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The Great Fall of China

The Economist Cover on August 29th, 2015, was titled the “Great Fall of China.” While that was not quite the trough in that episode or mini-cycle - the cyclical bottom was in January 2016 – it was published after MSCI China had already declined by 35% from peak and after a “surprise” de-valuation of the currency. The pessimism also coincided with a cyclical trough in the credit impulse (the rate of change in credit growth).

As we have often noted, credit growth has been a reliable signal of the mini cycles in China since at least 2008 given the large contribution of real estate and infrastructure to GDP growth. Credit is inflationary when taken on and deflationary when paid back. From a cyclical standpoint, an acceleration in credit tended to contribute to demand for raw materials and construction (chart 1).

Conversely, once credit growth slowed the process or cycle went into reverse and aggregate growth momentum slowed. In the current cycle since 2020, what’s notable is the weakness relative to previous mini cycles over the past decade, the credit impulse barely expanded above zero and well below the 2013, 2016 and 2019 peaks. From our perch, this might be one explanation for why the cyclical recovery has been so disappointing since the end of 2022.

Of course, the cyclical dynamics need to be viewed in the context of broader secular or structural trends in China. There has been a well-documented desire for policy makers to limit another speculative boom in real estate. The Goldman Sachs basket of real estate developers is 67% below peak. The bear case on Chinese real estate is well appreciated (chart 2).

The accumulation of debt since 2008 has more than doubled private sector credit as a share of GDP. The time series below excludes sovereign debt and local government sector liabilities that have been intimately linked to real estate, land, and construction. Note that private sector credit has exceeded Japan’s at the peak of their bubble (chart 3). The big picture point is that China might have already reached a debt constraint which has limited the policy response in the current episode.

While China’s sovereign debt is still low relative to peers, when local government liabilities are included, total debt is over 300% of GDP. In theory, China could pursue “helicopter money” to stimulate the economy out of its current phase of weakness. However, that might risk even further pressure on the currency. While China does not have an open capital account, three-month interest rates are well below US rates and warrant upward pressure on the USDCNY (chart 4).

A correlated challenge for China’s policy makers is that one of China’s major export competitors – Japan – has also experienced a large depreciation of their currency. Put another way, while the CNY has had a material depreciation relative to the US dollar, it has appreciated against the Japanese yen (chart 5). The CNY has also appreciated by 11% versus the Korean Won (another export competitor) over the past 3 years.

As we have consistently noted since early 2021, the bear market in Chinese equities was probably not an overreaction, but a genuine re-pricing of trend returns. The regulatory crackdown on billionaire entrepreneurs, property, on-line education, and the technology sector in the name of common prosperity might be partly aimed at addressing some of China’s trend growth and demographic challenges. However, it was also clearly intended to centralise control, which is ultimately not a positive development for private (minority) shareholders. Stated differently, it does not always make sense to buy when there is “blood on the streets” if there has been a legitimate destruction of fundamental value.

Looking forward, positioning, consensus beliefs and valuation remain extremely pessimistic on China. MSCI China trades on 11 times forward earnings and a 45% discount to the S&P500. From a behavioural standpoint, we still often get asked if it is appropriate to allocate to EM or Asia excluding China. Our sense is that question might be bullish from a contrarian perspective, especially when valuations or risk compensation is so attractive. To be fair, as we noted above, the secular challenges to growth and especially as that relates to cash flow returns to investors are genuine. Therefore, some of the fear is warranted. Although typically the best returns are achieved when we are deeply uncomfortable. Tactically, our positioning in China is also “tight and light”. Nonetheless, the extreme pessimism will likely create an opportunity to scale in over the coming months.


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