For most of the last 15 years, China was a darling for emerging market investors as its demand for commodities lifted the economic fortunes of countries in Latin America, Africa and Asia. But now, as China struggles with the hangover from its debt-fuelled boom, fund managers are increasingly shunning Asia’s giant.
“My way of describing our portfolio is to call it the post-China world portfolio,” said Ruchir Sharma, chief global strategist and head of the emerging markets equity team at Morgan Stanley Investment Management.
“The whole positioning is that China’s dream run is over and now you have to look for investments that are as uncorrelated to China as possible,” added Mr Sharma, who identifies South Asia, the Philippines, Vietnam, Indonesia and parts of eastern Europe as relatively attractive emerging markets.
His scepticism toward the world’s second-largest economy is echoed by several other fund managers, who see China’s mother lode of corporate debt, the flagging dynamism of its private companies and little progress in the reform of state-owned enterprises as weighing on the country’s prospects for years to come.
“Our portfolios are very underweight on China,” said Gerardo Zamorano, manager of emerging market strategies at Brandes Investment Partners, which oversees $26bn in investments.
“The gearing of the corporate sector in China has increased dramatically and a large part of new corporate loans are going towards paying off existing debts. Shadow finance is also a concern.”
Such disenchantment is reflected in a widening divergence between funds allocated to China-related assets and those invested in emerging markets as a whole, according to statistics compiled by EPFR, a research firm. The EPFR numbers show that while fund managers have poured capital into emerging markets as a whole since early July, they have withdrawn it from specialist China funds since mid-June.
The main deterrent is China’s corporate debt. Although this issue has been well-flagged in recent years, disquiet over its size and sustainability is deepening. A recent report by S&P Global Ratings, the rating agency, estimates that China’s total outstanding corporate debt in 2015 was $17.8tn, or 171 per cent of GDP, making China’s corporate debt mountain by far the world’s largest in both absolute and relative terms.
Not only is the ratio of Chinese company debt to GDP more than double that in the US and eurozone, it is projected to grow far more quickly as an increasing number of heavily-indebted corporations ramp up their borrowing simply to repay debts that are coming due. By 2020, China’s outstanding corporate debt will be $32.6tn, while its share of global company borrowings will have risen to 43 per cent from 35 per cent last year, according to S&P estimates.
But more worrying than the magnitude of China’s debt mountain is its shaky internal structure. Just over half of the 1,943 large Chinese companies assessed by S&P fell into the rating agency’s “highly leveraged” category, the most risky of five classifications based on a company’s perceived ability to service debts out of earnings.
Such dynamics have divided opinion among investment analysts. Some say a sudden slowdown in China’s growth rate would push legions of Chinese companies over the edge, resulting in a surge in bond defaults and non-performing loans. Others counter that the powerful Chinese state will ride to their rescue to prevent any systemic credit crunch.
The key to understanding China’s risk mitigation abilities is to realise that its debt is overwhelmingly a “family affair”, says Luke Spajic, head of portfolio management for emerging Asia at Pimco, an asset manager.
“We expect leverage to rise, but the important point is that they are borrowing within the family,” said Mr Spajic, explaining that China’s economy is largely a closed system in which state-owned banks that are answerable ultimately to Beijing lend to domestic companies while bonds are also bought mostly by state-owned financial institutions.
Beijing’s control over this system, allied to its policy of flooding the economy with liquidity, has meant that financial institutions take a dovish attitude to non-performing loans and encourage debt rollovers. The S&P report estimates that $13.4tn, or nearly half, of total credit demand in China by 2020 will be for refinancing purposes.
Thus, Mr Spajic says, while China has a plethora of problems including private sector investment growth falling close to zero, a reliance on inefficient state-owned enterprises and a high level of bad debts in the banking system, the strength of state control should allow Beijing to manage its frailties. Nevertheless, he does expect China resuming a policy of currency depreciation to boost growth.
But other managers say China’s debt problems bedevil the whole emerging markets investment opportunity because Chinese assets generally have a large weighting in benchmark indices, meaning that benchmark-linked funds cannot but take on a hefty exposure to China. For example, the MSCI emerging market index, the main equity benchmark, has a 26 per cent weighting to China.
“The resolution of the Chinese question is something that weighs across the EM asset class,” said Leon Eidelman, emerging markets portfolio manager at JPMorgan Asset Management.
“I don’t think it takes a lot to look at the Chinese financial sector and see just how precarious some of these banks are. The amount of off balance sheet loans, loans that are booked as receivables and short-term lending to non-bank financial institutions far outweighs their capital buffers.”
Alex Wolf, emerging markets economist at Standard Life, takes the view that China is such a large country that even though its GDP growth rate is likely to slow down gradually as Beijing grapples with its debt problem, there will be parts of the economy that remain attractive to investors.
While steel, cement, mining and other stalwarts of the “old economy” are struggling, there are plenty of opportunities in the service and technology sectors for those who take a more nuanced view of China, Mr Wolf added.
As for the rest of Asia, he says, economies such as the Philippines, Vietnam, Indonesia and India provide investors with plenty of scope for emerging market investing.