With China's markets falling and concerns arising about the state of the Asian economy, some wealth managers are starting to see parallels with 1990s Japan. Is this really justified?

History, so a saying goes, repeats itself: the first time as tragedy and the second time as farce. If that is the case, the current woes of China (its equity markets fell again yesterday before state-backed buying took them up) might suggest that the Asian giant is going to test investors’ sense of humour for a while.

As far as Samir Mehta, portfolio manager of JOHCM Asia Ex-Japan Equity Fund is concerned, the situation reminds him of Japan’s fall from economic grace after the late 1980s and its multi-decade slumber. Considering that China has been a significant driver of global economic growth in recent years, this isn’t encouraging news.

A great deal depends, from the point of view of such analysis, on how much one believes that China’s economic ascent since the late 1970s had been based on genuine movement towards a more market-based economy, with the necessary if painful discipline of bankruptcy and restructuring allowed to work, and how much is based on government-directed investment with all the attendant worries about “bridges to nowhere”, “ghost cities” and the like. Some investors who have spoken to this publication, such as Matthews Asia, the US-headquartered asset manager, have also argued that the role of exports in driving Chinese growth has at times been exaggerated so that recent adjustments are not a great worry.

Recent market shifts have certainly unnerved investors. The MSCI China A 50 Index is down by over 6.8 per cent since January and has fallen 22.83 per cent over the past three months alone. The MSCI World Index of developed countries’ equities shows total returns (capital growth added to reinvested dividends) of around 3.36 per cent (in dollar terms). Yesterday, stock indices in Shenzhen and Shanghai initially fell over 3 per cent before state-backed buyers lifted them higher (source: Reuters). The question is, however, whether state support for equity prices is wise or an attempt to delay inevitable adjustment.

Tragicomedy
JOHCM’s Mehta argues that "the successive attempts by the Chinese authorities to actively support a bull market in stocks and, later, at the first sign of a sell-off, devise creative ways of preventing a fall are almost tragically comic”.

He finds "many parallels" between China today and Japan in the 1990s, and "opine(s) that the probability is very high that China will become the new 'old' Japan", where government intervention helped "'zombie companies' stay afloat", and encouraged "misallocation of capital".

Ultimately he foresees stagnation and a farewell to double-digit growth for China, as well as a dawning global belief that China is no longer "an irresistible force."

Mehta piles on the negative news thus: “Already, there is serious evidence of a slowdown and deflation in China - we have now had 40 consecutive months of annual producer price deflation. Stuff gets produced in China even when demand is inadequate. Credit Suisse recently estimated that China has already exported as much steel this year as Japan has produced in total.

“The political priority in China, though, seems to be directed towards getting the yuan into the IMF's Special Drawing Rights (SDR) basket, which would see the yuan strengthen in response to increased demand as a reserve currency. The long-term economic consequences of that policy are likely to be dire for China in the years to come. Take a look at what Japan went through in the 'lost decades' of the 1990s and 2000s, when the yen appreciated steadily from around ¥160/US$ in 1990 to a high of ¥75/US$ in 2011 and deflation took hold,” he writes.

He goes on: “Corporate profitability was decimated, and the government's addiction to debt gradually intensified as it kept introducing stimulus budgets. Incremental capital output ratio deteriorated and corporate Japan’s returns on capital and assets plunged to abysmally low levels. Companies preferred to pay down debt or hold cash; capex was no longer a priority. Margins in corporate Japan cratered as ‘zombie’ companies competed to make enough returns to pay interest, while banks extended further loans and ‘ever greened’ or restructured loans to keep those customers alive. From an investment angle, cash and bonds became the asset of choice. Equities enjoyed sharp cyclical rallies, flattering only to deceive.”

Such a harsh viewpoint does not yet seem to be the consensus. China’s economic story to date is a very different one to that of Japan. There is no doubt, however, that last week’s surprise devaluation of the yuan, or renminbi, has shaken markets and made investors in emerging markets concerned that a rising dollar, and probable rise in US interest rates, could draw hot money out of places such as China. But then again, as Goldman Sachs told this publication about two years ago, no major economy has ever been able to adjust from a manufacturing-based strong growth phase to a more balanced pattern of growth without there being some form of financial angst. So it could be that China is going through some predictable pain.

Too early to see stagnation ahead?
Another commentator, James Klempster, portfolio manager, Momentum Global Investment Management, isn’t yet ready, it seems, to talk about parallels with 1990s Japan.

“There is no doubt that China has seen its competitiveness eroded over recent years by lower cost rivals such as Cambodia, Vietnam and Indonesia, but this is an almost necessary consequence of the government’s aim to generate a consumption-led economy, which requires a large and (relatively) comfortable middle class. It seems unlikely, therefore, that China is aiming for a currency war in the Asia region at least: a move of this magnitude will not materially alter their competitiveness, especially when the costs of reallocating production is taken into account. Furthermore, the efficacy of devaluation is reduced substantially when their currencies devalue in sympathy almost immediately,” he said in a note.

"One possible reason why China may be devaluing, which has received less coverage than the currency-war thesis, is that China is becoming increasingly worried about deflation. While their currency was pegged to the (strong) dollar they had seen substantial falls in a number of key input costs - such as energy - which are denominated in US dollars,” he continued.

"Over $1.6 trillion in foreign currencies has been borrowed by various Chinese bodies, and while devaluation of the yuan makes serving this debt more difficult at least an inflationary environment would ensure that the real value of outstanding local debt does not also increase. Indeed, China’s domestic debt has increased materially during its investment boom and while it still retains substantial reserves, China’s recent reluctance to use them may be driven by longer term economic concerns on the part of the government,” Klempster said.

An arguably even more sanguine read on the Chinese events comes from Alex Wolf, emerging markets economist, Standard Life Investments.

“Markets reacted negatively on views that the devaluation was a panicked attempt to boost the economy after inadequate results from monetary and fiscal easing.  Many who already believed growth was weaker than official statistics took this as proof that the economy must be shakier than the government has admitted,” he said.

“The timing of the move certainly did not help; weak export data in July was released only a few days before the PBoC [People's Bank of China] announced the change in policy. However, China’s strategy is not purely about boosting exports nor is it about SDR entry, but simply an acknowledgement that they need to allow greater market-based currency volatility as they pursue capital account liberalisation,” Wolf said.

“An attempt to boost exports would require a more drastic depreciation to make a difference, especially given the pace of devaluation among trade competitors. Furthermore, devaluation should only be thought of as competitive if it artificially suppresses a currency below its fair value in order to gain export market share. In this case Chinese authorities simply closed the gap between the artificially strong fixing rate to let the spot price dictate the currency’s value,” Wolf added.

Wealth managers do not yet, it seems, believe that China could be in the same sort of hole that Japan found itself in after property prices and other asset prices cratered in 1990. The country's foreign exchange reserves are formidable and the turn in fortunes lacks the jarring suddeness of what happened in Japan. People have talked about China's decelerating growth for some time.

History rarely repeats itself exactly – which given the stakes involved is just as well. The next few weeks and months are likely to test nerves.