China’s Dragon Takes a Breather, Growth Engine Halts
After successful triumphs over US and UK in the last decade bears are back in business in 2015 and this time they have laid their eyes on the world’s fastest growing economy China. It has been fueling the global economic growth for past several years and any slowdown will have repercussions not only on world markets but also on major asset classes.
In order to gauge a country’s economic performance, one can look at key economic parameters like Money market (Interest Rate), Economic growth (GDP Growth Rate), Business performance (Industrial Production), Consumer confidence (Retail Sales), Trade analysis (Exports), Housing sector (Newly Built Home Prices), Investment (Capital Flows), Government reserves (Foreign Exchange Reserves) and finally Equity markets (Shanghai). Let us understand how China’s financial and economic indicators are performing in the current scenario.
Chinese stock markets have seen a roller coaster ride this year sending jitters to the global equity markets. As seen from the chart, Shanghai – barometer of Chinese equity market was trading around 2300 levels in September last year. The index rose more than 100 percent within 9 months to 5100 levels driven by cheap source of funding – debt. In past two years, Chinese regulators had relaxed norms for margin trading in order to buy equities. Margin trading or borrowed money for trading has always been one of the major catalysts of ferocious movements on either side in equity markets in the past and China was no exception. The equity markets were trading way ahead of the fundamentals and the market eventually crashed in June. Shanghai has lost more than 40 percent in last three months despite Chinese regulators made numerous interventions to stem the fall. The exuberance in the Chinese equities was also reflected in the numbers of new trading accounts opened by Chinese. Around 40 million new trading accounts were opened between June 2014 and May 2015 far more than historical average, another sign of a bubble.
China’s second major problem is the slowdown in economic growth. In the below chart, Chinese economy did slump below 7 percent in 2009 but it was due to sub-prime crisis in US. China did bounce back with a V-shape recovery to record double-digit growth to 11.9 percent in March 2010. However, the fall post 2010 is a major worrying factor for the Chinese government and the world. Long-term economic growth is a function of changes in capital, labour and productivity. When three move in tandem on the upside, economy will boom. Currently for China, all three are moving in reverse direction. Working-age population numbers are on the downside, investments are drying up coupled with capital outflows and growth in productivity is also getting lower. As economy expands and gets bigger, law of large numbers applies and it becomes more challenging and tricky to sustain higher growth rates on a big base.
One factor which we cannot ignore is the splurge in China’s borrowing in past few years. History says all the major financial crashes are preceded by a steep jump in credits. China’s total debt comprising corporate, government and household debt is now more than 250 percent of GDP, which is at frightening levels for an emerging economy. A huge chunk of China’s debt is owned by companies which in turn have invested in the property market. Industrial production is a measure of business output from three major sectors of the economy mining, manufacturing and utilities. As seen from the chart, it has slowed down from peak of 16 percent to 6 percent in 2015. Retail sales a reflection of consumer demand has also hit fresh lows of 10 percent this year. With slowing industrial production growth, debt-laden companies will default on their debt and its consequences will also reflect cracks in the property market.
While the domestic problems continue to haunt China, slowdown in the global markets is also impacting significantly. Chinese economy thrives heavily on exports as manufacturing contributes nearly 60 percent of GDP and all of it is exported to the world. China’s largest trading partners – EU, Japan and South Korea are witnessing a severe slowdown in their economies which in turn will hamper the manufacturing and exports growth as seen from the below chart. The growth in Chinese exports year-on-year has been negative for past several months.
China was banking heavily on the construction sector to spur the next round of economic growth. Residential market is an important aspect for China since housing and housing décor businesses contribute more than 10 percent of GDP. As seen from the chart, the change in prices of newly built homes year-on-year is on downward spiral since December 2013. In addition inventory of unsold houses are at record levels. However, recent data suggest that property market has seen slight recovery but analysts are of the view that boom in property prices is over and Chinese government would have to cut rates further to make mortgages more affordable as the market remains burdened with a massive overhang of unsold flats.
Chinese government’s major headache for now will be the capital outflow. China’s GDP growth for past several years relied heavily on the investment and in the current scenario slowdown in China will dampen the investment sentiment which is reflecting in the capital outflow from China in last few quarters (See below graph). If this trend continues then China will take more time to come out of the woods.
China is sitting on huge pile of foreign exchange reserves. However, capital outflows would mean more intervention by the Chinese government in the forex market. Weakening yuan will further accelerate the capital outflow from China as investors will start converting domestic currency yuan to dollar or euros. As seen from the chart, China’s foreign exchange reserves are dipping and the reserves have come down to USD 3557 billion in August 2015 from USD 3993 billion in June 2014.
Chinese government is injecting the liquidity into the system by frequently cutting the interest rates (See below chart) and cash reserve ratio in past several months thereby trying to take the pressure off the lenders and the borrowers. While developed countries like UK and US banked on bond buying programs to revive their economies, China is relying on rate cuts. Weakening yuan is also likely to boost exports and reduce deflation risk. However, rate cut would also mean lower yields for investors and the fears of capital outflow may loom on China.
Only time will tell whether these measures would be enough to tackle all the major hurdles China is facing right now but it seems that Chinese growth dragon is getting tired and taking a pause before the next big move.
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