Managing the dragons – predictions for 2016

Managing the dragons – predictions for 2016

The Year of the Monkey got off to a rocky start in China, demonstrating once again just how much events in China now impact the rest of the world.

In 2016’s first day of trading, shares on the Shanghai Stock Exchange (“SSE”) plunged 7 percent, triggering circuit breakers that cut short the day’s trading session. The sharp price drop in China rattled stock exchanges in Asia and Europe, and aWall Street Journal headline the next day summarized the impact in New York: “U.S. Stocks Fall Hard After China Rout.” By the end of the week, the SSE was 10 percent lower and the Dow Jones Industrial Average had dropped by 6 percent, raising new concerns about the health of China’s economy, the credibility of the country’s stock markets, and the direction of its currency.

Why is China so important? The answer is quite simple. At its current size and growth rate, China’s economy accounts for 37 percent of the total annual growth in global Gross Domestic Product (“GDP”), compared to just 24 percent for the United States, the world’s largest economy. Of the 188 countries tracked by the International Monetary Fund (“IMF”), only 60 have economies larger than the $114 billion of global GDP that is lost forever if China’s economy grows just one percentage lower in any given year. No other country comes close to having this much impact on the global economy. As China goes, so goes the rest of the world.

What can we expect over the next 51 weeks?

Prediction #1: China’s GDP will grow between 6.5 and 6.7 percent.

Due to its impact on markets around the world, China’s GDP growth rate is one of the most closely watched numbers by economists. Forecasts for growth in 2016 are reasonably tight this year, with most falling in the range of 6.3 to 6.8 percent.

China’s targeted annual growth for the period from 2016 to 2020 is 6.5 percent, and the People’s Bank of China’s (“PBOC”) official forecast for 2016 is 6.8 percent. The World Bank predicts 6.7 percent growth this year, while the International Monetary Fund (IMF) is projecting somewhat lower growth of 6.3 percent. One outlier is State Street Global Advisers, which believes that China’s growth will fall to 6.0 percent.

China’s growth in the coming year will fall short of government estimates and be somewhere in the range of 6.5 and 6.7 percent. For those who yearn for the good old days when China grew at double-digit rates, note that in 2010, when China’s $6.0 trillion economy grew at 10.3 percent, the country contributed $618 billion of growth to the global economy. At a much lower 6.9 percent growth rate, China’s $11.4 trillion economy contributed $786 billion, or $168 billion more, in 2015!

Prediction #2: China’s currency will continue to be soft in 2016, and the ratio of 6.1 yuan to the dollar reached in late 2013 will be the high water mark for this decade. Expect more currency liberalization in 2016.

The renminbi is on a path to becoming a fully-convertible currency by 2020. Since 2009, China has signed bilateral deals with over 20 countries in order to increase the circulation and demand for its currency. These countries and entities include the UK, Russia, Turkey, Brazil, Australia, Hong Kong, United Arab Emirates, Switzerland, New Zealand, Singapore, the European Central Bank, Argentina, Canada, Belarus, Iceland, Indonesia, Malaysia, South Korea, Thailand, Uzbekistan, and most recently, the Kyrgyz Republic. It is expected that China will sign similar agreements with many of the 64 countries covered by China’s “One Belt, One Road” initiative.

The yuan now trades at different values in China where officials strictly limit the way the currency trades and in Hong Kong’s offshore market where the yuan trades more freely. In November, China’s currency took another significant step towards full convertibility when the IMF decided to include the renminbi, along with the U.S. dollar, the Euro, the Japanese yen and the British pound, in a basket of currencies that make up the IMF’s Special Drawing Right (“SDR”).  As of October 1, 2016, the RMB will be included in the SDR basket as a freely usable currency.

In 2016 and the coming five years, expect further measures to free up currency flows in and out of China. While China will remain an important exporter and destination for foreign direct investment, the combination of lower interest rates, declining exports, increasing levels of outbound direct investment and a desire for financial diversification on the part of the Chinese will create downward pressure on the renminbi in overseas markets. Don’t expect a stronger yuan anytime soon.

