China – Should the Current Crisis be Giving us Cause for Concern?
Posted by Laura Parsons on January 13th, 2016.
What’s happening in China?
While China’s outlook hasn’t been particularly upbeat for some time, poor domestic data and shifts in the nation’s stock market over the past 8 months have led to panic among investors and increasing concern that China teeters on the edge of economic disaster.
As China is the world’s second largest economy, its performance has an impact on not only the global economy but stock, currency and commodity markets. The commodities market in particular has borne the brunt of Chinese upheaval, with reduced demand for assets like iron ore and oil seeing their value plummet.
With China dominating the headlines since the outset of 2016, currencies have also seen some fairly wild movement over the past week with the Chinese Renminbi (or Yuan as it’s also known) dropping -1.5% from the Dollar standard last week. China’s foreign exchange reserves are also falling, leading some industry experts to state that the nation can’t support much more outflow.
So what’s really going on?
While China has been back in the spotlight since the turn of the year, the nation was already providing ample cause for concern in 2015, with the Chinese stock market registering a series of steep declines in response to waning optimism, domestic growth concerns and global economic developments.
Following a sequence of events in the summer of 2015, including a 7.4% decline in the Shanghai Composite Index, a fourth cut to interest rates in under a year and a 30% reduction in trading fees for mainland China’s two stock exchanges (Shanghai and Shenzhen), the uncertainty manifested itself dramatically towards the close of August.
On August 24th, a day which would later be termed ‘Black Monday’, the Shanghai benchmark dropped 8.5% – marking the biggest one-day loss in 8 years. This move was followed by an additional 7.6% loss the following day and the People’s Bank of China’s decision to cut interest rates for a fifth time in nine months.
While there was some notable upheaval in the immediate aftermath of ‘Black Monday’, trading calmed in September.
The rest of 2015 was comparatively stable, but a run of less-than-encouraging Chinese ecostats (from manufacturing figures to inflation numbers) has ensured that we’ve seen a very rocky start to 2016.
On January 4th the Shanghai Index dropped -6.9% as markets reopened following the New Year break. Trading was then suspended after the CSI 300 (a broad market index) dropped 7% and triggered a newly enacted ‘circuit breaker’ system on its very first day of operation.
The circuit breaker system was swiftly ditched as it was deemed to cause more chaos than it calmed, with investors scrapping to get to exit positions to avoid getting locked in.
Although China’s leaders have indicated that they are prepared to take additional steps to support domestic growth (like widening the fiscal deficit), many aren’t expecting that the situation will improve in the short to medium term.
Industry Expert Opinion
Investors might be worried about the latest developments in China, but is there any reason to fear that the world’s second largest economy is on the brink of financial collapse?
Economist Joseph Stiglitz states;
There’s always been a gap between what’s happening in the real economy and financial markets. What’s happening in China is a slowdown by all accounts. It’s a slow process of slowing down. But it’s not […] cataclysmic. The focus on supply measures doesn’t pick up what’s happening in the global economy. What’s going on is a shortfall in global demand. China has immersed itself in this global economy. There are domestic things that are affecting and exacerbating it, but if they don’t have enough demand-side measures there could be a deeper downturn.’
Christopher Balding, writing for Bloomberg, commented;
‘It would be a mistake to look at this cocktail of factors and just assume a crisis is inevitable. First, just because a country features elevated risk levels doesn’t guarantee disaster. At nearly 400% of GDP, Japanese debt levels far outpace those in China, yet few fear a crisis in Japan. By the same token, Chinese home prices in relative terms have been much higher for a number of years than in the US prior to the global financial crisis, without provoking a crash. While countries that suffer financial crises share common risk factors, not all countries with those risk factors succumb to crisis.’
In reference to the Renminbi, CICC analysts noted;
Because of China’s lack of policy communication over the path towards the new-float regime… exchange rate ‘flexibility’ has become a major source of uncertainty, rather than a cushion against external shocks. The Renminbi’s fluctuations could raise risk premiums over the global market, leading to sizeable asset reallocation and complicating the US decision to hike interest rates.’
What impact is the China situation having on the currency market?
In terms of currency transfers, Chinese instability has the effect of lessening demand for both currencies belonging to nations with strong trade links with China and higher-risk assets. Subsequently, currencies like the Australian Dollar and New Zealand Dollar may come under further pressure as 2016 continues.
However, the safe-haven US Dollar could also decline in the face of additional Chinese weakness as growth concerns could weigh on the global economic outlook and cause the Federal Reserve to rethink its current plans regarding raising interest rates four more times over the course of 2016.
Over the weekend China’s State Administration of Foreign Exchange attempted to calm currency-related fears by releasing the following statement; ‘China’s economic fundamentals are strong. Foreign exchange reserves are relatively abundant and the financial system is largely stable and healthy.’
China’s central bank also attempted to firm the domestic currency on Tuesday, but trader confidence remains low and the Renminbi fell in early trading.
According to The Guardian, Goldman Sachs has slashed its forecast for the Renminbi for both 2016 and 2017, asserting; ‘With export growth deeply in negative territory, and exports likely to remain weak in coming months, it is likely easier to reach a policy consensus to allow some depreciation.’
Morgan Stanley also negatively revised its projections for the currency and is anticipating that the Yuan could dip as low as 7.31 against the US Dollar by the close of next year. In the bank’s view; ‘While policymakers are still trying to maintain the trade-weighted (Yuan) exchange rate in a stable range, we now anticipate that they will transition towards targeting a depreciation… earlier than initially expected. This move will help policymakers to still cut interest rates to manage deflationary pressures, but will imply further depreciation of the Yuan.’
When China’s stock market crashed spectacularly in August 2015 UK officials attempted to soothe jittery investors by asserting that the risk of UK contagion from the event was minimal.
However, given that China is the world’s second largest economy, and a hugely prominent trading partner for nations like the Eurozone, Australia and New Zealand, we won’t be able to maintain a blasé attitude for long if the situation worsens.
China is likely to remain in the spotlight for the foreseeable future and investors will be looking ahead to next week’s official fourth quarter and 2015 growth figures. Although expansion of close to 7% is anticipated, many don’t feel this figure would adequately represent the true level of Chinese growth. A disappointing result in this area, or in Wednesday’s Chinese trade data, could spark more volatility.
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