Global financial markets have just gone through ten market days of high turbulence, blamed widely on developments in China. This note discusses (in increasing order of their importance for US investors) the bursting of China stock-market bubble and the policy response; China’s move to a more market-related managed float regime for the yuan and its implementation thus far; and the moderating growth of the Chinese economy, again in the context of the policy response.
The bubble in China’s mainland equity markets, Shanghai Composite and Shenzhen, cheered on by Communist Party spokesmen, peaked on June 12. The subsequent market slide became a precipitous tumble until July 8, when the government took very heavy-handed steps to shore up the markets (see our August 3 Commentary, “Are Shanghai and Shenzhen Broken?”). Despite an estimated $200 billion worth of stock purchases by state-owned institutions, along with the banning of short sales, halting of initial public offerings, and prohibition of share sales by major investors, etc., a partial recovery could not be sustained; and China stocks headed south again on August 17. The 8.5% fall in the Shanghai market on Monday, August 24, was the worst since February 2007.
The government had apparently finally realized the futility of spending more money in the attempt to prop up share prices when market sentiment was so strongly negative. The China Securities Finance Corporation indicated on August 14 that it would cease intervening in the market as long as there was no systemic risk. The market tumble that followed showed how difficult it is to get off the dragon of heavy market intervention. Political considerations apparently led Beijing to again reverse course and intervene in the market last Thursday, when Shanghai closed up 5.3%, and Friday, when an additional 4.8% gain was registered. This time the Chinese authorities were not fighting the market, as markets around the globe were in a recovery mode. The upcoming September 3 military parade, celebrating the 70th anniversary of the WWII victory over Japan, may well have been a political consideration in the intervention. Reports that the China Securities Finance Corporation has borrowed a further $220 billion from banks suggest that it is preparing for possible further interventions. Spokesmen have repeated that large scale government support is no longer intended and that the emphasis now will be on going curbing illegal market practices.
The bursting of the Chinese equity bubble should not have been a big surprise. Moreover, since in the past China’s equity markets have had little relation to developments in the real economy, the market decline itself probably does not signal new economic weakness. It was rather the mishandling of the bursting stock bubble by China’s leaders that had a strong negative effect on market sentiment. Some investors feared that their heavy-handed response signaled that the authorities had reasons to fear an economic slowdown sharper than generally expected. More importantly, both domestic Chinese and international investors were shocked at the mishandling of the situation by Chinese technocrat regulators who had been regarded as highly skilled. Deficiencies in government communications were very evident. The negative effects on both market confidence and the credibility of China’s leadership will be problematic going forward.
Devaluation
Adding heavily to the turbulence in global financial markets was the People’s Bank of China’s (PBOC) decision on August 11 to devalue the yuan by 1.9% and change the mechanism for setting the daily reference rate to a more market-related managed float. The IMF and the US Treasury welcomed the apparent move to a more freely floating currency. After letting the yuan slip down a further 2.5% over several days, the PBOC stepped in to support the currency in order to maintain “stability.” Since then the PBOC is said to have spent some $200 billion of the nation’s financial reserves to prevent further devaluation. Last Thursday the PBOC reportedly added intervention through commercial banks in the market for US dollar-yuan foreign-exchange swaps, an approach designed to affect currency-market expectations and to counter heavy selling of the yuan in offshore markets.
Clearly, the timing of China’s currency moves and again poor communications greatly aggravated the turbulence in global financial markets. While Chinese officials have stated that they have no intention to let the yuan fall significantly further, markets were shocked by the abandonment of the peg to the US dollar, a credible system that required very limited intervention to maintain. There is little confidence that China will resist further currency weakening for long. Emerging equity markets and currencies, in particular, were already suffering from the strong US dollar, slowing global growth, and the sharp decline in commodity markets. The fear of increased competition from China and further weakness in the Chinese market hit both emerging-market currencies and stock prices. Valuations in emerging markets have become relatively attractive as a result; but further downside risks, particularly currency risks for US-dollar-based investors, remain significant. An important consideration going forward is the direct or indirect exposure of particular markets to China. For example, India and Poland may benefit in this regard.
The slowdown in China’s economy is by far the most important China issue for US investors. It is not just the direct effect on US exports that matters; it is also the cumulative effect on other economies with significant exposure to the Chinese economy, ranging from Taiwan, Singapore, Malaysia, Brazil and Chile to Australia, Japan and Germany. Federal Reserve Vice Chairman Fischer underlined this point Saturday at Jackson Hole. China’s GDP, the world’s second largest, accounts for 16% of the global economy and about half of global growth in recent years. China is the world’s largest exporter and also the largest consumer of oil. The economic slowdown in China matters.
Growth
While the Chinese government’s economic statistics have indicated GDP growth of around 7%, some economists estimate that the real growth rate is closer to 5%. It is difficult to know the actual figure with any confidence, but the negative pressures from declining real estate investment and slowing industrial output are evident. Export growth over the January–July period was down almost 1% over the previous year. There is also a serious debt overhang. Overall debt is now equal to 280% of GDP. On the positive side, strong real wage growth is resulting in a robust expansion in domestic consumption and the services sector, a development that is important for the rebalancing of the Chinese economy. The lower estimates of China’s current growth may reflect some underestimation of the importance of this change and over-reliance on industrial sector statistics. Third-quarter GDP growth year-over-year is expected to slow to about 6.7%.
Tomorrow we will get the official August Purchasing Managers Index as well as the private Caixin PMI measure. The manufacturing sector components of both are expected to come in at below 50%, which would confirm weakness in manufacturing this month. The earlier Caixin flash estimate PMI for August was at the lowest level since 2009.
The Chinese authorities are moving aggressively to moderate the slowdown. Last Tuesday the PBOC reduced its benchmark one-year lending rate 25 basis points to 4.6% (it was 6% as recently as November 2014) and its one-year savings rate to 1.75%. It announced a 50-basis-point reduction in the reserve requirement ratio for large banks effective September 6, a move that will inject liquidity of about 650 billion yuan into the banking system. The Chinese financial system is suffering from inadequate liquidity, a situation that is getting tighter due to continued capital outflows and the central bank intervention in the currency market. China also has very high real interest rates. In July the real interest for bank lending (the weighted average lending rate, 4.85, plus producer price deflation, 5.40) was 10.25%, a severe real cost to companies. Further injections of liquidity by various means and further rate cuts look likely in the coming months as the authorities seek to loosen monetary tightness. Yet the PBOC will have to balance the domestic economy’s need for lower interest rates with the increased pressure on capital outflows and further depreciation of the yuan that would likely result.
It is noteworthy that the PBOC continues to press forward with financial-sector reforms. Coupled with the actions above, the PBOC announced that banks are now free to set the interest rates they offer for deposits of one year or longer. Together with the PBOC’s move last May to give banks greater (but not complete) freedom to set rates on short-term deposits, this step marks almost complete liberalization of bank deposit rates. This is a long-term positive for the Chinese financial system and economy, as banks will have to pay a market rate for funds; and it reflects confidence on the part of the central bank in view of the risks that come with interest-rate liberalization.
On balance, the growth of the Chinese economy is indeed continuing to moderate but remains stronger than some market commentators suggest. Government measures to stimulate the economy are likely to keep the growth rate above 6% for a year or so, and then allow it to trend down to 5% in the long run. While these growth rates would compare very favorably with those of other major economies, Chinese stocks risk further declines when government intervention is eventually unwound. Great caution is warranted.
Bill Witherell, Chief Global Economist