Vanguard on China: How much does volatility matter?
OREANDA-NEWS. September 25, 2015. Amid a slowing economy and pressures on its currency, China's stock market has seen sharp volatility as of late. Vanguard's senior economist in the Asia-Pacific region, Qian Wang, recently discussed the implications of these events in China with Peter Westaway, Vanguard's chief European economist and regional head of Vanguard Investment Strategy Group. This is an edited transcript of their conversation.
Peter Westaway: Qian, equity markets in China have reacted strongly to the possibility that economic growth will slow. Is that the right way to interpret recent equity price movements?
Qian Wang: Deleveraging as well as the disappointing developments in the fundamentals (or, shall we say, too much expectation of fundamentals improving) caused the volatility. But going back to late last year, the equity market was pricing in a "hard landing." Then policymakers became more supportive [of monetary stimulus measures designed to encourage growth] and the market started to price in a turnaround in economic and earnings growth. The market got ahead of itself and momentum was driven by retail investors piling in using their own money or buying on margin.
The market had stabilized somewhat with government intervention since early July, but we don't think the market has found the bottom yet. Many small- and mid-cap valuations are still quite stretched. Any news on policy changes, especially with regard to an exit strategy by the government is likely to spook the market. Continued volatility is what you should expect.
Mr. Westaway: So, is China heading for a hard landing?
Ms. Wang: No. The authorities are committed to supporting economic growth and have the capacity to do so. China has \\$3.7 trillion in reserves and the central government balance sheet is quite healthy. Nominal rates are quite far from zero and the reserve requirement ratio is still very high. But China's slowdown is cyclical and structural, which means we will see a protracted slowdown in the years to come.
Mr. Westaway: With all the recent volatility, should investors steer clear of China at the moment?
Ms. Wang: The recent volatility really serves as a reminder to global investors that China, even though it's the second largest economy in the world, is still an emerging market. In that regard, I think investors should expect to see more pronounced ups and downs than they might see in developed markets.
From a longer term [perspective], I would say China's economic importance, even with growth having shifted down a gear, will continue to expand. Chinese shares, therefore, represent a large and growing slice of the global equity market, and an important avenue for diversification for global investors.
Mr. Westaway: Can you describe the significance of the recent Chinese currency depreciation?
Ms. Wang: In our view, the magnitude and pace of further depreciation in the near term will be rather measured. The recent depreciation of about 4.5% is small in an historical context and long overdue. Since mid-2005, when China removed its de facto currency peg to the U.S. dollar, the yuan appreciated 26% against the U.S. dollar and 45% in trade-weighted terms. And in the last 12 months, the trade-weighted appreciation is about 13%. This has hurt China's competitiveness, exports, and growth and caused significant capital outflows since late last year. Last week's move was partly trying to correct some of the currency misalignment accumulated in the past and was also pre-emptive of a U.S. Federal Reserve's interest rate rise.
In terms of how much further it would go, the central bank has been stressing that China has no intention of engaging in a currency war and a sharp depreciation is unlikely. However, in the medium term, given the expected Fed hikes, the structural nature of China's slowdown, and the somewhat overvalued currency, I think the CNY [the Chinese yuan] should continue to depreciate against the U.S. dollar even though it might appreciate in trade-weighted terms.
Mr. Westaway: In addition to the exchange rate moves, what have the authorities been doing to maintain growth?
Ms. Wang: Since late last year, they have been trying to do more stimulus, both on the monetary and fiscal fronts. Since November, they have been trying to cut the benchmark interest rate and also the reserve requirement for banks. And infrastructure, which is primarily government-driven, has been used to offset the private sector investment slowdown. They have probably not been doing quite enough to achieve the 7% GDP growth target. Vanguard's full-year growth forecast is 6.8%.
Mr. Westaway: Do you have any concerns about the level of debt servicing relative to GDP for China?
Ms. Wang: At the moment, central government debt is really low, at less than 20% of GDP. Local government debt has increased quite significantly, especially since the great financial crisis, with infrastructure projects to support economic growth. But even adding them together, the consolidated government debt is still less than about 60% of GDP. This is within the safe threshold.
I would say the local government debt issue is more of a liquidity risk rather than sovereign risk. Local governments have been using funding vehicles to borrow money from the banks or through the shadow banking system. So they have borrowed at very high funding costs and also for short durations, which is a mismatch compared with the infrastructure projects they are doing.
In that sense, I think they may face some difficulties in repaying those kinds of debts, especially when the economic growth is slowing and their revenues from tax and land sales revenue also declines.
But the central government has allowed local governments to issue municipal bonds to replace those loans at much lower interest rates and also with much longer duration. That helps to ease liquidity risk in the local government debt area.
Notes:
- All investing is subject to risk, including the possible loss of the money you invest.
- Investments in securities issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
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