With the Chinese Communist Party's new leadership now in power, the next important cycle of structural reform is beginning to take shape in China. Because of China's massive economic and financial importance, expect to hear frequently about the country's reform story over the next five years. Whether you invest directly in China or your investments are sensitive to the value of commodities, commodity-influenced currencies, U.S. Treasury yields or other Asian emerging markets, China's structural reform may affect the value of your portfolio.
After many years of fast but admittedly unbalanced growth, the Communist Party understands well that significant reform is the only way for China's economy to continue growing in a sustainable manner. Years of reform stagnation under former leader Hu Jintao raised the stakes for the new Communist Party leadership because lingering structural imbalances like local government debt loads, the growth of shadow banking, an unsustainably high level of investment and environmental degradation pose immediate economic and political problems for the world's second-largest economy. Unsurprisingly, the party bypassed many of Mr. Hu's allies for positions on the seven-member Politburo standing committee.
One of the larger imbalances that reform will broadly tackle is China's overreliance on investment and exports for growth. Liberalization of interest rate markets helps to promote the desired new engine for growth — consumption — by shifting resources from companies and state-owned enterprises back to households. Under the current system, savers receive low interest rates in bank accounts to subsidize capital for state-owned enterprises and other large companies, and the government encourages disintermediation — companies and governments bypassing banks for market sources of debt funding.
Fiscal reform measures also will shift growth toward consumption by increasing spending on social welfare and decreasing spending on fixed-asset investment. Investment in 2012 accounted for nearly 50% of China's economic growth, a much higher level than most countries in the same stage of development. The financial crisis likely exacerbated overinvestment by prompting the government to flood the economy with loans. Lastly, liberalizing the capital account — essentially, how freely can foreign investors invest — will also raise international demand for the yuan, encourage a stronger valuation and promote a shift in growth toward consumption.
From an investment perspective, state-owned enterprises and state-owned banks in particular will be the biggest losers of reform. Liberalization of interest rate markets will drastically raise the cost of capital for state-owned enterprises and many of the larger companies. Whereas local governments and politically favored companies could access cheap loans without meaningful due diligence in the past, new funding sources will be more expensive and increasingly mindful of credit quality.
The most important implication for equity investors is that the biggest state-owned enterprises make up large portions of many exchange-traded funds offering China exposure. Despite new Chinese president Xi Jinping's historical support for state-owned enterprises, equity markets are already discounting an aggressive impact for reform. While the broad Chinese market as measured by the Shanghai composite was down 13.7% for 2013 through July 8, shares of smaller Chinese companies, as tracked by the Shenzhen-based ChiNextIndex are up 44.4%. We see that performance discrepancy as a reflection of the Schumpeterian market forces being released on the economy. We expect that state-owned enterprises and banks will continue to face trouble in the years ahead. “Big-bang” style reforms won't occur before 2014, however, because new leadership will need time to consolidate power before taking on powerful vested interests.
With the Communist Party more comfortable with a fairly priced currency to promote internal demand, we expect China's current account to be more balanced over the next decade. From 2006-2011 alone, China's currency manipulation caused the country to run massive current account surpluses and accumulate more than $1 trillion in U.S. Treasury securities, according to the U.S. Treasury. That accumulation played more of a role in pushing longer-term Treasury yields lower than they otherwise would have been in the last decade. With the current account now in balance, however, China's foreign exchange reserves are expected to peak next year. Although U.S. Treasury yields reflect many factors, losing such a large amount of demand will contribute to a higher equilibrium level for benchmark U.S. Treasury yields, and in turn, the remainder of the U.S. interest rate complex.
Although China can still grow at 6% to 7% with reasonable urbanization assumptions and a higher quality of economic growth, it will no longer support the elevated commodity prices experienced in past years. With reduced investment levels and export-related growth, we are positioning portfolios to benefit from structurally declining commodity prices. Many of the upcoming reforms seek an increase in the quality of growth at the expense of the quantity of growth. Financial market liberalization, for instance, will slow growth initially, but enhance long-term growth potential by improving the efficiency of capital allocation.
From a currency perspective, we believe the Australian dollar will feel the worst fallout from a slowing China. Latin American commodity producers are probably better positioned to withstand a China slowdown, but we would only purchase these currencies for tactical gain. Without doubt, other Asian economies and the global economy will benefit from a more expensive yuan and an outlook for sustainable Chinese growth over the longer term. Rising Chinese consumption will grow global export markets. Other emerging Asian companies should benefit by having a more level playing field on which to compete with Chinese companies no longer benefiting from subsidized capital.
The biggest winners from successful Chinese reform likely will be the Chinese populous. Global equity investors can also benefit, we believe, by focusing their Chinese and emerging Asian equity allocations to companies participating in China's internal demand growth story: companies related to consumption, internet/e-commerce development, health-care services, energy efficiency, high-end manufacturing and education.
Tracy Chen, CFA, CAIA is a senior research analyst and portfolio manager for mortgage-backed securities at Brandywine Global Investment Management.
