Why you should keep buying broken China

The renminbi has dropped and markets are jittery but a great long-termbuying opportunity for Chinese equities lies ahead, says Rupert Foster.

The 11th of August saw the dawn of a new currency regime in China. The first day saw the renminbi (or yuan) fall by 1.9% against the US dollar, the largest daily move in more than a decade. Markets reacted nervously.

Was this the start of a larger devaluation (10%-plus)? Was it a panic move by China's leadership, designed to boost exports? Had the government givenup on its efforts to shift the Chinese economy from investment-led to consumption-led? Was this China's opening salvo in the global currencywar that has raged since 2008?

Start your trial of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

By the end of day two the renminbi had fallen by a further 1.9% and the markets were more fevered than ever. Had China's central bank the People's Bank of China (PBOC) lost control? Were we facing a rerun of the 1997 Asian currency crisis? Investment banks circulated long lists of US-dollar-denominated Chinese corporate debt, to reveal who would take the hardest hit first.

On Thursday, the PBOC felt obligated to do that very un-Chinese thing of holding a press conference to explain a policy decision. And in more traditional Chinese manner, it intervened aggressively inthe currency market to halt the slide.

By Friday we returned to normal service a day of almost zero volatility in the currency and a sense of zen-like calm. Chinese markets fell again earlier this week, but the renminbi remained stable.

The truth about the falling renminbi

So what should we make of these events? The PBOC argued that the devaluation was designed merely to correct the pent-up misalignment of the exchange rate the renminbi needed to fall by 3% against the US dollar. This seems far-fetched at best. Micro-managing currencies like this is pointless no-one can be sure of the "fair value" of a currency to within a margin of 3%.

All we can say is that the renminbi has, along with the US dollar, strengthened by at least 15% in the last year against a whole raft of currencies belonging to China's production rivals, notably the Japanese yen. This has made Chinese exports less attractive to foreign particularly American buyers.

So it seems far more likely that the PBOC used the strong renminbi, along with the mostly unrelated slowdown in Chinese exports (which is really due toa slowdown in global growth), and also the likely increase in US rates in thenext 12 months, as an argument to convince China's government to drive through a necessary long-term reform. While China's political leaders are committed to long-term reforms, in the shorter run they also want to keep the economy buoyant and crucially hold down unemployment (various recent indicators have suggested it is rising).

So I'm sure that in his conversations with other members of the State Council last month, PBOC governor Zhou Xiaochuan stressed that the change in exchange-rate policy would benefit export demand and thus help with the unemployment rate.

The tricky thing is that for China's politicians reform is always unnerving, because it goes hand in hand with a loss of control. They are constantly walking a tightrope. The Chinese economy needs more market-led reform to allow it to shift to the consumption-led economic model that will create continued wealth for the Chinese people and their leaders are fully aware that their continued residence in power is founded on their ability to improve living standards for China's population.

But all of their historical experience and training points to the need for absolute control. As a result, the less reform-minded leaders end up in the unhappy position of trying to work out what is the slowest pace of reform they can get away with, while allowing for the successful progression of their economy.

For this section of the leadership, last week's exchange-rate reform became necessary,if frightening.The biggest concern for the leadership now is the risk that the new regime might lead to a noticeable devaluation of the renminbi. This in turn would mean a commensurate loss of confidence in the Chinese economy and the state, resulting in money fleeing its shores.

In the last year, $800bn has left China. This is dwarfed by the PBOC's $3.6trn of foreign currency reserves. But China's total deposits are vastly in excess of $3.6trn so any real loss of confidence would see the PBOC's reserves quickly swamped. The other frightening thing for these leaders is that one reform leads to another once it starts, reform must be progressed resolutely, or all could be lost. China's leaders are well aware of this, but it does not make each weakening of their power base any easier.

Two vultures with one arrow

The PBOC's stated desire to get the Chinese renminbi accepted into the International Monetary Fund's Special Drawing Rights (SDR see page 36) basket could very possibly seem a little esoteric for the less economically savvy of the Chinese leadership. However, they are very aware of the perceived risks of short-term economic weakness. So this may well have seemed a good opportunity to kill two birds with one stone or as the Chinese say "one arrow, two vultures".

