China navigates a soft landing

Contrary to worries about China, our view continues to be that the fiscal and administrative measures put in place by the Chinese government over the last two years to control lending, stabilise inflation, and maintain and rebalance growth will prevent a hard landing in 2012. Economic growth will indeed slow from its double-digit levels, but we expect it will still maintain a healthy clip of 8% in 2012. Similarly, in our view, monetary tightening has been effective in reining in inflation. Since banking in China generally operates as an extension of the government's fiscal authority rather than an autonomous sector, we also believe the government will be able to manage any potential issues in lending in 2012.

Still, as effective as government tightening has been on the real economy, the pull-back on liquidity had an adverse effect on equity markets in China and Hong Kong during 2011. This downward trajectory was further exacerbated by investor uncertainty over recurring debt problems in Europe and the US. By the end of September 2011, the Chinese equity markets had reached their lowest point since 2003 and 2008.² Throughout 2011 there was continuous pressure on the valuations of Chinese and Hong Kong equity markets, as the Chinese government raised interest rates, reduced liquidity and kept pressure on the banks to restrict lending. These measures were aimed at reversing the huge supply of liquidity pumped into the Chinese economy in 2008 and 2009 to drive domestic consumption and infrastructure spending, amid the global financial crisis.

Still, despite the economic logic behind pulling back on liquidity, bearish views on China continued to spread during 2011. As a result, we saw price-to-earnings ratios contract as a growing number of observers commented on the risks of a hard landing, warning that inflation was out of control; China's property market was a bubble about to burst; and unemployment threatened urban areas if European and US demand were to slow for everything from apparel to white goods. Our view continues to be that those fears are overblown.

Slowing inflation

According to government statistics, the inflation rate in China peaked in July 2011, levelled off and began to decline. We expect that overall inflation for 2011 will come in at about 5.5%, higher than the government's target rates, but not out of control. Our view is that inflation has now stabilised and should hover around 4.5% to 5% in 2012.

Inflation in China is driven by food prices. Over 65% of the CPI rise in the first three quarters of 2011 was accounted for by food prices, which rose 13.4% versus overall CPI of 6.1%.³ Pork price increases were the major driver of food inflation. At the same time, consumption remains strong as wages continue to rise. Inflation-adjusted income in urban areas rose 7.6% in the first half of 2011, the eleventh time in as many years that China has seen more than a 7% increase in real urban wages.⁴ Over the last decade, real disposable income has risen 150% in urban areas.⁵ In rural areas and for migrant workers, wages jumped 13.7% in real terms in 2011, up from 10.9% the previous year. These wage increases helped push consumption up by 16.8% in rural areas and 17.4% in urban areas in 2011.⁶

Growth slows but remains strong

We expect China's GDP will slow to 8% in 2012 from a bit more than 9% in 2011. That forecast assumes only a small (50 basis point) drag on growth from declining exports to the US and Europe. We believe the higher base effect of China's strong growth over the last decade means it is natural for GDP to stabilise at around an 8% target. Nominal growth is still over 13%, hardly a hard landing in our eyes, especially compared to the weaker growth expected for developed nations in 2012.

Strong property market fundamentals

Contrary to fears of an overheated housing market in China, we do not expect the housing bubble to burst in China in 2012. The demand for housing remains strong, as the country's urbanisation process continues apace. We expect expanding public housing will remain a priority for the government in its next five-year plan.

In addition to continued strong demand, there is no comparison between the highly leveraged and speculative housing markets in the US and other developed economies with that of China. In China, 89% of all residential property buyers are owner-occupiers; only 11% are buying property as an investment.⁷ Given the propensity of the Chinese to save, 23% of first-time homebuyers pay entirely in cash; 53% of all homebuyers pay in cash. For the other 47%, the average cash down payment is 44%. While stratospheric housing prices in Hong Kong, Beijing and Shanghai might dominate headlines, it is important to remember that more than 60% of all residential sales are in China's smaller, tier-three cities (home to 55% of the population) where prices are 70% lower than in tier-one cities.⁹

Government managing local debt

Similarly, we do not expect a crisis to arise from local government debt in 2012. Because China is a centrally planned and controlled economy, local debt is tantamount to central government debt. Prior to 2009, the growth of local government debt was in line with national fiscal revenue. In our view, the jump in 2009 levels was the result of a concerted central government effort to stimulate the domestic economy during the worst of the global financial crisis. We believe that bank lending to local government authorities to finance public infrastructure, which will ultimately create revenue, is really another form of central fiscal financing. While the short-term burden of RMB 10.7 trillion (US$1.7 trillion)¹⁰ in outstanding local government debt is not trivial, we still believe this amount is manageable and in effect guaranteed by the central government.

Attractive valuations for 2012

Not only do we not share the bearish economic views for China in 2012, we also believe the year might bring positive prospects for the country's equity market. We expect a relaxation in the Bank Reserve Requirement in the first half of 2012. This would add significant liquidity to the economy and might spur additional bank lending. We believe a 1% decline in the reserve requirement ratio (RRR), might lead to approximately US$400 billion in additional lending in China, equivalent to 8% of GDP.

In our view, this liquidity will spur the stock market. We have seen a de-rating in equities in China and Hong Kong over the last two years, and we believe the market is undervalued for its expected growth. We consider the financial sector to be particularly out of favour. We expect the government to continue to encourage the development of China's western and northern provinces, building out the infrastructure for second- and third-tier cities. Consumption in these areas should continue to remain strong; however, the market is discounting this high growth for many consumption-related stocks, so we seek to be very careful in our stock selection. The mid-cap sector also severely sold off in 2011, and we believe these stocks might be re-rated on their growth prospects as liquidity and risk appetite returns in 2012. The materials sector is another area we think has been oversold and is now attractively priced. This sector includes coal and specialty materials companies. We expect the development of the renminbi as an international currency will continue in 2012, significantly benefiting Hong Kong and China's financial sector. In summary, we believe the 2011 correction in China's equity markets has driven valuations down to levels not seen since similar downturns in 2003 and 2008 (the Hang Seng Index¹¹ was trading as of November 2011 at about 9x current earnings and 1-3x price-to-book value).¹² As a result, we believe 2012 might offer very attractive valuation levels for investments in this growth market.

1. BNY Mellon holds a 19.9% interest in Hamon Investment Group Pte Limited, which is the parent of Hamon Asian Advisors Limited. Hamon’s services are offered in the US by Hamon Asian Advisors Limited
2. Bloomberg, 01/10/11
3. National Bureau of Statistics
4. CEIC Data
5. Ibid
6. National Bureau of Statistics
7. CLSA
8. Ibid
9. Ibid
10. National Audit Office
11. The Hang Seng Index is a freefloat-adjusted market capitalisation-weighted stock market index in Hong Kong
12. Bloomberg