Volatility in Chinese equity markets has calmed down since the March peak, but for investors a key question remains: Is it a temporary pause or the calm before a storm? Many investors are under the impression that China is just kicking the can further down the road, and that a new phase of market turbulence is just around the corner.
In our view, there is a line between kicking the can down the road and buying time for structural reforms. We believe China is doing the latter at this point. The stronger policy support seems to be triggered by serious concerns about economic activity and financial stability earlier this year (see also the blog Is the Turnaround of China’s Economy Real?). In other words, the policy response is aimed at preventing a hard landing rather than stimulating a rebound.
A stabilization of economic conditions would buy more time for policymakers to focus on structural issues, as suggested by recent comments from China’s officials. The key issue is whether policymakers will take this opportunity to push planned reforms and facilitate structural transition. If not, such a short-term stabilization would only waste policy space, delay problems, and even possibly add to medium-term risks.
For now, our assessment is that China’s reforms and structural transition are still on track, despite market volatility. Since the end of last year, our reform tracker (a tool to assess the evolution of structural reforms) suggests that reform measures have been moving ahead across a broad range of areas. In particular, measures to help shift income, support consumers and rebalance the economy have made good progress after lagging behind financial and fiscal reforms over the last couple of years.
The latest evidence also suggests that capital outflow pressures have been easing over the last couple of months, despite strong concerns in January. The worries about a sharp devaluation of the Renminbi (RMB) are also gradually fading.
Foreign exchange (FX) reserves did not fall in March for the first time since October 2015. Other indicators, including net interventions by the People’s Bank of China and bank transaction data, also suggest that outflows have been easing after reaching high levels in December and January.
As noted, a key factor behind capital outflows has been a shift of RMB expectations. It was the strong fear about a sharp devaluation after August’s reference rate reform that caused locals to reduce dollar debts and increase dollar assets. That said, RMB expectations have been stabilizing, which seems to have helped ease outflow pressures. This has been largely due to:
- A weaker-than-expected dollar, with a relatively dovish Fed helping the RMB move towards its fair value against a basket of currencies, even as it was allowed to appreciate slightly against the dollar.
- The People’s Bank of China has improved its communications on FX management, emphasizing that it is watching more closely the RMB trade-weighted index rather than just the dollar exchange rate, with a strong commitment to avoiding a large devaluation.
- Recent positive developments in the broad economy should also help to improve the market’s perspective.
A constructive assessment of the reform path and a stabilization of economic conditions are in our view supportive for a medium term positive view on Chinese equities. In particular, with a Multi Asset perspective, we like the “New China” theme, which is very real, despite the significant problems with the “Old China”. To emphasize the importance of the success of reforms and the structural transition, we believe investors should focus on the MSCI China Index rather than the Hang Seng China Enterprises Index (HSCEI).
The former is more exposed to domestic consumption and service sectors (Health Care, Technology, Telecom) and it could benefit from the rise of the middle class and the transition towards a more balanced economy. The financial sector weight of the MSCI Index is less than 40%, while in the HSCEI it represents 73% of the index. Moreover, the MSCI Index is not exposed to the State Owned Enterprises that are the most inefficient corporations in China.