Lujiazui Financial District in Pudong, Shanghai. Photo: AFP
Lujiazui Financial District in Pudong, Shanghai. Photo: AFP

“China risk” was a Shibboleth for fund managers during 2015 and 2016, a specter haunting otherwise buoyant financial markets. A run on Chinese reserves, a collapse of Chinese corporate credit, a sudden slowdown in growth, and other disaster scenarios were at the top of the worry list of Western risk managers—until sometime in the middle of 2017, when China began to trade like a developed market.

By the conventional measures of risk, Chinese equities are about as risky as their American or European equivalents, and considerably less risky than Japanese stocks. In terms of valuation, though, important segments of the Chinese market are much cheaper than foreign equivalents.

That explains why Chinese financial stocks are melting up during 2018. The Hang Seng China Enterprises Index has risen 10% since Jan. 1, and more than three-quarters of its increase in market capitalization comes from the financials. The major banks have risen by 14%-27% (the lowest for Industrial and Commercial Bank of China, the most for Citic Bank).

The January rally reflects a belated recognition that China’s banks are trading too cheaply: the forward-looking price-earnings ratio for the major Chinese banks is around 6 or 7, about half that of their American and European counterparts. Investors now understand that China isn’t twice as risky.

volatility converges
Source: Bloomberg

Volatility is the universal gauge of risk. During 2014-2016, China’s Shanghai Composite Index showed volatility (the annualized standard deviation of daily returns) of 15% to 30%. In English, that indicates a roughly two-thirds probability of a 15%-30% change in the price of the stock index during the next year. Volatility surged with the 2015 equity market bubble and its aftermath, as China’s authorities first encouraged the run-up in stock prices by looking the other way while investors piled on illegal leverage, and then cracking down.

The devaluation of the RMB in August 2015, moreover, was clumsily executed. China needed to de-link its currency from the overvalued dollar, but it failed to signal its intentions to the market. Chinese corporate borrowers paid back roughly a trillion dollars of foreign currency loans over the next year, and China’s official reserves correspondingly fell by a trillion dollars. Inept Western analysts warned of a run on China’s reserves, although the Bank for International Settlements explained that this simply reflected a currency shift in balance sheets. Contrary to Western critics, China’s growth continued at close to 7% (and we don’t hear any more allegations that the numbers are faked).

What has changed? First of all, the threatened reserve run never emerged, and China’s external position net of corporate debt in foreign currencies remains as strong as ever it was. Second, the modest depreciation of the RMB helped to turn around the deflation in producer prices that in turn depressed corporate profits. As I reported in Asia Times Oct. 17, rising producer prices buoyed profits, and in turn helped Chinese corporate borrowers to improve their gearing ratios.

China’s authorities have learned a great deal since 2015. The People’s Bank of China is encouraging corporates to de-lever, which is not difficult when profits are rising, and rising fastest among the smokestack companies who took on the lion’s share of the corporate debt burden. The dodgy market for wealth-management products is shrinking, and overall credit growth has slowed.

Investors in Chinese stocks also show more discernment. In volatile stock markets, everything tends to move together. Markets are driven by what the finance profession calls “systemic risk,” that is, a risk affecting all stocks, such as currency problems, deflation, or central bank actions. Between 2007 and 2016, I calculate that 54% of change in the prices of Shanghai Composite Index stocks was driven by a common, “systemic” factor. During 2017, again by my calculations, the “systemic” factor explained only 28% of their change. Investors, that is, looked for value at the individual stock level, rather than responding to overall risk.

When stock-picking replaces concern about the currency, the central bank, or the overall growth outlook, some stocks rise and some fall, but the overall level of the index is less jumpy. That is one thing volatility captures as a measure of risk. Low volatility in the Shanghai Composite Index, in other words, shows that investors are trading Chinese stocks the same way that they trade stocks in developed markets—on the basis of valuation, management and growth prospects, rather than as stand-ins for fears about government policy.

That is a gigantic milestone in China’s economic maturity. It suggests that the equity market can become a more important source of capital for China’s growth, replacing corporate debt which grew too fast as China compensated for the 2008 world financial crisis. It implies that the cost of capital for Chinese companies will fall as the risk premium on their obligations shrinks.

China equity market risk is now on par with developed markets. But Chinese stocks remain much cheaper. The forward-looking price earnings ratio for the Hang Seng China Enterprises Index is only 8.5, compared to 19 for the S&P 500. When Chinese stocks were twice as volatile as American stocks,that made sense. Now Chinese stocks should outperform.

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