Craig Botham, emerging markets economist at Schroders, argues that weakness in China’s equity markets does not point to weakness in the broader economy and the main risk China poses to the world relates to its currency
Weakness in China’s equity markets does not reflect weakness in the broader economy; in fact, the main risk that China poses to the world relates to its currency. Poorer investment numbers reflect the challenges faced by the central bank in trying to maintain accommodative monetary policy whilst defending the currency.
- While a gradual depreciation does not prompt an immediate crisis, China is seeing a steady bleeding of foreign exchange reserves
- Uncertainty over the end point for the currency is exacerbating outflows
- Although we expect macro weakness to come back to the fore later in 2016 as stimulus effects fade, this does not signal an imminent hard landing.
There is a great deal of nervousness evident in global markets at present, with much of it stemming from China. The country’s equity and currency markets have exhibited a large degree of weakness since the start of 2016 and, just as in August, global markets have suffered. But should global investors be quite so concerned about China?
Beginning with the equity market, the first trading day of the year saw the Shanghai exchange drop 7% – a move many attributed to a weaker than expected Purchasing Managers’ Index print. To us, however, a more obvious trigger was the forthcoming expiration that Friday of a ban on sales by large stakeholders, coupled with the ‘circuit breaker’ mechanism whereby trading is halted temporarily if the market falls 5%, and suspended for the day if it falls 7%.
Concerns over the expected fall in the market when large stakeholders were allowed to sell likely led to heavy selling, which was exacerbated by a desire to sell before trading was suspended. Since the suspension of the circuit breaker, and new rules restricting sales by large stakeholders past the original 8 January deadline, market falls have been much smaller than in the first three days of the year.
We do not say this because we are bullish on the Chinese equity market, but to demonstrate that weakness there does not point to weakness in the broader economy – in other words, the renewed market fragility is technical, not fundamental. Nor, as we pointed out last year, does poor performance in the equity market generate poor economic performance – wealth effects are much smaller than in the US, given a much lower rate of share ownership.
In 2015, at the peak of the bubble, equities accounted for 15% of total household assets, against 10% in 2014, and the slump will have seen levels fall back. As an indicator for global macroeconomic health, the Chinese equity market carries very little leading information.
Our own view on the economy is that China is seeing some stabilisation, although recent data releases would suggest the rebound we were seeing has lost momentum. Higher frequency data in December, exports aside, were weaker than in November.
There will be some distortions due to pollution-related shutdowns, which could account for some of the softer industrial production numbers. However, the poorer investment numbers seem linked to slower funding growth and reflect the challenges faced by the central bank in trying to maintain accommodative monetary policy while defending the currency.
Local government bond issuance
Intervention to prevent depreciation tightens domestic monetary conditions and so runs counter to the rate cuts implemented in 2015. One other factor that may explain the investment weakness, particularly as it was driven by infrastructure, is that local government bond issuance was much smaller in December – at RMB133bn (£14bn) – than November’s RMB764bn. But this was not for want of projects, rather because the year’s quota of 3.2 trillion had been reached. This, along with the pollution distortions, implies December’s weakness may be a blip.
Comparing municipal bond issuance with infrastructure investment supports this theory but we would caution that the data series is necessarily very short (issuance only commenced in May 2015). Our own model of Chinese activity suggests growth remains on a recovery trend although this does ignore the financial sector, which led to the model showing weaker-than-actual growth in 2015, and may also see it predicting stronger growth than realised in the first half of 2016, as the financial sector drags on activity
All the same, we had not expected the effects of stimulus to fade quite so soon. As such, we think December’s weaker data will prompt further rate and reserve ratio cuts in the first quarter of 2016 – of 35 and 100 basis points respectively – particularly if intervention proves successful in stemming capital outflows. An increase in the fiscal deficit has already been mooted, and an actual number should be provided in March’s National People’s Congress session. Central government may find itself needing to provide more support at the local level to boost investment figures given a weaker lending environment.
One possibility is that yuan weakness may be encouraging outflows, although the direction of causation is unlikely to be one way. While expectations of currency weakness might prompt capital outflows, including from the equity market, the capital outflows themselves then cause currency weakness. It is easy to see how this can become a self-perpetuating spiral. Can we expect this to continue?