Prediction #3: China will embrace further financial and market reforms to encourage flows of domestic and foreign capital into its stock markets. An important target is the $21 trillion of deposits now sitting in China’s banks.

China’s problem is simple: How to re-circulate the vast amount of capital that already exists in the country to the companies and people that can use it best.

China has $3.4 trillion of foreign currency reserves; holds $1.3 trillion of U.S. Treasuries; and has a staggering $21 trillion in bank deposits—twice the amount held in U.S. banks and twice China’s GDP. China’s dilemma is that most of this capital is controlled by the country’s large state-owned enterprises and is not available to the country’s private companies and small and medium-sized enterprises (“SMEs”).

In order to move capital into its stock markets, where it can be accessed by a wider range of companies to grow their businesses, China has taken three positive steps since November 2014. First, it announced Shanghai-Hong Kong Connect to enable Chinese mainland investors to buy Hong Kong-listed shares and Hong Kong investors to purchase shares listed in Shanghai. Second, it introduced deposit insurance for bank accounts under RMB 500,000 ($77,000), signaling to large depositors that they could no longer count on government guarantees. Third, the PBOC has reduced interest rates six times over the past 15 months.

As a result of the above actions, the SSE increased by more than 50 percent from June 2014 to January 2015. While share prices were extremely volatile in 2015 due to the misuse of margin debt, the SSE remains well above the June 2014 level.

China will embark on further stock market reforms in 2016. Such reforms could include a relaxation of the restrictions governing the purchase of shares by foreigners under Shanghai-Hong Kong Connect; an extension of the program to Shenzhen; and perhaps to Beijing’s Third Board where more companies are now listed than on Shanghai and Shenzhen combined. The registration system for initial public offerings (“IPOs) is already scheduled to go into effect in mid-year, which should lead to more new listings.

Prediction #4: Recent declines notwithstanding, the SSE Composite Index will end the year higher.

Until recently, China’s stock markets have been missing in action as far as helping to grow the economy. With the exception of 2007 when it flirted with the 6000 level, the SSE has essentially been stuck at 2000 for the first 15 years of this century, a period when China’s economy grew almost tenfold.

At the same time, China’s private companies and SMEs are in dire need of capital. SMEs account for 99 percent of the total number of firms in China; 60 percent of the country’s GDP; 70 percent of employment; 65 percent of the patents filed each year; 60 percent of exports and 50 percent of tax revenues. Per yuan of investment, SMEs are eight to 10 times more efficient than China’s large companies in creating jobs and four to six times more efficient in generating GDP. Yet SMEs only have access to 20 percent of China’s financial resources.

In order to grow, China needs a robust stock market to provide much needed capital to its private companies and SMEs. While more IPOs on Shanghai, Shenzhen, and the Third Board will increase the supply of shares in 2016 and have a dampening effect on prices, a greater number of listed companies will provide more choice and increase investor awareness and interest in the stock market. Increased investor interest, combined with further market reforms, will put upward pressure on share prices.

Despite already being 10 percent in the hole, the SSE will end the year higher.

Prediction #5: The combination of connectivity and demand for new energy vehicles promises to transform the competitive landscape in China’s auto industry, tilting the playing field in favor of the local players.

Due to their long history producing cars, the international auto giants have dominated the Chinese passenger car industry through joint ventures with local companies. However, demand for connectivity and new energy vehicles is attracting new players to the industry and spawning partnerships between many of China’s most powerful internet firms and the country’s local car producers. For example, Alibaba has announced a joint venture with SAIC to jointly develop a connected automobile using internet technology; Baidu is teaming up with undisclosed carmakers to roll out a self-driving car; Tencent has joined with Foxconn to develop smart electric cars priced under $15,000; and Letv has formed a new car venture to develop the next generation of connected and intelligent electric vehicles.

The new players and partnerships bring substantial capital, knowledge of consumer electronics, experience and success in China, and extensive relationships throughout the country. As they develop, some could become new leaders in the Chinese and global auto industry. At least one new Chinese champion will emerge in this space in 2016.


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