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Commentaries

PMC Weekly Review - June 10, 2016

A Macro View – China Back in Focus

Next week, MSCI will decide whether to add Chinese A-shares to the MSCI Emerging Market Index. That situation has reawakened investor attention to Chinese stocks and the country’s economy as a whole. Goldman Sachs reported this week that the Chinese government is understating the economy’s leverage growth this year by almost 25%. As investors digest Goldman’s report and await MSCI’s decision, it is useful to take a step back to understand why China is so important to both the global economy and US investors.

As the world’s second-largest economy, China has its second-largest stock market. Its impact on global financial markets is real: Recall the sharp domestic equity sell-off in August 2015, when China allowed the yuan to drop against the US dollar. Because China’s economy is second only to ours, investors must pay attention to what happens there, as it will have an impact on both their portfolios and the global economy. Even if they only invest in domestic equities, a portion of investors’ portfolios is exposed to China via the revenues generated from US businesses that derive profits from outside the US. And potential financial contagion is yet another exposure risk.

That’s why investors should pay heed to Goldman’s report and MSCI’s A-shares decision next week. As China’s economy slows, its debt load could be an issue, as repaying it will be increasingly hard to do. Depending on whom you ask, China’s national leverage, which includes public- and private-sector debt, is somewhere around 300% of the country’s GDP. Some say it is 275%, and others say it is 325%, and therein lies the problem, as Goldman Sachs implied. No one knows what the real debt numbers are, and no matter who measures them, those numbers seem to be growing as China’s economy is slowing. The dilemma combines a shadow banking system, a lack of understanding of where this debt resides (or even how to calculate it), and a lack of faith as to the quality of this debt. Sound familiar? Anybody who lived through 2008 can explain it.

The US is not immune to high debt: Our total debt to GDP is around 335%, down from a peak of 365% in 2009. But the difference is in transparency—the market has a lot more faith in the accuracy and quality of our reported debt. Our reported numbers aren’t perfect—they’re just closer to being perfect. Investors have less confidence in China’s official government numbers, as the Goldman Sachs report notes. The more uncertain investors are, the more reluctant they are to lend to China and Chinese companies. As witnessed during the credit crisis, as well as the numerous bank runs throughout history, confidence is everything when it comes to investing. Once investors lose confidence, they stop lending. And that is how financial crises begin.

MSCI’s EM Index A-shares decision next week coincides with rising investor concern over China’s escalating leverage. As a reminder, 27% of the EM index comprises H-shares (shares listed in Hong Kong) and shares listed abroad. Adding A-shares will increase that figure to 40%, although the most likely scenario is that they will be added slowly to the index over time—the current proposal is to add 5% in the first year (less than 1% of the index weight). Despite this gradual approach, investors may feel the impact, signaling a glimpse of the future roadmap. A-shares include a high percentage of state-run companies that are less efficient and potentially have more problems with bad debt. When banks are removed, A-shares valuations tend to be much higher, and are higher still when state-run companies are not included. We believe that adding A-shares to the index will increase exposure to both debt-heavy, state-run companies and over-valued private enterprises. With more than $1.5 trillion in assets in various MSCI indices, the addition of A-shares will force investors’ exposure to them through both passive vehicles and active managers with tight benchmark constraints.

In reality, investors’ direct and indirect exposure to China will likely increase in the coming years as its economy slows, debt concerns rise, and valuations become stretched. It’s something investors should focus on.

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