Signs of Life in China

Key Points:

• After years of disappointment, China’s equity market has responded positively to recently announced fiscal and monetary stimulus.

• Unlike previous announcements, we think this stimulus, alongside a verbal commitment to do more if necessary, represents a step change in the Government’s reaction function and is likely to put a floor under economic growth.

• This, combined with cheap reasonable valuations versus developed markets and some signals from the Government towards positive support for the private sector of the economy, are enough in our view to warrant a small tactical allocation to Asian (ex-Japan) equities in the portfolios.

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After a few years of disappointing returns, China’s equity market exploded back into life last month following the announcement of a raft of stimulus measures. The announcements included interest rate cuts, support for the ailing housing market, direct support for the equity market, fiscal spending and support for local governments. As opposed to piecemeal previous stimulus announcements, these measures actually have a chance of putting a floor under economic growth. In this month’s Market Insight, we investigate why these measures have been put in place, whether they will be sufficient to lift the economy out of the doldrums and what can be expected in the period ahead.

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A Need to Act

China’s current problems have been long in the making and a consequence of its historic growth model. Since the original opening up of its economy, China has pursued an export driven growth model. This model is where a country focuses on increasing its exports to drive economic growth and development. This approach typically involves policies such as maintaining a cheap currency, export subsidies, and the development of export-oriented industries to boost competitiveness in global markets and attract foreign investment. This model had been adopted successfully from the 1970s by many East Asian economies and is quite effective at improving living standards and national wealth, to a point. Beyond this point, an economy needs to transition towards consumers and services to match the living standards of the most developed countries.

Alongside this, the property market in China has been a key national focus. The rising living standards of China’s population and the move from rural areas to urban centres necessitated a globally unprecedented amount of homebuilding. In addition to this, previously China’s Central Government has responded to economic slowdowns by stimulating the housing market directly, encouraging homebuilding from developers and homebuying from households. Local governments were also involved with supporting the ongoing growth in the housing market as they sourced much of their revenues from land sales to developers. Seemingly insatiable demand for multiple properties drove price to income ratios well beyond reasonable levels.

Decades of investment in manufacturing capacity to support the export led growth model and as well as overinvestment in housing had left China’s economy with too much of both. Recognising this as a structural problem, particularly with respect to the housing market, China’s Central Government had been actively trying to slow the housing market on and off for more than a decade. However, in 2020, China’s Government implemented the Three Red Lines policy, which was aimed at improving the financial health and sustainability of the property development sector. Evidently, this was the straw the broke the camel’s back and the property market has been deteriorating ever since. A number of property developers went bankrupt (not being able to meet the new Three Red Line Conditions). House prices have been falling since 2021 and housing construction has been falling in earnest since 2022. With property so important to economic activity and household confidence, the slowdown threatened to drag the rest of the economy down with it.

In response, the Central Government has been easing property restrictions for the past couple of years (though this has yet to have any material effect) and also increased support for the manufacturing sector. Importantly, this manufacturing support had mostly offset declining property construction from an economic growth perspective, leaving growth soft, but nowhere near as bad as many would have expected given the housing market weakness. Though corporate profits had been weak, surveys of manufacturers have been showing normal to slightly weak conditions.

Until recently, it seemed as through the Government had been satisfied with lacklustre growth, with generally small, targeted measures aimed at shoring up the weakest parts of the economy. A rebalancing in the housing market was necessary at some point and financial stability risks stemming from overinvestment across the economy had been growing (hence the original policy tightening measures which tipped the housing market over in the first place).

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A Lot Now and Perhaps More Later?

However, from late September, the tone has changed. Substantial policy measures have been announced by both the People’s Bank of China (PBOC) and Central Government. The table below shows a summary of the policies.

Perhaps more importantly, the measures came with a strong verbal commitment to do more, if necessary, from the Central Government. The guidance has been unprecedented, with the Politburo explicitly calling to “stop property market decline and foster stabilisation.” In addition, the Ministry of Finance has announced a local government debt swap which will be the “biggest in recent years.” Although the market reaction to further public statements since the original policy announcements in late September has been muted, what has been already announced should improve growth and we expect more stimulus to come in the months ahead, which should support growth and the market further.

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Room to Move

An important consideration around prospects for further direct fiscal stimulus in China is the Government’s capacity to borrow to finance the stimulus in the first place. The chart on the left below shows debt to GDP ratios for China and the United States. The countries have a similar aggregate debt burden but have a different split across the government, corporate and household sectors. Total government debt to GDP in China is around 85%, which compares favourably with the US total government debt to GDP of around 115%, but still isn’t great for a developing economy. However, the chart on the right shows the debt to GDP level of the Central (Federal in the US) Government. Here, the burden is clearly much lower. In China, most government debt is held by local governments and state-owned enterprises (who were directed to do the heavy lifting in previous stimulus efforts). In the US, it is held by the Federal Government. This is important as most expect stimulus this time around to come from the Central Government, rather than local governments. China has substantial capacity for stimulus based on this.

There is some nuance to this. To some extent the liabilities of state-owned enterprises and local governments in China are contingent liabilities of the Central Government. If the Victorian State Government defaults on its debt the Australian Government will almost certainly step into the void. China’s Government would operate in a similar fashion. However, this highlights the importance of the local government debt swaps in China’s recent stimulus announcements. However, the liability will not be one for one and there are substantial assets at the local and Central Government level which back the debts.

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Is China Investable Again?

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In our 2022 Strategic Asset Allocation Review we removed emerging markets as a structural allocation within our portfolios. We made the determination that the governance framework in China had deteriorated too much to deserve an indiscriminate allocation. Consolidation of power under President Xi and the emergence of state directed Common Prosperity as a framework for economic organisation rather than a private sector led growth model portended poorly for equity market returns relative to developed markets. However, we also reserved the right to make a tactical allocation to the asset class, most likely during periods of economic stimulus or during a credit easing cycle. In our mind, that box has been ticked. In addition to this, the poor performance of China’s share market since 2022 has taken its relative valuation compared to developed markets close to historic lows (even following the sharp rally in China’s equity markets since September). China’s price to book ratio is currently around a 60% discount to world equities.

Finally, and perhaps most importantly from a strategic allocation perspective, there has been some positive commentary from China’s government around the role of private enterprise in the wider economy, perhaps winding back some of the more punitive elements of the Common Prosperity agenda. Specifically, the National Development and Reform Commission and Ministry of Finance recently released proposed guidelines for a private economy promotion law which would (to paraphrase) increase private sector involvement in many key areas of the economy, as well as lower financing and transaction costs. It remains to be seen how far this push back to the private sector will go (and has not gone anywhere near far enough to change our view from a Strategic Asset Allocation perspective), but any steps in this direction would be positive for equity markets.

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Portfolio Positioning

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In line with the above, we established a small tactical allocation to passive Asia ex Japan equities in October, taking our portfolios back to neutral growth exposure.