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China: Danger or Opportunity?
20 Aug 2015
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The current economic slowdown in China and the recent sell-off in Chinese shares are sending ripple effects throughout the globe. But which countries will be worst hit? Which sectors will be the most severely affected? And what will happen if the slowdown turns into a nasty hard-landing?

The Chinese word for crisis consists of two characters that sound the same as danger and opportunity, though there is some debate about the accuracy of its interpretation. It was former U.S. President J.F. Kennedy who popularised this cliché.

The recent sharp correction in Chinese equities highlights the perils of investing in the Middle Kingdom. At the same time, one wonders whether the sell-off is a good opportunity for a profitable ride on the Red Dragon.

Between September 2014 and June 2015, one of China’s main stock market indices, the Shanghai Composite, gained no less than 130%. But, by August 13, it had fallen by about 24% in very volatile trading. The more speculative ChiNext Index lost about 33% of its value over the same period. The authorities, alarmed by the sharp falls and mindful of an incipient crisis, swiftly moved in and took extraordinary measures to stabilise the market. One such measure was the suspension of more than half of all stocks from trading, albeit many have now returned to normal trading.

The negative impact of the persistent growth slowdown in China
The stock market sell-off was partly trigged by signs of a weakening economy. In the second quarter of 2015, the Chinese economy expanded by 7%, the same as the first quarter. Growth has been on a steady decline from the 7.9% registered in the third quarter of 2013 and 11.9% in the first quarter of 2010. It can be argued that the current growth rate matches the government’s own plans and is indeed the product of an engineered slowdown from previous unsustainable levels. It is also consistent with a deliberate re-balancing of the country’s growth engines away from an investment and export-driven model, to one more biased towards domestic consumption.

However, a slowdown of such proportions in the world’s second largest economy, whether engineered or otherwise, has caused many to worry about the ripple effects on the global economy. One of the biggest reasons a slower-growing China is a cause for concern is that the country of 1.4 billion people absorbs an enormous amount of the world’s exports. China’s gross imports account for 2.9% of world gross domestic product (GDP), compared to 3.6% for the European Union and 3.8% for the United States.

China is a country where the government has a very visible hand in the economy. Recently there have been fears that it is losing control of the slowdown it has brought about and that growth may be slowing below the government’s target. This has triggered warnings that the economy could soon suffer a hard-landing as it falters under imbalances and weaknesses in key sectors, especially in the construction and property sectors. In an attempt to re-energise the economy, the People’s Bank of China (PBoC), the country’s central bank, embarked on a series of measures aimed at loosening monetary policy and supporting the slowing economy. More recently, in an attempt to make the country's exports more competitive, the PBoC devalued the Chinese currency, the yuan, by about 3%.

What risks does the Chinese economy face?
The Chinese economy faces three major risks.

First, since monetary policy is more of an art than a science, the level of support being provided by the PBoC may not be enough and fails to reach its objective of avoiding a hard-landing. This task is made even more difficult by the fact that the PBoC has to sustain the economy but, at the same time, avoid creating asset bubbles. So its room for manoeuvre is somewhat limited.

The second risk is China’s fast-growing debt pile. On some estimates, China’s stock of debt could be as large as 250% of GDP including all the different sources of on- and off-balance sheet debt (i.e. central and local governments, households, and corporates). This represents an increase of around 100 percentage points since 2008 and is tantamount to a credit boom that could pose a systemic risk to the financial system. As economic growth continues to slow, profits will shrink leading highly-leveraged companies down the road to insolvency. But, unlike many other countries, China’s state has an enormous stock of assets which could help minimise the risk of a classic debt sustainability crisis.

Thirdly, the stock market could fall further. Notwithstanding the measures taken by the authorities to halt the collapse, many investors remain nervous. Experts say that tens of millions of ordinary citizens, many of whom have entered the stock market for the first time as it boomed over recent months, face losses which could have a knock-on effect on consumption. However China’s stock market still plays a relatively minor role in the economy. Less than 15% of household financial assets are invested in the stock market. This may explain why soaring share prices did little to boost consumption and it may be safe to assume that falling prices will do little to hurt it. Moreover, borrowing money to buy shares is not endemic. It comprises only 1.5% of total assets in the banking system and therefore is unlikely to pose a systemic risk.

The impact of China’s slowdown on the world economy
China is a major contributor to global growth. So the knock-on effects of a Chinese slowdown on the global economy would be significant. The OECD reckons that a two-percentage-point decrease in the growth of Chinese domestic demand for two consecutive years would lead to a reduction of world GDP by half a percentage point (including financial market corrections).
The knock-on effect of a China slowdown would not be evenly spread. Countries with stronger trade links with China would be more severely affected. The countries with the largest export exposure to China as of year-end 2013 are Australia (31%), South Korea (29.8%), Japan (20.3%), Malaysia (20%) and Brazil (19.4%). By contrast, the exposure of the United States was 9.2% and Germany’s 6.6%.

Impact on specific sectors
Further slowing of the Chinese economy would affect some sectors more than others. The sectors which would be hardest hit would likely be the commodities and the industrial goods sectors.

As demand in China wanes, so will its appetite for commodities, driving commodity prices lower. The nations most affected by this would be Australia, Canada, Brazil and Indonesia - the economies most heavily dependent on commodity exports.
Furthermore, with China's property construction deceleration set to deepen this year in a multi-year slowdown, we may see a longer-term decline in China's appetite for foreign industrial imports. This would impact capital goods suppliers that supply China with industrial goods (such as factory machinery, bridges and power generators) and the tools that help China build its infrastructure (such as excavators, building equipment and transport vehicles).

The auto sector is also not immune from weakening Chinese growth. China is the world’s largest automotive market, with close to 22 million vehicles sold every year. So, the major source of uncertainty for the auto sector at this point in time is probably China.

Car makers with the greatest exposure to China have every reason to be worried. German luxury car maker Audi AG said on July 9 that it has put its sales target of 600,000 cars in China this year “under scrutiny,” suggesting that the company could be considering the target unachievable. And on August 4 BMW AG, another German luxury car maker, said that the Chinese slowdown might force it to revise its forecasts.

On the other hand, Daimler AG's Mercedes-Benz is confident of a good second half of the year in China, despite problems experienced by rivals.

A hard-landing scenario
Although most analysts expect growth in China to stabilise at about these levels, a hard-landing scenario, where annual growth would fall below 5%, cannot be ruled out.

A China hard-landing would have profound ripple effects all over the world economy. It would seriously hit the appetite for riskier emerging market assets and would lead to companies holding back investment and suspending hiring decisions globally (even those not directly exposed to China). Turmoil in financial markets would further amplify the uncertainty shock as risky asset prices collapse.

Danger or Opportunity?
It is hard to tell how the dynamics of the current slowdown in China will play out. Investors in Chinese equities or in China proxies should be aware of the dangers and uncertainties that lie ahead. But, like the Chinese word for crisis, the current danger may be the seed of the next opportunity.

Disclaimer: This document is issued by Bank of Valletta p.l.c. (BOV) for information purposes only and should not be construed as an offer or recommendation to sell or solicitation of an offer or recommendation to purchase or subscribe for any investment. It is therefore recommended that if you require investment advice or wish to discuss the suitability of any investment decision, you should seek financial, legal or tax advice from your professional advisers as appropriate. Opinions, estimates and projections, based on reputable but not independently verified sources in this report, constitute the current judgment of the author as of the date of feature and is subject to change without notice. Income from an investment may fluctuate and the price or value of the financial instrument described in this report, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results. Bank of Valletta p.l.c. is licensed to conduct investment services by the Malta Financial Services Authority.
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