A Closer Look at China's Economic Slowdown 27 Jan 2016

A Closer Look at China’s Economic Slowdown

During the early part of 2016, the financial and economic news was dominated by developing news in China. Both business owners and investors are probably paying closer attention to China’s economy and the stock market as an immediate result of this early 2016 volatility — especially since it appears to be quickly impacting other worldwide markets. For example, the first two weeks of 2016 for the U.S. stock market represented the worst start to a calendar year ever.

Is China really that important to the international economy? In a word — Yes, and here’s why. China is currently the second-biggest economy in the world. As long as China occupies this key position, global effects will continue to be likely when the Chinese economy either heats up or slows down. The impact on other economies is hardly a new development. Bloomberg Business noted this relationship with an appropriate headline in 2009 — “When China Sneezes, the U.S. Increasingly Catches a Cold.”

China’s economy grew by 6.9 percent in 2015 — while that might initially seem to be a positive result, it is actually the weakest annual growth witnessed in China for the past 25 years. Due to reduced economic growth in China and throughout the world, the International Monetary Fund (IMF) has reduced global growth targets to 3.1 percent.

The central bank in China and other Chinese government agencies have been making adjustments that are designed to improve growth prospects as well as curtail stock market volatility. What about the future? China’s National Bureau of Statistics is forecasting what they refer to as “a critical period during which challenges need to be overcome and problems need to be resolved.”

Whatever happens in China is likely to have repercussions for investments and growth prospects throughout the world. Research Optimus helps government organizations and businesses of all sizes by providing data analysis and management services that enable executives and managers to acquire key insights about what is happening — both in China and everywhere else. In the following paragraphs, we provide additional discussion about China’s current economic slowdown.

Action Taken by the People’s Bank of China

Chinese regulators and banking officials know that financial markets and economies are closely intertwined — the People’s Bank of China (PBOC) has been particularly active during the past seven months. Negative volatility in the Chinese stock market began during the second half of 2015. After an extended period of positive stock market performance, the Shanghai Stock Exchange Composite Index was down about 40 percent from July to December 2015. With this backdrop, government officials were determined to keep financial markets under better control in 2016 and beyond.

One strategy implemented by the PBOC was to install “circuit breakers” on the stock exchange — in this case, trading was to be shut down for the remainder of the day if averages declined or rose by 7 percent. The theory behind the circuit breaker strategy is to avert a panic when stock markets suddenly rise or fall, and the temporary delay in trading is designed to provide extra time for investors to get more information before trading resumes. Most other exchanges such as the New York Stock Exchange have their own version of circuit breaker rules.

With the new rules operating in China, stock markets were closed twice during the first full trading week of 2016. After realizing that the circuit breakers might have fueled panic instead of averting it, financial regulators removed the new circuit breaker rules.

A second strategy used by the People’s Bank of China was to revise currency valuations. It is not unusual for central banks to make currency adjustments during economic slowdowns and inflationary periods. However, this action is slightly more complicated in China due to two currencies — the onshore Yuan CNY (traded against the U.S. dollar) and the offshore CNH currency. With the recent stock market crash in China, many investors chose to move their money to other countries, resulting in “capital flight” that depreciated the Yuan.

The immediate result was to increase the spread between the two currencies. However, the International Monetary Fund has long considered the spread between the CNY and CNH to be problematic. In economic terms, recent currency volatility in China simply made a bad situation even worse. IMF officials previously agreed to include the Chinese Yuan in the IMF’s reserve currency basket only if China committed to narrowing the spread.

In the face of earlier commitments to the International Monetary Fund, PBOC officials probably felt added pressure to take further actions designed to narrow the currency spread. As one approach to this, the People’s Bank of China has been buying its offshore currency (CNH) in order to drain Yuan liquidity in foreign markets.

While this has helped somewhat, the PBOC cannot keep this up forever. Worsening economic conditions will inevitably pull the Yuan down when the People’s Bank of China stops its stabilization strategy. What should businesses do in the face of this uncertainty? The currency valuations in China as well as elsewhere should be monitored on a regular basis — using experts like Research Optimus is a prudent alternative for accomplishing this.

China’s Structural Transition

The Chinese economy is currently undergoing a transition from an economy driven by exports to one that is more dependent on internal consumer buying. This raises an obvious question — how much growth is enough to avoid the label of an economic slowdown? Whether we are talking about individual stocks or countries, rapid growth rates can rarely be sustained forever.

As noted above, the 2015 growth rate for China was just under 7 percent — and both investors and economists seem to be saying that this is “not enough.” What is enough? According to one economic expert and Professor of Economics at Cheung Kong Graduate School of Business, Li Wei — “We think it’s very likely that China will have a growth rate below 7 percent. Some people may get alarmed. But in general, I think 6 percent is good, even 5 percent is okay. We are just so used to high growth rates that we can’t grow like that forever.”

In a similar fashion, the Chinese government has already realized that the country can’t rely on exports forever. To balance the transition away from exports, the government is attempting to stimulate domestic consumption. Consumption-driven economies traditionally have lower growth rates than a manufacturing-driven economy — the productivity growth of services is typically less than the productivity growth of manufacturers.

Other factors will also contribute to a lower rate of growth for manufacturing in China as we move forward. During the past three decades, much of the rapid growth rates in China were due to cheap labor and a large technology gap with developed countries. However, recent trends show increasing salaries and manufacturing costs while the technology gap has narrowed. The inevitable result is that previous high growth rates are simply not sustainable — an economic slowdown is not at all surprising after 30 years of double-digit growth.

Another Concern — High Debt Levels in China

As many governments throughout the world are learning, there are practical limits to how much debt is manageable for both developed and developing countries. The “official” government debt level for China is currently reported to be under 50 percent. While this is a relatively low level, it might not be a reliable number. Even if we take this data at face value, some additional debt statistics should be a source of concern for the Chinese economy:

  • Debt is growing at a more rapid rate than economic expansion — the debt-to-GDP ratio has increased by 50 percent since 2012.
  • Local governments in China borrowed aggressively — and now creditors are applying pressure to repay debts. For another example where this is occurring, think of the U.S. territory of Puerto Rico.
  • Total debt (including corporate, household and government debt) represents 250 percent of GDP — up 100 percent since 2008.
  • The real estate sector has a record-high inventory of unsold homes.

The rapid increase in debt is certainly a major factor underlying the previous high rates of economic growth. It does not appear that the current excessive debt levels are sustainable, and this is another factor supporting the likelihood of slower economic growth. What is the time horizon to reduce debt levels to healthier amounts? Reducing the debt levels will probably take at least 3-5 years and possibly longer.

Conclusions: Expect Slower Economic Growth in China

While the “bad news” increasingly suggests that double-digit growth rates will not return anytime soon in China, there is significant “good news” — recessionary conditions are also not on the horizon at this time. Positive growth rates are still expected in 2016. Nevertheless, there are at least three factors that require continuing due diligence and monitoring by business owners, managers and investors:

  1. Currency depreciation of the Yuan.
  2. The transition from a manufacturing-driven economy to a service-driven economy.
  3. Elevated debt levels for individuals, businesses and government entities.

Each one of these factors can be complex. To add to the challenge, official figures are often biased. The experts at Research Optimus provide an unbiased source of international economic and financial data to use in business and investment planning.

– ResearchOptimus

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