China is in the midst of a transition from an export-led to more "balanced" economy. There are concerns about its banking system. What to make of the world's second-largest economy? Citi Private Bank gives its views.

In between prolonged disappointments and attractive valuations, China has confounded many investors. Some see credit and property troubles as preludes to an inevitable financial crisis. More sanguine views give the policymakers the benefit of the doubt on having enough wits and resources to prevent disaster. This article is by Ken Peng, investment strategist for Asia-Pacific at Citi Private Bank. The views contained here are those of the author and the firm and not necessarily shared in full by the editors of this news service.

China’s structural reform push is similar to running a marathon. The runner goes through multiple cycles of optimism and near exhaustion, and can only finish the race by maintaining a steady pace. China’s policymakers are trying to maintain a balanced pace between reform and growth. Not finishing the run could potentially mean economic and political turmoil, which they see as unacceptable, but also unnecessary given still ample policy options.

We can view China’s principle problem as how to channel massive savings. 30 years of high growth generated savings to fund fixed investment and the large trade surplus. Households, businesses and governments enjoyed fast growing wealth, which was then channelled back into investment through equities, property and deposits.

The global financial crisis reduced returns on investment, but policymakers sustained high growth through credit to State Owned Enterprises and local governments. Unattractive equities and home purchasing restrictions limited options for households to invest their savings. Hence, deposits were practically the only channel to park additional savings. Yet, with capped official deposit rates, new savings went overwhelmingly into opaque wealth management products, which in turn fuelled accelerated credit growth, and led to current headlines that China’s financial system is in danger.

But China continues to save 40-50 per cent of gross domestic product (depending on the exact statistical methodology), and the big dilemma remains how to channel the savings more efficiently into investment and preferably more consumption. While China’s consumption growth seems rapid relative to many economies, it is considered quite moderate for China as housing markets are weak. So investment would have to remain a key use of savings.
If not invested, China’s savings could be reflected in a larger trade surplus, which is only possible through significant currency depreciation. A move to weaken the currency has gained popularity, since the recent 3 per cent depreciation in the renminbi. But significant further RMB depreciation could invite a trade war, which is not beneficial for anyone. Besides this, investment shortfall would be simply too large for net exports to offset. The depreciation view also ignores other possible channels to release credit pressures.

Pushing the limit
Policy-driven credit and currency risks appear to have already been pushed to the limit this year. Indeed, easing is underway. The People’s Bank of China cut the required reserve ratio, or RRR, targeted at small and medium enterprises and agriculture, and the banking regulator adjusted the calculation for loan-to-deposit ratio. These measures have marginally eased liquidity, keeping China’s credit default swaps and interbank rates stable at relatively low levels.

Moreover, equity issuance could become the next top choice for policy makers to buy some time to repair the other channels of financing. This could help avoid crisis from widespread defaults or a sharply weaker currency. Moreover, equity issuance is an important part of capital market development and state-owned enterprise reforms, which may increase shareholder value. The introduction of preferred shares, the Hong Kong-Shanghai Equity Connect, and new regulations on transparency and oversight may help to improve overall stock market quality for investors. The supply risk to equity prices may be partly offset by possible expansion in equities demand, particularly from passive fund flows, if A-shares become included in the MSCI Indices.

To keep growth and reform at a reasonable pace, policymakers still have many tools at hand. The decline in property prices has spooked equity investors more than bond investors. While the peak in property investment growth likely has passed, a crisis still appears unlikely. Some relief came when the PBOC and the housing ministry eased mortgage and purchase restriction policies. If still not enough, minimum down payment standards can be relaxed, and transaction taxes can be cut, while expanded social housing efforts can keep construction workers busy.

A generally lower required reserve ratio (currently at 20 per cent for large banks) would also be consistent with interest rate liberalization and more market based pricing of capital. There have been draconian measures to contain property prices, but these would likely need to be removed eventually to pave the way for a more efficient market governed by market forces.

The pro-growth measures implemented so far have already produced results. China’s macro data have largely surprised markets on the upside since April. Credit and money data reveal easier financial conditions, which have typically led to further limited improvements in economic activity and earnings. Moreover, the depreciation in the RMB since February could likely translate into higher earnings growth in 2Q and 3Q. With the MSCI China index still trading below 10 times earnings, there remains some potential upside to China equities.

Currently, markets are enjoying a period of pro-growth policy tilt not only to contain domestic risks, but also external ones. Although we expect the US Fed to take a gradualist approach to exit from unconventional monetary easing, the amount of additional liquidity from the Fed could still dwindle in the coming months. This may keep the PBOC concerned over the implications on capital flows, and thus maintain an accommodative stance until the economy is on a more solid footing.

To be sure, it seems China may still have much longer to run on its reform marathon. A more sustainable economy based on consumption and services would likely grow at a slower pace than now. Engineering a smooth transition toward this goal would likely involve periodical trade-off between growth and reform. When policymakers refocus on reform, perhaps late this year and early next year, markets may again focus on concerns associated with rising leverage, such as credit and property.