The Week In Hindsight 21 February 2014

Chinese stocks saw their steepest decline for nearly two months this week as the HSBC Manufacturing PMI posted a sharper contraction than expected on Thursday. The Shanghai Composite Index declined by nearly 2.5% in response as Chinese investors called time on their stock positions.

Elsewhere in the economy, foreign direct investment in China reached its highest level in 2 ¼ years indicating that some have remained undeterred from investing in the country despite fears over an economic slowdown. The next major announcement for China is the CFLP (Chinese Federation of Logistics and Purchasing) Manufacturing PMI due at 0100 am next Saturday morning.

Our view in relation to China remains unchanged at present. This is that we continue to believe that price action surrounding Chinese stocks is best observed from a safe distance for the time being.

A Perspective on China

Credit creation within the economy remains an issue, which has led the government to continue its attempt to crack down on the shadow banking sector. Although this holds positives for financial stability in the longer term, the economic impact in the short term is likely to be felt first by Chinese companies. This is as funding is likely to become more expensive and much more difficult to secure.

This muddies the waters for the growth prospects of those companies without access to international capital markets, while it also highlights risks among secondary finance providers (wealth managers). In addition to this, many analysts are concerned that there are also risks building up among the larger financial institutions in China.

This is as some of the largest debtors for these institutions are local government authorities, many of whom have borrowed to excess in order to fund unprofitable public infrastructure projects. Many of these projects today either stand unfinished, or they have failed to realise their forecast level of returns.

China’s National Audit Office (NAO) reported late last year, that local government debt liabilities had increased by 70% in the three years between 2010 and 2013. This is a trend that has led lawmakers to rewrite the rule book on debt roll overs and defaults. This means that due to credit expansion in the public sector, the rules have now been changed so that local governments are able to borrow new money in order to avoid falling into default on old debts; implying that the likelihood of default has became an issue.

Much of the debt issued to fund the aforementioned projects is now facing the expensive process of continuous roll over as the economy slows and investor appetite for infrastructure funding opportunity diminishes. With liquidity conditions already tighter, the risks are increased to tier 1 financial institutions in China as well as to the shadow banking sector which enables wealth managers and private investors to buy new debt issues.

Although these events do not guarantee any kind of catastrophe in the near term, with what is still a relatively young financial system they do moderately increase the likelihood of one occurring, while also offering to magnify the effects of one should it actually take place. For these reasons, we continue to feel that there is a better risk-reward ratio available with investment opportunities elsewhere.

SSE Composite Index