently, new regulations are being introduced to reduce issuance by tightening monetary conditions, reducing the profitability of leveraged investment and preventing guarantees being offered on these products. These new rules have had some impact by decreasing in the number of wealth management and trust products available in the market, together with a resulting decline in yields, but there is still some way to go. This is because the government is more inclined to take a measured approach in order to avoid hindering growth or triggering a financial crisis.
4) Balancing liquidity costs in the market
The People’s Bank of China (PBoC) is actively influencing financial market liquidity conditions to reduce leverage. Although official rates have remained unchanged, other quasi-monetary policy rates have effectively increased in line with the Federal Reserve raising the official federal fund rate in the US. This has made borrowing more costly and unpredictable, but it should be noted that the central bank’s strategy is not without risks – a spike in China’s repo rates towards the end of 2016 triggered losses in leveraged products and prompted selling to cover outflows, which in turn pushed bond prices lower and elicited further selling. A vicious cycle was narrowly averted after the PBoC subsequently injected liquidity to stabilise the markets.
5) Addressing the credit challenge
Government and corporate bond issuance has increased sharply over the past few years as the economy requires more borrowing to sustain slower growth. We are now seeing debt pressures on both corporates and banks increasing, with many (particularly smaller banks) issuing debt in the wholesale market to sustain their growth objectives. This leads to greater risk as wholesale market lenders can demand much higher rates to lend money or such investors could rapidly disappear if the reputation and/or credit quality of the issuer deteriorates. This has been reflected in the weakening of both China’s credit rating (Moody’s downgraded China’s sovereign rating from Aa3 to A1 in May this year) and that of corporate and financial institution issuers.
How should corporate investors respond to these challenges?
It is certainly good news for investors to know that we have moved beyond the high risk and high volatility that characterised much of 2016. Growth is improving, as is profitability, which is favourable for companies doing business in China, particularly those in services sectors, where consumer demand is strong. Improved revenues lead to more cash to invest, and with lower risk and improved yields, the investment landscape for corporate investors is far more positive than a year ago. For example, year-to-date the average yields on 1 year Treasury bills and 1 year policy bank bonds are both around 100bps higher than in the same period last year.
However, at a micro-level, credit, interest rate and regulatory risks are still a very real issue, and investments which previously benefitted from an implicit government guarantee can no longer rely on a government support. Consequently, corporate investors are now required to conduct more rigorous risk and credit analysis in order to confidently invest in this new regime.
How is J.P. Morgan Asset Management helping with this?
We tend to suggest that in the current environment, corporations need to achieve a balance of cash that they hold in China: prior to 2015/2016, many corporates held large cash levels, which they then reduced to close to zero in recent years. The optimum level of cash is usually somewhere in between, so that companies have enough cash to take advantage of investment opportunities and to fund day-to-day operations. Investing a portion of this cash into money market funds can be a useful way of diversifying the portfolio whilst ensuring flexible liquidity and achieving an attractive return. In addition, better cash segmentation may allow investors to achieve an improved yield by investing further out the curve or in more illiquid instruments to take advantage of spread differentials. Finally, we are seeing an increased demand for ‘bespoke’ separately managed accounts that specifically reflect each investor’s risk, liquidity and return objectives.
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Having a liquidity solutions partner such as J.P. Morgan Asset Management (JPMAM) gives corporate treasurers better assurance that thorough credit analysis, policy compliance and transaction management are being conducted in accordance with international best practices. J.P. Morgan Global Liquidity (part of JPMAM) provides corporate and institutional cash investors in China with access to the valuable investment insights and local market expertise of one of the world’s leading money market fund providers.
How is the investment landscape in China likely to continue evolving?
Regulatory developments are likely to continue in order to support robust and sustainable growth and contain risk; for example, we are anticipating greater oversight over shadow banking activities. These reforms with improved disclosure and transparency, as well as an increased consistency with international standards, are likely to be positive for typically risk averse corporate investors.