We would firstly note that foreign exchange weakness has so far largely been in line with the trade-weighted basket, which the authorities believe is a “more appropriate reference” for the currency than the bilateral rate versus the dollar. The trade-weighted renminbi still looks strong compared with its history, whereas the yuan/US dollar rate has returned to 2011 levels. Intervention aimed at reducing the spread against the offshore yuan has seen trade-weighted depreciation but, in our view, this is unlikely to persist.
Further weakness against the dollar is to be expected in a world of dollar strength. However, the question then is whether the authorities will continue with the existing policy of gradual depreciation, or pursue a more aggressive one-off devaluation. This would drive down the trade-weighted exchange rate – a bigger threat to the rest of the world.
“The main risk posed by China to the rest of the world presently is currency weakness.”
Big devaluations are typically associated with big risks for emerging markets, with two particular channels to worry about, One is foreign exchange mismatches as foreign-denominated debt in the government, corporate and financial sectors becomes a much larger burden; the other is inflation jumping significantly, depending on the level of pass-through.
Small FX debt burden
In China’s case, the foreign exchange debt burden is generally quite small. Although there has been a lot of press coverage of the build-up of foreign exchange debt in the private sector, it remains small relative to Chinese GDP. Private sector foreign exchange debt has also likely been significantly reduced since the August devaluation, as suggested by the large capital outflows. We have also seen more hedging by Chinese corporates since the devaluation.
On the inflation front, with the Consumer Price Index at 1.6% and the Producer Price Index at -5.9%, there is little to worry about here (the inflation target is 3%). So, again in our view, the macroeconomic risks from a large devaluation seem limited – at least for China.
While a gradual depreciation does not prompt an immediate crisis, China is seeing a steady bleeding of foreign exchange reserves as the authorities intervene to prevent a gradual depreciation accelerating into a rout. Uncertainty over the end point for the currency is exacerbating outflows.
At well over $3 trillion (£2.1 trillion), reserves are still substantial but, even before we worry about reserve exhaustion, there is an economic cost in the form of monetary tightening as capital exits the financial system, leading to a tightening of domestic monetary conditions, leaning against the attempted easing by the People’s Bank of China. This weighs on growth and counters any small gains to exports from the competitiveness boost (which is itself small given the renmimbi remains little changed in trade-weighted terms).
In terms of their implications for the world, both a one-off devaluation and a gradual depreciation would prove deflationary – particularly for economies, such as the US, not undergoing their own depreciation. A one-off devaluation would have a larger immediate impact but would be more likely to settle markets by clearing uncertainty; after a large enough devaluation, expectations for further currency weakness should dissipate.
By contrast, gradual depreciation provides no endpoint and so uncertainty and volatility remain high. It is also possible that the currency will ‘overshoot’, weakening more than is necessary or than the authorities desire, as expectations of depreciation form a vicious circle of self perpetuation, ultimately proving more deflationary for the world.
In our view, a one-off, large devaluation – of, say, 20% – would be preferable for China to a gradual depreciation of the same amount. For now, policymaker preference (insofar as this can be inferred) appears to be for a gradual depreciation. The renminbi will likely sit at around 6.8 dollars by the year-end, against a present level of 6.58.
Three currency possibilities
From here, on the currency, we see three possibilities. The first, and most benign, is that the recent moves are primarily aimed at maintaining a stable trade-weighted renmimbi exchange rate, and that this will continue to be the policy setting.
The second is that the currency weakness reflects policymaker fears about growth and deflation and a larger policy move lies ahead – potentially a significant devaluation. For the global economy, particularly markets, this would prove immensely disruptive in the short term. Finally, another take is that the authorities have no control, capital outflows are outstripping their willingness to defend the currency and so depreciation is the path of least resistance. Our base case remains the more benign scenario, but we view devaluation as a definite risk.
To conclude, we are not worried about equity market weakness in China, nor do we yet see the recent macroeconomic data as suggestive of impending collapse. The main risk posed by China to the rest of the world presently is currency weakness, given the deflation this exports. We do expect macro weakness to come back to the fore later in 2016 as stimulus effects fade, but still we would not regard this as signalling an imminent hard landing.