The private bank examines the changes - some of them painful - taking place in China and sets out some investment conclusions.

China’s recent devaluation of its currency, the renminbi, or yuan, coupled with the deceleration of its economy from previously rapid growth rates, has rattled investors globally. Now that several weeks have elapsed, there is a chance to stand back and take a more considered view of developments in the Asian giant. In this article by Benjamin Pedley, head of investment strategy, Asia-Pacific, for HSBC Private Bank, he examines what is happening in China and how investors could act. As always with such items, the editors are grateful for the contribution to debate but don’t necessarily endorse all the views expressed, and invite readers to respond. 

Chinese authorities in August announced a change that makes the previous closing price for the currency in onshore trading the approximate starting point for the next session. Previously the currency traded in a band either side of a mid-point, meaning the new regime allows it to trade more freely, and to better reflect supply and demand factors, though Beijing will continue to intervene in the market as it sees fit. 

Against a backdrop of sharply falling Chinese equity prices and a US dollar that has risen more than 20 per cent against a basket of major currencies during the past year, it was little surprise that the renminbi dropped sharply on the news. The decline of around 5 per cent in the yuan in days following the change sent shockwaves around the world as investors worried that Beijing had fired the first salvo of a “currency war” in a bid to revive flagging exports and a slowing economy. 

A currency in transition 
We think the fears of a currency war are misplaced, with the currency change more targeted at winning International Monetary Fund’s approval for the inclusion of the renminbi in its "special drawing rights" 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. As of 17 March 2015, 204 billion SDRs were created and allocated to members (equivalent to about $280 billion). While the IMF postponed the possible inclusion of the yuan in SDR’s reserve basket of currencies (currently comprising the dollar, euro, yen and British pound) until late 2016, it hailed the more liberal currency regime and the IMF’s chief, Christine Lagarde, said that the yuan’s incorporation in SDRs is “not a question of if, it's a question of when”. 

Market participants speculate that inclusion of the yuan in SDRs could trigger buying by global central banks of the currency equivalent to hundreds of billions of dollars. We believe China would be unlikely to promote a weaker currency to spur export growth as this would be inflationary at a time when their economic growth is slowing down, and would likely dent investor confidence in mainland equity markets that are already down substantially from their highs in June. Indeed, Chinese Premier Li Keqiang said Beijing would never start a currency war by artificially sinking the yuan, as it would rebound on China. The purpose was to keep the yuan “basically stable at a reasonable and balanced level”. He also said it had nothing to do with supporting exports. 

The mainland government expects the economy to grow 7 per cent this year versus an expansion of 7.4 per cent in 2014, which was its slowest pace since 1990. Official statistics show gross domestic product expanded at an annualised rate clip of 7 per cent in the first half of this year, but indicators from the manufacturing sector, industrial output data and trade numbers all point to the slowdown extending through the end of this year despite the rollout of significant monetary and fiscal stimulus during the past 12 months. 

Adding to the potential volatility of the renminbi under the new more market-based mechanism is the freer access to the mainland share market afforded to foreign investors via the Shanghai-Hong Kong Stock Connect programme. 

The facility also allows mainland-based investors access "southbound" into Hong Kong. The increasing liberalisation of Chinese financial markets, however, is somewhat of a double-edged sword as typically, volatility accompanies change. As discussed earlier this was very much the case in the wake of the changed renminbi pricing mechanism, and also for Stock Connect. Since its commencement in October 2014, the benchmark Shanghai Composite Index surged by 120 per cent, to an eight-year peak level of approximately 5,200 on 12 June. Since then, the index at one point almost halved as a wave of margin calls engulfed this retail investor-dominated market.

An economy in transition 
There has been an evident shift in China’s long-term focus. This is a rebalancing from being the outward looking, export and investment driven economy that it has been thus far, to turn into a more domestically focused, consumption driven economy. 

But, a big structural hurdle facing policymakers in Beijing in achieving this goal is the same as that facing their counterparts in Japan and other parts of the developed world: namely an aging population. A key determinant of long-term economic growth with accompanying benefits for corporate earnings and equity market returns is a growing population. Japan’s equity market decline since the late 1980s and its economic malaise for much of the period since is due in part to a shrinking and aging population. China is now facing similar problems and last year in response eased its decades-old one-child policy as part of a plan to raise fertility rates and ease the financial burden on China’s aging population. 

Some observers argue that the one-child policy is something that has helped drive wage growth of around 30 per cent a year in the industrial heartland of southern China, as parents seek to promote their child’s employment in the white-collar arena, creating job shortages on the factory floor. 

An alternative would be to boost productivity growth, which is healthy in the gradually expanding private sector, in stark contrast to Chinese state-owned enterprises, which have been too dependent on increased leverage. It is in the private sector where most urban jobs have been created in the past 10 years, and the level of innovation seen in private sector companies could culminate in the much needed productivity growth. Thus, the growing private sector offers the potential to lead the transition from old to the new economic structure. 

In light of the aforementioned, we think that some investors may now be too negative on the outlook for China both in the short and the long term. The economic transition may seem painful, but we’d like to look at this as “growing pains”. Although the longer term trend growth is declining as the transition happens, we think it is much more gradual than the market expects, while the extent of the short term decline can be eased by policy initiatives, in our view. 

After recent declines, so-called H-shares (listed in Hong Kong) are trading at historically cheap valuations and can be attractive for investors with a medium or long term view. With “real” interest rates in China (as calculated using the wholesale price index) running at close to double digits, there remains plenty of room to ease monetary policy further and the same can be said on the fiscal side of the equation. Indeed, as the urbanisation of China continues, government-funded infrastructure projects are not only an ideal source of stimulus for the world’s second largest economy, they are much needed as it transitions toward becoming a more developed economy.

Therefore, in the years to come, investors may need to “settle” for slower annual rates of economic growth on the mainland, but as financial markets become more liberalised, this may not necessarily be to the detriment of investors in the Middle Kingdom.