Deutsche: China?s cheap for a reason

Another growl from Deutsche Bank?s emerging markets bear, John-Paul Smith. This time he?s had a close look at Chinese corporates ? and doesn?t like what he sees.

He?s worried about the overcapacity created in the recent huge investment wave, compounded by Beijing?s failure to maintain discipline over its free-spending regions or enforce loudly-touted consolidation plans in key industries, eg steel.

Investors should therefore be wary of the apparent cheapness of Chinese stocks. Far from being a buying opportunity, low prices are signalling ?a major break in the growth model?. Caveat emptor.

Smith argues that the state is the dominant influence in the Chinese economy, and in the activities of leading Chinese companies. So investment decisions are often made for non-economic reasons, notably in strategic sectors, including banking.

Even though listed companies are generally efficient in terms of their operating ratios, they function in an economy with widespread misallocation of resources.

The key driver of Chinese growth over the past thirty years has been rising productivity. But the pace of improvement has slowed, so the authorities have increased investment to try to maintain economic growth.

Beijing responded to the 2008 global crisis with an even bigger economic stimulus than has been generally realised, argues Smith. The combined boost in the fiscal deficit, bank loans and bond finance over 2008-10 reached 27.5 per cent of GDP ? far in excess of Beijing?s original 12.5 per cent aim (which was itself significant by global standards).

Smith says the central government has now realised that it lost control over policy implementation as regional administrations pursued pet projects and the financing created fiscal liabilities backed by assets ?of questionable financial viability?.

And Beijing is now trying to restore discipline ? as highlighted in the Bo Xilai affair. And to give market forces a bigger role in the allocation of capital.

Smith says that?s good in the long run. But in the short-term such reforms ? if they go ahead ? would be disruptive for companies, and for equity investors. Global conditions will make life very difficult for Beijing:

Against this discouraging backdrop, we expect the authorities to proceed extremely slowly, to the extent that for relatively long periods of time, it may not even be obvious that there is any coherent policy direction. There is also the possibility that if there is a major shortfall in growth, we may see the sort of policy easing, which investors were anticipating at the start of 2012, or even in extreme circumstances a reaction against a more market oriented economy, which would shift the balance of power within the ruling elite away from those favouring market oriented
reforms.

Chinese companies, which have already seen return on capital declining because of overcapacity, will struggle.

Source: Deutsche Bank

Chinese stock prices are low by historic standards and diverging from the upward march of GDP, as the charts below show.

Source: Deutsche Bank. Click to enlarge

But Smith says that investors should not be tempted. He draws parallels with apparent cheapness of US stocks in 2007 ? which was followed not by a stock market recovery but by economic turmoil. Smith writes:

The implication? is that China, like the US five years ago, faces a major disruptive economic event, though at this stage it is too early to tell whether this is more likely to take the form of a lengthy transition period, or a major financial crash.

Smith concedes there could be some bullish surprises that might influence his general bearishness. In the short term, oil prices could fall or Beijing could engineer a stock market rally. In the medium term, China?s legion of private companies could grow faster than expected. Longer term, the huge state-led infrastructure investments of recent years could pay off (though, naturally, Smith doubts this will happen).

Smith?s arguments dig deeper than the standard macro-economic debate on whether China faces a soft or hard landing, or something in between. He may not be right ? but his corporate level analysis begs a response from the China bulls. Any horned beasts care to comment?

Related reading:
Deutsche: if you think 2011 was bad for EM equities, just wait for 2012, beyondbrics
China?s economy: back in a bind, beyondbrics
Here be dragons: Anthony Bolton, FT

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