2015 From Cyclical to Structural

China Macro Monitor 2015 From Cyclical to Structural. After half a year of spectacular equity market performance to some the clouds of slowing economic growth cast doubt on China’s ability to maintain the rally.

However, that view over-emphasises the correlation between GDP performance and equity market performance. The link between economic and equity market performance has never been straight-forward. Indeed, China may follow a path similar to Japan, South Korea and Taiwan during their early stages of development. That indicates that equity market performance will accelerate during periods of financial market liberalisation rather than periods of strong economic growth.

A number of exogenous events may also prove to be supportive for both China’s domestic equity market and China’s role in the global economy. MSCI is due to evaluate the inclusion of China A-Shares in its Emerging Markets Index this June. The IMF is also due to conduct its five-yearly Special Drawing Rights (SDR) basket review this October. Renminbi inclusion discussions could become a catalyst for significant currency market liberalisation and a seismic shift in the role of the Chinese currency in international trade and finance.

We expect reform to remain the focus of policy makers’ agenda this year, with lower economic growth an acceptable by-product of stability. The authorities are unlikely to let growth fall substantially lower however, as that could stoke political unrest and undo the hard work of the reform agenda. We expect some policy easing, primarily in the form of lower interest rates and a reduction the Reserve Requirement Ratio in coming months.

A ROCKY PATH TO STABILITY

Although Chinese GDP growth of 7.4% in 2014 surpassed consensus expectations, it was the lowest reading in 24 years. The outlook for growth is lower still in 2015. Both the World Bank and IMF have downgraded their 2015 China growth forecasts to below 7%t this month. The message from policy makers in China is that sub-7% growth is acceptable, so long as its reform agenda continues apace.

Over the next decade China’s growth model will migrate away from cheap-currency dependent mercantilism and China will become increasingly more capitalist. Market forces will help the allocation of resources1 and the legal framework will be strengthened to improve quality of China’s institutional infrastructure2.
Transition will inevitably involve winners and losers, but society as a whole is likely to benefit from the new model. China will be careful not to move too quickly and aggravate political instability. With that in mind, it is likely that China will stimulate the economy further in 2015 to avoid a marked slowdown, especially in light of a faltering Euro area dampening global demand their good and services.

In spite of economic growth deceleration in H2 2014, the domestic equity market rallied 58%3. That is not unusual and the experiences of Japan, South Korea and Taiwan in their transition paths in earlier decades highlight that this is what we should expect. For example in Japan during the 1960s, a period of financial repression, the stock market underperformed relative to the overall economy. However in the 1980s when economic growth was subdued relative its past, the stock market performed particularly well in an environment of financial market liberalisation. South Korea and Taiwan experienced similar bouts of equity market outperformance during periods of financial market liberalisation, which countered the underperformance during earlier periods of financial repression and relatively stronger growth.

We believe China’s equity market underformance in recent years prior to the opening up of the Hong Kong-Shanghai Connect initiative in November 2014 was a symptom of a lack of market access. The Connect initiative significantly opened up market access. The fact that volumes traded on the Connect have not met expectations is irrelevant. The market has priced Shanghai stocks as internationally accessible now. The eventual opening of a Shenzhen Exchange link4 will give further access to Chinese domestic stocks, which will also become priced-in at some point.

We are likely to see equity market volatility rise. While structural shifts will move the equity market higher, periodic disappointment over growth figures are likely to lead to frequent corrections. This tug-of-war between the structural and cyclical drivers of the market will continue to divide analysts and see volatility remain high. Investors attracted to the recent rally should recognise the need for a significant degree of risk tolerance to weather rising market volatility.
In 2014, it was clear that Chinese equities were cheap by international standards. That is no longer the case. The MSCI China A-Share P/E is now close to the MSCI World P/E. P/Es in 2009 were undesirably high (it was a period of earnings weakness and price optimism in light of policy easing) and so should not be treated as a benchmark for where equity markets should go back to. Trading China on cheapness should be a thing of the past. Investing in China is once again about buying into structural change.

THE GLOBAL STAGE AWAITS

A number of events this year could prove to be a catalyst for further capital market deepening in China.
Firstly in June, MSCI will reconsider whether to include domestic Chinese equities into its emerging markets index. With approximately US$1.5tn benchmarked to MSCI China Emerging Markets Index, even a small allocation of 0.5% to the China A-Share market in the broader index could drive US$7.5bn into the market on the back of index replication by investors.

As a point of reference, the MSCI United Arab Emirates Net TR USD index rose over 90% between the time MSCI announced UAE stocks would enter its Emerging Market Index and actual inclusion (see shaded area of chart). While the Chinese and UAE markets are vastly different in size and composition, we believe the increasing probability of index inclusion will bode well for China A-Shares.

Secondly, in October the International Monetary Fund will review which currencies it will include in its Special Drawing Rights (SDR) currency basket. The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. If the Renminbi is included in the basket, central banks buying/selling SDRs will have to deliver/receive Renminbi (in proportion to its weight in the basket).

In its last review in 2010 the IMF decided not to widen the currencies in the basket. At the time the IMF noted that China was the third largest exporter of goods and services but felt that the Renminbi was not a freely useable currency. However, they urged that this issue be kept under review. Since then, the Chinese Yuan has become the fifth most used payment currency according to SWIFT5, jumping from seventh position only a year earlier. The Renminbi became the ninth most actively traded currency according to the Bank of International Settlement’s 2013 triennial survey, jumping from 17th position in 2010. Over that period average daily turnover soared from US$34bn in 2010 to US$120bn in 2013.

Significant expansion in RMB offshore clearing centres around the world has helped fuel this trend and access to the currency has never been easier. In 2014, the Yuan-HK Dollar convertibility cap was abolished in recognition of the demand for Renminbi (timed with the opening of the Hong Kong-Shanghai Stock Connect initiative).

While capital and exchange rate controls will continue to hold back the Renminbi from SDR inclusion, we believe the IMF’s review this year will facilitate a road-map for further internationalisation of the currency. With the internationalisation of the Renminbi a stated policy objective we believe that the Chinese authorities will continue to dismantle controls on the currency.

With the Yuan trading very close to the edge of its trading band (see chart on front page), we could see further flexibility in the trading band this year. The recent depreciation against the US Dollar seems to be more about the strength of the US dollar than Yuan weakness, with the nominal effective rate actually having appreciated in December. Indeed there has been no increase in foreign exchange reserves that would occur if the authorities were intervening to depreciate the currency.

POLICY EASING IN 2015

With consumer price inflation weakening and property prices continuing to fall, we expect the Peoples Bank of China (PBoC) to cut interest rates further this year. We also expect the central bank to cut the Reserve Requirement Ratio (the amount of reserves banks need to hold with the central bank), thus improving banks’ ability to lend.
The transition away from shadow banks to the formal banking sector will continue in 2015, increasing pressure on the PBoC to provide liquidity support to banks. On January 22nd the PBoC injected CNY50bn into the banking system through the 7-day repo market. That was one of the many injections the central bank has provided in the past six months (see page 10 for other examples) and we expect the PBoC to maintain a strong hand on facilitating the transition in the financial sector.

1 “The focus of the restructuring of the economic system… is to allow the market [forces] to play a ‘decisive role’ in the allocation of resources”, Third Plenum Communiqué, November 2013
2 ”Comprehensively advancing the rule of law”, Fourth Plenum Communiqué, October 2014
3 MSCI China A-Share, between 30 June 2014 and 31 December 2014
4 Although no formal announcement has been made, Premier Li Keqiang has openly encouraged the opening of an Shenzhen link
5 December 2014

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