China bonds: Can challenging times deliver long-term transformation?

It has often been said that when the US economy sneezes, the rest of the world catches a cold. However, market observers will have noticed that this year it has been concerns about China that have had worldwide repercussions. Credit events have drawn parallels with past crises including the 2008 US subprime collapse, shock regulatory intervention has unnerved international investors, and the post-Covid-19 recovery has accelerated deglobalisation trends and set China’s central bank on an opposite course to its global peers.

In the Age of Transformation, the growing dominance of China on the global stage is set to be a central investment theme. Accordingly, events in China are expected to have a wider and more consequential reach. So should investors take notice of short-term turbulence or stay focused on the longer-term growth opportunities?

Positive regulatory intervention?
Over the last year, the Chinese government has imposed stricter regulations on several key sectors, including education and technology, in an effort to prevent market abuse and improve oversight. While this increase in regulatory scrutiny has had a negative impact on investor sentiment, it should be noted that Chinese regulation previously lagged other markets. Moreover, China’s actions towards the technology sector are in line with the efforts of the EU and the US to tackle the omnipotence of big tech companies. So do tighter rules on anti-trust, fintech and capital markets, data security and social equality simply mean the authorities are merely playing catch up and will these measures help contain systemic risk and prevent a disorderly expansion of capital?

This is not the first time since President Xi Jinping came to power in 2013 that the authorities have intervened to stabilise debt and productivity growth, as well as cleaning up corruption. If history repeats itself Chinese assets should embark on a sustained recovery from these initial short-term declines. If this is the case, it could be a good time to invest in Chinese tech, biotech, aeronautics, artificial intelligence, electric cars and companies focusing on quality consumer products.

Letting property defaults play out
The recent debt crises at major Chinese homebuilders have triggered a round of credit ratings downgrades and driven the risk premium for weaker firms to record highs. In particular, the financial trouble of a major developer with over USD 300 billion in liabilities and 1,300 real estate1 has rattled markets and raised concerns about potential systemic and contagion effects. With the Chinese property sector, at USD 5 trillion2 , accounting for around a quarter of its economy, are investors right to be worried?

The risks associated with China’s expansive and often heavily indebted property sector are not unsubstantiated but, again, the lack of intervention from China’s authorities is suggestive of its efforts to use this as an opportunity to reorient its economy away from past lax practices. Should this develop into a more systemic crisis, China’s monetary authorities have previously shown that they know how to manage home-grown financial stress and are expected to provide selective help to prevent a financial system seizure. However, this is certainly a situation to watch closely.

Deglobalisation, what deglobalisation?
Away from these domestic stresses, Sino-US tensions have not abated under the Biden administration and post-pandemic re-shoring agendas have accelerated investor concerns that China may lose out from the deglobalisation trend.

There is little evidence of this so far. Rather than shrinking, foreign direct investment into China so far this year has jumped 19.6% year-on-year up to September3 , with high-tech services and manufacturing seeing large rises, suggesting at present deglobalisation fears have been somewhat overblown. Bilateral trade between the US and China has also risen, even though China has fallen short of its agreed Phase One commitments.

That said, supply chains have broadened out to the wider Asian market – meaning Asia has become ‘the world’s factory’ rather than China in isolation – although China remains the dominant player. In essence, rather than buying less and/or decoupling from China completely, many businesses are adopting a ‘China-Plus-One’ risk diversification strategy, under which companies continue to produce in China for the domestic market while moving some capacity elsewhere (mainly in the ASEAN region).

Central banks take divergent paths
An area where China really is becoming an outlier among the world’s biggest nations is monetary policy. China’s growth momentum has been falling this year, partly engineered by the government’s regulatory tightening. Unlike other central banks, which are desperately trying to dampen down fears over forthcoming monetary tightening amid rising inflation, the People’s Bank of China (PBoC) has shifted gears to a policy easing bias and has released more liquidity into the Chinese system. Expectations suggest that the PBoC will continue this selective easing by using its sizeable policy flexibility to manage macroeconomic risks and balance its policy goals.

While diverging macroeconomic policies between China and other major nations – notably the US – have generated market volatility amid concerns that China’s growth slowdown could spill over into Asia, the PBoC’s actions should mitigate current downside risks, stabilise growth and be supportive for the region overall. Even so, policy mistakes can happen. China’s policy shift could unexpectedly crush growth or US inflation could be higher and more persistent than expected. Investors should continue to pay close attention.

Chinese assets: a selective, long-term play
Chinese assets should be expected to exhibit more market volatility in the near-term, particularly as Chinese authorities continue their efforts to reorientate the economy, but there is little reason to doubt the strength of China as a long-term investment theme.

While the ‘old’ industries may remain under scrutiny, sectors that cater for ongoing Chinese demand, those that are capitalising on the supply chain shifts and high value added manufacturing and high-tech industries should continue to prosper. And for international investors China is continuing to open up its economy and capital markets, meaning the performance of Chinese assets are more likely to be determined by market forces.

In terms of Chinese bonds, international investors have only recently gained access to this roughly USD 15 trillion market, which is the world’s second largest bond market. With the three major rating agencies now licensed to rate Chinese debt, more foreign investors could feel encouraged to buy it. Moreover, the recent spate of bond defaults could actually be a blessing in disguise by showing that the authorities are no longer willing to prop up bad or zombie companies.

Invest in China for China
As we have seen this year, China is becoming an investment story that is impossible to ignore. However, any investors considering China still need to do their homework. This year has shown that while the Chinese market has undoubtedly matured, it is not as stable as more developed markets and still retains the potential for nasty surprises.

At BNP Paribas Asset Management, our investigative process means we explore all angles to find the best investment opportunities for our clients. Our investment experts have identified three long-term structural trends in China that should stand the test of time regardless of the pandemic or further Sino-US trade tensions:

  • Technology and innovation focuses on China’s economic transformation and tech advancement and we see opportunities in the fields of capital goods, tech and industrial upgrading.
  • Consumption should benefit from rising household income, financial innovation and more diversified consumer profiles – this theme is likely to accelerate further in the next five to ten years.
  • Industry consolidation is being driven by regulatory tightening, environmental cost pressures and industrial upgrades, we favour companies that focus more on research & development, productivity and costs.

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