Two main themes stand out in China over the past few months.

The first is increased acceptance that China’s recovery is firmly in place. We are now at the point where it would be very difficult to argue that China’s recovery is in any way illusory (though some investors still do…).

All the data point to a firm recovery that has broadened out well beyond government stimulus and re-stocking. For instance, industrial production growth accelerated to 13.9% yoy growth in September vs. 12.3% in August. This was largely bolstered by real demand as opposed to restocking, which can be seen from accelerating retail sales growth and private sector investment (notably residential property construction). Power generation output, which had initially lagged due to a slower recovery in energy-intensive heavy industry, has begun to catch up as well, silencing some of the more vociferous doubters. Most are now comfortable with a world where China continues to grow at 8% or above – even if the developed world faces a lacklustre recovery at best.

The second main theme is policy tightening, or as the bulls like to call it “withdrawal of policy stimulus”. This has begun to happen in dribs and drabs. Back in July, the tone and language of policy changed decisively, with increased pressure on the banks to tone down the lending spree, and increased willingness to implement longstanding policy objectives of controlling excess capacity in several industries such as steel, cement, chemicals and polysilicon. Especially of note is the increased coordination across ministries.

Nothing, of course, has been done to indicate any willingness to move on bigger blunter instruments such as interest rates, reserve requirement ratios or the currency.

With the US dollar weak, the Renminbi has generated a fair amount of interest lately, with everyone from Tim Geithner to various Nobel laureates making comments. We agree that its quasi-peg at roughly 6.83 to the US Dollar is too low. But the currency is typically the last tool in China’s policy toolbox to be considered and judging by recent moves to approve additional QDII quota, there is still some way to go before this changes.

It is having an impact on monetary policy though, making China reluctant to move interest rates for fear of hot money inflows. Given the even easier monetary policy in America, where the economy is now in a very different place from China’s, Beijing’s monetary policy is arguably too loose. Many economists think this means that China will have an asset bubble. We can see that this is theoretically possible, but if it does, we do not think it is likely to be as big or as sustained as many seem to hope, largely because we think Chinese policymakers are more aware of this risk and more prepared to act to advert it than many economists give them credit for.

We are still comfortable with China’s outlook for growth. High savings rates mean that China’s reliance on investment as one of the central pillars of its economic growth will be financed. And we are not too worried about inflation just now – there is still plenty of excess capacity, labour markets are healthy but not tight and the continued focus on investment means that the output gap will stay wide even in the face of strong growth. Inflation will turn positive and generate a fair bit of commentary but runaway hyperinflation remains just one of several relatively unlikely outcomes. Headline GDP may decelerate somewhat over the coming 6 quarters, but this does not take away from the fact that China is enjoying a solid, broad-based economic recovery.

But now that the existence of a recovery is acknowledged and as confidence has grown about its sustainability, investors will need to come to terms with a different world. In this world, policymakers may attempt to prick developing asset bubbles and are likely to show an increased willingness to lean into the wind than in past cycles. The memory of the US mortgage bubble looms large. One notable example is the Hong Kong Monetary Authority’s recent move to tighten loan-to-value criteria for luxury flats. While we do not see this move as having any actual impact on the market, it does signal intent.

In this context, we recently had a chance to see a number of global macro/asset allocation type of presentations and they were all saying that you had to buy Emerging Markets now because the developed markets were done for. Apart from the liquidity argument, the persistent growth differential also figured prominently. Now in principle we agree that EM economies are “better” than developed market economies in so many ways – they are surplus economies, with a better growth outlook, stronger fiscal positions, less of a debt overhang – all of that. But the “buy emerging markets while you still can” tone was a little frenzied. Recent retail fund flows into Emerging Markets have also been very large, especially set against the back drop of overall mutual fund inflows. In this context, the risk-reward ratio is temporarily less attractive than it might be, and we have thus temporarily adopted a more cautious stance.

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