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By Ash Misra of Lloyds TSB Private Banking
Chinese shares have substantially outperformed their developed market peers over the past four years, as China bulls will remind you, but this has left them overvalued.
This valuation premium seems unsustainable given the huge challenges China faces. The country must transition away from an export and investment-led growth model that is becoming progressively less effective. It must cope with changes in its labour market, which may prove inflationary, and with international pressure to revalue the renminbi, which could increase stress on its banking system.
We estimate the valuation premium at 25-30 per cent. It is widely argued that it is supported by a superior growth dynamic at work within the Chinese economy, which compares favourably to the period of sub-par growth that seems to be in store for developed economies. But that notion of superiority is open to question.
We believe that China is on the cusp of a profound transition. Its growth model, reliant on exports and investments, is going to have to change. This evolution will be fraught with risk which makes us doubt the durability of Chinese equities’ value premium relative to developed market peers.
Consider China’s export-led growth, a victim of its own success. Its dominance in both the global raw materials and finished goods markets is paradoxically eroding pricing power and squeezing margins. For example, Chinese demand for iron ore (a raw material) drives prices higher, while its supply of refined steel (a finished product) lowers prices. There are signs of this margin squeeze: the return on equity for Chinese equities has trended downward since its 2007 peak of 16-17 per cent.
Wage inflation too is eroding profit margins - and the drivers of this appear more structural than cyclical. The rising incidence of collective bargaining is securing ever-larger wage increases for Chinese workers. Elevated prices of agricultural commodities are raising rural incomes and reducing the incentive for labour migration to urban centres. The one-child policy also appears to have had unintended consequences such as a drop in applications for university admissions. These changes could prove more durable sources of structural wage inflation than China bulls hope.
China’s well-oiled fixed investment growth engine, too, has been firing on all cylinders, at times reaching levels of 40-50 percent of GDP. Impressive as this is, much of this has happened against a backdrop of negative or excessively low real, wholesale price index-adjusted, interest rates. Nor is it particularly sustainable. Beyond a point, excessive fixed asset investment is simply borrowing growth from future years. Crisis-stricken economies like Dubai, Greece and Ireland, are, to an extent, cautionary tales. GDP growth from excessive fixed asset investments and negative real interest rates, as well as local currency strength (though this last factor is not yet a problem for China), can have dire consequences.
Into this mix must also be included the politics of exchange rates and monetary policy. For now, China seems committed to a gradual re-alignment of its currency with fundamental value. Its trading partners - the US and Japan, among others - prefer a speedier re-adjustment but that simply isn’t on China’s agenda at this time.
Chinese banks are probably not ready to cope with higher interest rates and a stronger renminbi just yet. Even without tighter monetary policy, banks are vulnerable to borrower delinquency arising from runaway credit growth during 2008-09. At least some of that will likely come from over-leveraged regional governments and the corporate entities they own.
This is not to throw in our lot with those who believe China might spectacularly crash. We cannot pretend to understand how Chinese policy-makers - in particular the new president-in-waiting, Xi Jinping - might deal with the numerous internal challenges to come and other exogenous volatility arising from a multi-year global re-balance of trade, consumption, savings and investment.
China’s remarkable progress over the last three decades puts it on a firmer footing than most to meet these challenges. Our view is simply that Chinese asset values have gotten ahead of themselves and will need to pause for breath while the gains are digested and China builds a more durable base for future performance.
The author is head of investment strategy and research at Lloyds TSB Private Banking
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