The PBOC for its own part has made very plain its desire to see a reform of the renminbi exchange-rate mechanism.The last three State Council meetings have expounded the need to "strengthen the RMB exchange rate two-way floating flexibility". And in what looks like a pre-arranged comment, the IMF stated on Wednesday that the change was a "welcome step". The renminbi's inclusion in the SDR has previously been described by the IMF as a "when, not if" situation, so we must presume that the "when" is now nearer.

The benefit for China of this inclusion is mostly related to status and is a measurable step towards the renminbi becoming a new reserve currency for the world (a key leadership long-term goal). In short, this shift in exchange-rate policy is part of a long-term reform plan and recent weak export data makes now a convenient time to push it through.

The move is bad news for Chinese firms with non-renminbi borrowings (thought to be around $1trn in total), as this makes those debts more expensive to repay. It's also bad for importers into China, notably global commodity players and, to a lesser extent, luxury brands. That said, on the latter, a proposed cut in import taxes on luxury goods arriving in China is far more significant (it means a 10%-20% cut in prices) than this exchange-rate move (4%).

There's also the chance that other Asian countries will retaliate we've seen early signs of this, with Vietnam moving to devalue the dong.Overall, this announcement is good news for those who believe that the Chinese leadership is committed to reform.

The more such announcements are made, the less likely a genuine reversal of reform becomes. Confidence in China from foreign investors remains low after the mishandling of the Shanghai stockmarket correction, but after this announcement, a correction in Western markets feels a greater risk to Chinese equities around the world than a total collapse in the Chinese economy.Note that, while China's industrial sector has slowed this year, there is no sign of a sudden slump.

The looser monetary policy initiated late last year takes longer to take effect in China than in Western economies, but it is starting to feed through. The property market is turning sales volumes in the largest 44 cities in China rose by 34% in the first half of 2015, compared to 2014. Meanwhile, Vanke, the leading property developer, reported earnings last week.

Land acquisition was up 92% on last year, and construction starts up 5.2%. We are in the early stages of a new property cycle. In short, I remain a buyer of Chinese equities with the autumn likely to prove a wonderful long-term buying opportunity.

Rupert Foster has been a pan-Asian equities fund manager for the last20 years.

Four ways to buy into China's long-term bull market

As we outlined in our previous China story in June, writes Matthew Partridge, Chineseshares can be divided into two broad groups: "A" shares, listedin mainland China itself, and those on exchanges outside China,such as Hong Kong and even the London Stock Exchange,writes Matthew Partridge. The second group is often referred toas "H" shares, "S chips", and so on.

There are still restrictionson foreign investors buying "A" shares and Chinese investorsbuying foreign stocks, so the two groups often behave verydifferently. So when you consider investing in China (and asRupert suggests, now is a good time to consider your options),you need to be clear on which shares you want to buy.

There is a growing number of "A" share exchange-traded funds(ETFs), such as the MSCI China A GO UCITS ETF (LSE: CASH),which tracks the MSCI China A index, or the db x-trackersHarvest CSI 300 China A-Shares ETF (LSE: ASHR). These arerelatively expensive for ETFs, with ongoing fees of 0.88%and 0.80% per year respectively, but both physically hold theshares, rather than using derivatives to gain exposure. Activelymanaged funds are now taking advantage of the opportunitiesprovided by rule changes.

While we've previously been criticalof the Fidelity China Special Situations (LSE: FCSS) investmenttrust, the fund has performed much better under its newmanager, Dale Nicholls. Just under a third of its holdings arenow in "A" shares, with plans to expand this even further. It hasan annual management charge of 1%, although a performance relatedfee and other costs have pushed this up to 1.46%. Itcurrently trades on a wide discount to net asset value.

First State Greater China Growth Fund is another wayto get broad exposure to China it's managed by the highlyregarded Martin Lau, and invests in companies in Hong Kongand Taiwan, as well as those from mainland China.