What is behind the recent market decline in China?
After the US Federal Reserve's (Fed) meeting last week, the market is once again concerned over the potential for the Fed to exit its strategy of quantitiative easing (QE). In fact, the most recent comments by Ben Bernanke, Chairman of the Fed, were simply a reiteration of the Fed's current stance, so nothing new was learnt.
Weak flash Purchasing Managers' Index (PMI) data issued in June did not help either. In addition, liquidity in China has tightened lately as the authorities have taken action to deal with irregular banking activities such as export financing and wealth management products. With the unwinding of irregular export financing activities and the slowdown in wealth management products, there might be a short-term liquidity squeeze which could be negative for equity markets.
Are concerns about a liquidity crunch in China justified?
Chinese banks have been under pressure recently because of rising concerns about asset quality. Recently, interbank rates have shot up and have remained elevated, mainly driven, in our view, by a deliberate regulatory crackdown on some shadow banking financing channels.
We expect liquidity to remain tight in the short term given that the central bank is aimed at deleveraging, especially in shadow areas. Funding costs are likely to go up and we could see rising defaults. However, we do not foresee any major blow-ups as the People's Bank of China (PBoC) can release liquidity if things deteriorate too much. Currently trading is at <1x price/book (2013); we believe the banks' valuations have priced in most of the risks, given that they are generating >20% return on equity, high-single-digit earnings growth and >5% dividend yield.
What measures do we expect the PBoC to take in order to re-establish trust in the banks and the market?
We believe that the PBoC's current course of action will be positive in the long-term for the health of the Chinese financial system, which will ultimately help to restore public confidence. For a long time, people have been quite concerned about the high leverage of corporate China and the rapid growth of shadow banking. Now it looks like the PBoC is quite determined to deleverage the system, in particular the shadow sector. In our opinion, the PBoC might do some neutralizing in the short term but will largely let the banks adjust and adapt.
We should see rising defaults if the tight liquidity stays for some time, but we do not foresee any major blow-ups as we believe the PBoC is in control and has plenty of procedures in place to deal with potential systemic risks.
Should European investors regard this as a buying opportunity or wait and monitor the situation?
In the short term, we expect to hear noise about the monetary policy and credit situation within the banking system, while the equity markets may remain volatile. Long-term investors may await for the situation to be stabilized.
For the medium to long term, we believe low valuations will protect the market from downside risk while the coming long-term reform measures provide a potential upside with market re-rating if those measures are well accepted.
What is our overall outlook for Chinese equities until the end of 2013?
We believe that the sell-off is overdone and we expect the Hong Kong stock market to recover in the short term. Valuations are very low, particularly for H-shares which now have the lowest valuation in the Asian region. News flow relating to reform measures should provide a catalyst for a market bounce back. Market expectations on economic growth in China have been revised downwards which will reduce the risk of disappointment going forward.
The new government in China seems to be taking a more prudent approach, focusing on dealing with potential risk in the financial sector and long-term reform measures instead of short-term economic growth. This should reduce the risk of a boom bust going forward.
Senior Portfolio Manager
The impact on the renminbi currency (RMB)
From a currency perspective, the RMB was able to remain relatively stable compared to other Asian currencies, since market concern began at the end of May regarding the prospect of QE coming to an end. The liquidity shortage in the Chinese interbank market has led to much higher money market rates in recent weeks. While we agree that foreign exchange flows into China may have diminished quite substantially in May as a result of China's tighter regulations on interest arbitrage-related inflows, we do not believe that there have been any substantial "hot money" outflows and therefore the RMB has been able to hold up relatively well compared to other Asian currencies.
With the RMB having seen such a strong run since Q4 2012, we have been expecting the pace of appreciation to slow down. It is conceiveable that the RMB could experience a mild pull-back in the short term given its strong run on a relative basis, but the long-term positive trend for RMB appreciation should remain intact.
We continue to hold the view that full year RMB appreciation will be in the low single digit range with weaker economic growth likely to result in the RMB appreciating closer to the lower end of the range, around 2%, during 2013. We do not envisage the current situation to develop into a full credit crisis in China as we feel the PBoC's intention to control the credit growth is positive for the financial sector over the long term. Recent developments do not represent a reversal of the Chinese government's monetary stance. In fact, we expected the government to adopt a prudent monetary stance for the year and we anticipate it committing to continuous financial reforms, such as the liberalisation of interest rates and currency. Our long-term positive view on the RMB continues, underpinned by the continuing internationalisation of the currency, although clearly investors should be aware that the current negative sentiment to the Chinese stock market could have an adverse impact on the currency in the short term.