Thursday 15 November 2018

China's market turbulence shines a light on economy

Turmoil engulfed Chinese markets this week, but the real story is what's happening in the economy, writes Colm Kelpie. Amid concern over the Chinese government's response, experts argue that a possible 'hard landing' for the country's economy will likely have repercussions for the rest of the world.

China enjoyed GDP growth of 7.7pc in 2013. But the estimate from the World Bank is for just 6.9pc growth last year, 6.7pc this year and then growth dropping and levelling off at 6.5pc by 2017
China enjoyed GDP growth of 7.7pc in 2013. But the estimate from the World Bank is for just 6.9pc growth last year, 6.7pc this year and then growth dropping and levelling off at 6.5pc by 2017

Colm Kelpie

Less than half-an-hour. That's all it took for mayhem to engulf Chinese markets on Thursday. Trading had to be initially suspended just under 15 minutes in, in order to calm the nerves of the traders who'd barely had time to get their sleeves rolled up.

When the market reopened, the session lasted about another minute before the circuit-breaker mechanism kicked in once more and trading was shut down for the day as the country's CSI 300 index - an index of the state's biggest stocks - plunged 7pc for the second day of the week.

Billions were wiped from shares around the world this week in what was a dramatic and pessimistic start to 2016 for the international money markets.

The turmoil echoed the turbulence of last summer when the Chinese central bank staged a devaluation of the yuan and sent shockwaves around global markets.

On Thursday, China allowed the biggest fall in the yuan - also known as the Renminbi - in five months.

Investors and analysts alike are expecting more to come.

In many ways, though, it's a sideshow to the real story.

The stock market theatrics of the last week - and indeed last summer - throw attention on to the wider and much more important underlying issue: the happenings in the Chinese economy.

A slowdown is under way and the signs have been there for some time. As has the concern.

The markets in China have been late to the game.

Laura Eaton, China economist with London-based financial consultancy firm Fathom, said only since last summer, when Beijing devalued its currency against the dollar, has investor confidence in the Chinese leadership's ability to steer the country's economy and financial system been dented.

"We don't see the market as reacting to the real slowdown in the economy. I think investors before saw bad news as good news - but I think now there's been a massive reduction in the confidence which investors have in the authorities to be able to step in and successfully get the results they want," Eaton says.

China's markets are known for their volatility and their connection with the rest of the economy is questionable. Markets were rallying up to the middle of last year, despite talk about the economic slowdown.

Even with the dramatic scenes earlier in the week, by Friday, battered Asian shares had rallied, with strong gains for Chinese stocks.

And the market volatility, analysts believe, won't have much of a lasting effect outside of China.

Direct investor exposure to China from this part of the world is limited, they argue.

"Some Irish investors might have a degree of exposure as part of a fund, but predominately for us it would be indirect exposure," says David Donnelly, senior investment analyst with Cantor Fitzgerald Ireland.

"Irish investors might be invested in a company that does business in China. For example, a large chunk of BMW sales is in China - so for somebody holding BMW shares, you might have to question if the average person in China, who has just lost 50pc of their discretionary wealth, is going to be able to afford to buy a BMW this year."

Indeed, Donnelly sees the turbulence as a potential opportunity for canny investors who are able to spot a good deal.

"In short-term periods like this, it can be very alarming to see the decline that we've seen to date. But the important message is not to panic," he says.

"Ultimately, this kind of volatility presents opportunity and certainly for the longer-term investor who is well informed, these kind of declines in equities present a great opportunity to pick up really good companies with good management and a strong track record and strong earnings outlook for really attractive prices.

"That's something we haven't been able to do for the past three or four years."

But while China watchers may not be overly concerned about the markets, they argue that there are real reasons to worry about the world's second-biggest economy.

It's no secret that a slowdown is taking place as Beijing attempts to rebalance the economy from one focused on manufacturing and investment to one more centred on services and consumption.

Manufacturing has been waning for some time, but the services sector isn't doing much better.

Data released on Wednesday showed that the services sector expanded at its slowest rate in 17 months in December, further heightening fears that one of the world's major growth engines is losing steam.

Overhauling such a massive and complex economy was always going to be daunting. But the hope has been that Beijing's push to restructure the economy, with a greater emphasis on services and consumption, would more than offset the economic drag from weakness in manufacturing.

That doesn't yet appear to be happening. And trying to get a handle on what's going on isn't easy either.

Beijing suffers from a credibility problem when it comes to official data, which is often called into question, whether it is the level of hazardous smog engulfing the country's big cities or the level of haze hanging over the strength of the economy.

China was enjoying GDP growth of 7.7pc in 2013.

But the estimate from the World Bank is for just 6.9pc growth last year, 6.7pc this year and dropping and levelling off at 6.5pc by 2017.

President Xi Jinping has acknowledged that China's leaders are concerned about the economy, but he has described the problems as simply "growing pains".

"We do have concerns about the Chinese economy and we are working hard to address them," he told Reuters last October.

