Whenever the Chinese economy slows and its stocks take a serious hit, investors have come to expect the government to unleash large-scale fiscal and monetary stimulus. Another heaping spoonful of sugar may do more harm than good this time around, however. It’s time for the ailing market to take some medicine.
The MSCI China A Index has tumbled by more than 26% through November 23 on concerns about a weakening domestic economy and the escalating trade war with the US. Many investors who were attracted to the opening of the Chinese domestic market earlier this year are now watching for signs of a bottom.
This is the point at which the government would normally administer a generous shot of domestic stimulus, as it did in 2008 and 2015. If the government pumped enough money into the economy, it could help offset the pain from higher tariffs, buoy the domestic economy and lift stocks out of the doldrums. But stimulus also has its dangers, particularly when it’s used as a tool to manage markets.
The Debt Discount
Ask investors and economists alike what worries them most about China, and debt levels would inevitably be at the top of the list. China’s ratio of corporate debt to GDP is 164%, the fifth-highest among the 44 countries tracked by the Bank of International Settlements. Its corporate debt ratio has grown more in percentage terms than that of all but eight other countries since 2013.
Who’s to blame for this heavy debt burden? Past stimulus packages are partly responsible. In addition to funding massive infrastructure projects, these packages usually involve lowering interest rates, reducing bank reserve requirements and something called “window guidance,” in which the central bank essentially telegraphs which industries they would like banks to lend to.
Private companies and even individuals have taken full advantage of loose credit conditions. Rising corporate bond defaults and nonperforming loans, as well as the recent collapse of hundreds of peer-to-peer lending platforms, suggest that at least in some cases, the money came too easily. Concerned global equities investors are already applying a substantial discount to Chinese stocks because of debt issues.
Another borrowing binge won’t help that situation, in our view.
How Effective Will A New Mega-Stimulus Be?
The government is aware of the problem. Recognizing the danger posed by the high level of debt in its economy, the Chinese government had until recently been committed to a well-publicized deleveraging program that included raising key interest rates and cracking down on shadow banking.
It also made clear that bank officials—and even local bureaucrats—would be held to account for nonperforming loans, and those officials may be reluctant to shift gears and return to easy lending mode. So, a massive stimulus now simply may not be as effective as it was in 2008 or 2015.
Too much stimulus can also have unintended side effects, including over-investment. Barely used bridges and uninhabited ghost cities have failed to generate enough revenue to justify their existence and can’t produce the kind of economic multiplier that can have a broad-based impact on financial markets. China still needs infrastructure, but we think rampant stimulus is the wrong way to achieve it.
The Right Stimulus
Though it may be counterintuitive, China investors should be happy that the government has taken a relatively hands-off approach to market moves this time around. The central bank has cut interest rates and reserve requirements, but Chinese securities regulators have not intervened to stop trading to prevent a free fall in the stock market, as they did in 2015. In fact, they announced a new limit to the amount of time companies can suspend their shares, which should reassure investors looking for signs that markets function more or less independently.
Still, we’re not arguing against any government action. Loosening fiscal and monetary policy when economic conditions deteriorate is part of every well-run economy’s playbook. We’re advocating for a targeted, strategic stimulus that would allow much-needed structural reforms to proceed.
We believe that Chinese markets would benefit most from tax cuts, rather than monetary stimulus. Companies run the risk of overextending themselves when it’s too easy to borrow, and they have an incentive to engage in capital expenditures rather than other forms of capital distribution. Lower taxes would allow companies to allocate resources to what they see as the most productive ends, including share buybacks and dividends.
China cut the value-added tax rate for several key sectors earlier this year, but we think there is room for further cuts. We also would like to see corporations, particularly private enterprises, which are responsible for the bulk of job creation, bear less of a burden for funding Social Security.
Pain Is Priced In
Anything short of another mega-stimulus will inevitably disappoint investors, but much of that disappointment is already priced in. China is already the cheapest major equity market in the world.
Besides, the domestic equities market stands to gain more in the long term from doing stimulus properly than it will suffer in short-term losses. The right kind of stimulus would reduce the risk of moral hazard, incentivize better distribution of financial resources and help create a growth model that doesn’t rely on massive amounts of debt, which in turn would help investors properly price risk.
In other words, if the government ever wants foreign investors to stop levying an automatic and steep discount on its stocks, it must rethink its tactics. And investors who want to tap into China’s long-term growth potential should prefer a plan that supports sustainable growth and returns rather than the fleeting high of an artificial sweetener.