The View from China

Both on- and off-shore Chinese equity markets have been hit by significant sell-downs. However, it’s important to make a distinction between A- and H-shares – the two markets are quite separate. A-shares are still not cheap even after the recent correction, especially in the small/mid-cap space. H-shares, on the other hand, have reached 1.2x PB* (equivalent to levels seen during the GFC), despite the fundamentals being nowhere nearly as poor as back then. We see support for H-shares at the current level.

Three key factors lie behind the recent volatility:

1. A disorganised situation in the A-shares market

Sentiment – and a retail-driven rally – got out of control in late 2Q15. When a reversal came, initial intervention / responses from Chinese policy makers were not well-received and confusing. After a few weeks of ‘breaking the fall’, the China Securities Regulatory Commission (CSRC) indicated that direct intervention/purchasing in equity markets would not continue unless there are extraordinary circumstances, a further sell-off ensued.

2. Slow domestic growth and a looming Fed rate rise

Much of the market excitement this year has been driven by the prospect of successful implementation of structural reform. Worries that the cyclical situation may hamper or delay such efforts appear to be affecting sentiment.

3. Currency devaluation

Investors worry that policy makers could lose control of the economy if the RMB is subject to wild fluctuations or if outflows worsen, driving more capital back to developed markets as the Fed rate hike hovers on the horizon.

H-shares have some degree of valuation support, but a significant portion of A-share valuations are still extremely stretched; however, value is starting to emerge in certain sectors largely in the blue-chip space.

Policy makers may lose credibility if they were to intervene directly again in the A-shares market. Instead, we believe policy response should be focused on stabilising cyclical fundamentals and on restoring confidence in the structural reform agenda overall.

The People’s Bank of China (PBoC) and the Chinese government has a meaningful arsenal of policy measures at their disposal – perhaps more so than any other major economy (most of which have limited policy bullets left to fire) – including, on the monetary side, rate/RRR cuts and targeted liquidity injections. Reliance will be on reducing funding cost rather than the style of the 2009-10 stimulus (accelerating credit growth), and on better using stock and flow of credit towards healthy areas (social housing, subway, underground pipe, water irrigation, environmental etc.) rather than overcapacity areas.

While the PBoC are willing to tolerate slight further RMB devaluation, this is likely still range-bound. We expect aggressive intervention should there be moves beyond single-digit thresholds; China’s central bank has deep FX reserves. In our view, any further adjustments on the currency may be on hold until after Xi Jinping’s US visit and IMF’s SDR discussions in Sept/Oct.

The impact of the recent sell-off on the real Chinese economy is limited – most household wealth is concentrated in cash deposits and property with only single digit exposure to equity, and the A-shares are still posting positive returns over the past twelve months. That said, financial sectors’ increased activity probably did contribute around 0.5% to GDP in 1H15**.