Uncertainty around the fate of a large and heavily indebted Chinese property conglomerate, Evergrande, spooked equity markets at the end of September and prompted many market participants to question whether the much-discussed potential for the country to drive investment returns in the coming years continues to hold true.
The scale of the company’s debts and the potential for it to destabilise the wider financial system prompted many investors to conjure images of a 'Lehman moment'; a reference to the collapse of Lehman Brothers, a US bank that precipitated the global financial crisis.
But after an initial and sharp market sell-off, global equities swiftly recovered, and even when Evergrande missed a debt repayment, this did not seem to negatively impact sentiment towards global equities.
George Lagarias, chief economist at Mazars Wealth, says: “If the market went back up because it was taking a view on the Federal Reserve monetary policy decision, I would be a lot more comfortable with that than the market deciding to rise because Evergrande was sorted. There is just so much we don’t know about it.”
Silvia Dall’Angelo, senior economist at Federated Hermes, is among those who do not believe the problems at Evergrande will pose a risk to financial stability globally, but says events with the company could pose a threat to global economic growth.
Dall’Angelo says: “In China, the Evergrande saga is still front and centre, with policymakers facing the challenge of reining in imbalances (including rising debt, bubbly prices and excessive risk-taking in the property sector), while also avoiding contagion risk and sharp repercussion on the growth outlook. The base case is that Chinese authorities will manage an orderly dismissal of Evergrande, making sure the goals of systemic stability and ‘common prosperity’ are preserved.”
Simon Edelsten, global equity fund manager at Artemis, says, despite its size, China is a relatively small part of economic demand for most companies, but the issue is on the supply side of the economy, and if China were to face a period of economic disruption, this would have consequences for the wider world.
The middle-income trap
While China's total GDP places it second in the world, its GDP per head of population is about $8,800 (£6,500), which is below the global average and puts China 86th in the world by that measure.
The danger for investors focused on China, or with portfolios heavily predicated on China growing swiftly, is that the economy becomes stuck in what the World Bank defined in 2006 as the “middle-income trap”.
This occurs when an economy moves from being – relative to the rest of the world – poor, to being in the middle of the income range, but is then unable to progress to being a 'rich' country.
The World Bank says only 15 nations in history have escaped the middle-income trap.
Countries typically become middle income as they move from being predominantly agriculture-based to being the manufacturer of low-cost goods for export.
The challenge this poses for an economy's development over the long term is that as a country exports more, the value of its currency would be expected to rise, and this creates domestic inflation and more liquidity in the economy.
The traditional way to deal with higher inflation is to put interest rates up, but doing this causes the price of the country’s exports to rise, which could hinder the export-led growth that caused the economic growth in the first place.
In order to prevent this, many economies keep their currencies weaker and rates lower than is justified by the economic data.
This leads to banks lending more and consumers borrowing more, with a significant portion of this debt going into house purchases.
Politicians often justify this by saying the economy growing through domestic demand is a positive as it diversifies away from exports.
The challenge comes if the excessive liquidity in the system creates a housing bubble, which typically bursts when a global economic downturn happens.
The downturn also reduces demand for many exported goods and so makes the debt harder to service, causing a housing market collapse.
When exports recover, the level of household debt remains very high, which makes it not the right time to put rates up.
Evergrande had debt that originated in products sold to retail investors in the country.
The middle-income trap is not strictly an emerging markets phenomenon; Ireland probably experienced the same trajectory in the years approaching the financial crisis, while Italy has also struggled.
Escaping the trap
Gerard Lyons is chief economic strategist at Netwealth, and also an independent non-executive director of Bank of China (UK), a state-owned bank. He says: “People first began talking about the middle-income trap impacting China a decade ago. China has introduced policies such as the belt and road initiative and the dual circulation policy, which aim to address the imbalances.
"But it is very hard to escape the middle-income trap. And in China, the issue is that while consumption as a total percentage of GDP has risen, it has only risen by a small amount. The government there talked a good story about moving out of the middle-income trap, but the amount of consumption has risen by only a small amount.”
The notional solution that enables escape from the middle-income trap is for the country’s exports to be of services and more sophisticated goods, and so less reliant on being the cheapest source of production.
In such a scenario, the goods being exported are less price sensitive, so policymakers can raise rates if need be, helping to address imbalances.
Lyons says that while the large cities around Hong Kong have probably escaped the middle-income trap by becoming technology hubs, the remainder of the country is still stuck in the trap.
Will Hobbs, chief investment officer at Barclays Wealth, says: "Escaping the middle-income trap is not easy. And it is not the case that it is inevitable that China will dominate the world as had been expected. The Chinese government are trying to navigate their way out of a crisis, but are doing so while walking a tightrope."
As part of his role, Lyons has spoken in the Great Hall of the People (which is the Chinese parliament), and first visited the country in 1994.
He says he believes that as China moves out of the fixed income trap in the coming years, the trend, or average rate of economic growth, will be lower but will be higher quality; that is, more resilient to external shocks over the longer term, but also more volatile over the shorter term because a feature of an economy moving out of the middle-income trap is a greater reliance on consumption-led growth, where volatility tends to be higher in the short term.
Lyons says traditionally one would expect to be able to address the issue by having more open stock markets, as this provides an alternative route to capital to go than into housing market investments. However, he notes that while the UK has a well-developed stock market, it does not appear to have prevented over investment in housing.
Lyons is long-term very positive on the outlook for Asian economies and Netwealth has significant allocations to China, Korea and Japan.
Robert Horrocks, chief investment officer at Matthews Asia, says that as policymakers in the country try to move away from housing investment, it is likely this will reduce demand for commodities and be negative for global mining stocks.
He expects policymakers in China to take actions in the years ahead to boost the income of lower earners, as this would increase the level of consumption in the economy, and this is one of the pre-requisites for an economy to exit the middle-income trap.
He says one of the problems with the domestic stock market is “that it's filled with lots of poor-quality companies”.
But he notes that unless China actually stops growing, the wider Asian economies will continue to benefit.
David Thorpe is special projects editor at FTAdviser
