China take outs

China greed Hong Kong market Shanghai Exchange

Following on from the article we posted on Greece last month, we thought people might be interested in a take on what’s happening in the Chinese markets. As per usual, there is a lot of media hype – some of which isn’t particularly helpful (or even accurate). Although China is more important to both New Zealand and the rest of the world than Greece is, the vast majority of what is happening in their markets is more to do with growing/maturing pains as their economy and people become used to capital markets. The emotions of fear and greed often drive markets, and this has certainly been the case for the Shanghai exchange (which is dominated by the ‘mums and dads’ investors/speculators – many of whom have borrowed to invest).

The Hong Kong market is where most international investors have funds, and that exchange has been significantly less volatile than Shanghai. Even with falling growth expectations, the Chinese economy is still going to be a key driver of investment growth over the next decade or so, and although it is always prudent to keep an eye on investments anywhere (China included), we continue to see value in maintaining exposure to China within a diversified portfolio.

Harbour Investment Research

7 August 2015| By Christian Hawkesby

Economists often point out that China is more important to New Zealand than Greece; and that we should therefore re-orientate our focus from the West to the East. So how worried should we be about the recent period of dramatic volatility in the Chinese sharemarket? And what does it really mean for New Zealand?

The much anticipated Third Plenary session of the Chinese Communist Party in late 2013 set out a series of social and economic reforms, ranging from relaxing the one-child policy right through to the staged liberalisation of the banking and financial sectors. They were ambitious, wide ranging, and challenging to implement.

We know from our own experience in New Zealand that liberalising the financial system is not straight forward. There are clear long-term benefits from having a broader access to capital markets and a more efficient system to allocate resources; but in the short-term it is difficult to avoid an overenthusiastic boom followed by an inevitable bust.

In New Zealand, our financial liberalisation of the mid 1980s was followed by the 1987 sharemarket crash and banking problems of the early 1990s. This link between financial liberalisation and financial fragility is borne out in the academic literature. The seminal research in this area was undertaken by the IMF and World Bank in 1998, analysing a panel of 53 countries between 1980 and 1995.1 More recent research continues to identify the link.

1 “Financial liberalization and financial fragility”, Asli Demirguc-Kunt and Enrica Detragiache, IMF Working Paper 83, June 1998.

This is not to say that financial liberalisation is something bad that should be avoided. We teach our teenage children to drive because it is clearly the best outcome for everyone in the long-run, but the reality is that insurance premiums are high in those early years of adulthood because that is when they are more prone to accidents. In other words, we shouldn’t really be surprised that the Chinese sharemarket is experiencing heightened volatility in these early years of freer capital flows. The more important question right now is whether it matters for New Zealand?

Between November 2014 and June 2015 the Shanghai Composite rose by roughly 100%. This went largely unreported in the mainstream Western media at the time, partly for the same reasons as in the past: the Chinese sharemarket has never really displayed a close resemblance to the Chinese economy; the companies listed on the exchange are not a representative cross section of economic activity; and until recently the market capitalisation of the Chinese equity market has been small relative to the size of the economy.Again there are parallels with New Zealand’s own experience in the 1990s and early 2000s. Back then the market was dominated by listings in specific sectors (telecoms and utilities), and not a good proxy of broader activity in agriculture, manufacturing or technology (although that has changed for the better in the past 5 years).

Despite the Shanghai Composite falling around 30% since its June peak, the market is still around 15% above its level at the start of the year. There will be winners and losers within this period of volatility. Any short-term hit to Chinese consumption may depend on whether investors have over-extended themselves by funding their investments with credit. Evidence is mixed, but many sharebroker accounts are operated on margin leverage.

Over the medium-to-long term, New Zealand’s strongest links to China are around the secular trend of a growing middle class, and the increased demand from these types of consumers for protein, and in particular dairy products.

At the same time as we have been digesting stories about sharp falls in Chinese share prices, we have been confronted by news of sharp falls in dairy prices. It is important not to confuse these two issues. While it is true that GDP growth in China has been moderating, at this stage the recent fall in dairy prices appears linked more to excess supply than insufficient demand. A number of factors have combined to result in an expansion of supply, including stockpiles from previous seasons, changes in European subsidies, ambitions for Russia to become self-sufficient, and the growth of dairy herds in the United States.

China is clearly more important to New Zealand than Greece. So we should continue to focus on the East and monitor the Chinese sharemarket closely. However, we also need to remember why China is important to New Zealand.

Our economic linkages through trade are much stronger than the linkages between our financial markets, which are at much different stages of development. So we should consider the impact of any Chinese news through this prism. In the short-term, China faces the challenge of navigating the moderation of economic growth to more sustainable levels. In the long-term, the ultimate test is whether any developments threaten the secular trend of a growing middle class that demands New Zealand products.