As China nears exhaustion investors must look elsewhere

Emerging markets are flattered by the view that they are the least bad option, writes James Kynge

by: James Kynge

With the Olympics just ended, we are refreshed in the terminology of physical exhaustion: athletes hit the wall, suffer glycogen deficits or exceed their lactate thresholds, before restoring themselves by simply taking a rest.

Monetary exhaustion is different. The injection of cheap cash by central banks into increasingly listless economies recalls Arthur Conan Doyle’s observation that exhaustion is how a “battery feels when it pours electricity into a non-conductor”.

The economic unresponsiveness to the monetary defibrillator is becoming a crucial issue not only for central banks but also for emerging market investors. The key question is how signs of quantitative failure may influence the fortunes of the developing world.

So far, emerging markets have been beneficiaries. A record-breaking flow of funds into emerging market bonds in recent weeks has been driven largely by foreboding over monetary exhaustion in the developed world, as investors pay to hold some $13tn in negative-yielding bonds.

“I have never seen this in my life. The cost of credit simply should not be negative,” said Gerardo Zamorano, a director at Brandes Investment Partners, an emerging market fund.

“We are thinking a lot about [monetary policy] exhaustion and the costs of misdirected incentives in the developed world.”

Such a situation makes emerging markets look interesting to investors, not because of any innate quality but by omission. As they have not engaged in quantitative easing — the practice through which central banks in the US, Europe and Japan have printed money to buy bonds — they are not now facing monetary exhaustion and interest rates in their economies are still positive.

Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, puts this into stark perspective. “The drive behind this intense demand for EM has nothing to do with EM,” he said.

“The one thing that emerging markets have that everyone wants right now is not raw materials or cheap labour, it’s yield. When you have negative interest rates in Europe and Japan, and zero rates everywhere else, the politics and economics of these countries becomes irrelevant.”

Thus, emerging markets are flattered by a perception they are the least bad option for investors. But although those markets are free from the type of quantitative failure stalking Europe and Japan, they are acutely vulnerable to another form of financial exhaustion.

China’s debt binge has not come through quantitative easing, but through direct lending by state-owned banks to local governments and companies. Nevertheless, the evidence of fatigue is obvious.

Whereas before the global financial crisis in 2008, China needed just over one dollar of credit to deliver one dollar of gross domestic product growth, the ratio is now six to one, according to Morgan Stanley.

Private enterprises exhibit China’s brand of exhaustion. Although the economy is said to be growing at 6.7 per cent, investment growth by private companies slowed to 2 per cent in July, demonstrating that the most potent force in the Chinese economy sees scant hope of a return.

Scarcity of opportunity amid an abundance of growth defines China’s enervated state. So generous have banks, capital markets and shadow financial institutions been to virtually anyone who wishes to borrow that almost every industry is in a state of oversupply, slashing profits.

Standard & Poor’s, the credit rating agency, is the latest to raise the alarm. The anaemic profits of Chinese companies is likely to intensify their need to borrow more merely to repay maturing debts, helping to drive global corporate debt levels to worrying levels by 2020.

All this sets up a classic paradox. On the one hand S&P says the credit-fuelled growth pursued by central banks around the world has contributed to financial risks. On the other hand, the response to this situation by companies, it predicts, will be to borrow more.

Corporate debt is set to expand by half to $75tn over the next five years, according to S&P. China’s share of this debt is likely to rise to 43 per cent in 2020 from 35 per cent in 2015, the rating agency said, largely through companies borrowing to repay debts that are coming due.

Such dynamics have convinced some fund managers, such as Ruchir Sharma, chief global strategist at Morgan Stanley Investment Management, to advocate a “post-China world” investment strategy in which investors should look to emerging markets that have little connection with China.

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