“If you buy a Chinese business its short-term liabilities exceed its short-term assets,” Reynolds continued.
“Although you can buy good-return equity, such as 1.65x book value, the ratio of current assets and liabilities is 0.83 compared to an emerging market average of 1.19 and global average of 1.27, so there are certain areas where debt-to-equity is 194% in Chinese companies against the emerging markets average of 131%.”
He went on to explain that these unattractive metrics, combined with both apparent fundamental flaws and market volatility, are evidence enough as to why China represents just 0.336% of his portfolio.
“The risk in China is huge compared to other areas,” said Reynolds. “Volatility over the last 260 days in the MSCI China Index was 18.6%, whereas the Hang Seng China Enterprise Index was 23% in the same period. It is a hell of a bumpy ride, and the returns are not even as good as they are elsewhere – over the last year they have had a good run, but the fundamentals are not good.”
“Even in the long-term, the huge economic imbalance means there are better opportunities elsewhere. China has grown on debt, and there is more debt in the system than the government will say,” Reynolds added. “If you buy an asset management company, it is funded by bonds issued by the government which are then bought by the bank, so there is this circular motion of clearing the banks’ balance sheets and sweeping all this toxic debt into the asset management companies.”
However, while Akbar conceded that debt-to-equity ratios are not ideal across the board, she is confident that the Chinese government is aware of the importance of prudent economic management, and is working towards resolving the existing issues.
She countered: “Debt-to-equity ratios are perhaps a bit higher than you would like, but the authorities do want to see the Chinese equity market develop going forward, which should stem from the recapitalising of the banks.
“China’s government knows that the economy is slowing and needs to be managed carefully. Historically a lot of money has gone into property and the ‘shadow’ banking sector – those are the two areas that the government wants to clamp down, and the equity market is a natural home for the excess liquidity that is being created. Economically, China is slowing, but it comes down to whether or not you are of the view that the government can manage that.”
