Capital crackdown is no reason to divest from China, says Nikko AM

A Chinese crackdown on shadow lending and unchecked credit growth has caused the Shanghai Composite Index to drop 6.6 per cent in the past three and a half weeks, making it one of the worst-performing equity markets this year.

But Robert Mann, a senior portfolio manager for Nikko AM's Asian equity team, says investors would be unwise to drop out of the market, which still offers cheap exposure to one of the world's true growth stories.

"If you're buying Chinese investments, you don't buy based on one quarter, or you shouldn't," he told The Australian Financial Review on a recent trip to Australia. "The growth of the middle class, the growth in services, is still ongoing. [The liquidity crackdown] won't necessarily affect the assets we look at. Picking old-fashioned cyclical stocks isn't something we want to get involved in anyway."

Asset classes greatly influenced by China's growth cycle - including iron ore whose global price is set in China - have tumbled in recent weeks as Chinese institutions undertake a number of reforms intended to limit lending for speculative purposes and direct capital instead to the real economy.

Chinese stocks have dropped to their lowest level since October last year, with at least $US453 billion erased from the value of Chinese stocks and bonds, according to Bloomberg.

These reforms are ongoing and widespread, involving many different government agencies and regulators. On Sunday, the China Insurance Regulatory Commission announced it would look at settling up new rules on the equity ownership of insurance companies.

On Friday, the equities regulator flagged that some companies were still not abiding by laws prohibiting cash pools (a source of liquidity risk). Meanwhile, Chinese state-owned banks have been given a mid-July to August deadline to report back on the extent of their arbitrage activities, which is expected to prompt some further government policy reaction.

"It's a big positive in my view," Mr Mann said. "They've identified the issues, they're collecting information, they're scaring the banks.

"It's effectively a tightening of monetary policy - people are lending less - though it's not done through higher interest rates. There's strong growth, so they can afford to do it now."

The cost of not cracking down on capital growth, Mr Mann said, is that "growth would stay strong for a couple of years, but then you'd get a major crisis".

But the fact that the Chinese government is proactively addressing risks in its economy should encourage, not deter, global investors, Mr Mann said.

Western investors, he added, are still often discouraged by the complexity and difficulty of investing in China, which means many Chinese stocks don't get the global attention and capital inflows they necessarily should.

"Here's something to think about. There are three big Chinese internet companies - Baidu, Alibaba and Tencent. There are three big US internet companies - Amazon, Facebook and Google. China has four times the population, yet the market capitalisation of the Chinese companies is 40 per cent the size of the US ones.

"The Chinese market is closed, so the Chinese companies face no external competition. And they're pretty inventive, particularly on the fin tech side of things.

"In the longer-term, who do you think will grow more? Clearly, given China's large population, that's a pretty interesting investment."

Mr Mann acknowledges there are difficulties for Western investors in China. Nikko AM does its Chinese investment through a joint venture, with Shenzhen-based Rongtong Fund Management.

"There's a huge number of companies and most don't produce English reports," he said. And then, there are the China-specific complexities. The Chinese market, for example, is far more momentum-driven than usual, and so acts differently to Western markets.

"We have a joint venture with a Chinese company - we jointly manage a fund with them," Mr Mann said. "That's our approach. You need people on the ground. And it is a very large market."

The concern with China, he said, is whether it will be able to manage a transition to slower annual growth - the Chinese government's growth target this year is 6.5 per cent, the lowest figure in two decades.

"Can China move out of this first phase of growth smoothly, to move into the phase of growth that countries like the US or Australia are in, which is much more reliant on service and consumption demand. Can they do that smoothly without a crisis?

"China's leaders are showing all the signs they recognise they need to do this, they are watching for signs it isn't happening, and they are clearly trying to manage a very difficult transition. Most other countries have crises on the way there. But if anyone can do it without a crisis, it'll be China."