News: The great Chinese deleveraging

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on February 12, 2018 - February 18, 2018.

If China really wants to engage in deleveraging, it will have to compel banks to address their non-performing loans. > Gillan

The scenario here is not unlike that in the US during the subprime mortgage crisis. > Huang

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As China’s deleveraging gathers pace, portfolio managers are banking on new sectors of its economy as well as state-owned enterprises (SOEs) in the banking and insurance industries. The country’s IT sector should remain a priority for investors despite the recent global sell-off prompted by the exuberant jobs report coming out of the US. 

Meanwhile, portfolio managers are avoiding sectors they think will bear the brunt of the deleveraging and ongoing supply side reforms, such as old economy manufacturing and commodities, as well as smaller commercial city banks. 

Despite the sell-off scare, Affin Hwang Asset Management Bhd senior portfolio manager Huang Juin Hao tells Personal Wealth that retail investors with holding power should be looking at the longer-term prospects. “The longer-term picture is still very bright. The new economy sectors will continue to overturn a lot of the old economy, with the former gaining market share in the process. 

“The fact is that there are a lot of growth areas, such as artificial intelligence, financial technology and cloud computing, that will drive the longer-term growth and earnings of the new economy sectors in China. There is no doubt in my mind that we have to be invested in technology and that the sector will go on to take up a higher proportion of the MSCI China index.” 

As at Jan 31, the IT sector’s weightage made up 41.2% of the MSCI China index. 

According to Huang, the top weights for his funds are the big state-owned banks and IT sector, followed by insurance firms. He thinks SOE banks are set to be beneficiaries of the sweeping reforms to China’s wealth management scene, a sizeable portion of which is dominated by so-called “shadow banking”, a form of off-balance sheet financing heavily practised by smaller private sector city commercial banks.

“We see bigger SOE banks gaining market share as smaller commercial city banks struggle to comply with these new regulations. Needless to say, our China funds are not investing in the smaller banks, and we would advise retail investors to stay away from investing in commercial city banks or buying into their wealth management products,” says Huang. 

In addition, he points out that the IT sector is currently enjoying very strong structural growth. So, although it tends to trade at very high price-earnings ratios (PERs), he believes retail investors are compensated by the sector’s growth profile. 

Andrew Gillan, head of Asia ex-Japan equities at Janus Henderson, concurs. He cites investment opportunities in China’s new economy over the longer term. “Tencent Holdings Ltd and Alibaba Group Holding Ltd are the flagships of the country’s new economy and they have a number of years of good structural growth ahead of them,” he says. 

To this end, the likes of Alibaba and Tencent have seized on a new consumer growth area in the form of China’s fledgling property rental sector. Last month, Tencent participated in an investment round for online rental start-up Ziroom, which is similar to Airbnb, but for long-term rental. The investment round, led by private equity giant Warburg Pincus, Tencent and Sequoia Capital China, raised US$621 million for Ziroom. 

Ziroom leases apartments from individual owners before renovating and sub-leasing them to users of its portal and app. The start-up currently manages 500,000 rooms across nine Chinese districts, including Beijing, Shanghai and Shenzhen. 

Meanwhile, Alibaba’s payment arm — Ant Financial — introduced a home rental service in the fourth quarter of last year. It allows those with good credit scores on the Alipay app to rent an apartment without a deposit. The rooms are partly provided by online property start-up Mogo Room, which is backed by Alibaba founder and executive chairman Jack Ma’s investment firm, Yunfeng Capital. 

Gillan cautions that the new economy is not without challenges. “As Tencent and Alibaba become more embedded in the country’s financial ecosystem, they will be subjected to greater regulatory oversight. There is also the possibility of Alibaba listing Ant Financial at some point, which will add another layer of regulation,” he says. 

In August last year, the People’s Bank of China (PBoC) required all mobile payment providers to channel payments through a newly created clearing house by June this year. Dubbed the China Nets Union Clearing Corporation, the clearing house is the regulator’s attempt to regain oversight over online transactions. 

Previously, users could transfer money from their Alipay account to a friend’s account directly on the Alipay platform. This meant that the central bank was not able to track a significant amount of capital flow within the system. 

There also are growing concerns of data monopoly. An August 2017 news report out of China quoted the head of PBoC’s 

Financial Research Centre, Sun Guofeng, as saying, “We see that there are some online financial giants gathering massive data and there is the possibility that these companies will become financial data monopolies. Data monopoly could potentially be more harmful than technology monopolies and result in a gigantic information gap.”

With the requirement to channel all payments through this new clearing house, giants such as Alibaba and Tencent will now risk having to share their massive amounts of user data with other public and private sector stakeholders of the clearing house. 

Affin Hwang’s Huang is also bullish on the insurance sector. “We benefited from this sector last year because we identified it as one to watch out for in 2016 and started building our position in insurance companies. To date, the sector has seen an average weighted return of 70%,” he says. 

According to Huang, the insurance sector has benefited from rising 10-year bond yields. “There was a rate-cutting cycle in 2015 and because of that, bond yields collapsed. Insurance firms tend to benefit in a rising yield environment and suffer when yields are cut,” he says. 

“Since the middle of 2016, however, 10-year bond yields have started to move up. And as most of China’s insurers have about 90% of their assets in bonds, it explains why the sector is doing well right now.” 

