How bad is the economic situation in China?

Min Lan Tan  UBS Wealth Management

Concerns over China’s slowing economy and accelerated Chinese yuan depreciation, mounting US recession fears and the plunge in energy prices have marked 2016 as one of the most tumultuous starts to a year in recent history.    

Key China-related equity benchmarks have sunk as much as 27 per cent in the past month, fuelling speculation over the actual extent of China’s economic woes. While current volatility is unlikely to abruptly subside, investors may have become excessively cynical on Chinese markets.

For one, it’s important to observe the nuances that are cooling the economy’s decade-long trail of blazing growth. While overcapacity in the old manufacturing and industry-reliant economy hinders investment-fuelled growth, the new economy of services and consumption has remained resilient. More visibly, valuations are now harder to ignore given the 14 per cent drop in offshore equities in just the past month alone and the 40 per cent drop since last April. 

Yet, the fundamentals in China are considerably stronger today than they were in 1998 – GDP deceleration and consumer inflation is much more modest, foreign reserves have swelled 23 times since 1998, and its basic balance is in surplus. Additionally, a backdrop of still ample fiscal ammunition and monetary policy options have the ability to prevent the economy from falling out. On the flipside, however, heavy stimulus usage will likely send fiscal spending creeping up in the coming years.

Economic stability aside, concerns over steep yuan devaluation also appear exaggerated. So far, stability in the interbank rates and onshore yuan deposits suggest that capital flight remains contained. At issue is whether Beijing can concurrently enforce strict capital controls while ensuring monetary policy freedom and relative yuan stability. We expect another one to two interest rate cuts, 300 to 500 basis points of reserve requirement ratio cuts and 50 to 100 basis points of standing lending facility cuts from the Chinese government just this year. Such an accommodative backdrop should help spur the economic cycle enough to guide a gentle landing. 

The yuan, meanwhile, will continue to track US dollar strength – any sharp devaluation is not in China’s interests, and hence unlikely.  

So what is needed for China to catch a bid? Beijing needs to do a better job at convincing markets of its policy intentions. Equity sentiment should improve as Chinese government stimulus bears fruit and the market becomes more comfortable with the currency regime and economic outlook of the new China. We are tactically overweight Chinese equities within our Asia ex-Japan portfolio. Sectors exposed to China’s old, ailing economy like steel, cement and other infrastructure-related industries will continue to bear the brunt of the slowdown. But new economy sectors, including healthcare, alternative energy and select consumer discretionary segments, stand poised to usher in a new phase of growth for the Chinese economy.  

Christophe Donay  Pictet Wealth Management

Christophe Donay, Pictet Wealth Management

Sell-offs in Chinese equities and volatility in the yuan in early January triggered jitters across global financial markets. 

This was just the latest manifestation of the uncertainty surrounding the shift in China’s economic model, which implies a slowdown in growth and volatility in economic and financial data. The country is in a delicate transition period, between its ‘emerging’ phase (roughly 1990 to 2007), when it joined the capitalist club and posted astonishing rates of real GDP growth, at 12-13 per cent annually, and ‘maturity’, which should begin before 2020 and will see growth settle at around 5 per cent.

The Chinese sell-off was not in fact prompted by any major change in China’s economic fundamentals. Indeed, notwithstanding frequent market jitters over Chinese growth data, the evidence is that China’s authorities are actually managing economic rebalancing reasonably well. Although industry has slowed sharply (hence the negativity that tends to surround the manufacturing PMI), it accounts for only 40 per cent of GDP. Services have a larger share in the economy, at 51 per cent of GDP, and have been growing robustly. 

Overall, the authorities appear to be achieving a controlled slowdown, with real GDP growth decelerating to 6.9 per cent in 2015. They have shown that they have the tools and control – through ‘stop-go’ policies, providing fiscal and monetary stimulus as needed – to keep growth on target and avoid a recession (for the next couple of years, at least).

They are proving less successful in avoiding financial instability. First, recent turbulence has shown that the Chinese authorities remain relative novices at managing financial markets. Policy is broadly moving in the right direction—for instance, towards a more flexible exchange rate—but the uncertainty that results from frequent mis-steps (such as the ill-conceived circuit-breakers introduced and swiftly withdrawn in January) and poor communication fuels market volatility. Moreover, markets remain unconvinced that a sharper economic slowdown can be avoided.

Second, the authorities’ attempts to smooth economic growth, most notably through the massive RMB4tn ($586bn) stimulus programme deployed in 2008-09 but also through excessive credit growth (directed lending) in recent years, may ultimately undermine their economic management by exacerbating imbalances— credit growth has been running above nominal GDP growth for several years, which typically creates imbalances, and lending to firms and households has now reached 207 per cent of GDP, up sharply from 125 per cent in 2008. This creates the risk of a ‘Minsky moment’ for the economy—a sudden, sharp collapse of asset prices—in a few years’ time.

In the short term, market sentiment in China will continue to suffer from concerns over economic growth and policy uncertainty. A likely poor corporate results season will add to instability—earnings expectations were still being downgraded going into the fourth quarter—as will the authorities’ ongoing anti-corruption investigations of financial market officials, with preliminary findings expected to be unveiled in February. Despite inexpensive valuations, investors are unlikely to find the strategic case for moving back into China compelling yet.