3rd July 2013
The shadow banking situation in China is not catastrophic but it does require swift action says Stuart Parks, head of Asian equities at Invesco Perpetual.
In an interview this week, Parks says the wealth management products, which form part of this shadow sector, vary dramatically in profile. These products have been used to get around regulations controlling the rates that can be offered on mainstream cash deposits by many Chinese banks.
Yet some offer little more than 1% yield over normal rates. Others offer much higher rates of interest and are linked to what Parks calls some very strange areas of business. He says that on paper the products may struggle to repay depositors on maturity though most Chinese investors believe the banks will stand by the promised returns and Parks thinks they are probably correct.
He says: “Bank deposit rates in China are, to a large extent, still regulated, and as such depositors have been looking for a better return on their cash, with wealth-management products emerging to meet demand.
“These come in all different shapes and sizes. Some are pretty innocuous and may well only have a 1% yield increment over normal bank deposits, and find themselves going into pretty standard, justifiable forms of lending. However, others have much higher interest rates attached, and have been moving towards some very strange areas, particularly local-government financing, where one must question the ability of certain projects to produce a cash flow with sufficient returns to repay depositors on maturity.”
He suggests that depositors have a “rather touching faith that, if things do go wrong with the project they are effectively financing, the bank or whoever is behind the wealth-management product will step in and pick-up the bill.
“That is probably right. However, over the next couple of years we will see exactly where the ultimate price is taken, and may see banks’ overall non-performing loans going up, with potential recapitalisation requirements for some of the smaller banks in China.”
However he says this has implications for China in that such inefficient capital allocation goes to the heart of why Chinese stocks trade so cheaply.
“This capital could be more sensibly allocated to deserving privately owned firms in need of cash that are otherwise unable to get a bank loan. Meanwhile, there are lots of quasi-state-related entities still being financed, leading to horrible returns on capital overall, as well as an unwanted build-up of capacity in the economy. We don’t see this changing any time soon.”
Positives about China
Parks says there are signs of change at the edges with overall growth at around 7% driven by consumption and less by fixed asset growth.
“I am also heartened by the fact that retail-sales growth in China remains well above double-digit levels, in spite of the crackdown on corruption, which has led to a substantial reduction in overall gift-giving, historically a large part of overall retail sales.
“It is also important to remember that the figure is being understated as government retail sales figures don’t even include e-commerce, which is going through the roof, and already accounts for around 6-10% of total retail sales.
Overheating in China is not an issue overall, but there are still specific headwinds for markets. For these to be addressed we need genuine reform, which we are unlikely to see until later this year, when the government starts to push through reform measures.”
However he believes it could surprise as a result.
Park says there are pockets of real concern with regard to overheating and the effect of too much liquidity in some Asean economies.
He says: “The best example of this is the case of Indonesia, where the 10-year bond yield in $US has fallen from over 10% to, at the low, around 3.5%. Anybody buying an Indonesian 10-year bond with a yield of 3.5% is making some pretty optimistic assumptions, certainly when looking at Indonesia’s history with regard to interest rates, which have rarely been anything close to 3.5%, and also with regard to the ability of the government in Indonesia to implement reform.
“Indonesia has been a huge beneficiary of China’s demand for resources, which has boosted the economy, while there has also been the desire of foreigners to tap into Indonesia’s overall growth. Both of these factors are now under question. Inflation is going up, while subsidies are leading to quite a large current-account deficit. I would “mind your eye” with regard to Indonesian fixed interest prices. If they do come under pressure, so in turn will the currency and the equity market.”
Finally, he says the Philippines which has been a market in favour over recent months may well pull back in the short-term, as people worry about emerging markets in general. But he notes that the Philippines has 50 years of underinvestment to catch up on. Its inflation rate remains stubbornly low, at around 2.6%, with unemployment of about 7%.
Conclusion: China fairly rated, Indonesia overheating, India some momentum
Parks concludes: “Some areas of Asia are very close to overheating, particularly Indonesia as reflected in its current-account deficit. China is currently cheap at below 10 times 2013 earnings, but it is cheap for a reason as investors have limited conviction about the ability of those earnings to grow. This is partly due to banks being such a large part of the index, with concerns over the mushrooming of non-performing loans over the next couple of years, concerns that I would probably share. It is also due to the fact that state-owned enterprises in China make limited returns.
“We are more enthusiastic on India. This time last year, people’s pessimism reached quite sizable levels, but over the last six to nine months, we have seen a genuine move by government to try and start changing things. This has been a positive surprise for the market and I think it will continue. There has been significant reform progress, with foreign direct investment being allowed into areas it has never been before, such as retail.
“We have seen some sort of kick-start on infrastructure projects, with moves to make power more readily available by removing bottlenecks in coal supply. In addition, problems with quite a lot of the transmission power companies being unable to pay for increased power due to huge debts is starting to resolve itself. As ever in India, it is going to be two steps forward and one step back, but at least there is some positive momentum.”