"We also worry about the sluggish world economy, which affects all countries, especially developing ones."

But as the main driver of global economic growth in recent years, particularly when other major economies languished in recession, a 'hard landing' for China would mean bad news for the rest of the world.

And that's a major worry, says NUI Galway Professor Alan Ahearne, the former principal economist at the Federal Reserve in the 1990s covering the Chinese and Japanese economies.

"It's important to differentiate between what's happening on the Chinese markets, and in the country's economy," he says.

"The Chinese stock market is a casino.

"If you look at what happened to prices in 2014 and 2015, the way they rose, it's just a speculative frenzy. I'm less worried about volatility in the stock market.

"But the Chinese economy, that's more of a worry."

One commentator on Bloomberg speculated the stock market gyrations may also be a symptom of yet another problem - the end of a huge property-based debt-fuelled boom.

What the stock market volatility did last week was to focus concerns once again around what's taking place in China, its effects on the rest of the world and the shape of the global economy for the year ahead.

The warnings have been ominous.

The International Monetary Fund has warned that global growth will be disappointing in 2016, with the prospect of rising US interest rates and the slowdown in China contributing to uncertainty and a risk of economic vulnerability.

UK Chancellor George Osborne warned last week that 2016 had opened with a "dangerous cocktail of new threats". Last year, he pointed out, was the "worst for global growth since the crash".

Billionaire investor George Soros warned global markets were facing a crisis and investors needed to be cautious. And even more worryingly, he said the current environment has echoes of the financial crisis of 2008, thanks to China.

Eaton believes the Chinese economy has been in a hard landing since the beginning of last year. She questions the ability of China's leadership to deal with the issues.

"Our central scenario is based on the Federal Reserve raising rates as the market expects, and in that world we believe the Chinese authorities will act just as they have been doing - day by day.

"We don't see them stepping in to sort out any of their long-term issues."

The impression that the leadership is struggling to contain not only the economic problem, but also the financial volatility, was given credibility when the Chinese government announced on Thursday that it was essentially being forced to scrap its so-called circuit-breaker mechanism, which was introduced in the wake of the market crisis last summer and had been used twice already in its first week, sparking criticism. China's leaders have been criticised for communicating badly and meddling in a bungled manner.

Eaton believes there are various tools available to the government that it is likely to use to stimulate the economy, such as cutting interest rates and continuing to devalue the yuan.

The prospect of weakening demand from China has already hit the price of oil (although other factors are at play here also), industrial metals, energy and resources. That means that the economies of countries that rely on the export of commodities - mainly emerging markets - are likely to suffer.

What the yuan devaluation suggests is that China is deliberately trying to engineer a weaker currency to ease the impact of the slower economy.

That sustained depreciation will heap pressure on Asian neighbours to similarly weaken their currency in order to compete with the massive Chinese export machine on their doorsteps.

"Policymakers in China will be tempted to try and rebalance their economy by devaluing their currency. There's no doubt about that," Ahearne says. "They're trying to make up for the fact that business investment has slowed dramatically. What they need to do is boost consumer spending and the services side of their economy, but that's difficult and requires long-term structural reforms.

"The temptation will be to try and reignite exports by devaluing their currency. That's a worry for the rest of the world - but the Chinese leadership will see that as a safety valve: to try and get their exports going by a 'beggar thy neighbour' type policy.

"It is possible that we will see the mother of all emerging-markets financial crises coming out of China that would dwarf the 1997/1998 emerging-markets financial crisis."

So what does all this mean for us?

China has a big effect on the global economy and on world trade. As a small, open economy that depends to a large extent on our exports, Ireland will be affected, says Ahearne. "We're also affected in other ways, although not all of them negative. Energy prices have fallen and we benefit from that and other commodity prices and that's largely due to what's happened in China.

"That's kept inflation low and therefore interest rates are very low. But certainly a hard landing in the world's second-biggest economy has to affect us."

But the big question remains: how hard will it be? Not everyone is as pessimistic as George Soros. Capital Economics, just before Christmas, stated it believed there were signs that the Chinese economy was stabilising.

And it said it expected conditions to improve over the coming months. In October, the head of banking giant HSBC said market volatility in China was inevitable as the country implements reforms, adding it was unlikely that a hard landing would occur.

And even with growth dropping to 6.7pc this year, that still far outstrips global growth.

"If I was betting, I'd still think it's much more likely that the Chinese leadership will be able to control things and manage the transition that they need to do," says Ahearne.

"So we'll avoid the doomsday scenario. But China's very non-transparent and hard to read."

He points to the fact that the country holds a large amount of foreign reserves, which, while they've fallen sharply in recent months, remain over $3 trillion.

"That's a big war chest," he adds. "So there is room for the government to increase fiscal spending, which could support economic activity, if they needed to.

"The Chinese leadership is very skilled and they take a long-term view of things, so I wouldn't underestimate their ability to contain and manage their way out of this.

"But the transition that the economy has to do is enormous and there may be lots of mines hidden that we don't see that might trip them up."

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