China: What's Driving the Downturn?

So far, 2008 has been quite disappointing for most investors in the Chinese stock market. Major market indices posted one of the worst performances in the world, down by almost 50% in the first six months, and the average China Equity fund lost roughly 28% in the period. While some had predicted a correction from historical highs reached last November, given feverish speculation in the Chinese market at the time, the velocity of the downfall since then caught many by surprise. After all, the Chinese economy fared much better than many economies that barely expanded in the first half of 2008. For this period, China grew by more than 10% and remains on track to reach its 10% growth rate target for the full year.

To understand what drove the Chinese market decline and what may happen in the months ahead, we first need to assess several factors at play in today's Chinese economy. We think slowing economic growth, high inflation, and the squeeze of corporate profits have combined to weigh heavily on the Chinese market. In today's article, we will take a closer look at each of these factors.

China: Slowing Economic Growth
For almost 30 years, the Chinese economy has benefited from strong net exports to major markets, especially the United States and Europe. However, the growth started to show signs of slowing recently, as declining housing prices and shrinking job opportunities forced consumers in those markets to cut back on spending. Currency appreciation further eroded the competitiveness of Chinese goods, sending some buyers to other low-cost countries such as India and Vietnam. At the same time, rising oil and commodity prices pushed imports to sharply higher levels. In the first six months of 2008, China's trade surplus declined by 12% year over year to approximately $99 billion. The government now expects its trade surplus will likely decline for the full year--for the first time in five years.

In this context, people investing into China's growth story have started to adopt a more critical view of the economy. This has led to the cooling of investor confidence. Structural issues that were previously masked by robust growth--excess capacity, undifferentiated products, and inefficient energy and raw material consumption--began to surface one after another, adding to investor worries. Many believe an economic slowdown may force China to iron out the inefficiencies in the economy, which should benefit the country in the long run. However, for now, policymakers are walking a tightrope trying to balance the need to spur growth and the need to prevent those structural issues from ballooning into even bigger monsters. It remains to be seen how well the government can handle the situation.

China: High Inflation
After several years of relative calm, high inflation once again came into the limelight this February, as massive snowstorms and the subsequent widespread transportation disruptions pushed up the consumer price index (CPI) by 8.2%--a 12-year high. The situation improved slightly in the following months, as CPI growth gradually fell below 8%, but China still needs to wrestle with inflation levels at least twice as high as what the government would be comfortable with. One cause of the inflation was temporary food supply shortages, exacerbated by snowstorms, a devastating earthquake in western Sichuan Province (one of China's main food producers), and the flooding in southern China. We think food price inflation should subside somewhat in the coming months after the supply situation stabilizes. Another major cause of inflation--the rising oil and commodity prices on the global market--may persist much longer, in our opinion. High oil prices have already forced the Chinese government to cut subsidies on gas and diesel, hiking prices by as much as 18% in June. Chinese manufacturers also face higher prices for iron ore and other important raw materials. Steelmakers, for example, recently had to accept a 97% increase in order to secure Australian iron ores for their factories. We believe at least part of these price increases will creep into prices to consumers.

The Chinese government has taken several measures to try to tame inflation. The central bank had hiked bank reserve rates several times this year to 17.5%, in an effort to tighten monetary supply. The currency appreciation also accelerated in the first half of 2008, rising 6.8% against the U.S. dollar--a pace twice as fast as the year-ago period. However, we think China is in a tight spot; on the one hand, it needs a stronger yuan to help offset higher import prices, but on the other hand, the expectation of currency appreciation may attract more speculative money into the Chinese market and lead to still-higher inflation.

China: Corporate Profit Decline
It comes as little surprise that Chinese corporations are having a tough time, sandwiched between sluggish demand and rising material and labor costs. Other challenges include price controls and a higher cost of capital due to monetary supply reduction. In the first six months, some companies saw their profits shrink by as much as 50% year over year. The shortfalls can be even more pronounced for firms that saw earnings in the last two years padded by stock investment gains.

Given the challenging macroeconomic conditions, we think the profitability picture for most Chinese firms will remain uninspiring for the rest of 2008. Some well-capitalized industry leaders might use this difficult period to strengthen their product competitiveness and improve operations, but we think more firms will have to spend all the time trying to stay above water.

Summary
Investors may find China attractive for its long-term growth prospects or its risk diversification potential. Regardless of what drives your interest, we think it definitely pays to look underneath the surface to uncover what really drives the market. Learning to say "Ni Hao" (Hello) may be enough to make you a welcome tourist in China, but you will need to learn the A to Zs of the Chinese economy before you can feel more at ease with investing in China.