Baillie Gifford: risk of a Lehman moment in China ‘very low’

The comments are a strong rebuttal of the main headwinds that have led some investors to sell out of the world’s second-largest economy. 

Over the past 12 to 18 months, some professional investors have turned their backs on China over concerns about its economic troubles.

However, according to the fund managers Roderick Snell and Sophie Earnshaw, who oversee Baillie Gifford China Growth Trust (LSE:BGCG), such fears are overblown.

While there’s an element of the fund managers talking up the prospects of the market they invest in, the duo’s comments in the trust’s latest half-year report (released yesterday) are a strong rebuttal of the main headwinds that have led some investors to sell out of the second-largest economy in the world.

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Snell and Earnshaw point out that concerns over China’s economy, due to its slumping property market and Covid-19 lockdowns in a number of cities, are “being exaggerated”.

The trust has no direct exposure to the property developers or banks, but poor investor sentiment to the region on economic grounds has proven to be a headwind for short-term performance. Over the six-month period to the end of July, the company's net asset value per share (NAV) fell by 10.7% compared to a 5.4% decline for the MSCI China All Shares index.

The pair note that property sales are down 30%-40% from their 2020 peak, but ruled out a financial crisis erupting.

China’s second-largest property developer Evergrande Group (SEHK:3333) has run up massive debts, totalling $300 billion (£267 billion) in liabilities. In addition, there are reports that some property developers have halted building work on homes that have already been sold amid concerns over their finances. In response, some homeowners have been refusing to pay their mortgages on unfinished homes.  

Snell and Earnshaw note that the People’s Bank of China continues to provide strong liquidity support for the banking system. They add: “As such, the risk of a Lehman's style moment in China is very low.”

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They also point out: “The property market is weak with sales down 30%-40% from their 2020 peak. However, it’s important to note that this peak resulted from stimulus provided by the government in 2020 in the wake of Covid.

“If we compare sales figures to 2018, numbers are down but not drastically so. More importantly, the loan-to-value ratio is sitting at only circa 25%.

“Most people are still paying for the majority of their properties out of cash. This contrasts markedly with most other housing booms and busts we’ve seen in emerging or developed markets where loan-to-value ratios tend to reach circa 90%.

“Some property developers are impaired, but the majority are not, and the system itself is both incredibly large and incredibly fragmented. China Evergrande, one of the largest developers, and one that is facing serious difficulties, represents less than circa 2% of total system assets. The next 10 combined do not even add up to 10% of the total.

“So while China has dropped and is unlikely to achieve its previous target for GDP of 5.5% growth in 2022, the risk of financial instability is low in our view.”

The duo also played down the risk of tensions with Taiwan boiling over. They said: “While acknowledging the complexity of the issue and the limitations of our own predictive powers, we would say that we believe the risk of military action remains low.”

China is being shunned by more and more investors as the Communist Party intervenes in markets. Last summer, the Chinese government launched a crackdown on its own technology and education industries, sparking a sharp sell-off for the entire market.

In short, a number of new regulations have been imposed, which threaten the future earnings and profitability of companies in those sectors, while political risk and uncertainty have led to concerns over whether capital from overseas investors would be withdrawn from China’s equity market.

Snell and Earnshaw argue that there’s been “a marked improvement on the regulatory front within China”.

They said: “Over the last six months, significant political capital has built up behind the idea that regulation needs to be better signalled and more transparent. This culminated most recently with [Chinese leader] Xi Jinping (pictured above) stating that ‘normal supervision’ of the platform economy will resume and that specific measures to support it will be rolled out.

“This is a significant positive for the platform companies in which we invest and it was echoed by founders of companies such as Alibaba Group (NYSE:BABA), Meituan (SEHK:3690), Tencent (SEHK:700) and Bilibili (NASDAQ:BILI), all of whom we met during the period.”

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Among the fund managers who have completely exited China are Jason Pidcock, manager of the Jupiter Asian Income fund, and Simon Edelsten, manager of the Mid Wynd International Investment Trust (LSE:MWY).

Pidcock expressed concerns that the heavy interference by the Chinese government in the economy is having an impact on growth.  

He said: “There have been widespread reports of mortgage holders boycotting payments due on unfinished homes and the property sector is weighed down by very heavy debts. Indeed, a number of developers have already defaulted on loans.

“In order to ease the situation, there has been some heavy-handed government-directed bank lending – this is something we do not expect to see in well-functioning economies. The continued zero-tolerance Covid restrictions are straining the economy further, and GDP growth is likely to be low this year and next. It is even possible that a deflationary period could begin in the year ahead if China’s banks recognise a higher proportion of the bad loans on their books.”

As the world’s second-largest economy and home to some exciting entrepreneurial businesses, China is difficult for investors to neglect in their portfolio, despite its political risks.

For those who want exposure to emerging markets without China, be aware that Taiwan is likely to feature heavily in the remaining mix. For example, the Lyxor MSCI Emerging Markets Ex China (LSE: EMXC)has 20.5% of the index in Taiwan.

Pacific Assets (LSE:PAC), a member of interactive investor’s ACE 40 Sustainable Investments List, has only 8.2% in China, but 9.5% in Taiwan. Its largest allocation – just under half the portfolio – is in India.