The Strategist

Resurrection of the Dragon: Why It's Too Early to Bury the Chinese Economy

01/13/2016 - 15:53

China's stock market collapsed in the new year is dragging down financial markets across the globe, falling prices for oil and other raw materials.

Chinese epidemic

Chain reaction in global stock markets and panic among the financiers were provoked by Shanghai Composite’s 7-percent drop, suspension of trading on the Shanghai Stock Exchange on the first trading day of 2016, and ensuing regular devaluation of the RMB backed with ongoing fall of the Chinese stock market. In early January, even the US market demonstrated the largest decline for the last 119 years. The experts once again are talking about risks of a global financial crisis similar to the one the world experienced in 2008.

Investors’ emotions can be understood. China is the second country in terms of GDP after the United States, and most importantly, the Chinese economy - a significant and integral part of the global economy and the global trading system. China provides one-third of global economic growth and is the largest consumer of raw materials and industrial metals. Besides, the country is the second largest buyer of oil in the world. However, now China's economic growth is slowing and it is unlikely that China's GDP will show rates higher than 6.5% per year in the next 5 years. For China, there comes time to change current economic paradigm, and there is no clear idea of what might replace the extensive growth. All of this is very scary for the world’s financiers.

China, who survived an investment boom in the last decade, is now faced with a huge outflow of capital, which was estimated at an astronomical amount of $ 850-900 billion in 2015. According to the People's Bank of China, volume of foreign exchange reserves fell by $ 512 billion to $ 3.33 trillion over the past year, and in December 2015, the slump amounted to $ 107.9 billion. It is not only that investments in the Chinese economy will not bring high profits to foreign investors. To some extent, outflow of capital was triggered by decision of the US Federal Reserve to start a cycle of rate hikes, which forced Chinese companies to rapidly allocate funds to repay the multibillion dollar loans.

China is responding to fall in exports and capital outflows with devaluation of the RMB, large-scale intervention, easing monetary policy and reserve requirements. Yet, it doesn’t stop capital flight. Moreover, the newsflow from China, and the state’s attempts to influence the financial markets are causing new investors’ concerns about prospects for China's economy, and are giving reason to go bull on stocks, currencies and commodity assets. Major banks such as Citigroup, Merrill Lynch, Morgan Stanley and others noted that further slowdown in Chinese growth could push the global economy into a prolonged recession.

Talks about the "hard landing" in China have a lot of pressure on the stock prices of industrial metals and oil, which reached multi-year lows.

Rumors of the death

Despite of all the above mentioned, the Chinese economy may not experience "hard landing", neither the country may provoke a new global financial crisis. There will be something else - a global and very tough economic competition.

First, China is still rising, not falling. It is growing at an impressive pace, and at the end of 2015, volume of China's annual GDP was close to the value of $ 11 trillion. Even if rates drop to 6%, it is still significant growth, given the base effect and the scale of the Chinese economy. In 2016 and in 2017, China will provide more than a third of global economic growth.

Oil consumption in China is growing, not falling. Seven new strategic storage facilities for oil and petroleum products are being built at the same time in the country. In 2015, oil imports to China increased by 8.8% compared with previous period and amounted to 334 million tons. If there wasn’t dumping of Middle Eastern countries, supplying more than half of China's crude oil purchased, then we would see a completely different price levels for hydrocarbons. Imports of iron ore in China has also increased at the end of 2015, so did production of steel and rolled metal, but it is ignored by players in the commodity markets.

Secondly, judging the Chinese economy by dynamics of the stock market is absolutely wrong. The Chinese stock market does not reflect the situation in the economy as the stock market presents a fairly limited number of issuers, and only a third of the total stocks issued is in free float. Global investors are difficult to get access to the country. China has not opened its stock market to foreigners, so professional players are in the minority there. The Chinese themselves, as private investors, do three-quarters of the trading volume on the Shanghai Stock Exchange. Chinese citizens have very few opportunities for private investment, especially when it comes to property overseas. Real estate and shares are the most popular of the few permissible and possible investment assets for the population of China.

Thirdly, devaluation of the RMB began to bring a positive effect to China, what is proven by recently published statistics. The trade balance of the country has increased in December to a record $ 60 billion, which was much higher than expected. For the whole year, this balance amounted to almost $ 595 billion, what largely enabled China to compensate for the capital outflow. Most importantly, devaluation of the RMB returns competitiveness to Chinese producers of goods and ensures growth of exports, which in December was significantly higher than analysts' expectations. It also help expand production. All of this takes risks of "hard landing" away and does not give real cause for concern for the Chinese economy.

Fourth, and most importantly, China has found a new national idea, which will be put into effect from March 2016, when the next Congress of the CPC will approve program of the country’s development in the period from 2016 to 2020. It is the Silk Road Economic Belt.

Total amount of the estimated investment is comparable to the size of China's GDP, and this will not only provide the Chinese economy with new orders, but also unite consumer markets where Chinese goods are delivered, with a total population of 4 billion people. Parallel to this, China's economic program assumes doubling of per capita income of all segments of the population within five years, which will necessarily affect increase in consumer demand and economic growth.

based on Bloomberg's materials

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