To bank or not to bank 

Janus Henderson’s Gillan takes a much dimmer view of China’s banking scene. “If China really wants to engage in deleveraging, it will have to compel banks to address their non-performing loans (NPLs),” he says. 

According to Gillan, Chinese banks were unpopular last year due to scepticism about the state of China’s economy. But a series of tailwinds — improvements in the economy on the back of a 2016 government stimulus package, as well as supply side reforms to the old economy sectors — meant that investors eventually came to the conclusion that the economy had stabilised. 

“Banking stocks were starting to look quite cheap. This explains why Chinese banks enjoyed a bit of a run in the second half of last year,” says Gillan. “But as a quality growth investor, I do feel sceptical about banks for the longer term because I am not sure that we know the true level of NPLs on their balance sheets.”

Huang says it is the smaller commercial city banks that are suffering from a high NPL rate. The major SOE banks have not had to rely on pushing controversial wealth management products to generate income, thanks to the huge volume of deposits they currently enjoy.

Shadow banking used to comprise just 5% of the country’s total system funding. That number has now jumped to 20% in the last 10 years, says Huang. Borrowers who take advantage of shadow banking are most often smaller property developers and local government authorities who cannot obtain loans from the more established banks, possibly due to bad credit. 

Smaller commercial city banks would offer and structure loans to highly leveraged private property developers. These banks, according to Huang, would then structure the loan into an asset-backed security (ABS), and sell it on as a high yield wealth management product to retail investors on the hunt for higher returns. 

Huang says, “If consumers were to buy into unit trusts, they would get a basket of securities, including bonds and equities, from which they could derive an income from the returns. But with these ABS, what the retail investor is getting is a right to the repayment cash flows arising from these loans, many of which are approaching NPL status. The scenario here is not unlike that in the US during the subprime mortgage crisis.”

He adds that retail investors in China find these wealth management products very attractive because they come with much higher yields than traditional bank deposits. “Although Chinese consumers have a very high propensity to save, the fact is that the government sets the deposit and lending rates. And it just so happens that the latter is much higher than the former, which effectively means that consumers make next to nothing on their money by simply leaving it as savings. That is why they are attracted to these high-yield wealth management products. However, many of them are unaware of just how risky these products are.” 

Further exacerbating this problem is that in addition to retail investors, other city commercial banks and financial institutions have started to purchase and hold on to these shadow banking products. “We do not know how systemic this network of ownership could be, which is why in order to control the systemic risk from spreading, the regulators have begun to clamp down on the sale of these wealth management products,” says Huang. 

In November last year, China’s financial watchdogs proposed sweeping rules to curb shadow banking risk in the country’s US$15 trillion asset-management sector. The PBoC said in a joint statement with other financial regulators that financial institutions had to offer yields based on the net asset value of the products they issue to better reflect the risks and returns of the underlying asset, as opposed to the prevalent guaranteed principal repayment or rate of return. Crucially, regulators have moved to break an implicit guarantee of rescue in the event these investment products turn sour. 

Other regulations in the draft proposal include stipulations that closed-end asset management products should have a maturity of longer than 90 days and that products with longer durations would enjoy lower management fees. Also, asset management products can only invest in one layer of other investment products. Regulators have given firms a grace period until June 30 next year to comply with the new rules.

A word on commodities

Although there isn’t much by way of good news in Chinese commodities at the moment, Huang says he has found a sweet spot in oil and gas refinery. “I like the chemical players more than the exploration and production (E&P) players in the sector. The problem, however, is that a lot of the refinery companies are also focused on E&P. Low oil prices have forced these companies to hold back on capital expenditure investments and this means that new additions to refining capacity have been slow.”

The lull in new refining supply meant that gross refining margins jumped from US$5 or US$6 to about US$10 a barrel. “So, if a retail investor has a high exposure to refineries and minimal exposure to E&P, he stands to benefit from the improved margins, with none of the downside risks of E&P operations currently affected by low oil prices,” says Huang. 

Janus Henderson’s Gillan thinks supply side reforms arising out of the deleveraging exercises had an unexpectedly positive effect on China’s commodities sector. Nonetheless, he isn’t bullish on longer-term prospects. 

“In the short term, commodities have benefited from the supply side reforms. Once inefficient capacity was shut down, commodity stocks came back stronger than expected over the last year, and that is some positive sentiment for China’s old economy stocks,” he says. 

China’s steel supply reforms were announced in a January 2016 five-year plan, which among others, requires 150 million tonnes of outdated or redundant official capacity to close by 2020. According to government data, more than 100 million tonnes have already been shut down. The government has also forced large-scale closures of illegal and so-called “grey economy” plants that utilise low-tech induction furnaces — operations that were never counted in official steel output data. 

These supply-side reforms generated some unexpectedly positive effects on stocks in China’s commodities sector. However, Gillan thinks this is a short-term gain and does not have a very positive outlook on commodities over the longer term. 

“Taking a 5-to-10-year view, I wouldn’t want to allocate a lot of capital to these companies. Although supply side reforms helped certain commodity stocks perform in 2017, if we look into these companies’ balance sheets, they still have very high debt-to-equity levels,” he says. 

This is down to the fact that old economy companies in China have lost ground to countries with low-cost advantages. Compared with 15 or 20 years ago, China has ceded a lot of the low-cost advantages to countries such as Vietnam and Bangladesh. As a result, these companies are struggling to make good money because in addition to international competition, their costs are high and revenue growth is weak, says Gillan.